Keywords: Growth & Innovation
This is a long paper, and is in two parts. This is the second part. Go to Part I. There is also a short version (of about a third the length).Despite its length of the long paper, many of the arguments have had to be abbreviated. Some guidance is given in the text of web references where there is greater detail. More material will be found in the Index of New Zealand’s Economic Performance. The foundation source is the book “In Stormy Seas”
“In Stormy Seas”Part II consists of
Appendix II Recent Developments in the Terms of Trade
Part I consists of
1. The Political Economy of New Zealand’s Economic Development
2. Changing Sectors
3. The Course of GDP
4. The Long Run: 1861-2003
5. The Post-war Era
6. The 1966 External Shock and After
7. Explanations for the Slow New Zealand per capita GDP Growth
8. Non-Explanations for the Slow New Zealand per capita GDP Growth
9. Some Errors of Method
Appendix I: Rankings and Relativities
The charts (in Part I) show that GDP broadly stagnated from 1985 to 1993. There even appears to be a sequence of six years when GDP per capital fell one year after another. There is no obvious external shock in the mid 1980s of sufficient magnitude to explain all the stagnation. I looked at the third oil shock (in 1985 when the real price of oil fell, so that the New Zealand gas based major projects became less profitable) and the hike in real interest rates (as a result the change in monetary management of the US Federal Reserve under Paul Volkner in 1979). While both impacted unfavourably on the New Zealand economy, neither were large enough. (Appendix II updates my recent thinking.)
There is no obvious external shock in the mid 1980s of sufficient magnitude to explain all the stagnation. I looked at the third oil shock (in 1985 when the real price of oil fell, so that the New Zealand gas based major projects became less profitable) and the hike in real interest rates (as a result the change in monetary management of the US Federal Reserve under Paul Volkner in 1979). While both impacted unfavourably on the New Zealand economy, neither seems to have been sufficient to explain the stagnation.
There is evidence – say from the Quarterly Survey of Business Opinion – that the fiscal measures which the incoming National Government undertook in late 1990 converted an incipient business cycle expansion into a contraction, as businesses deferred investment plans and lower income household cut back spending. It can be argued that the Great Stagnation had finished by 1991, and the fiscal package prolonged it. (The long term gains were probably that fiscal control was regained, with a regular budget surplus after 1993, albeit at the expense of replacing the fiscal deficit with a social deficit. Any semblance of fiscal control having been lost during the disinflation of the 1980s.) A consequence of the resulting contraction was that the cyclical expansion of 1993 and 1994 was stronger than had it begun in 1991 (as suggested by the third upswing pattern in Chart 7) and also was out of synch with the OECD (which gave the impression of a stronger growth than is justified retrospectively).
There is a left wing view that the stagnation was due to the general liberalisation, but it offers no account of why liberalisation should generate stagnation, and really belongs to the A therefore B category of non-arguments. Australia went through a similar liberalisation, but it did not experience a stagnation.
A middle view is that poor policy sequencing lead to a financial liberalisation which distorted the economy, leading to a temporary economic boom, and then the crash of 1987 (which seems to have been the most severe of all the sharemarket crashes in the OECD). There is some merit to this argument, and I shall return to the question of poor macroeconomic policy shortly. But I do not see how the theory explains the length of the stagnation. (I have already the issue of whether there investment gains, the impact of the third oil shock on the major projects, and the hike in international real interest rates. These are dealt with in greater detail in my In Stormy Seas.)
The right wing view is as illogical as the left wing one, again claiming A therefore B. It argues there was going to be a severe contraction or even an economic crash in the 1980s and that the liberalisation may have been associated with the stagnation but it prevented a far more serious occurrence. Regrettably there is no evidence provided for this possible crash.
The one attempt to predict the medium term course of the economy in 1985 was by Bryan Philpott. His forecasts were regarded at the time as ‘outrageously pessimistic’, but by 1990, in Philpott’s words, it ‘was clear that they were all too realistic’. He also forecast on the basis of an alternative economic policy package, one whose exchange rate was more favourable to exporting. Whereas under the rogernomes the economy grew at 1.0 percent p.a., under the alternative package it would have grown 1.9 percent p.a. (I caution, however, that the alternative required a degree of wage restrain by unions which may have been impractical.) In conclusion the claim that the policies of the 1980s and 1990s made no contribution to the stagnation is contradicted by the one piece of analytic empirical evidence.
A stronger version of this argument, is that the economy had not adequately adjusted to the 1966 wool price crash by 1977, and was still adjusting in the 1980s, when there was still the need for the liberalisation package and for disinflation.
Rather than look for an external shock, we look for an internal shock which impacted on the external sector. Table 2, which compares New Zealand’s economic performance with other OECD countries over the 1985 to 1998 period, shows there was a problem in the external sector.
Table 2: Economic Performance: 1985-1998
percent p.a. unless otherwise stated. (average for period, unless otherwise stated)
|Private Consumption Deflator|
|Unemployment (% of Labour force)|
|GDP Volume Growth|
|Labour Productivity Growth|
|Export Price Change|
|Import Price Change|
|Terms of Trade Change|
|Export Volume Growth|
|Import Volume Growth|
|Current Account Deficit|
|Average (% GDP)||3.7||4.8||-0.8||0.2|
OECD Economic Outlook (December 1998). The New Zealand figures do not always correspond to the official figures, but are used here for consistency, The OECD consists of 28 economies. *G7 for unemployment.
The picture is that New Zealand had the inferior economic performance, compared to the rest: poor GDP growth, poor productivity growth, high unemployment growth, despite the most favourable terms of trade boost. The one success was the dramatic reduction in inflation. Most of all, New Zealand had a poor export performance – worse than its import growth.
The import growth is not surprising, given that border and internal protection had been reduced, although without the import substitution of the ‘Think Big’ major projects it would have been even higher. Similarly reason the poor growth of the export sector is better than one might expect because it is boosted by some Think Big exports, and by the horticultural and forestry exports from plantings before 1985.
Table 3 with the available data for the 1978 to 1985 period shows that the whole New Zealand economic performance was much better during the Great Stagnation, except for inflation. In particular export growth was higher: more comparable to the rest of the OECD.
Table 3: Economic Performance: 1978-1985
percent p.a. unless otherwise stated. (average for period, unless otherwise stated)
|Private Consumption Deflator|
|GDP Volume Growth|
|Labour Productivity Growth|
|Export Volume Growth|
|Import Volume Growth|
|Current Account Deficit|
|Average (% GDP)||5.8||4.0||8.4||0.5|
OECD Economic Outlook (June 1993). The New Zealand figures do not always correspond to the official figures, but are used here for consistency, The OECD consists of 24 economies.
Why did exporting do so badly in the late 1980s and early 1990s? One might have expected the liberalisation to have resulted in higher – not lower – growth. However crucial to any sector’s performance is its profitability. A good proxy for export profitability is the real exchange rate – or rather its inverse. The higher the exchange rate the lower the profitability of the export sector.
There is no agreed measure of the real exchange rate in New Zealand, so this paper uses a simple – although not perfect one. the ratio of the GDP deflator to the geometric average of export and import prices. (In this case the deflator applies only to domestic products, having had exports removed, and is measured at factor costs, so indirect taxes and subsidies are also omitted.) Note that the measure does not adjust for the border protection which comes from import quotas and other non-tariff interventions, nor export subsidies like the EPTI and SMP. To include them would strengthen the story I am about to tell.
(However this real exchange rate it is not as imperfect as that used by the Reserve Bank of New Zealand which uses consumer price indexes. That means they exclude export and investment prices, but they do include consumer imports prices. Now the whole point of a real exchange rate is to assess the relativity between domestic producer prices and external producer prices, so including the latter with the former is not as rigorous as one might hope. I have used other measures of the real exchange rate and the story I am telling is robust to the broad choice.)
Chart 9 shows a leap in the real exchange rate in the late 1980s. Why did this happen? The short answer is that, unlike many of the East-Central European liberalisations, the New Zealand government had no view on what the exchange rate should be and thought the market would set the appropriate rate. It did not appreciate that its macroeconomic stance tended to push the real exchange rate up. The government was running a large budget deficit in the 1980s, which meant that the economy had to suck in overseas savings, and that tends to push up the exchange rate. An even great influence may have been the disinflation. The Reserve Bank targeted the Consumer Price Index, which being a measure of expenditure rather than production, has a large import – and therefore exchange rate – component. The easy way to depress the CPI was to hike the exchange rate. The Reserve Bank will deny that was the intention of their monetary policy, but that certainly its effect.
A high – ‘overvalued’ – exchange rate means that the profitability of exporting and import substituting was compromised. This has two effects. First, some parts of the tradeable sector contract and close down. This is most evident in the import substituting industries. Second, other parts of the tradeable sector would cease to expand: the mechanism is that the fall in profitability means there are fewer attractive investment opportunities, while sales are not generating the cash flow to fund the investment. Of course this slowdown would phase in. The medium term outcome would be that the tradeable sector would slow down, as we saw for exports in Table 2, and the non-tradeable sector, would slow down too, because in a small economy as a general rule the tradeable sector drags the non-tradeable sector along with it.
This is evident in Chart 11, based on the work of Bryan Philpott. He divided aggregated the subsectors of the economy into the three sectors, exportables which largely exported as well as supplied domestically, importables which are largely import substitutors supplying the domestic market, but also export a little, and the non-tradeable sector which neither exports nor competes directly against importers for the local market. Philpott’s data can be presented in many ways. Chart 11 shows the volume outputs for the three his sectors. (I have not included the mining and quarrying and the chemicals , petroleum and rubber sectors from the tradeables. I wanted to eliminate the effect of the hydrocarbon based industries – and remind myself of the importance of sector disaggregation. In fact the adjustment makes little change to the general patterns.
The most spectacular pattern is for the importable sector. Up to 1985 it grew faster than the other two, although close inspection shows this was in part to jumps in 1969/71, 1981/2 and 1984/5 mainly due to increases in output from New Zealand Steel. (Without those jumps the importable sector – that is without steel or hydrocarbon processing – was stagnant from 1975.) In 1985, the sector goes through a seven year contraction (reducing volume output by almost a third), before beginning to expand again from 1992. This is not an unexpected pattern, because this is a period in which border protection was stripped out which together with the high real exchange rate exposed the industry to the imports, and led to widespread closure. Indeed the rump of Philpott’s importable industry may be those businesses which are strictly in the non-tradeable sector (such as local job printing) or have become exporters. (Shortly before he died Bryan remarked to me that there was very little import substituting left.)
The theory was that as the importable sector contracted, the exportable sector would take up the released resources, and so it would expand to offset the additional foreign exchange that the imports which replaced the import substitutors needs. It is clear from Chart 11 and Table 4, that did not happen. Instead the exportable sector stagnated in the late 1980s and early 1990s. Moreover, notice that while it returned to a growth past, whereas previously it had grown faster than the non-tradeable sector it now was growing at roughly the same rate. So the totality of the tradeable sector was a period of stagnation and contraction followed by slower growth. Not surprisingly the non-tradeable sector and the economy as a whole slowed down too. Had the importable sector grown as fast as exportables it would have added 5 percent to the 1997/8 GDP, more given that it would have also generated activity in the non-tradeable sector.
Table 4: Sectors before and after 1984/5
|Total Factor Productiivty||Exportables||2.7||2.7||0.0|
Note that the tradeable sectors exclude the hydrocarbon based subsectors.
In summary, despite a terms of trade recovery, very little went right after 1984/5. Output growth deteriorated, employment growth deteriorated, but still labour productivity growth deteriorated, although the exportable sector, but no other, by becoming less capital intensive was able to maintain its TFP growth (which, recall, is an arithmetical measure of the coefficient of ignorance).
All this could be used to argue that there was a natural growth slowdown (as hinted by the polynomial trend in Chart 6). However the rise in the real exchange rate offers a more comprehensive story.
A deterioration in the real exchange rate (or the terms of trade) leads to a reduction in the profitability of those exporting and importing. Initially there is a sectoral growth slowdown, stagnation or contraction, eliminating all the activities which are unprofitable below the new profitability rate (but were profitable at the old one). Eventually, the residual tradeable sector adjusts to the high real exchange rate, at which point it begins expanding again, apparently at roughly the same rate as had occurred before the exchange rate hike, and the profitability depression.
In summary step-up in the level of the real exchange rate will lead to step-down in the level of GDP with a lag, a transition path of a period of slow GDP growth or even stagnation.
That is the story after 1985. evident in chart 10. It supports the theory that the liberalisation which took place after 1984 did not necessarily lead to the stagnation, but the associated poor quality macroeconomic management of the period did. Underlying it is a similar economic mechanism as to what happened after 1966. A deterioration in the profitability of the external sector, leads to an economy-wide growth slowdown, stagnation or contraction, and eventually an resumption of the growth path but at a lower relative level. The same story broadly applies to the Great Depression, although the subsequent growth path was faster, probably because the economy as catching up from the depressed conditions of the 1920s too.
See also The Sectoral Approach to Economic Growth.
Tractatus Developmentalis Economica offers a borader policy context.
There are many lessons in this paper. Here it focuses on the importance of thinking sectorally. To explain both the step-downs – the periods of slow growth and stagnation between periods of OECD-normal growth – we had to go inside aggregate GDP and observe individual sectors. We could have gone to even lower levels of disaggregation, had there been time.
Suppose we wanted to think about the possibility of an annual GDP growth rate of 4 percent p.a. Those trapped in the aggregate GDP paradigm would write down a mathematical tautology, perhaps leading to a level of TFP growth that had to be obtained, and would then hypothesis how the coefficient of ignorance might be increased. In contrast, a sectorally focussed approach recognises that different sectors grow at different rates. Let me group sectors into four.
The first sector category, perhaps called the tens, are those which are likely to grow at 10 percent per annum or more in volume terms. Typically these are very dynamic industries perhaps responding to a new technology or fashion. The government identified some ‘tens’ in its Growth and Innovation Strategy: biotechnology, creative industries, and export ICT (although each has a cross-sectoral growth enhancing role as well). However ‘tens’ are small industries. As their rapid growth makes them larger they tend to slow down to join the second category.
The second sector category, to be called the sevens, are those which grow faster than the economy as a whole – say around seven percent p.a. Examples of a ‘seven’ are the agribusiness and wood processing industries. Because they are big enough and fast enough to drag the rest of the economy along with them they are the key sectors in economic growth. (‘Little tens’ mature into ‘big sevens’. Very often a ‘ten’ is a sub-sector of a ‘seven’.)
The third sector category, to be called the fours, are those which grow about the same rate as the economy as a whole. Examples are wholesale and retail trade. They are not unimportant and can be quite dynamic. But they are not economic drivers.
In the final sector category, to be called the ones, are those which grow markedly below average. Not all sectors can grow above average. ‘One’ industries often still have productivity growth with their demand stagnation. How do we shift their underutilised resources into the ‘sevens’?.
What are the characteristics of ‘sevens’? A possibility unavailable to the New Zealand economy is the ‘bootstrapping seven’, a domestically oriented sector which can drag the entire economy along with it. Bootstrappers may exist in large economy like the United States, but rapid domestic growth in New Zealand spills out into imports. It might seem something like the ICT sector is a bootstrapper, but its growth is largely at the expense of the ‘ones’ which it is displacing. The same applies to the business and finance sector. A domestic investment boom – such as putting in ICT cables – may give the economy a temporary fillip, but that reverses when the construction phase runs out and the use and repayment phase begins.
Import substitution might seem to be a bootstrapper but, like exporting, it is displacing overseas producers. For the most common ‘seven’, is a tradable industry – in today’s circumstances an exporter – competing here or overseas with foreign suppliers. Tables 2 and 3 have already shown that in the postwar era, OECD exports and imports grew faster than output. there is a second reason why a small economy like New Zealand is likely to have ‘sevens’ in the export sector. As a general rule, New Zealand is only a small exporter relative to market size (there are some agribusiness exceptions, and the statement is not true if the only export market is Australia) so it can expand its share of the market without severely disrupting competitors. Thus its export sectors can grow faster than the domestic sector and, in doing so, drag the rest of the economy onto a faster growth path.
Tradeable sevens seems to be the only broad growth and development strategy available to New Zealand. That is the lesson of the ‘step-downs’ of the post-war era, for on both occasions the poor economic performance was associated with a poorly functioning exportable sector. While the first occasion – from 1966 into the 1970s – was through an event over which New Zealand had little control, the second step-down has all the hallmarks of our own fault, when we ignored that the key requirement for successful growth, an industry is that it has to be profitable.
To finish with a little speculation about the future New Zealand political economy. While it has transformed from one dominated in the first two-thirds of the twentieth century by the pastoral sector into a more diversified one, there is still an underpinning resource base for most of the major industries: tourism, dairy products, meat products, forestry, horticulture, fish products, wool minerals and energy. It is broadly a food, fuels fibre, and ‘fisitors’ tectonic plate.
If I have understood the Growth and Innovation Strategy aright, the government – without abandoning the resource based industries – wants to accelerate the roles of human capital and creativity.
To understand how this fits into the international trading pattern – I am now no longer describing the government’s strategy but interpreting and extending it – recall that there exports grow faster than output. Now there is nothing inherent about exports that their income elasticity of demand should be substantially greater than unity (except perhaps because of novelty). What seems to be causing the rapid growth in changes in the patterns of the location of production.
Today, about a quarter of the world’s trade is in oil, a quarter in primary products, and a quarter in general manufactures which are traded according to the rules of comparative advantage. The final quarter of world trade involves intra-industry trades, which occur when the two countries trade broadly the same goods or services – say the French buying Volkswagens and Germans buying Renaults. There was negligible intra-industry trade immediately after the war, so this is the fast rising part of international trade. That may be a major factor in the rising share of exports in production and imports in expenditure.
Intra-industry trade is governed by the rules of competitive advantage not comparative advantage. Its theory is a recent one. It is based upon products which are similar but can be differentiated by the market – Renaults and Volkswagens, it involves economies of scale in production and other advanced technologies, and it is driven by the falling costs of distance.
New Zealand has probably the poorest intra-industry trade record in the rich OECD. An issue is whether New Zealand can get into intra-industry trade – exporting pharmaceuticals to Europe, software to the US, films to Hollywood, while, of course, also importing pharmaceuticals from Europe, software from the US, films from Hollywood. A way of interpreting the ‘innovation’ part of the Growth and Innovation Strategy is it aims to create industries involved in intra-industry trade which are small tens, and grow them strongly enough to become the big sevens. This upwelling of a new political economy tectonic plate need not subduct the diversified resource plate. There may be synergies between them – to mix metaphors.
Whether we are economic theorists or practical policymakers we are feeling our way about the significance of competitive advantage and intra-industry trade. Much of my research program over the next few years is trying to understand it. So I conclude with the more fundamental messages with which has pervaded this paper.
Even narrow economists should not think about the growth process solely at the aggregate level. One has to think about it sectorally, including about what is happening to product prices and factor prices (including profitability).
More fundamentally, economic development is different from economic growth. It is not simply about increases in aggregate output. but about the changes in the mix of sectoral outputs, the products consumed, the production technologies used, the way the economy and society is organised, and the way people live.
Preparing this paper, I extended the Commodity Terms of Trade (TOT) graph of In Stormy Seas (Figure 5.1, page 76) a further eight years in Chart 8. I am now inclined to see a lift in the terms of trade from the late 1980s. There may be even an upward trend from then. At this stage it is speculation as to why this has happened – noting the composition of exports and, to a lesser extent, imports has changed greatly over the years. Among the reasons for the TOT recovery which occur to me are
– the third oil shock dropped the price of oil without depressing our pastoral export sales to oil producers;
– the world trade reforms may beginning to benefit agricultural prices (while the rationalisation of export support in New Zealand may have reduced its supply on the margin and raised pastoral prices);
– the commodification of manufacturing in East Asia may be pressing down prices to the benefit of resource producers; and
– the productivity gains in the ICT manufacturing industry from technological innovation has been reducing its product prices.
Whatever, the implications are that there was a TOT recovery during the latter part of the Great Stagnation and it has continued. Without it, the stagnation may have been even more prolonged. This may explain something I had noticed, but had not resolved. The 1966 TOT shock and the 1985 Real Exchange Rate shock appear to be roughly of similar magnitude, but the stepdown from by the latter appeared to be only about two thirds of the stepdown of the former, (11 percent of the GDP track vs 18 percent of the GDP track). But the TOT lift of the late 1980s might represent a stepup of, say, 9 percent of the GDP track, about half the magnitude of the 1966 stepdown. That suggests that without the TOT lift, the 1985 Real Exchange Rate shock had a similar impact to the 1966 shock.
Clearly I have more work to do.