Speech to the Auckland University of Technology Residential Course on Regional Development, Tatum Park, Levin, May 30, 2006. The author is an adjunct professor of the Institute for Public Policy at AUT.
Keywords: Globalisation & Trade; Growth & Innovation;
Tonight I am going to talk about what New Zealand’s Economic Transformation might look like, and some of the things which need to happen in order to accomplish it. However, I need to begin with two caveats.
The first is that while ‘economic transformation’ is a phrase which the government is increasingly using, and was mentioned frequently in the 2006 Budget, the government has not published any authoritative account about what exactly it means. As far as I can judge, the policy development is still at an early stage in its thinking although there are some useful hints. So there is no sense that what you are hearing tonight is a gloss on the government’s thinking about the economic transformation. I am trying to preview it.
Second, I happen to be a member of the government’s Growth and Innovation Advisory Board, which is its most senior private sector advisers on its economic strategy. What I have to say tonight need not reflect the views of any other member of the Board, nor the Board as a whole. We simply have not yet discussed the Economic Transformation at a level at which we have a collective view.
So tonight’s paper is not the government’s view and is not GIAB’s view. It reflects my views. If in retrospect it provides guides to future thinking on the Economic Transformation, then so be it.
I begin with a brief historical overview. It is from a Labour-Left perspective, because that is where our current government comes from. That will take me up to the current state of thinking, including defining more systematically the notion of ‘Economic Transformation’. The paper then collects together as to what the government has said on the Economic Transformation, and extends it a little its Auckland and regional perspectives.
The Context
To begin with the Great Depression of the early 1930s, into which New Zealand was pitched by a dramatic decline in the price of our exports – in those days wool, meat, butter and cheese which went mainly to Britain. Its implications were not lost on economists: pastoral prices are volatile, and we should not over-specialise but instead diversify products and markets.
This conclusion was reinforced in later years, by the observation that the terms of trade for many primary products – what they would earn relative to the cost of imports – tended to fall in the long run. This phenomenon is not peculiar to New Zealand. My book The Globalisation of Nations illustrates the principle with Argentina, although I could have used Australia or Uruguay as well as New Zealand as the exemplar. Again the obvious strategy is to diversify.
A third strand in this thinking, arising out of the inter-war consolidation of our urban centres, was that cities offered opportunities that country life does not, thus enriching New Zealand life, for a sophisticated society requires strong and thriving cities. We’ll come back to the role of cities.
Sutch’s Vision
The logic of these themes was taken up by Dr Bill Sutch. What makes Sutch important is not only was he a senior public servant in the 1950s and early 1960s involved in implementing the policies, but that he was a prominent articulator of them. Thus, insofar as some of the policies became obsolete, he is blamed for them, although others long forgotten were just as involved. On the other hand where the policies he advocated have become the conventional wisdom, his contribution is forgotten.
In his historical context, Sutch was a progressive and subtle thinker. When he returned to New Zealand in the early 1950s a strategy known as ‘Import Substituting Industrialisation’ (ISI) was fashionable. It argued that a country should be less dependent upon earning foreign exchange by producing more at home. This requires domestic businesses to be protected from overseas competitors, at least initially (the so-called ‘infant industry’ argument).
New Zealand got involved in ISI from the late 1930s, before Sutch was involved. What was evident was that the export sector would not generate enough foreign exchange to employ all New Zealanders. To husband the scarce foreign exchange New Zealanders would have to be employed in production activities, mainly manufacturing, which would save foreign exchange. This typically requires protection and assistance.
Sutch came to a similar conclusion in the 1950s, albeit based on more detailed quantitative analysis than was available earlier. As time went on, he realised that such import substitution would not generate enough jobs by itself. So step by step he moved towards a more complex view that might be summarised as that as well as import substitution there should also be
(1) Exporting of primary products other than pastoral ones. Among those Sutch mentioned and promoted were fish, forestry, horticulture and tourism.
(2) Additionally, export of any primary products should be processed as much as possible in New Zealand. Thus he promoted exporting scoured wool, woollen tops and woollen carpets: that meat carcases be prepared in New Zealand for overseas shops instead of exporting them intact;
(3) He also saw opportunities for manufacturing and service exports not based on the primary sector. I shall have a lot more to say about them.
Sutch’s vision is now so routine a part of the conventional wisdom, that we overlook how extraordinary it was forty years ago. Unfortunately in 1965, Sutch was stood down from his position as Secretary of Industries and Commerce in charge of industrial policy. Away from the job’s pressures of industry strategy he turned to the role of education, health, social security, women, and national identity. So we cant be sure what he would have thought had he stayed on, or what he would think today – anyway he would be 99.
Had I to guess, I think he would be attracted to the approach of the South Korean economy which maintains a fortress home market protecting itself from international competition, and uses the protected domestic markets as a base for aggressive exporting. But if everyone has a fortress at home there is nowhere to export, so in a multilateral trading world the strategy is, alas, no longer generally available, and we missed the opportunity to avail ourselves of it when it was.
What one can report is that out of Sutch’s vision and the foundations it led to New Zealand seized the opportunity to diversify in the 1970s. According to economic historian John Gould, New Zealand went through the greatest diversification of any OECD country in that period, changing from being an extreme example of dependence on a few markets and commodities to a more typical one.
Sadly, the policies of the 1980s thwarted the diversification.. That story belongs to another paper. Here we note that for much of the 1980s and 1990s New Zealand economic development marked time. The ‘development strategy’, of which Sutch was a part, became unfashionable. But it remained in the political arena via Norman Kirk, who in turn passed it on to Mike Moore and thence Helen Clark, today under the term ‘global connectedness’.
I dont think Sutch would be that uncomfortable with the last major economic strategy document which the government has published Growing an Innovative New Zealand. This includes the ‘Growth and Innovation Framework’.
• A stable macroeconomic framework.
• An open and competitive microeconomy.
• A modern cohesive society.
• A healthy population.
• A highly skilled population.
• Sound environmental management.
• A globally connected economy.
• A solid research, development and innovation framework.
Good policy builds up on past successful policies. The key new idea here was ‘innovation’. The Economic Transformation will build on the growth and innovation strategy, further shifting us away from the import substituting strategy towards global connectedness.
Export Oriented Industrialisation (EOI)
Export Oriented Industrialisation (EOI has been the successor to Import Substituting Industrialisation. I doubt that anyone saw its logic immediately after the war. Merchandise exports were then around 5 percent of World GDP only a quarter of the 20 percent proportion of today. There were hardly any exports of services other than freighting and a trickle of tourism. Fifty years ago it was inconceivable that many products which are normally internationally traded today could be traded then. For the expansion of international trade has been one of the most spectacular changes over the last half century, in part the result of the falling costs of distance, and reinforced by reductions in protection and domestic assistance.
But is this exporting beneficial to the countries involved? There are two important reasons to think so. The first is that production in small economies lacks economies of scale if it is supplying only the domestic market. So they either abandon one of the most powerful forces for economic development, or they reap the economies of scale by specialisation in particular industries, exporting the surplus and importing what they do not specialise in.
There is second reason, which is more subtle, and also applies to large economies. Exporting is a highly competitive activity, which forces the successful exporter to innovate more efficient processes and new products. Protected domestic markets are not nearly as dynamic and do not have the same pressures to innovate. (Many of the protected industries which required assistance in their infant stage were soon asking for assistance in their senile stage, without ever having gone through a period of unassisted adulthood.)
That, in my judgement, was the major weakness of the Import Substituting Industrialisation strategy. There was not enough pressure to innovate and any such pressures were frequently thwarted by interventions protecting the domestic producers, which they promoted in their self interest and to which the politicians acquiesced. The same deal is not available in export markets because exporters dont own the foreign market’s politicians.
The need to specialise for economies of scale and the effect of competition driving innovation are at the heart of the EOI strategy. It is not a strategy without its risks. It is damned hard to export. Moreover the exporting country loses a degree of de facto sovereignty since, like any in mutually beneficial transaction, one has to make some concessions. And third, we should never forget that if the international order turns to custard the more one exports the bigger the mess.
The Structure of an Economy
The detail we have gone through, illustrates an important message. Economic development is not just about the economy as a whole. We need to think about the various sectors of an economy and businesses that operate in those sectors, and how they change.
Instead, much of the public debate focuses an account of the economy as a single commodity, in which there are no individual economic sectors. While there is much angst about New Zealand’s average productivity being below the OECD average, do we really believe that every sector of the economy is below the OECD average? Some might be above average – agriculture for instance.
Much of the productivity debate is incomplete. I have no problems with the workplace productivity campaign with its aim of improving workplace performance and upskilling the workforce. But productivity does not just come from more productive workplaces. It also comes from closing down low-productivity industries, shifting them offshore to low wage countries, and redeploying the released resources into high productivity activities. That was the problem with the Import Substitution Industrialisation strategy. It refused to close down low-productivity industries. There are always political reasons not to close them down.
Wouldn’t it be progress if we knew which industries were low-productivity compared to other rich countries? It need not be that they are inherently low productivity. We might be that we would find that all our manufacturing was above average, but the sector as a whole was below average because we had few manufacturing activities in those subsectors with inherently high productivity. It may be that our transport and distribution sector have low productivity by international standards because of our low population is over a large area. It happens that the way the figures are calculated, penalises producers of protected agricultural exports. And so on.
But it seems likely that the productivity of some of our industries is too low. We need to think about why: are the policy settings right? is the management up to it? should we not close it down and deploy the resources for a more productive purpose?
Sadly we dont have the data to enable us to think systematically about these questions. Because we think in terms of the aggregates, we know very little scientifically about the reasons for the poor performance of the New Zealand economy. That leaves plenty of room for ideologists. Sadly, ideology has been so dominant that there is a reluctance to acquire useful research about New Zealand’s growth problem.
Exporting
There are some exceptions. One of the most compelling conclusions is that the export sector is at the heart of the growth process. If the export sector does not fire, then the economy does not light up either. Over the last twenty odd years New Zealand has had a poor export performance. This is hardly noticed by those who look only at the economy in aggregate, but once you begin to look from a sectoral perspective, the conclusion is so obvious that you wonder why it has not been at the core of economic policy for the last two decades.
Let us not be too pessimistic. In recent years the government has been paying more attention to exports than any of its recent predecessors. But there is an enormous gap between where we are and where we should be. A New Zealand Institute report, Dancing with the Stars, gives a measure of the gap. It points out that the ratio of exports of goods and services to total output (GDP) is below 30 percent, but argues that for the typical rich country of New Zealand’s size, the ratio would normally be about 50 percent.
There are a number of problems with this 50 percent figure. It does not come from the sort of robust empirical investigation which I, and the NZI, really want. But were such a study be done, we may be sure that the optimal ratio of exports to GDP would be markedly higher than the current 28 percent for a country in New Zealand’s circumstances. That means that New Zealand is not specialised enough, that we are involved in too many low-productivity activities. Instead we should be importing their products, paying for them with the proceeds from the exports from high-productivity sectors.
Here is a crude calculation, to grab your attention about the implications of this export failure. Export industries have to have higher productivity than import-substituting industries, because they have to get over the hurdle of the trade costs – shipping and the like – of exporting. How much higher? A not unreasonable guess is that export business productivity would have to be about double that of a domestic supplier. If so, were New Zealand exporting an extra 20 percentage points of GDP, then the nation’s productivity would be 20 percent higher, and that would shift us from being below the OECD average to about the average.
This is a very heuristic calculation. But the general implication is true enough. A small economy which does not pay sufficient attention to the export sector will experience lower productivity and lower incomes.
What Kind of New Exports?
There is a second measure which underlines New Zealand’s poor export performance. So out of date is much of New Zealand’s economic thinking, it is not easy to explain. Two hundred years ago David Ricardo pioneered the theory of comparative advantage, in which a country specialises in what it can do well, exchanging it for the products which it is not as good at. We call this ‘inter-industry trade’. However there has evolved in the last fifty years a quite different form of trade, in which two countries trade the same product.
Why should two countries trade essentially the same product? Take cars, a common form of ‘intra-industry trade’. To our discriminating affluent perception we may think a Renault and a Volkswagen are different, and certainly their makers try to get us think that way. But there is not a great deal of difference between a four-door 1600cc sedan of the two marques. So Germans buy Renaults and the French buy Volkswagens, and the two countries trade the same product.
Intra-industry trade is an increasingly common phenomenon, thought to make up a quarter of all international merchandise trade, although the exact figure is dependent on statisticians’ definitions. It occurs where there are strong economies of scale and rapid technological innovation, with outputs subject to product differentiation, together with low costs of distance.
In contrast to the ‘comparative advantage’ of inter-industry trade – where having some natural advantages enable the industry to export – success in intra-industry trade involves ‘competitive advantage.’ Because existing technology and products are continually undermined by the innovations of other firm, the successful firm has to innovate too in order to keep its costs down and its products evolving. The business may not have any natural advantages, but makes up for them by the excellence of their competitive innovation.
New Zealand performs lamentably badly in the intra-industry trade stakes. We are at the bottom of the OECD (rich) countries, with Australia, a long way from the average. While the rich world has seized the opportunities presented by intra-industry trade, New Zealand has missed out..
It is easy to say that New Zealand is not good enough for competitive advantage, and we should stick to comparative advantage. But we produce pharmaceuticals from milk despite importing pharmaceuticals, we make films but also import them from Hollywood. We have firms committedly exporting by competitive advantage. We just dont have enough of them.
Intra-industry trade may seem to be antagonistic to the primary sector. It need not be. Since the totality of exports has to increase, there is room for more primary product exports as well as more manufacturing and service ones, although the share of primary product exports will fall in total exports. Moreover, some intra-industry trade exports, such as milk-based pharmaceuticals, will come from the primary sector.
The difference between them and, say, milk-based butter is that the butter has been exported for a hundred and more years. It is a commodity sold into markets where the supplier is a price-taker. In contrast you can be sure that the current milk-based pharmaceuticals, where the supplier is a price-maker, wont be around in a hundred years, or if they are they will be long out of patent and a commodity like aspirin. But by then the dairy industry should have created more pharmaceuticals. It will have to, in order to maintain its competitive advantage.
But what are these new industries and products going to be? In 2002 the government listed three which it wanted to pay greater attention to. They were
1. Biotechnology: Biotechnology is a bit of a catch all – it ranges from the production of new products such as pharmaceuticals to improving productivity in the biologically based traditional sectors. It could be argued that New Zealand has the potential for competitive advantage here arising from traditional scientific strengths, and primary sector experience.
2. Information Technology: Again this is a very wide-ranging activity. While we have some direct exports in IT goods and services, far more important is IT as an enabling technology which will be embodied in other exports.
3. Creative Industries: This again proved to be a very wide sector which divided into two. One group is activities like film, video, and sales of creative products to tourists, again direct exports. The other is industrial design, again an enabling technology which should be embodied in every product we sell overseas.
Were the government to review this list in today it would probably add:
4. Materials Science – Nano-technology: where we may have some potential competitive advantage in this area.
And perhaps even
5. Environmental Goods and Services if we are going to be world leaders in sustainability.
However, the government is unlikely to publish another list, because while it was intended to imply these were areas of special interest, the list was widely misinterpreted to imply that they were the only sectors of interest. The majority of export growth is going to come from sectors not on this list, albeit their performance may be enhanced by the enabling technologies.
There may be expansive growth of a single sector. Who twenty-five years ago would have predicted Nokia, the world class mobile telephone company which now contributes 5 percent of the Finnish GDP? But we cant predict a Nokia for New Zealand. What we have to do is make sure that an embryonic one is not aborted or goes offshore because it faces poor business conditions, poor infrastructure, skill shortages, and/or a lack of shrewd public support.
An increasingly higher proportion of our exports and imports will be shipped out by air or a telecommunications line, where the costs of distance have fallen sharply. Did you know that our second biggest international port by the value of exports and imports is Auckland International Airport (behind Ports of Auckland)? The comparison does not include the value of tourists.
But one day – perhaps a hundred years off – our biggest gateway for our products may be the satellite station at Warkworth, as we export services on line. My favourite example is translation services – despite languages not being a New Zealand forte – in which we turn around European documents over their night and our day. It is not a big industry, but it indicates there are new opportunities by using telecommunications to overcome the costs of distance. Royalties from intellectual property will come through Warkworth.
Ultimately the Economic Transformation is ending the butter mentality, shipping out bulk commodities over which we have little control over their conditions of sale, and more about innovative opportunities present by high value competitive advantage products.
What the Government Has Told Us About its Vision of Economic Transformation
About 40 percent of the 2006 budget speech was devoted to the Economic Transformation. It mainly covers topics such as higher education, infrastructure, business regulation and business taxation, all of which are very important but equally necessary if there is no transformation. They are necessary developments, they dont tell us where we are going,
There are two major clues in the budget to indicate what the government really means. First the government says it affirms its ‘commitment to transform New Zealand into a high value, innovative export-led economy that can compete effectively in global markets’, a notion clearly related to the economic analysis I have just been through.
The section then goes on to highlight a group of policies which contribute to this redirection. They include assistance for export market development, increased venture capital funding and more expenditure on research, science and technology. While some of the RST expenditure will be (rightly) used to seek productivity improvements in traditional industries, most of the new spending is about (new markets and) new products which if successful will be a part of New Zealand’s intra-industry trade.
The Future Role of Auckland
There is a further clue to the government’s thinking in its approach to Auckland. The traditional government attitude has been a smug ‘isnt it a good thing that Auckland’s politicians cant get their act together, because that means we dont have to address Auckland’s problems.’ Recently the attitude has switched to an impatient ‘for goodness sake, Auckland politicians need to get their act together, so that we can help them resolve Auckland’s problems.’ The cynic may think this is a political calculation based on the need for Auckland’s votes. While politicians do such calculations, Auckland is also a key part of the Economic Transformation.
Earlier I mentioned the importance of economies of scale, that is, how average costs fall as production increases. We normally think of them in the production process, but they also apply in a region. Congestion aside – it must be taken into account of course – large urban areas have lower costs of production in many of the industries critical to the Economic Transformation. We call these ‘agglomeration economies of scale’ They are very powerful, as the extraordinary growth of New York attests.
I was first impressed by their strength when I was studying the biotech industry. The US has no biotech industry. Rather, about a dozen American urban centres – the smallest slightly bigger than Auckland – are major biotech centres. That is because biotech is not a handful of stand-alone firms. They need firms supplying specialised services including in law, accounting and other business services, a sophisticated labour market for their workers, major knowledge bases, institutions of advance higher education, and so on. That requires a critical mass of the population. Only Auckland is near that critical mass in New Zealand.
The need for a critical mass also applies to other industries central to the Economic Transformation. They reinforce one another. An intellectual property lawyer fixing up a bio-tech patent may also be doing a software one.
The realisation of the importance of agglomeration effects has forced the government to think about Auckland in the Economic Transformation. We see it in its addressing Auckland’s roading deficit. The policy is more pervasive, including on health care, tertiary education, and cultural services. I have not the time to deal with it all, but I want to say something to the rest of New Zealand, which may be apprehensive about Auckland getting more than its fair share of the available resources.
Many industries will either be in Auckland, or not in New Zealand. That includes headquarter companies, biotech, and some specialised health care and education services. The choice may be having them in Auckland or them going offshore; of your children or grandchildren living in Auckland or instead living overseas because that is where the jobs are.
Yet as I began to think more about Auckland’s size I became gloomier. Auckland is about the 350th to largest urban area in the world by population, perhaps 150th in terms of total economic activity. While Auckland has some advantages, which might ameliorate its size disadvantage – it is New Zealand’s gate city – its agglomeration effects may not be as powerful as in many of the overseas urban centres it is competing with.
I mentioned that in biotech terms Auckland is at the smaller end of the successful US centres. That led me to wonder where Auckland’s boundaries are. Hamilton is going to be an important part of the Auckland biotech industry. Perhaps we should add it in our calculations – and Rotorua, Tauranga and Whangarei. Some of Auckland’s biotech companies get work done for them in Wellington, which by air is as close as Hamilton is by road. So are Christchurch and Dunedin (which is another important part of our biotech industry).
So perhaps to get the strongest possible agglomeration effects we have to treat the entire country as an urban area. I am not sure how to do this. But if we could be successful, New Zealand would be the around the 65th largest urban area by population, 45th by economic activity. And the downside of congestion need not be as extreme.
The implication that the whole of New Zealand needs to be involved in the promotion of the agglomeration effects for the Economic Transformation. Giving Auckland some priority is no more than when you want to do up your town you start with the main street. But that the redevelopment is paid for by the commercial centre. I am not arguing for the rest of the country providing unlimited subsidies for Auckland.
The Regional Implication
The short answer to the regional implications of the Economic Transformation is that as far as I know they are yet to be addressed. There is going to be a spectrum of regions. At one end there will be Auckland with its gateway role and as home of a high proportion of the new industries that transformation requires. At the other with be some regions which will almost solely be founded on resource-based industries and their processing.
The inter-regional communications network will be vital. We need to upgrade the national roading system, we need to get a high quality rail system for heavy goods transport, and quality broadband is essential. Some of Auckland’s key workers will be lifestyle living in distant Kaitaia and the Bluff, connected by telecommunications to Auckland.
But that is not the whole of a regional strategy. Articulating it with the Economic Transformation will be a major challenge.
A Knowledge Economy?
I have not mentioned the ‘Knowledge Economy’. The government uses ‘knowledge-based economy’. Its official website identifies but 78 uses of such phrases, which means minister refer to it but once a month. They hardly ever use the expression ‘knowledge economy’. (A Labour government may be reluctant to use the ‘knowledge economy’ phrase because it was the name of a 1998 economic package of the National government. Most users of the phrase are probably not aware they are referring to a policy of a previous government.)
The 2006 budget uses the phrase only once referring to ‘a high-wage, knowledge-based economy’. There is no mention of ‘knowledge’ in the Growth and Innovation Framework: closest is a ‘highly skilled population’ and a ‘solid research, development and innovation framework’.
In contrast to the careful use by the government, a New Zealand Google identifies almost 49,000 sites using the ‘knowledge economy’ and 10,000 site using ‘knowledge-based economy”, so it is much more popular with the public than with the government. The knowledge economy is such an evidently good thing, that one does not have to think about it. Instead the phrase is used rhetorically, commonly to justify unlimited government expenditure on education and research, particularly one’s own part of it. Thus a Sanskrit scholar may praise the ‘knowledge economy’ in order to advocate further funding of Sanskrit. But without a lot more thought – ironically enough the application of knowledge – the phrase does not amount to a policy.
The reason that the phrase is not so central in economic strategy is that it is so obvious – unless we hit oil we are not going to be rich without using knowledge – it does not tell us what has to be done, which bits of knowledge should be promoted and why. The Economic Transformation is an attempt to do this.
Conclusion
Nevertheless, the phrase ‘Economic Transformation’, is in danger of becoming a rhetorical expression with as little content. I hope it wont, that before the end of the year we would see a carefully thought out analysis of what it might mean.
At its heart has to be a change in a structure of the economy to one which is more globally connected, but a more diverse connectedness.
Michael Cullen, who was a historian before he was a politician, cautioned that Economic Transformations are not one-off. An economy’s structure is always changing. What this paper is about is a change which our grandfathers and mothers started in the 1930s, and has evolved since, except in the 1980s when it was slowed down when economic policy turned its back on the importance of economic structure. We are again on course, but we still have a long way to go.