Chapter of TRANSFORMING NEW ZEALAND. This is a draft. Comments welcome.
Keywords: Business & Finance; Environment & Resources; Globalisation & Trade;
One of the curiosity of standard economics as it is presented to the public and, indeed, often as it is taught, is the neglect of transaction (and information) costs. Ronald Coase, recipient of a Nobel Prize in economics in 1991, for some seminal insights (identified 30 years earlier) into the way that economic behaviour is modified by them. The section on the Resource Management Act below, sketches the insight. Subsequently, a handful of economists, most prominently Joe Stiglitz who received the Nobel Prize in 2001, have elaborated their role. In fact a considerable amount of government activity is focussed on reducing transaction costs, despite their role often being overlooked. All the more puzzling because those most involved in the economic debate – economists, accountants, bureaucrats, lawyers, politicians, even managers of businesses – are at the transacting end rather than the providing end, of the economy.
In the 1990s, the world was brought up with start over the truism of the importance of transaction costs, following the collapse of the Soviet Empire. The assumption had been that Russia would develop rapidly into a successful orthodox capitalist economy. Mismanagement by the international institutions and the greed of the Westerners who arrived to exploit the opportunities and of Russians keen to help them, did not help. But the lack of the institutional infrastructure was an underlying problem.
I was involved in a small way of a project to provide the Russians with a cadaster (land survey and registration system). New Zealanders take it for granted that the land they purchase is accurately identified, and the ownership title secure. It took along time to develop these institutions. But they did not in a Russia dominated by feudal and communist governments. Yet how is a bank able to make advances on a property whose boundaries and ownership are uncertain, with the danger that it will end up in litigation, which undermines the security on which the advance is made, and so losing all its investment.
The danger was illustrated to me by a lawyer who investigated credit law in Bangladesh. Their middle class had no access to consumer credit – no hire purchase nor credit cards. Bangladeshi law proved perfectly adequate, but the courts are so chock-a-block it takes ten years to recover any defaulted credit. No one is willing to advance credit, because if anything goes wrong there is no simple way of recovering the debt. New Zealand creditors rarely have recourse to the courts, but without them lenders face substantial handicaps dealing with that handful: perhaps more borrowers would join them. Without this effective judicial structure, even the honest Bangladeshi cannot get consumer credit from sources that New Zealander consider normal. So they only borrow from relatives, or friends – or from informal lenders charging very high interest, and using dubious extra-legal enforcement techniques.
Some institutional arrangements are more efficient than others. New Zealand was fortunate in the nineteenth century when it instituted the Torrens system of land registration, which involves a government administered registry where title is guaranteed. More recently the records have been computerised. The New Zealand judicial system of courts and enforcement are enviably free from corruption. Even so, they are costly, and cheaper arrangements such as the small claims court, have evolved.
While thus far the illustrations of the institutional infrastructure have evolved big things such a property owning and debt, the institutions are far more pervasive. How does a shopper know that the ‘kilogram’ of the butter being bought weighs a thousand true grams? We could carry around our own scales, but the government’s system metrology, which includes laws, laboratories, and enforcement, does it in a less clumsy and costly way, as we trust some mysterious (for most of us) system of enforcement. It does not occur to us that every morning the supermarket has verified the accuracy of the scales, nor how that verification is anchored back via various public and private institutions to an international standard set in Paris. The system applies to others than consumers. When Fonterra sells 5000 tonnes of butter to an export destination, both purchaser and seller have a detailed common understanding of the specifics of what the quantity means, while even the definition of ‘butter’ requires metrology.
Perhaps at an even more fundamental, and yet intangible level, the New Zealand economy runs well because the actors trust one another sufficiently not to require complex contracts for minor activities. It is only when one is in unfamiliar economy that the convenience of trust becomes apparent. (It should be added that often those other economies have their own systems of trust, which a visitor is not a part of. The expression ‘honour among thieves’ is an example. ) There have been attempts to put ‘trust’ at the centre of modern economies. We will return to this in a later chapter, but in the interim note that intangibles like trust can also be a part of the infrastructure which reduces transaction costs.
By international standards New Zealand has a high quality institutional infrastructure – allocating and enforcing property and other rights, simplifying transactions, that reduces the (transaction) costs of the economy. It is almost invisible, and so gets overlooked. But it is the foundation for sound economic growth. Sometimes some elements of it need attention. One of the points of dispute is the Resource Management Act, which illustrates how the Coase Theorem works, and how sometimes it does not.
The Resource Management Act
A brief version of the Coase Theorem is:
If property rights are properly allocated and transaction costs are zero, the utilization of the resources will be independent of the initial allocation of property rights.
Suppose one wants to build an airport, where the aircraft noise will overflow the airport boundaries affecting neighbouring properties. The theorem says whether the airport goes ahead is not dependent upon whether the airport owner has the right to make as much noise as the owner likes or whether the neighbours are entitled to quiet. Instead (providing the costs of settling any dispute are zero) the airport will go ahead if it the most efficient use of the resources involved. Assuming the airport has the property right to make noise, the neighbouring property owners can buy the owner out to prevent the noise. Alternately, if the neighbours have a property right to silence, then the airport developer can buy them out. In either case the outcome is independent of who has the rights to the noise or silence.
Note how the proper allocation of the property rights (so they are well defined. fully allocated, and transparent) leads to a market resolution to allocate the use of the resource. The implication is that once property rights are allocated properly, all the subsequent decisions can be left to the market, where – and this involves a long held conclusion of economics – the outcome will be “efficient”, in that they give the most output for the resources available. Further bureaucratic intervention is unnecessary.
While many have grave doubts about market outcomes, the Coase theorem attends to one of those by allocating fully property rights so that the externalities form them – that is where an market decisions did not take into full consideration all its impacts on the economy – can be internalised. Thus in principle one of the most fundamental justifications for traditional planning becomes eliminated if property rights are dealt with. This, of course, is a big ‘if’.
The vision of creating a market environment which would give efficient outcomes of the use of resources by allocating property rights, drove many of the reforms of the 1980s. In the case of the individual transferrable quota for fishing and the (almost) freeholding of the radio licensing spectrum it was, with considerable success. The Resource Management Act, enacted in 1991 consolidating and systematising a wide range of existing statutes, was another attempt to leave decisions to the market, by properly allocating environmental property rights.
Importantly though, the Coase theorem says nothing about to whom the property rights should be allocated. All it concludes that once they are allocated, the use will be efficient, But suppose property rights worth a million dollars have to be allocated to either A or B. For each the efficiency consequences are unimportant compared to whether they or the other person gets the million dollars. The application of the theorem does not resolve the fundamental political problem, which entails allocating property rights, which are ultimately rights to income, power and prestige.
How to do this? Conceivably the government could have constructed a mammoth doomsday book of all the various rights and who owned them, although that would have created considerable contentions. Instead it created a law which wrote down general principles of entitlement, and set down a process by which they could be applied in particular circumstances, to identify the entitled.
From this perspective the main economic function of the RMA is to identify the property rights of the participants. Once they are identified the owners can (in principle) directly negotiate with the developer or whomever in the way implicit in the Coase theorem notion of market outcomes (and which is allowed for in the RMA). In effect the developers purchase property rights – agreements to their support for (or silence to) consents – from property owners.
However in practice those with the rights may be unable to do so, most notably future generations whose rights are embodied in the notion of ‘sustainability’, and those non-human owners who have their rights derived from the intrinsic value provisions.
A secondary function of the tribunal process is to provide a cheaper way of exercising property rights by owners, where the normal market process would be cumbersome. It reduces transaction costs. Consider the horrendous difficulties an airport owner would face if each neighbour had to be individually negotiated with.
Even so, the purity of the application of the Coase theorem is muddied. In all economic activities there are transactions costs, so the theorem does not strictly apply. While in principle the RMA reduces those transaction costs, it cannot eliminate them. But this is not the failure of the RMA in principle. It is inherent in the economic realities. That does not mean that the RMA process should not seek to minimise transaction costs. A particular problem has been the considerable differences in practice among councils, between the best and the worst practice. Another failure was until recently the government provide insufficient funding to enable the tribunals to deal expeditiously with disputes. (A developer may incur greater costs in delay, than the costs of even a very complex tribunal hearing.)
However this focusing on transaction costs ignores that the real point of contention is the allocation of property rights. Some of the criticism of the RMA, which to an attempt to reallocate the property rights between the various parties, in favour of – given who are the most vociferous critics – the developers. Recall A and B disputing over a million dollars, totally uninterested as to whether ultimately there will be an efficient outcome. The critics wanting to shift property rights from the future, from the public, from that which represents intrinsic environmental values. These rights would go to the developers.
There is a transactions cost issue here too, though. In some circumstances, they appear to be so costly that parties negotiating before the hearings as potential claimants accept payments in return for not appearing. Presumably the developer and the claimant has calculated that is cheaper to do this, than go through the tribunal with the costs and a probability of having to make the payment anyway (Sometimes the developer instead makes concessions to avoid lengthy tribunal hearings.) . There has been a public outrage of some incidents, perhaps reflecting the public’s misunderstanding of the process, although some concerns about the implicit allocation of property rights.
The problem arises from the transaction costs. The policy aim has to be to reduce the resource costs that the RMA generates, as is true for the other parts of the institutional infrastructure. The big gain, were it possible, would be to reduce the costs of identifying the property rights, although it might be that as they were reduced and the public understanding improved, there would be more pre-consent payments and concessions.
So while the RMA and its associated processes reduces transaction costs compared to what happened earlier, it needs to be made more efficient wherever possible, preferably without undermining the intended allocation of property rights. More generally, it is a part of the institutional infrastructure, which is more contentious that than is usual.
The Physical Infrastructure
Thus far we have focussed on the institutional infrastructure, in part because it gets overlooked, despite its critical importance to economic growth. However there is also a physical infrastructure, which typically are involved in facilitating the goods and services being shifted around the economy. Most economic dictionaries list them: air and sea terminals, railways, roads, telecommunications, water and waste water systems … It is common to include energy systems, but while the gas and power grids and networks conform to the earlier definition, power generators do not. The connection may have arisen because in the past the energy networks and generators were run by the same business. That is not true today.
Another common feature of the physical infrastructure is that they tend to be natural monopolies, in that practically there can be only a single provider. (However, not all natural monopolies are necessarily physical infrastructure.) As a result there has been a tendency for them to be publically owned and typically, whatever the ownership form, they are subject to greater regulation than ordinary businesses.
The issue of forms of ownership is a vigorously contested one with strong advocates for public ownership and equally strong advocates for private ownership. Much public infrastructure was privatised in the 1980s and 1990s. I come from the political tradition which says that the issue is not the question of social ownership of industry but its social control. In many sectors the tradition accepts that private ownership in a competitive market (with appropriate institutional infrastructure) is the best practical form of social control. (There is an implicit requirement of a tight labour market, again with appropriate social regulation, so that workers are not exploited.) In the case of natural monopolies, there cannot be a competitive market, so this option is not available. Instead there has to be some other means of social regulation, which may include some form of public ownership. (Social ownership best applies where the fundamental objectives of the leading firms in an industry cannot be readily subsumed in the simple indicator of profitability. These include schools, hospitals, and broadcasters, so they belong to another chapter.)
Regrettably, there is no ideal form of social regulation of a natural monopoly, and the particularities of the market will influence the regulatory framework. Sometimes social ownership has a role together with price and other controls (and, sometimes, subsidies). A key element is that the business should usually be confined to those markets where it has a natural monopoly, and not be allowed to compete in other markets since it can use its monopoly to leverage against potential competitors. This suggests, for instance, the separation of the electricity line to the house (which is a natural monopoly, insofar as it would be expensive to provide every house with two or more lines) from the generation of the electricity.
Getting the right pricing and investment for physical infrastructure is a critical part of a growth strategy. They play a vital role in reducing the transactions costs of an economy, insofar as the ‘costs of distance’ are integral part of the growth process as explained in the next section. The costs of distance include transport costs and the associated storage and related costs, together with other disadvantages of distance (such as fewer contacts, slower information transmittal and the like). They are not usually classified as transaction costs in economic theory, although I think it a useful extension, and it explains why the physical and the institutional may both be called ‘infrastructure’.
The Cost of Distance and Economic Growth
Distance is central to the history of New Zealand. For tens of millions of years isolation from major land masses protected the flora and fauna, resulting in a unique biota. It meant that New Zealand was the last inhabitable significant land mass to be colonised, and the Pacific Islanders who settled, isolated for a hundreds of years, evolved into the unique Maori. The European settlers, arriving less than two hundred years ago travelled further than any other colonisers, and correspondingly felt more cut off from the centres of their civilisation. The resulting culture, with its peculiar mixture of stout independence and colonial cringe. So did the economy was shaped by this distance. Industries started up which would have been overwhelmed by the metropolitan industries had they been closer, while the export sector was shaped by the costs of distance.
The biggest transformation came in 1882. Refrigeration technology complemented with steamships and the ability to use the telegraph to find out how much product was needed in Britain enabled New Zealanders to produce profitably meat and, later, dairy products and sell them successfully in Britain 12,000 miles away. British migrants could continue to do much the same things as they did in Britain, but make use of a superior climate. If that reduction in the cost of distance had not occurred New Zealand would today be a much smaller – and more impoverished – society.
However reducing the costs of distance enables more than the international reaping of natural advantages. Even locally they enable the reaping of economies of scale. Consider the Taranaki. Once the region was covered with dairy factories for initially it was costly to ship milk any great distance and dairy farmers took the cream to a nearby factory. As the roading network improved, and tankers became bigger, the costs of distance became less important. Fewer factories were needed, and only two are left.
The costs of distance change the balance between regions. When the costs of transport were high every town of significant brewery. Over time they became concentrated into a single factory in each region, and later the number were reduced to a handful each of which supplies many regions
(‘Boutique’ small breweries arise where the economies of scale are not overwhelming and where there may be a demand for nonstandard products – fashionware is another example. But boutique producers also benefit from lower transport costs if their few consumers are widely scattered. That such boutiques exist reminds us that economies of scale need not be decisive, which has an important implication for New Zealand’s development strategy.)
A similar phenomenon applies at the international level, which is central to the globalisation process, but that belongs to a later chapter. Here we observe that reductions in the costs of distance are nationally important, not only because the reductions release resources which can be deployed for other purposes, but also because it enables production units to reap economies of scale, again releasing resources. Indeed there has been a dynamic between the two processes, reinforced by larger businesses being able to be technological more innovative.
Infrastructure and the Internal Costs of Distance
Reducing the costs of distance is therefore an integral part of a growth strategy, although it will disrupt the existing regional balance. Will a country invest sufficiently in its infrastructure? Where there is not a proper charging regime the short answer is that there is no guarantee there will be enough investment, even though the resulting congestion costs can add to GDP, but not national welfare, but inhibit growth of GDP (and welfare).
This seems to be happening to the roading system, where congestion seems to be rising rapidly in some urban areas, some of which interact with the national transport network and so also reducing regional integration. At the centre of the story of roading policy is a paralysis induced from the inability of the ideologues of the 1980s to think of an effective charging regime for the roading system (and hence corporatise or privatise). Further complications include that the externalities of road users borne by non-road users (such as residents and pedestrians), that the taxation imposed on motorists has been a significant source of general government revenue as well as the main source roading maintenance and investment revenue, and that despite a national uniform taxation system the congestion occurs in particular areas – it is not obvious that the motorists of Bluff should be paying for Auckland motorways. Water and waste water systems suffer from similar problems to roading, except that they are regionally financed and not nationally taxed.
In contrast, it might appear that where the user can be fully charged, there will be sufficient investment in physical infrastructure. Standard economic analysis acknowledges that a monopoly may under-invest, and needs to be taken into consideration in when designing the regulatory regime (so that it is not just a pricing regime but has the investment implications fully understood). But even where there is competition between a few providers there may be inadequate investment if production is lumpy (that is plants which are large, onerous to construct, and involving significant economies of scale).
The results became evident in the electricity industry in 2003. Earlier, we observed that power generation may not be a part of physical infrastructure, although the national transmission grid definitely is. (Some engineers think that the grid and production are so integrated they cannot be separated without management failure. Their theories are still to be tested.) However the problem seems to one of ‘incomplete markets’, which is a unifying notion in the next chapter, where the issue is dealt with.
In summary, the record is that investing in the physical infrastructure often raises problems that are not so pertinent to other parts of the market economy. This does not argue an uncritical case for central planning, but it suggests that the best regulatory regime may not always be the conventional market, and that sometimes a degree of intervention may be necessary. For an inefficient physical infrastructure in raising transport costs, can inhibit economic growth, just as an inefficient institutional infrastructure can do the same by raising transaction costs.
Other Approaches to Infrastructure
There is no economic theory of infrastructure, just some ad hoc insights around a list of activities. Perhaps this chapter by focusing on a transaction/transport cost approach has offered some preliminaries to the development of one.
However, an alternative definition of infrastructure needs to be mentioned. This sees infrastructure as those parts of an economy which cannot (or cannot easily) be transferred to another country. That would include all the above but could include other commercial activities such as buildings and plantation trees, and also social, cultural and environmental artifacts such as housing, the nation’s archives, and landscape. (Nowadays it could not include the labour force, given the international mobility of labour.) It is a useful to focus on an important aspect of globalisation – the parts which are fixed despite everything – but it is not obvious that the idea is more useful for contributing to growth policy.
There is a tendency to attribute items to the list of infrastructure, because it is a notion with positive connotations. A common next step is to apply policies applied to other, less contentious, items on the list justified by that they are all ‘infrastructure’. However the policy treatment depends upon the specific properties of the item, not on whether it belongs to a particular list. In any case this chapter has shown that even if infrastructure is confined to those natural monopolies which reduce transaction and transport costs, there is a general policy framework for their enhancing growth, but it may lead to quite different to specific applications item by item.
The framework may have some relevance to social, cultural and environmental ‘infrastructure’, but the specifics are likely to be very different, and belong to later chapters.