Is Small Beautiful?

Draft Chapter 10 of Transforming New Zealand. Comments welcome.

Keywords: Growth & Innovation;

New Zealand economics suffers from a cultural cringe. Much of the debate is dominated by an idealised model of the American economy. Very little thought is given to in what ways the New Zealand economy differs from the US economy, other than to assume that th differences are unfortunate and must be addressed by making New Zealand more like America.

There is probably a tendency throughout the world of professional economists to treat the US economy as a norm, given the dominance of the US economy and the dominance of US economists. But there are particularities of the US which do not apply elsewhere, nicely illustrated by US economist Todd Buchholz’s discussion of the public choice school in New Ideas From Dead Economists. Public Choice Theory – its founder, James Buchan, was awarded an economics prize in honour of Alfred Nobel in 1986 – uses economic models to describe a government process in which politicians and public officials behave in their own self-interest rather than the public good. It is a deeply pessimistic account of the practical possibilities that governments offer and has been seized on by the New Right to justify minimum government, on the basis that public officials and politicians could not be trusted and so needed tight controls. It also underpinned much of New Zealand’s governance reforms of the 1980s and 1990s.

Having set down the theory, Buchholz’s asks ‘why didnt Keynes anticipate the Public Choice School?’ The point he explores over more than a dozen pages is that Keynes assumed that the officials could be trusted to act in the public interest. Buchholz concludes that ‘if Public Choice Theory is correct, Keynes was politically disingenuous.’ It never occurs to Buchholz that Keynes was writing about a government system very different from that which Buchanan was, one where officials did act to a large degree in their assessment of the public interest (one not unlike New Zealand’s in the middle of the twentieth century).

In fact the ‘rational economic man [sic]’ which the theory assumes is not a complete account of human behaviour. The institutional arrangements on which the US system of government is based tends to encourage the self-interested behaviour of the theory, whereas the British (and New Zealand) institutional arrangements encourage public interest. This is not to say that Americans are selfish and Brits altruistic. Rather, the way a society’s government is organised can change the balance of behaviour. (Thus the public sector reforms of the 1980s and 1990s probably resulted in greater self interest and less public interest among New Zealand’s bureaucrats.) The 1986 prize in economics was awarded for a theory which did not apply in all times and places. This is true for much of economics. Theories which purport to be generally true, frequently assume particular circumstances which are not universal.

This is evident in the American economic textbooks used in most first year economics courses in New Zealand. Typically the external sector, where the domestic economy engages with the rest of the world, is introduced about three-quarters of the way through the book. This may be appropriate for the US which exports an eighth of its output (and which is so big that there are strong feedback effects from its external sector to other economies and back into the US domestic economy). But is certainly not particularly relevant to the New Zealand economy which exports a third of output (for which international feedback effects are negligible). Often the economics course teachers are probably trained in America too, and have little conception of how the New Zealand economy works. No wonder New Zealand’s economic debate is distorted.

New Zealand is also much smaller than the US. So those with a colonial cringe look only at the disadvantages of being small, and ignore any advantages. Undoubtedly there can be significant economies of scale in some industries – such as the construction of jet aircraft – which cannot be reaped in a small economy. (But a jet aircraft industry may not be that advantageous if it requires large government subsidies.) However, an industry in a large economy, may in fact be located in a small region of that country. There is not so much an American pharmaceutical development industries, but a number of localised industries, usually in regions which in geography and population are not much bigger than New Zealand. Many parts of America – say the state of Kansas which is similar in size to new Zealand – do not have significant pharmaceutical development industries. (Where the US pharmaceutical development industry may have a national advantage is its greater access to private American venture capital.)

In a recent book, The Size of Nations, economists Alberto Alesina and Enrico Spoloare argues that middle size nations (that would include New Zealand) perform economically more effectively that larger ones. While there may be economies of size in some economic production processes which benefit large economies, they seem to be offset by diseconomies of governance. Large nations have difficulty managing the diversities in their population. The authors are arguing there are diseconomies of scale in the supply of government services – governments of large communities are inefficient compared to governments of small groups. (This is a different argument to ‘big government’, discussed on the next chapter.)

Small economies offset any economic size disadvantage through international trade. New Zealand may not build jets, but it can purchase them from those that do. This has the very important implication that smaller economies will have different economic structures to large economies, where these economies of scale are important (typically in the manufacturing sector). It would be easy, then, to say that the New Zealand economy (or its manufacturing sector) was ‘imbalanced’, by treating the US economy as a norm (as many textbooks do), but then so is that of the state of Kansas. But just as Kansas functions perfectly normally as a part of a larger American economy, so can New Zealand as a part of a world economy.

The advantage that New Zealand has (and Kansas) may have over a larger economy is that it is cheaper to govern. There is a challenge to conventional economics here. The usual discourse about size focuses on those sectors were there are strong economies of scale (notably manufacturing), as if there is no significant differences from size in any of the others. That may be true for most of the other sectors: the primary sector will depend more on geography and much of the service sector appears to be independent of significant economies or diseconomies of scale. However government provision is more complicated where there is heterogeneity in the population. Centralised delivery systems, which are inherent in government, become less efficient as they attempt to provide for an increased diversity of communities. Intimate New Zealand is much easier to govern than unwieldy America (unless it adopts the US style of government). The challenge implicit in the Alesina and Spoloare model is that economists need to consider the provision of government services much more carefully, rather than assuming they are just like the rest of the economy.

Alesina and Spoloare observe that the counter-example to their argument that medium size is beautiful is the US, which is both large and economically successful. They argue that US government is organised in a very decentralised way, so the economy gets the benefits of economies of scale in manufacturing industries without the disadvantages of diseconomies from government. However, observing the performance of the core education and the health sectors, the sceptic might say the consequence of this decentralisation is poor quality or expensive services.

That New Zealand is too small – if it is – does not explain why it has grown slower than the rest of the OECD. The slightly smaller Irish economy has grown substantially faster recently. One has to put a whole series of additional conditions to explain Irish growth and then to explain why Greece, which joined the European Union at the same time, did not grow as fast. Ultimately the caveats will overwhelm the size argument. In any case, if smallness is a disadvantage how does one explain that New Zealand was once relatively richer than it is today, even though it was relatively smaller. Again the contradiction can be rescued by a series of caveats (although those who make it rarely do), which ultimately overwhelm the size thesis.

Grumbling about the size of an economy being a disadvantage – if it is – does not lead to any practical policy responses. As the previous chapter noted, an extra 10,000 immigrants a year would take almost 50 years to make the population 10 percent larger – a drop in the bucket as far as size was concerned. What about amalgamation of economies? Alesina and Spoloare observe that many boundaries are artificial. The straight lines which encompass Kansas hardly reflect any geographical reality, and more subtlety most national boundaries in Europe are the results of recent history rather than some inherent economic cultural verite. The English Channel is an obvious exception, and so do the seas around New Zealand even more so. Any amalgamation New Zealand would be involved in would be political rather than geographical.

The obvious candidate for some kind of amalgamation is Australia. One might see the Closer Economic Relations (CER) arrangement as a step on the way. Even at the time some people did. Much of it was a response of desperation. For as long as they could recall, Britain had been New Zealand’s economic and political patron. In 1973 it had abandoned such a role and entered the European Union. The reaction of those with a colonial mentality was to seek another patron, and Australia was the best available (although the longer term ambition may be for Australasia to become states of the US).

However there was an internationalist rather than colonial interpretation of CER. It saw the need for New Zealand to open up its economy to the rest of the world, rather than rely on a few export sectors which shielded the rest of the economy. This opening up would have to be done incrementally both for political reasons (since the shielded would not particularly like the exposure) and to ease the process of economic adjustment, CER was the a step on the way to opening up. There were Australians who took a similar view of CER. New Zealand was not central to their economic future – even then they were looking to Asia in a way we were not – but they saw this as an opportunity to drive internal liberalisation.

Many of the liberalisation policies induced by CER – I was involved with the internal transport reform – were necessary anyway, but CER became a part of the mechanism to implement them, not only because it provided a political rhetoric but because there was a political coalition committed to the whole of CER and therefore the whole of the reforms it might induce, even if particular elements of the reform were uncomfortable. (One might add that for these advocates the speed of opening up under the Muldoon administration was too slow for them, and the speed under the subsequent Lange-Douglas administration too fast.)

This strategy was largely successful in its contribution to opening up the economy, but – and this was no surprise to its advocates – Australia did not replace Britain. Today about a fifth of New Zealand’s exports got to Australia compared to three fifths and more that use to go to Britain. There is no expectation that the Australian market will expand quickly, indeed there is a danger that New Zealand will lose some of its Australian markets and Australia some of its New Zealand markets, as China becomes an alternative supplier, especially as tariff barriers fall.

Should the CER relationship be intensified? There can be no quarrel with joint measures which are about improving both countries with the world as a whole. For instance streamlining of customs procedures makes sense providing the outcome is consistent with the likely streamlining that will happen internationally. However, such improvements are likely to be administrative and minor. There are a few issues of greater potential significance.

The most prominent economic one is the possibility of monetary union, which in effect, given the relative size of the two countries, would be for New Zealand to adopt the Australian dollar (although it might still issue a separate notes and coins, albeit one which was backed by holdings of Australian securities). A consequence would be that interest rates in the two countries would be equal, so there would be monetary union too, with a common monetary policy. There are a number of technical issues here (not least, what would be the parity between the two currencies, for setting the rate would be not unlike a New Zealand pilot trying to land on Australian Aircraft Carrier, in sa raging stormy in the middle of the night using antique radar).

But suppose the mission is accomplished with a common currency and monetary system, with interest rates set by a ‘Reserve Bank of Australasia’ based in Sydney, with a couple of New Zealanders as a minority on its board. Perhaps everything would go fine, but the recent experience of Argentina shows that if things go badly, they go very badly.

Argentina locked its peso onto the US dollar in a slightly different manner to that proposed here. But its problem would occur anyway. The US dollar appreciated relative to most other currencies, and the locked peso followed it up. As a consequence, Argentinian exporters into third markets found their profitability undermined, while domestic producers competing against importers found their market cut away by low prices. The ‘correct response’ is that the Argentina economy should have dis-inflated, that is lowered its domestic costs by cutting wages and other charges. This proved more difficult to implement than to write the previous sentence, and Argentina went into a severe depression, because the tradeable sector contracted, threw people out of work, and with less spending the non-tradable sector contracted too, throwing more people out of work. The major internal collapse led to an abandonment of the peso-dollar lock, but much hardship and financial distress. (Why did the policy advisers not predict this when they introduced the lock? Probably they were well-trained in the US economy, and did not understand how a small open economy was different.)

Now it would probably not be so bad if the same thing happened to the Australian currency. First, it would probably not appreciate as much as the US dollar did, second the export share of New Zealand to Australia is about double the export share of Argentina to the US, and third the Trans-Tasman labour market is more fluid (for unemployed Argentinians could not migrate to jobs in the US). Even so it is possible that an Australian currency appreciation could severely damage the New Zealand economy, without doing the same to Australia given its different export mix.

Why is a locked currency not as damaging to a US state such as Kansas. First it exports a much higher share of its output to the rest of the US, second there is even more labour market fluidity, and third it is fiscally integrated into the US economy. Fiscal integration means that as the economy contracts, it pays less taxes to the Federal centre, and Federal spending in the state would arise. Some states of the US have suffered when their business cycle has got out of kilter with the rest of the US economy or they have had a great structural shock (recall the dust bowl states of the 1930s). Without the fiscal integration (and the ability of people to go to more prosperous states) the hardship woul;d have been even greater.

So currency union, really requires fiscal integration of some sort. The most likely form it would take would be for New Zealand to become a state (or two) of Australia. Now this policy is only discussed in the most cryptic way within the policy elite, but some certainly see extending the scope of CER to currency union or some other major change as a step on the way.

The other prominently advocated change is closer defence relations. This book is about economic rahter than military matters, so it does not judge the appropriateness of such an integration. However it must be said that not a few advocates of greater military cooperation are as concerned about changing New Zealand’s military and foreign policy stance, mot obviously abandoning the ban on nuclear weapons and ships. That is a proper matter to debate, but what must be said is that it is not proper to hitch it on to economic policy proposal. Typically the argument is presented economic integration is a good thing (little more being added to justify that), so we should and since inconsistencies in the military stances of the two countries would discourage the economic integration (again a statement of fact rather than analysis) New Zealand should change its policies there too. Too often unpopular non-economic polices are attached to poorly thought through economic policies, which are easier to argue.

A case in point is that New Zealand has to allow nuclear ships into its ports, in order to get a trade deal with the US. Even the US president has said this is a nonsense, but it will be persisted with. The problem a NZ-US Free Trade Agreement faces, is that we will not settle unless there are concessions in terms of agricultural access, but we have so few restrictions of US (or any one else’s) agricultural exports to New Zealand (other than sanitary and phyto-sanitary ones) that we have little to offer the American farmers and ranchers in return.

At the heart of the issue of New Zealand’s economic (and political) foreign relations is that we are no longer a colony. Britain abandoned us, although we were both growing out of the relationship. Orphan New Zealand looked around for a successor. Australia was never really strong enough, and the US was not interested. (One may ponder on what might have happened to New Zealand had the US opened its borders to our meat and dairy foods after the war.) Ultimately we are going to have to function as an adult in the world. It is fortunate it is no longer bipolar.

That means some friends will be closer than others. Britain will remain our sentimental bridgehead into Europe. Australia, the US and Canada as (mainly) English speaking with similar cultural values will continue. However the friendship should never be so acquiescent that we cant tell them they are doing something stupid (such as invading Iraq without an international mandate). And we need to remember that in a number of military adventures New Zealand troops were put at risk by the incompetence of others. A soldier mentioned Gallipoli, Flanders, Greece and Crete. I would add Vietnam for although our troops were not under great threat, we were there because of those friendships, even though it was little of our business. We need to remember that the strategic interests of our friends are not necessarily ours. Australia, for instance is concerned about the Indian Ocean in a way we are not, and could claim a greater strategic interest in Vietnam in the 1960s.

Of course we must be friends with our Pacific neighbours but commercially they are not major markets. (In total they are about the same proportion of GDP relative to us, as we are to Australia.) The big opportunities appear to be in East Asia, although predictions of growth regions for the world have a bad habit of failing, so we also need to keep an eye on Latin America and South Asia. And we should not forget Europe. Forty years ago it was our largest market (or excluding Britain from Europe our second largest after Britain). But its significance has slipped away, not so much because today the European Union (including Britain) is only our second largest market, but because we don’t give it much priority. We still think of Europe as a set of separate markets, as if the Maastricht ‘one market’ Treaty had never been implemented. Certainly it is a set of sub markets, but so is the US. Ever noticed there are proportionally more European cars on the American East Coast and Asian ones on the West?

However, while it is proper for a business to think regional market by regional market, its that appropriate for New Zealand? A judgement about commercial possibilities hat has to be a major factor in its location of embassies, but there is an underlying strategic issue here – although I shall primarily address the trade element. How does NZ function in a world where there is no imperial mentor?

The ideal answer would be a multilaterally, that is New Zealand would work with the world as a whole to pursue global objectives including those which are of particular concern to New Zealand. This has been a growing thread in New Zealand’s political stance. Even when its commercial interests were dominated by Britain in the 1940s New Zealand had a strong and distinctive support of the United Nations, a position that was repeated as recently as in 2003 when New Zealand was not opposed to the invasion of Iraq, providing it was under a UN led coalition. The comparable commercial stance is evidenced in New Zealand’s commitment to the World Trade Organisation or WTO.

Now the WTO is not top of the pops for many New Zealanders, because of its changing the nature of national sovereignty. We return to this issue shortly, but at issue the WTO is a rules based regime for regulating world trade. That is often to New Zealand’s advantage.

In 1999 the US slapped a tariff of at least 9 percent and up to 40 percent on our lamb exports despite an agreement that it was bound to (could not be higher than) only a few cents per kilo. The surcharge was entirely for domestic political purposes, and it may have cost New Zealand farmers up to $45m over three years. Our redress against the bullying was to follow World Trade Organisation (WTO) procedures, which found in our favour. The US, having stated it was bound by international trading rules, reduced the tariffs to the bound levels.

In fact at one stage the WTO had made 44 rulings in cases involving the US – of which 22 were for and 22 against. Thus while the US (or any other major power) may bully in the short term in the long term the rule of law rules. Let’s be clear that a rule of law does not always result in just outcomes. Typically initially the rules are designed to the benefit of the powerful. But over time they become democratised. That we insist that we are judged in court by our ‘peers’ harks back to the Magna Carta when the aristocrats, meant just that, little thinking one day their serfs would have the same rights.

The proposed Multilateral Agreement on Investment was a classic example of this bullying. It of course makes good sense to have a set of rules about investment, as much for a borrowing country as a lending one. For by clearly setting out the terms on which it allows investment to come into a country clarifies the situation to investors and makes it easier for them to invest. Moreover there is a logic in having a multilateral agreement, because uniformity would make it simpler for investors, but it would also protect borrowing countries by setting minium standards below which they could not compete. The weakness of the proposed MAI was that it was developed by rich countries, with the intention that all countries would adopt it. If they did not it would peril their relations with potential investors. As it happened those outside the decision making circle revolted, while those within proved less cohesive than at first appeared, and the MAI was dropped. But in the course of tiume one will be proposed again, probably – next time – after negotiations in which all countries participate. (Given the difficulties of getting agreement on trade rules, such a time may be some way off.)

Thus New Zealand has gone down a path of backing the WTO and the rule of law in international trade, albeit with an understanding that some of the rules are unfair – as I explain shortly that the rules about agricultural trade are particularly unfair to New Zealand and other specialised agricultural exporters – but over time they can be made fairer. And in any case what is the alternative. Perhaps a large economy – say the US or the EU – could stand outside the WTO but they do not. (We are fortunate they do not: that they dont perhaps tells us how useful the rule of is in international trade. Instructively once they are inside, countries like China have been eager to join them.) But a smaller economy such as New Zealand does not have as much choice. Is there an alternative of, say, specific bilateral deals with the hundred odd countries with which we trade?

International Trade

More to come

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