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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Third draft of Chapter 6 of Transforming New Zealand. Comments welcome. (Second Draft).

Keywords: Growth & Innovation;

What determines a successful exporter? (Observe the question is in the Porter approach that ‘firms, not nations, compete in international markets’, although we shall see that national economic policy has a role.) The list is long and includes the right product, advanced and advancing technologies, a capable work force, effective marketing and distribution, entrepreneurial initiative, good fortune … However, the single most important requirement is medium term profitability. If the business is not getting enough revenue to pays for its inputs and its debt servicing, it will eventually go bankrupt.

This is a pretty obvious characteristic of a market economy, although curiously it plays little role in most economic analyses. As a result, little consideration is given to what determines the profitability of an export business and, consequently, how economic policy can impact on its success or failure. The experience of the Fortex company illustrates the issue.

The Fortex Fiasco

The meat processor, Fortex, was formed in 1985 from three smaller firms, with a commitment to add value to 90 percent of animal carcases, whereas most processors of the day were adding only 30 percent. It was a heroic vision, enthusiastically – if uncritically – endorsed in the business press, and for which the company received a number of prestigious awards. Yet in February 1994, the receiver was called in. Apparently there were $90m of assets but $160m of liabilities. Some 1800 workers lost their jobs. Farmers, contractors creditors, and investors lost money.

(Among the idealisations of it performance, was those by parliamentarians who justified the Employments Contract Act on the basis it would allow every business to have Fortex-like labour relations. After the company’s collapse it turned out that Fortex was a high cost producer compared to the other industry businesses. The parliamentarians did not revoke the statute on learning their arguments were wrong.)

It turned out that since 1988 the company had been entering loans as incomes in it accounts. This inflation of revenue disguised that it was often making losses when it reported profits. Even so, immediately after the collapse, Canterbury University accountant, Alan Robb, showed the pre-crash (but fraudulent accounts) reported cumulative operating cash flow (after interest and dividends) had sunk $40m between 1989 and 1993, which should have been an early warning to anyone who had cared to do the sums. In 1996, the company’s managing director and its general manager were jailed for ten and a half years between them for misleading accounting. (There were no allegations of misappropriation of funds in their personal interests. This fraud was on a different planet from Enron’s.)

It is a sad story: for many individuals it involved heartbreak. The economic lesson is that Fortex’s enthusiasm for innovation and value-adding overrode the financial discipline of the market. The effect of the accounting deceptions was to understate the company deficit, keeping the company in business for longer than was financially justified. But, importantly, as Robb’s calculations showed, even had there been no financial deception, the company was doomed.

The fact is that Fortex could not make enough profit from the adding of to 90 plus percent of its carcasses. The conventional companies only processed what was profitable – 30 percent – and survived. Fortex in its vision and enthusiasm (and its advanced technology) was processing past that point of profitability. What could have made the processing more profitable for Fortex, or induced the other companies to do more value-adding? Since profits are (roughly) the difference between revenue and outlays, either the first is too low or the second too high.

Now Fortex did have higher costs than the industry average, although not enough to bankrupt the company as quickly as occurred. Its fundamental problem was that its revenue was too low. Most of its revenue came offshore, so we can trace how it happened.

Fortex was selling in foreign markets where, broadly, the foreign currency price was being set by the domestic producers in the export destination, who bought the carcases (possibly from another New Zealand meat processing company) and processed them locally. Fortex’s revenue, and hence for a particular cost structure the determinants of its profitability, was the foreign currency revenue converted into New Zealand dollars. If the exchange rate was low then the company received many New Zealand dollars, and there was a surplus over its costs. If the exchange rate was high, the company received fewer New Zealand dollars. In Fortex’s case they were insufficient to cover the costs the company was incurring. Fortex embarked on its high value added strategy, when the exchange rate was high,. Hence its crash, despite fraudulent accounting to hide part of the deficit.

If an unfavourable exchange rate signals against value-added exporting, and high interest rates signal against expanding, then a business must respect the signals. If it does not, eventually and inevitably the company will be bankrupted. The fraud at Fortex obscured and prolonged the dire state the company was in, rather than caused it. Value added exporting was not viable when the macroeconomic settings are hostile.

Exporting and the Exchange Rate

The illustration of an exporter like Fortex shows that its profitability was determined by the ratio of its production costs to the costs of its foreign competitors, measured in the same currency units. This is called the ‘real exchange’ rate in contrast to the ratio of the value of the two currencies, which is the ‘nominal exchange rate’. Most of the public discussion is about the nominal exchange rate, because it is easier to measure. However for the exporter or importer it is only part of the totality. (For instance when New Zealand switched to decimal currency in 1967, the nominal exchange rate changed but the real exchange rate remained the same.)

****************

The formula of the definition is

The real exchange rate =

(the nominal exchange rate) X (the cost of production in New Zealand in NZ currency) /(the cost of production in the Export Market in local currency)

where

the nominal exchange rate =

(the value of the export market currency)/(the value of the NZ currency)

****************

What the formula in the box says is that

The real exchange rate is HIGHER when
New Zealand production costs are HIGHER
Export market production costs are LOWER
The nominal exchange rate is HIGHER.

Under simple mathematical assumptions an increase (or an decrease) in the real exchange rate leads to a decrease (or an increase) in the exporter’s profitability. (The world is never as simple, but the model’s simplicity capture a powerful truth about the actual world.) Thus

Since when the real exchange rate is HIGHER,
The exporter’s profitability is LOWER, so

The exporter’s profitability is LOWER when
New Zealand production costs are HIGHER
Export market production costs are LOWER
The nominal exchange rate is HIGHER.

The first two are obvious enough, but the third is crucial. Other things being equal the higher the exchange rate, the less profitable is exporting. As we saw with meat processing, a high exchange rate limits the ability of the industry to value add. That is equally true for other exporters not only in the value adding activities, but other exporting including commodity exporting. A high exchange rate eventually reduces the return to meat producing farmers (and dairy farmers, plantation owners, and so on).

Moreover profitability not only affects the cash flow of each business, but it affects the ability of a business to expand. Firms wont invest if there is no promise of cash flow to service their borrowings and provide a return for their own investment and some cover for the risk. Past cash flows are one of the sources of investment funds, either directly through retained earnings, or indirectly in that it provides external investors with evidence of the soundness of the enterprise.

Thus the real exchange rate, by being a major determinant of the profitability, is also a major determinant of the growth of the tradeable sector. The lower the real exchange rate, the faster the sector can grow. Since the growth of the tradeable sector is a major determinant of the overall growth rate in a small open economy, the real exchange rate is a major determinant of the growth rate of the economy.

How Low a Real Exchange Rate?

The logic of the previous section might suggest to have as low a real exchange rate as possible, since that will maximise the economic growth rate. The option is usually dismissed on the basis that competitive devaluations are self-defeating, as other countries will follow. But this reaction is not inevitable for a small economy such as New Zealand, since few economies would bother to follow it down – perhaps only some Pacific Islands. (We have yet another example of the uncritical adopting the US as the policy model, for competitive devaluations are a real policy reaction to it deliberately devaluing.)

However there is a practical reason why a country does not pursue an excessively low real exchange rate. (Fundamentally it is really about economic growth not necessarily being the same as public welfare.) Suppose the real exchange rate was cut by reducing wages. (Alternately the country might reduce its nominal exchange rate, which would increase the cost of imported goods, so the prices facing workers would go up. In effect their effective spending power (real wages) would be reduced, just as if they took a (nominal) wage cut.) That would reduce domestic production costs, and stimulate exporting because expanding production and selling overseas would be so profitable. Import competing businesses would also find it easier to survive against their overseas competitors.

In this scenario the workers would experience an immediate cut in their standard of living, with the prospect of a gain at some later stage as the economy grew faster. Whether they would be willing to accept this tradeoff depends upon the exact parameters (there is some discussion of them below) and their trust that the strategy would work, and whether they would be beneficiaries of it.

The strategy will only work if the workers remain. Many New Zealanders – especially skilled ones – have the option of migrating to where wages are higher. Others might not bother to return from OE. Additionally, poorly paid workers tend to be sicker, have higher absenteeism, less incentive to work smart, and less incentive to upgrade their skills. The quality of the workforce would deteriorate, offsetting some of the gains from the lower real exchange rates. The danger then, is a low real exchange rate strategy could be self defeating, as it locks the economy into a low wage development path, perhaps dependent upon exporting general manufactures – in competition with East Asia.

There is also a practical limit to how low the real exchange rate can go, set by the capacity of the economy to produce. At full employment any reductions in the real exchange rate cannot lead to more exports, because there can be no additional production.

In summary there is a limit to reducing the real exchange rate to stimulate exports, set by the economy’s ability to produce, and by the capacity of the workforce and other factors to take an immediate cut in its remuneration.

Does the opposite of hiking the real exchange rate to a very high level make sense? This could be brought about by a higher nominal wages and a high nominal exchange rate. The workforce would now be better remunerated, but exporting and import competing firms would find their cash flow undermined. They would stop expanding and eventually lay off workers, so unemployment would rise.

This happened after 1985, when the exchange rate was at a high level as a part of the anti-inflation strategy (discussed below). The difficult situation facing most tradeable business was compounded by the removal of protection from imports and the withdrawal of subsidies. Exports slowed (part of the small expansion was various commodities – such as kiwifruit – coming into production following investment occurring before 1985); imports boomed; GDP stagnated; unemployment rose; and New Zealand per capita GDP fell fifteen percent behind the OECD average in less than a decade.

Now of course, as we saw with the Fortex example, there are some export businesses which survive at the higher exchange rate. Typically they are commodity producers with only a little value added processing, or general manufacturers to Australia where New Zealand wages make them competitive (and where CER still gives preferential access against alternative export sources). At some stage the tradeable sector will downsize to businesses which are viable at the particular exchange rate, and the economy will begin to expand again – as happened in about 1993 – probably at the same growth rate as the rest of the OECD.

Thus the economy behaved exactly as the analysis would predict.

Why did economists pursue what even at the time was obviously a growth inhibiting strategy. To understand this we need to understand how economic policy influences the exchange rate.

Monetary Policy and the Real Exchange Rate

By the late 1980s, there evolved the view that the Reserve Bank operational independence over monetary policy although the objectives of monetary policy were set generally in statute as ‘price stability’, and practically by the Minister of Finance as that the consumer price inflation should lie within a particular ‘band’. (The range shifted from 0 to 2 percent p.a. to 1 to 3 percent p.a. over the decade). The approach was justified by a mixture of wanting to minimise political meddling in monetary policy (a response to the style of Robert Muldoon), and a particular theory of the how monetary policy worked. Unfortunately the theory was based on a model of a closed economy for which economic growth was not a major preoccupation. Regrettably it has given little attention to monetary policy in an open economy.

It did work. Initially, in the 1980s, there was a rapid reduction in the rate of inflation (disinflation). Subsequently, in the 1990s, the New Zealand inflation rate stayed broadly within the bands throughout the period (although it must be said that the 1990s was a period of low inflation in the OECD). However it worked in a different way from what the theory of the closed economy said, and what the Reserve Bank said. The consequence was that economic growth has been inhibited.

The theory focusses on the inflation caused by shortages in the domestic economy. For instance, if workers are scarce, businesses are likely to pay higher wages to attract the workers they need. The bidding will push up wage costs, and that will feed into inflation. The Reserve Bank cannot investigate the pressure in every market, so it looks at the aggregate output gap in the economy and behaviour in some key sectors – the Auckland housing market is a favourite. If it thinks the gap is narrowing so the economy is ‘over-heating’, that is inflation inducing scarcities are beginning to happen, the Reserve Bank tries to restrain the economy by raising interest rates. The intention is that as borrowing gets more expensive, consumers will buy less, and businesses invest less, so there will be less expenditure in the economy, less production, less potential for shortages, and less inflationary pressures.

This ‘circuit’ is entirely characterised by domestic activity, as if the economy is closed to the rest of the world. However there is also an external circuit, and a faster acting one in a floating exchange rate regime such as New Zealand’s. As interest rates rise, investing in the New Zealand dollars becomes more attractive to foreigners. The effect of foreign investors being attracted to invest into high returning New Zealand financial securities, is that the nominal exchange rate rises.

(Many readers will skip thorough this paragraph but the circuit works this way. Convert foreign currencies into New Zealand currencies, involves finding someone who wants to transact in the opposite direction, converting New Zealand dollars into the foreign currency. Usually New Zealanders obtain foreign currency by finding an exporter who want to transfer their export receipts into the home currency to pay for their domestic inputs and investors. With investors also offering to sell, the price of the transaction will be depressed from the perspective of the foreign currency suppliers, and so the nominal exchange rate will rise.)

That is great as an anti-inflationary mechanism because the higher nominal exchange rate reduces the price level as measured by the consumer price index. Over 40 percent of the basket of consumption goods which makes up the regimen of the Consumer Price Index are imports. So a hike in the nominal exchange rate, reduces the price of imports which feeds through into lower consumer prices. The Reserve Bank would deny that it consciously hikes the nominal exchange rate. It says, rightly, that it does not set the exchange rate, as it would for a fixed exchange rate. But undoubtedly its interest rate settings influence the exchange rate. Of all the policy instruments available to the government, the Reserve Bank’s interest rate settings have the greatest short term influence. Moreover the circuit works far faster on the price level than the domestic circuit through inhibiting expenditure. Whatever the Bank says, it is a beneficiary of a high nominal exchange rate, and there has to be a tendency in its policy to favour policies which influence that outcome.

Unfortunately a rise in the nominal exchange rate raises the real exchange rate. (Follow the equations in the previous section.) So the faster, more certain, and more effective anti-inflationary mechanism at the Reserve Bank’s disposal reduces the profitability of the tradeable sector, and thereby the growth rate of the economy.

The Reserve Bank does not seem to have any specific view of the growth rate of the New Zealand economy. The model it adopted to underpin its operational settings was of a closed static economy. (It is perhaps a miracle that there has been any growth at all.) However there is an implicit growth rate it calculates the output gap of the economy, which amounts to an average of the growth rate in the recent past (which, note, has been inhibited by the Reserve Bank’s high exchange rate outcomes).

Clearly then, accelerating the economic growth rate requires the Reserve Bank to use a more sophisticated theory in implementing its monetary operations. However it cannot do it by itself. Fiscal policy also has a role.

Fiscal Policy and the Real Exchange Rate

For much of the late 1980s and the 1990s aggregate fiscal policy, the use of net government spending to contribute to the management of aggregate demand in the economy was considered irrelevant. Instead the government was expected to run a budget surplus to reduce government debt, and when that was low enough to mechanistically ‘balance the books’ with neither a deficit nor a surplus. In recent years, the fiscal policy stance has swung back to the more orthodox view of it having a role in aggregate demand management. In particular if there is a major depression, the government account will be allowed to go into deficit. One of the reasons for running a budget surplus at the moment is to reduce government debt, so the depression deficit is easier to manage, just as a family builds up a nest egg for a rainy day.

However this section is concerned with the different, although not unrelated, issue of aggregate fiscal policy as a part of a growth strategy and, consequentially, the need to coordinate it with monetary policy. The microeconomics of fiscal policy, individual government taxes and spending, is the topic of a later chapter. This one is concerned only with the aggregate impact, summarised by the size of the budget deficit or surplus.

There is a widely helped view which argues that the fiscal stance should be as expansionary as possible, with a large fiscal deficit. This would result in the unemployed resources (such as labour) being used for production, and give business the incentive and confidence to invest and expand. Such ‘expansionism’ comes from a simple reading of Keynes’ theory, and may be very appropriate in a severe depression. However the standard model used to justify it involves a closed economy – or a semi-closed one like the US where the external sector is a relatively small part of the economy, and yet there are strong feedbacks from its importing, through the other economies that are stimulated, to importing. Aggregate fiscal policy in a small open economy such as New Zealand has to be thought about in a quite different way.

Practically, the problem is that an expansionist stance blows out through the sucking in of imports for production and consumption, and the inability to be able to obtain the foreign exchange for paying them. (The complications of using quantitative import controls to prevent the blow-out, need not detain us, except to note that while they may restrain consumption of imports, producers also need imported inputs, so at best the controls slow down, rather than prevent, the foreign exchange blow-out. Note that expansionist policies are more likely to generate inflation. That is true for closed economy expansionism too, although there are differences in the precise inflationary mechanisms.)

If the government is running a budget deficit it is absorbing national savings, if it is running a surplus it is contributing to national savings. Those savings are used for investment. In a closed economy national savings exactly equals national investment, an identity which has a crucial role in the Keynesian theory of a closed economy. However an open economy, may borrow or invest outside, to make up the difference between national savings and investment. New Zealand is usually a net borrower, that is the economy wants to invest more than the savings which are available. The foreign borrowing appears as a deficit in the nation’s current account, which is not the same thing as a deficit in the government’s accounts. (We make the distinction by calling the current account of the nation which includes the actions of private entities such as businesses and households, the ‘external’ account, and the current account of the government as the ‘internal’ account.)

Suppose the government increases its (i.e. the internal) deficit by reducing taxes. (The effect of increasing its spending gives broadly the same outcome.) With more cash in hand, because their after-tax income is higher, individuals will increase their spending, some of it being outlays on imports, so there will be an increase in the external deficit too. The increase will not be the same, because individuals will not spend all the extra income they receive from the tax cut and the subsequent increase in economic activity, but they will save some. Even so there is a direct connection between the internal and external deficits.

What does a larger external deficit mean? That means more borrowing from foreigners, which drives up the nominal exchange rate, just as we described in the previous section. Thus the higher internal deficit not only does nothing to contribute to export expansion, but it inhibits it. By doing so it inhibits economic growth in the long run.

Practically, New Zealand has a private sector which does not save sufficiently to fund all its investments, and which does not save a lot out of any additional income. Compared to what New Zealanders want, private savings are too low on average and on the margin. The New Zealand government has to offset that deficiency by being a high saver itself. Thus it needs to run a budget (i.e. internal) surplus in normal circumstances.

That is a very painful decision. There are understandable political demands to spend any surplus on urgent issues of concern to the public (health, education, the environment, culture and leisure) or to increase individual’s spending power with tax cuts or increases social benefits. In the short run that generates a surge in economic production and a general feeling of prosperity. But soon the economy experiences undue inflationary pressures and, if it is an open one, the import suck which begins to compromise the balance of payments or drive up the exchange rate.

At this point, the Reserve Bank will step in, and boost interest rates to ease the inflationary pressures., further raising the exchange rate, inhibiting exporting and undermining the growth potential of the economy. One implication is that monetary and fiscal policy need to be coordinated, rather than operated independently. (In the past, the Governor has been more willing to talk of about social security and education than about aggregate fiscal policy.)

A second implication is that an internal surplus means interest rates can be lower (all other things equal). An internal deficit involves the government unloading its debt (government stock) into the financial markets. The more there is the more investors will demand a higher interest rate to take on the additional stock to their portfolio. However in a small open economy such as New Zealand this effect seems smaller than the impact on the exchange rate.

Of course the government should manage its fiscal stance to maximise the utilisation of productive capacity. What we learn here is it has to trade off its ability to stimulate domestic demand against inhibiting exporting via the pressure on the exchange rate, and hence slowing down the prospect of economic growth in the long run. In my view it should aim for an exchange rate which maximises the growth of high productivity exports (values added and intra-industry-trade type products). Identifying the right macro-economic settings is not easy, but it gives the prospects of a high quality sustainable economic performance.

The remainder of this book assume that the macro-economic settings are to maximise this growth rate. But can we tweak the rate by better microeconomic settings?

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Third draft of Chapter 5 of Transforminng New Zealand. Comments welcome. (Second Draft).

Keywords: Growth & Innovation;

As a general rule, but not exclusively, the sectors which can grow fast in New Zealand – faster than the rest of the economy – are exporting. Indeed world trade – exports and imports – grows about as twice as fast as the world economy (we mention below why this should be so). The export sectors have a key role in the growth of small open multi-sectoral economies, drag the domestic economy along with them, accelerating its growth rate, while largely funding the imports which also tend to grow faster than the rest of the economy. However not all exports can be accelerated.

The Resource Based Commodity Export Sector

Historically New Zealand’s export growth has been dependent upon the growth of commodity exports based on sophisticated production processes which utilise resources. For almost a hundred years the most prominent commodity exports were wool, meat and dairy products, but in the last quarter of a century they have been joined by horticultural products, forest products, fish, and some energy and petrochemical related products. The diversification is welcome but this group, which makes up over 60 percent of merchandise exports (i.e. excluding service exports), suffers from two major weaknesses.

On the supply-side, commodity growth is typically constrained by some physical or biological limitation, such as the growth of grass and the numbers of livestock to eat it. The jewel for the future is the so-called ‘wall of wood’, as the radiata pine forests double their production every 7 years through to 2025. But that is the result of past plantings. So the sustainable maximum rate cannot be changed much for about 25 years when today’s plantings, whose rate can be varied, come on stream.

On the demand side, the prices of resource-based commodities fluctuate more than manufactured exports. Because it is not possible to change world supply in the short run, any demand shift (say a fall-off because of a world recession) results in a fall in price ( manufactures will hold their prices and cut production). A way of defining a commodity export is that the seller is a price-taker rather than a price-setter. Historically, this was the fate of New Zealand’s export sold in auction markets. Producers may get used to being a price-taker, although they’re grumpy when their prices are at the bottom of the cycle. The more ominous problem whether those prices tend to decline in the long run (secularly rather than cyclically) relative to the price of (manufacturing) imports.

There are a range of reasons for believing commodity prices tend to fall relative to export prices. Many have been undercut by alternatives – wool (synthetic fibres), sheep and cattle meat (white meat including chicken and fish) and butter (margarine) – although the alternatives are also commodities. There is also the worry that in some key traditional markets of some New Zealand food commodities (such as animal fats), consumption is near saturation and may even fall because of perceived health consequences. This would slowdown sales expansion, and depress prices. But there is also rapid growth of affluent populations in the Middle East, East Asia, Latin America and East-Central Europe, whose consumption is not yet near saturation levels. A countervailing tendency is that some resources – oil and other minerals but also trees (as the tropical forests are cut down) and fish (as there seems to be world-wide over-fishing) – are being depleted to the point that their prices may rise. The demand for some products – paper, fish and horticultural products – is rising with affluence. We may conclude there is not universal law of declining relative prices for export commodities.

However the relative prices for New Zealand’s pastoral products declined in the post-war era. (We saw that in Chapter 2 in the story of the terms of trade.) A major factor in the decline (in addition to the rise of synthetics and changing market demand) has been intervention in the world agricultural markets. The US and the EU protect their domestic producers with high production prices and high consumer prices, which result in over-production. The surplus is usually ‘dumped’ into third markets, depressing their prices, with the price deficit for the protected producers made up by subsidies. Producers which do not get such subsidies – New Zealand’s are particularly clean in this respect – suffer lower returns. This seems to have been a major factor in depressing prices for meat and dairy products in the post war era.

In recent years, the world economic community has tried to reduce international agricultural protection. Even the protecting countries are getting tired of the costs to them of supporting inefficient farm producers: the subsidies frequently do not go to ‘deserving’ farmers but to large capitalist ones. The international trade negotiations of the early 1990s – the ‘Uruguay Round’ – curbed some of the worst excesses of world agricultural protection. It appears that there was a significant lift in the relative prices for some pastoral products as a result. The Doha Round which should (eventually) end all dumping of agricultural products is likely to result in further price gains, although New Zealand producers will still have restricted access to many affluent markets.

In summary, New Zealand need not assume that its commodity exports will necessarily face falling relative prices in the future, although most will continue to be subject to higher price fluctuations than for other exports. Moreover the diversification of exports means that the New Zealand economy as a whole is not as vulnerable to external price changes as it was a third of a century ago.

Why Commodity Exports Are Not Enough

However, even with a boost in prices New Zealand cannot rely upon commodity exports in the way it did in the past. So today around 40 percent of merchandise exports are not commodities. Add in service exports and today commodity exports generate less than a half of current external receipts – an enormous change from their excess of 90 percent of exports a third of a century ago.

Once domestic import substitution, stimulated by protection, seemed to be a possible strategy to eke out the available foreign exchange and create jobs. However import controls have now been entirely abandoned and tariffs are for the most part very low or zero. Thus the artificially protected import substituting sector is small, and probably will not expand greatly unless there is a massive – and unlikely – change in the world trading arrangements.

It is impractical in the current world trading regime to return to the high levels of protection that once existed, so it is not proposed to rehearse that debate. New Zealand could, of course, break from the regime, but that would mean the losses of most of its commodities export markets, as its competitors fell over themselves. Free trade involves mutual obligations. (However that the drift is to ‘free trade’ does not justify New Zealand unilaterally abandoning its protective structure, as it has done in the past. Better to disarm in negotiations.)

Instead of import substitution, New Zealand has extended its exports with products which are not commodities. Part of the strategy was to use the commodities as a raw material for an ‘added value’ product. Instead of exporting wool, why not export woolen fashionware and carpets? Instead of carcases, why not meat packs to go direct into supermarkets and pharmaceuticals from the offal? Butter and cheeses, why not use the milk as a raw material for packaged dairy foods and pharmaceuticals? Instead of farm products, why not farm management services? Instead of wood, why not furniture? Rather than ingots why not aluminium based products?

Another leg of the strategy has involved exporting general manufactures, mainly but not exclusively to Australia, on the basis that New Zealand could produce them more cheaply than the destination market. That meant that costs would be low relative to productivity. Since the main variable cost was labour, the strategy meant keeping New Zealand wages low – ‘competitive’ in the jargon. While New Zealand learned a lot about exporting of manufactures, ultimately it will fail, because other countries can undercut New Zealand wages (or New Zealand workers will migrate overseas to where better wages are offered). The practical fate of the world’s general manufactures is likely to be dominated by exports from the Chinese economy which has an almost unlimited supply of cheap manufacturing labour. The entry of China into the World Trade Organisation means they face now lower tariffs and easier entry to New Zealand’s export and domestic markets than in the past, and the Doha trading round which will lower tariffs generally. New Zealand will find it increasingly hard to export general manufactures – even to Australia. If it wants to stay in the business of exporting additional to commodities, it will have to move into specialist high quality products the Chinese cannot produce.

Intra-Industry Trade

What would a manufacturing sector not based on import substitution or the export of general manufacturing look like? Aside from those which come from the added value resource based sector, they will belong to a phenomenon known as ‘intra-industry trade’.

Intra-industry trade occurs where broadly the same product is traded between two different countries., as when Europeans buy Boeings and Americans buy Airbuses. While it hardly existed fifty years ago, about a quarter of all international merchandise trade today is intra-industry trade. The remaining three-quarters – oil, other primary commodities, and general manufactures in roughly equal (quarter) shares – is explained by the traditional theory of ‘inter-industry trade’ based on comparative advantage, where different products are exchanged. Intra-industry trade is the rapidly growing sector of international sector, and a major factor why world trade expands faster than total production.

Intra-industry trade seems counter-intuitive – what is the point of buying a similar product from a different region? In part the answer is because the products are not exactly identical. Consumers may want to difference themselves by such distinctions. Product differentiation may assist consumer preferences for differentiation and fashion, but ultimately it may not matter much if general consumers have access only to, say, Volkswagen cars and not Renaults. (What is important is the consumer benefits from the competitive pressure each puts on the other.)

Traditional international theory predicts trade between unlikes (inter-industry trade) on the basis of comparative advantage in which each country specialises in what it is most productive at. (Additionally there is trade based on absolute advantage – it is no surprise that countries with oil reserves export oil to those which do not have them.) But the theory does not predict intra-industry trade. About twenty years ago, economists developed one where the following characteristics were important.
– economies of scale in the production process;
– low costs of distance – transport costs, but also costs of storage, communication, control and so on (The costs have to be low so that producers from different regions could compete with each other and so reap economies of scale from the larger markets)
– product differentiation.
The outcome is intra-industry trade. (Intra-industry trade is not so surprising if one thinks of intra-regional trade in a single country. Virtually the same product will be produced in different regions and supplied nationally.)

Intra-industry competition is important in economic growth. Consider of two countries each with a car making firm. If each only sells in its own market there will be little pressure to perform (except self imposed engineering excellence). But if the company is also exporting to the second market, each is under competitive pressure from its rivals, and there is no longer a secure home base. This requires them to be more customer focussed. Neither firm can afford another business to get a significant lead on it: a new model from one firm will be disassembled to the basic components by a rival in order to learn how it was made and how much it cost.

Tthe place where technological enhancing competition is most likely to occur is where there is monopolistic competition, that is where a number of firms are offering differentiated but similar products. Economists are ambivalent about monopoly. As Joseph Schumpeter emphasised, monopolies can invest in new technologies and get a reasonable return, because they initially capture any benefit in their own profits. But as John Hicks pointed out, a monopoly may take advantage of its lack of competitors to pursue the comfort of the quiet life, and fail to be technologically innovative. The monopolistic competition associated with intra-industry trade means a quite life is not an option, but technological innovation has to be.

An important theoretical curiosity is that, compared to the traditional economic theory, the pattern of intra-industry trade is not easily predictable. No one has is surprised that those with oil reserves export oil, and economies with relatively more labour than capital export labour intensive products. However the theory of intra-industry trade says it may be an accident of history that the manufacturing plants are in one country and not another. Thus intra-industry trade theory predicts that a firm like Nokia, the mobile telephone giant, will arise, but it cannot predict it will develop in Finland. There is a strong element of luck as to just where it will. The implication is that a ‘Nokia’ could, and by luck will, arise in New Zealand (especially as the cost of distance falls). While governments can probably not create such ‘Nokias’ they should ensure that when the accidents of history are favourable, they encourage rather than retard its growth.)

The Service Sector

Historically the primary sectors were those that had to be located close to the resources they were based upon, while the service sectors had to be located close to the customers. Manufacturing was footloose with its location being determined by the tradeoff the minimum distances costs from its suppliers and markets, and the economies of scale a larger production runs (and industry clustering) could reap. As a result, the majority of economic discussions in international trade focuses on manufacturing (as did the above discussion on intra-industry trade). The service sector (the ‘invisibles’ in the balance of payments) tended to be ignored in economic analysis of international trade.

Increasingly, however, some services are proving just as mobile as the manufacturing sector, for they can be provided some distance from consumers, especially via cheap telecommunications.

Who a couple of decades ago would have envisaged virtual retailing such as amazon.com? In America 14 percent by value of books are sold on-line, as are 5 to 10 percent of music, event tickets, leisure travel, videos, clothing and computer hardware and software. Less visible is business processes services. For example, an Indian based in Bangalore (India is always the example) may enter the data embodied in an emailed image of a form filled out in the US into an electronic file which is emailed back to the US. Or he may decide whether a US applicant is creditworthy (because of the time zone differences, this reduces the decision period by two days). Or he may develop some software rather than have it done in America. Between business and consumer services is outsourcing, which also may occur offshore.

Other parts of the service sector are mobile too, where the customer is moved to the service. That is how the tourist industry works. It also applies to education, with New Zealand earning over a billion dollars a year, from overseas students. It can apply to health treatment, when people travel to get better care in a foreign hospital.

Thus increasing parts of the service sector are joining the tradeable sector. (But not all. Dry cleaning is still a relatively local operation, but then so is fresh bread baking.) The analysis which applied to the merchandise export and import substitution sectors also applies to the tradeable service sector.
Today, for every three dollars that New Zealand merchandise exports generates, the service sector generates around another dollar: a quarter of current receipts of foreign exchange come from services. Services can be part of the rising intra-industry trade too.

New Zealand and Intra-industry Trade

In practice, any pair of trading economies combine inter-industry trade with intra-industry trade. The relative balance depends on the degree of economic similarity and difference between the two countries. One would expect New Zealand, which is relatively rich in resources compared to its population to be involved in inter-industry trade more rather than intra-industry trade.

But New Zealand is hardly involved in intra-industry trade at all, other than with Australia. With every other country New Zealand’s trade is primarily inter-industry. One study found that most rich OECD have an intra-industry merchandise trade index level of around 70 percent or more. The index for New Zealand with Australia was only 50 percent: with other economies it is even lower.

Moreover there has been little improvement over the previous decade. Indeed with some countries there has been a reduction, probably as a result of the reduction and elimination of protection. (The index falls for those Asian countries which have increased their clothing imports to New Zealand following the reduction of protection on clothing.) New Zealand elaborately transformed manufactures (another measure of export sophistication) do not even rise as a proportion of total exports to Australia, while Australian ETMs to New Zealand do.

It could be argued that New Zealand is a specialist economy, very different from the rest of the rich world, and so inter-industry trade is its natural mode of international intercourse. But the commodity trade which underpins this strategy is insufficient to provide to accelerate the country’s growth rate. In any case, even the commodity producers do not neglect intra-industry trade, both in order to diversify and to seize profitable opportunities. Any exchange revenue deficit is not going to be covered by general manufacturing exports because low wage countries will undercut New Zealand. It has little choice than to move into intra-industry trade as a means of generating the additional foreign exchange it needs, and adopting high productivity technologies to maintain and enhance a high income economy.

There are those who are deeply pessimistic about New Zealand’s ability to get into intra-industry trade, whether it be based on value adding to commodities or in other sectors. They see New Zealand’s future in commodity exports and tourism, based on its natural resources, since – they argue – New Zealand is too small to pursue anything else. The good news is that many numerous advance technology export oriented firms largely ignore them. When Fonterra strips out a chemical from milk and exports the resulting pharmaceutical it is participating in intra-industry trade. It is not only commodity trade will not provide the foreign exchange requirements for the country’s current and future population and affluence. Moreover New Zealanders want a life style which cannot be supported by a commodity based economy. New Zealanders may want to develop software, create pharmaceuticals or make films. They can do so in New Zealand if we can sell software to America, drugs to Europe and films to Hollywood as well as import them from there.

What drives intra-industry trade? We have that seen economies of scale and low costs otrf distance are important, but they are not enough to generate monopolistic competition. The term for these other factors is ‘Competitive Advantage’. Since intra-industry trade will be vital in New Zealand’s future, we turn to that notion, observing that the same policies to promote it will also enhance the contributions of the commodity export sector and the domestic non-tradable sector.

The notion of competitive advantage is developed in Michael Porter’s book The Competitive Advantage of Nations, a work undervalued by economists who complain his analysis is vague. Perhaps in popularising he has obscured his relationship to economic analysis. The book emphasises that factor endowment, that which drives of the traditional comparative advantage theory of inter-industry trade, no longer explains international trade between rich nations. The new trade is based upon ‘competitive advantage’ – the active seeking and implementing of new technologies, which is also the foundation of intra-industry trade. Indeed Porter’s term ‘competitive advantage’ may be used interchangeably with ‘intra-industry trade’ without a lot of adaption. I really like Porter’s emphasis that ‘firms, not nations, compete in international markets’, and yet his recognition that nations have a role in fostering successful businesses.

(Porter’s reputation in New Zealand has been damaged by the report Upgrading New Zealand’s Competitive Advantage. Illustrative of its weakness is a diagram which purports to demonstrate why New Zealand has sustained international success in rugby. However the very same diagram applied to soccer or cricket or tiddlywinks would demonstrate that New Zealand was a top nation in those sports too. But see John Yeabsley’s Global Player?: Benchmarking New Zealand’s Competitive Upgrade for an attempt to recover the value of the analysis. Moreover Porter tends to focus on large economies which may sustain a number of rivalrous firms all exporting the same product. The Nokia phenomenon, which may be more relevant to New Zealand, tends to get underplayed)

Michael Porter’s theory of competitive advantage emphasises that ‘firms, not nations, compete in international markets’ even though it recognises that nations have a role in fostering successful businesses (p.33). Thus the focus on exporting has to be on the businesses involved.

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Third draft of Chapter 3 of Transforming New Zealand. Comments welcome. (Second Draft).

Keywords: Growth & Innovation;

Once upon a time – not so many years ago actually – economic growth was thought to be the result of increasing combinations of labour and capital. Because of ‘diminishing returns’ – that is that each additional dollop of labour and capital was less productive, it was generally assumed that at some time – perhaps in the time of today’s children – economic growth would come to an end and there would be economic stagnation. This was before the days about the worry of exhausting the available resources, and issue returned to briefly later. The stagnation was seen as solely due to diminishing returns in capital and labour.

However by the late 1950s economic growth had been to persistent for too longs to be entirely comfortable with this thesis. Moreover, economists observed that additional labour and capital could not explain all the economic growth. There had to be another source.

The central finding, replicated over many other data sets, including for different periods and for different countries (Bryan Philpott was New Zealand’s researcher par excellence in this regard) can be summarised as follows. Suppose the amount of capital and labour increase in an economy by 10 percent over a period. Under the old theory we would expect that economic output would increase by 10 percent (or a little less, given diminishing returns). However the practical experience is that output would increase by more than that 10 percent – significantly more. something else which is increasing output over time on top of the additional labour and capital and so on.

The seminal paper by Bob Solow in 1957 described this other source of output, and hence the main source of economic growth, as ‘technical change’. Source labelled this source by:
‘the phrase ‘technical change’ .. a shorthand expression for any kind of shift in the production function. Thus slowdowns, speedups, improvements in the education of the labour force, and all sorts of things will appear as ‘technical change’. (Solow’s italics)

So technical progress – today it is sometimes called ‘total factor productivity’ (TFP) – is anything that cannot be explained by increases in labour and capital. A couple of British economists, Tommy Balogh and Paul Streeten went as far as saying that the residual was a ‘coefficient of ignorance’. You could say that those who think that we can increase economic growth by higher technical change are saying we should increase our coefficient of ignorance.

Economists have, of course, tried to reduce this ‘coefficient of ignorance’ by directly estimating the other factors contributing to economic growth. The results are not particularly satisfactory for various reasons, and even so usually there remains a significant residual.

Ultimately the problem is that the Solow approach is so aggregate it obscures the really interesting issues. For instance the method, and much of the discussion based on it, assumes that capital is a well defined and readily measured notion, but how does one aggregate together a one horse shay with a Boeing 747 into a single index? How can one compare one hour of my working time with that of my grandfather’s work?

Similarly the approach assumes that the output of the economy can be represented by a single measure (such as GDP). At the heart of the next chapter is the theme that economic growth is about different sectors and products growing at different rates so the paradigm is not going to capture one of the most important features of the problem it claims to be studying. Solow was aware of the problem of aggregation, neatly sidestepping:
‘I would not try to justify what follows [that is the measurement of technical change and the aggregate production function] by calling on fancy theorems on aggregation and index numbers. Either this kind of aggregate economics appeals or it doesn’t. Personally I belong to both schools.’

‘Crude but useful’. Exactly. That is the best that we may hope for from such analyses. And Solow’s marvellous paper is just that. It points out the issue of economic growth is not just additional capital per worker. There appears to be some other important phenomenon which contributes to economic growth, and without which there would be little improvements in productivity. But we are far from clear what is this ‘technical change’, although there is a tendency for everybody with an axe to grind to attribute the residual to their particular axe.

What then can this ‘technical change be? The best explanation Think of ‘technology’ as a series of blue prints – plans which tell how to combine labour and capital to get an output (a metaphor we owe to Joan Robinson). The amount of output for any given amount of capital and labour will vary. (Although the expression ‘blueprints’ makes one think of the natural sciences such as physics, chemistry, biology, they also included social possibilities including such important social technologies as money, the market mechanism, managerial approaches, and property rights.) Businesses (and households) then chose from all the known blueprints – the technologies. Typically they chose the one that gives them the highest output for the resources available.

The idea of choosing these blueprints should not be too complicated. Suppose you want to go to the beech for a swim. Your blueprints might include using the car, or a bike, or walking, or taking a bus or … What economists conclude is that ‘frequently’ – a word used by Adam Smith in this context – the choice of blueprint will result in the minimum use of labour, capital and other resources. And that will lead to – frequently – the highest output in a certain sense.

Suppose a new blueprint turns up – the neighbours want to go too so you can share a car. Perhaps it uses less resources, so not only do you chose it, but that releases resources which can be used to increase output even further. So the supply of new blueprints may be contributing to the increasing output of the economy.

For a long time we tended to treat the supply of new blueprints as if it was ‘exogenous’, that is the rate they came along could not be changed. It was if there was someone at the counter of the Great Blueprint Warehouse regularly handing over blueprints for new technologies at a rate determined by the counter staff. Not all the blueprints handed over are used (since they may be less efficient than others) or are immediately useful, but in this story businesses snap them up, and the process of market competition means the most productive ones get implemented reasonably quickly. It may have been that in earlier eras – say before the industrial revolution – the flow of new blueprints was much slower so the rate of growth was slower. Possibly the industrial revolution depended upon the unlocking the door to the counter which provides the blueprints.

This is a very simplified account of the implicit process of technological change which underpins what was for many years the standard model, I doubt that any economist – certainly not Solow – actually believed it. But in practice the account seemed to give a reasonable description of what happened at an aggregate level.

However at the level of a business it is clear that nobody acts on the basis that they have no control over the blueprints available. Indeed businesses spend much effort trying to generate new ‘blueprints’ (including implementing old ones better) through research and development, while governments invest in science in the hope that it will generate better blueprints. In that sense we have to think of the technical change as endogenous.

What this means in the blueprints fable, is that there is no manned counter at the warehouse. Instead, behind the counter is an enormous labyrinth, with unexplored badly lit passages and caverns, stacked high with blueprints of technology, the ones in front preventing access to more advanced ones. The process of technological progress involves individuals and firms going into the unexplored part and guessing from all that is readily available those which are potentially interesting.

The resulting picture is of a much more active process in the seeking of technology, an activity that can be encouraged or discouraged by policy. For instance the government could subsidise people to look for the blueprints; it could assist the seekers and implementers to acquire skills that will enhance their chances of finding and implementing good blueprints, it could introduce intellectual property rights (such as patents) so businesses would have an incentive to seek blueprints because they own them and can charge others for their use; and so on. On the other hand the government could put regulatory barriers which reduced the opportunities to exploit blue prints, discourage people from acquiring skills, or set its property rights regime that the control of one blueprint prevents anyone else accessing the blueprints behind it.

It is even possible that different societies have different attitudes to seeking and implementing the blueprints, attitudes which are sometimes summarised under the rubric of ‘creativity’ although also important are attitudes to science, to the social sciences, to the arts and to entrepreneurship. Economist Richard Florida thinks a crucial element may the degree of tolerance in a society to the different and to the new. He argues that those US cities which are more tolerant also have a better economic performance.

Sitting behind this account of technology is the implication that it is not possible to regulate knowledge entirely by the market mechanism, because it not all of it can be readily commercialised. (It has seemed to me that the Rogernomics antagonism to intellectuals – shared with Lenin who said that after the revolution ‘first kill the intellectuals’ – may be in part because much of an intellectual’s output cannot be bought.)

Much knowledge is what is known as a ‘pure public good’, for one person having it does not prevent another person from having it, and one person using it does not exclude another person from using it. Consider a poem I much enjoy. But you can enjoy the poem too, without in any way infringing on my enjoyment. (In contrast if I drink a can of juice you cant.) Once the poem is published I cannot exclude anyone else from enjoying it. (I can exclude others from drinking the juice by charging for drinking it.)

Insofar as knowledge is a public good the commercial market will under-supply it compared to private goods (such as cans of juice). What market incentive is there for a poet to provide new poems? The requirement of copyright payments to publish the poems provide some – albeit frequently inadequate – reward. In practice most countries have a variety of non-market rewards such as grants, subsidies, and prizes to enhance the supply. We need not be surprised that for knowledge creation there can be considerable non-market interventions to increase its production, for the market does not always deliver well.

Consider the supply of pharmaceuticals for treating HIV-AIDs. The cost of making the drugs is small, but drug companies charge many times over to pay for the enormous costs of development, so they say. (‘Fossicking around in the warehouse’ obtaining pharmaceutical blueprints can incur a billion dollars – and the result is not always a successful drug.) But these are past costs. ‘Why should’, you might say, ‘people in desperate need of the drugs pay for them?’ The big Pharma explain that they only went ahead with the development that its expenses would be paid, not to mention all the development they did on drugs that did not make it to the market. If those costs are not, the Pharma will go bankrupt, because they have incurred a lot of debt to fund the development. And even if they dont, they will have no incentive to develop new and better drugs. To which the infected say, ‘that is all very well, but I am going to die unless I get the drug.’ Let me stop at this stage, simply saying that when I was doing some work on the economics of pharmaceuticals, I thought the current way of funding the extension of knowledge about them was terrible – but all the alternatives were worse. The point of this paragraph is that there are often not easy solutions – market or otherwise – to funding the acquisition of important knowledge.

That not all knowledge can be made fully commercial has an important implication for New Zealand. The fable of the technology warehouse refers to the entire world and not just to a small country. Most useful technology is generated offshore. There are a lot of countries wandering around the technology warehouse. Much of what they find cannot be charged for.

So New Zealand has been a beneficiary of the computer hardware revolution, by importing and utilising increasingly powerful but nevertheless cheaper computers – even though it has not contributed much to its development. The favourable terms are the result of competition driving down price while enhancing technology. Producers cannot keep all the benefits of their innovations to themselves. As a general rule new technologies tend to benefit consumers in the long run as above normal profits get driven to zero, although producers get the supernormal profits in the short run.

There is a tendency for lower per capita GDP countries with good economic infrastructure to grow faster than the top income countries, and eventually catchup with them on a GDP per capita measure. The best explanation for this ‘convergence’ of production levels between the rich and poor (OECD) countries is that the poorer ones take on the technologies of the richer ones at less than it cost to produce them. While there will need to be special adjustments in the new location and thus some technological sophistication is still required, the advantage. in terms of the cost of access to technology enables countries lower in the technological pecking order to catch up although once they have their growth slow down to the others’ growth rate. The free lunch from access to top technology is over.

(However while New Zealand research and development needs to be concerned with technology transfer, in some sectors where there are New Zealand – pastoral farming, specific horticultural products, pinus radiata, deep sea fishing … – technology creation, that is the identifying of blueprints in the warehouse, needs to be as pursued vigorously simply because nowhere else will they be doing so for the particularities of local resources, so the technologies cannot be imported, where New Zealand industries or production processes lead the world.)

The blue print fable ignores that there are many other actors – scientists, workers, entrepreneurs, managers, financiers, … – involved in the implementing technology. Possession of the blueprints is not enough. Each claims to have the crucial role in the process. One is reminded of another fable in which the various parts of the body claim to be the most important. The argument is settled by one of the parts going on strike and the reminder suffering. I cannot recall which was the critical body part, I read the story as a child, but with hindsight one observes that if any part of the body goes in strike, the remainder are likely to suffer. Arguing one is crucial relative to the rest is for children. The same point applies to the application of technology.

Where do resources fit into this story? They were implicit in the opening paragraph in the reference to diminishing returns, because resource depletion is one of the sources of that effect. As a general rule, however, there has to been a tendency for technology to enhance existing resources and find new ones, so although there are regions which have been run down because of resource depletion – the West Coast for example – ths far the world economy has not. That does not mean it never will. One day all the hydrocarbon reserves may be consumed, and the room in the blueprint warehouse devoted to liquid fuels may have been emptied. At which point diminish returns will kick in with a vengeance and economic growth may slow down or even contract.

Another issue which this economic growth exposition needs to touch upon is that of efficiency. Production efficiency is the notion that the production process gets the maximum output foir the resources available to it. This is the concerns of engineers and managers and – if the management is wise – the production workers. Additionally, economists are concerned with allocative efficiency – that all resources and factors of production are deployed where they make the greatest contribution to total output or whatever is the economic objective. Thus an economist is not simply concerned with whether each car is efficient, but they are also concerned that the petrol and cars are being used for the best social purpose.

Over the years economist have developed an elaborate theory which said that under certain circumstances – the realities of which can be disputed – a market economy in which there was a minimum of government interventions would result in the best allocation of resources, and therefore the highest material output. At the superficial level the thesis was that the market system provided incentives for each player to maximise his (or her – the theory is not noticeably sensitive to women’s concerns) own wealth. In doing this individual improves the overall efficiency of the economy.

One of the earliest formulations of this thesis was Adam Smith’s famous ‘invisible hand’, which meant that while the butcher and baker pursued their own self interest, in doing so they ‘frequently’ (Smith’s caveat) resulted in a socially beneficial outcome. Alas two hundred and more years later, economists still have to say ‘frequently’. They know it is not ‘always’ and not ‘mostly’ (and noyt ‘occasionally’ either) but they do know a bit more about when there is an effective alternative to the invisible hand.

It was such considerations which led to the market liberalisation we associate with the rogernomics of the 1980s. Sadly many of the reforms were extremist as the reformers seemed to forget the Smithian ‘frequently’. Their promised gains of ‘twenty percent ‘of GDP never occurred. The extremists did not notice that the underlying theory was essentially about a static economy. The irony never struck them that when they applied their theory the economy stagnated.

(Nevertheless their were useful gains to the economy from the market reforms including:
– they increased market choice (for those who maintained their income) including better quality of products, which are not easily measured in GDP;
– they reduced the range of government involvement in the economy, enabling the government to concentrate on what it did well (and, many would argue, with gains in political liberty);
– the economy became less rigid, and more able to deal with technological and external shocks.
– they made the disinflation (the rate of inflation falling from around 15 to 2 percent p.a.) less painful.
But of course there were costs too.)

Thus the market is an important part of the growth process, but it is not as important as finding and implementing technology. Its most important roll may be to help find and implement the best technology.

How Fast Can New Zealand Go?

There is a long history of promising to accelerate the New Zealand economy’s growth rate – and not delivering. In the early 1970s, the National Development Conference projected a growth rate of 4.5 percent p.a. for the economy. Impractical in the circumstances, the economy averaged nearer half the target over the next few years. A 1991 study concluded that it would take almost twenty years to return to the top half of the OECD (The 1991 slogan was ‘10 in 2010′). The stretch growth rate was about 4 percent p.a. In the 1990s the New Zealand economy grew about as fast as the OECD (3 percent p.a.) so there was no significant movement up the OECD relativities.

Both of these projections followed an enormous effort collecting and analysing data. Today’s calls for an economic growth rate of 6 percent p.a. are probably even more irresponsible, and the demand that New Zealand should return to the top half of the OECD in GDP per capita terms by 2011 is totally unrealistic. The target seems to have been set by a group of Auckland business people, without any economic advice. As one Auckland businessman, remarked to me, all it involves is doubling New Zealand’s productivity growth rate. That is arithmetically true, but that does not make it feasible. In fact that businessman was one of the best in the country, but he was unable to double productivity growth in his enterprise. Reality is more than arithmetic.

A salutary image from the America Cups was the sleek black yacht limping back to port. Twice they tried to sail it faster than conditions allowed, the boat shipped (literally) tonnes of water, bits broke, and they gave up the race. Business people know the equivalent thing can happen if they try to drive their businesses too fast. Economies can also be like that. We are unlikely to be able to turn the ship around much faster than in 1991. Certainly the sorts of demands being made by the strident but uninformed look quite unrealistic. They need to remember that trying to sail a boat – or an economy – too fast, can break a boom into a bust.

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Third draft of Chapter 2 of Transforming New Zealand. Comments welcome. (Second Draft).

Keywords: Growth & Innovation;

This chapter looks at the level of New Zealand’s production since the war. It uses GDP as an indicator of that level. In doing so it is mindful of the weaknesses of the GDP measure discussed in the previous chapter and its appendix. But GDP remains the best measure we have, and as the book argues later, it seems likely that were a different production objective to be adopted (so products are valued differently form the way they are in GDP) the overall result would not be too different from using GDP as an indicator.

The rest of this chapter is an extension of my findings published in In Stormy Seas: The Post-War New Zealand Economy. It reflects the experience of an additional decade, new data bases, and consequentially has some deeper theoretical insights. However this is not a book to detail these developments and their rigorous underpinnings. Rather I just present the conclusions.

Since then the OECD has published a new data base. This chapter updates the relevant parts of the book, using that data base. Despite the changes, the new data series confirms that the book’s analysis is reasonably robust to the choice of data base.

The OECD is the ‘rich man’s club’. When I wrote In Stormy Seas it consisted of 24 economies – virtually all the richest in the world excluding those Middle Eastern states based on oil. Recently another six have joined – Mexico, South Korea, and the three East-central European ones of the Czech Republic, Hungary, Poland and the Slovak Republic. Additionally, West Germany has since absorbed East Germany. The main reason I used the OECD data is because it has the best internationally comparable data base.

The basic series used here is the ratio of the New Zealand per-capita GDP to the OECD per-capita GDP, shown in Table 1.1 and Figure 1.1. Thus if New Zealand GDP was $1200 per person, and OECD GDP per person was $1000 in the same prices, the ratio would be 1.2. The figure only shows the data after 1960, because economists treat the period before as the special case of post-war recovery.

New Zealand versus the OECD

Table 2.1 Ratio of NZ GDP per capita divided by OECD GDP per capita*
Table 2.2 NZ Ranking by GDP per capita*

* excludes the Slovak Republic.

The overwhelming message of Table 2.1 and Figure 2.1 is that the ratio of New Zealand to OECD per capita has been falling. [1] That means that NZ output per person has been growing slower than the OECD as a whole. The decline is substantial: following the post-war recovery, New Zealand started in 1960 at an average of 31 percent above the OECD average and it finished in 2002 at about 14 percent below, a relative decline of 34 percent over the 42 years. That means that New Zealand per capita GDP typically grew 1.0 percent p.a. slower than the OECD average.

However, while there was an overall decline, it was not a steady one. Allowing for the difference between the New Zealand and OECD business cycle, the relativity remains broadly flat from 1960 to 1966, from 1969 to 1975, from 1977 to 1986, and after 1992. The total decline in those periods amounted to 7 percent , or an average decline of .24 percent p.a., smaller than the likely bias from measurement problems in the service sector. [2]

The significant declines occur only in the 1966 to 1969 period, a fall in the relativity of 10.5 percent, 1976 to 1978, a decline of 10.0 percent, and 1986 to 1992, a decline of 14.3 percent. In Stormy Seas shows the first decline was due to the collapse of the world price of crossbred wools in late 1966. It attributes the second decline to this source too, for the original data base showed a different pattern. If so the total decline from the wool price shock was about 20 percent, and was largely over by the mid 1970s. An alternative view is the second fall was the result of the oil price shock of late 1974. Whichever explanation is correct, the first two falls can be unequivocally attributed to external shocks over which New Zealand had little influence. (That the falls were the result of external shocks, makes the arguments of the early 1980s that New Zealand’s relative decline could be corrected by the reforms of the late 1980s all the more absurd, especially as the advocates were paying so little attention the actuality of the New Zealand economy they failed to notice the external shocks.)

The other big fall occurred in the late 1980s and early 1990s. There was no significant external shock. Rather, the decline seems to have been caused by the poor performance of the export and importing sectors due to an overvalued exchange rate, especially while public support for this ‘tradeable sector’ was stripped out. This is not to argue all the reforms were wrong (although some were extremist and unnecessary.) Rather, a faulty macroeconomic policy (rather than the microeconomic reforms) ignored the health of the tradable sector which is at the centre of the growth process, as later chapters explain.

This fall poses a major problem for those who want to ignore the reforms and yet advocate returning New Zealand to the top half of the OECD. New Zealand’s relativity was at the OECD average just before the reforms were implemented. It seems likely that had there been no reforms – or to be more precise, had the reforms been akin to those implemented in Australia: more practical and less ideological – New Zealand would still be at the OECD average.

In summary in periods encompassing only eleven of the last 42 years, could it be said that New Zealand was growing significantly slower than the OECD. More encouragingly, in almost three quarters of the period after the post-war recovery, New Zealand grew as fast as the rest of the OECD (despite the handicaps of measurement error, population growth and convergence discussed below). The message that the New Zealand has been in long term economic decline in the post-war period is a dangerously misleading one.

The Irrelevance of Rankings

Nowadays, the conventional wisdom prefers to use rankings rather than relative levels. As discussed in In Stormy Seas rankings are problematic, not only because of instability but because they are misleading about progress. Rankings make sense in a tournament in which each countries plays the other in a zero sum game. Economic growth is more like a running race, where a runner slower than the pack may remain ahead of it for long periods, and then suddenly get passed by a bunch.[3], [4]

Even so, some rankings were reluctantly published in In Stormy Seas As there is a public demand for the figures, it is better to publish the best available, rather than have them rely on inferior listings. A new set based on the new data base are shown in Table 2.2 and further details are available in Appendix III.

A comparison between Tables 2.1 and 2.2 shows how misleading the rankings can be. During the post-war recovery period of the 1950s, New Zealand holds its high rankings, even though it is growing markedly slower than the OECD average. Later, there is no indication in the rankings of the much slower growth in the late 1980s and early 1990s (they remain constant at 19th). But in the late 1990s, when New Zealand is growing as fast (or perhaps faster) than the OECD average, the ranking falls one place, because Ireland was growing even faster. In a race one’s place is not only a matter of how fast one runs but how near are those in front and behind you.[5]

There is a grudging acceptance of the wool price explanation of the first major decline. However there is a reluctance to address the decline of the 1980s and 1990s, perhaps because the writer, or the writer’s institution, was involved in advocating policies which are associated with the period of the second relative fall. A consequence of focussing the rankings is that it avoids facing up the relative decline in the late 1980s and early 1990s, when New Zealand had got behind the front bunch and while the back bunch were catching up – but only Ireland was to overtake it in 1997.

Why the Poor Post-War GDP Performance?

In Stormy Seas identified a set of explanations for the long term decline of the New Zealand economy:

1. Post-war recovery in the 1950s, when the war devastated European continent rapidly recovered its productive capacity, catching up to those which had not been invaded – like New Zealand.

2. Higher population growth than the OECD average, since population growth tends to slow down per capita economic growth.

3. ‘Convergence’, the effect that high GDP per capita countries grow more slowly than low ones, because the latter can adopt cheaply the technologies and methods that the former pioneered. (Note that this effect is now favourable to New Zealand, now that it is on a relatively low income, which may explain the slowing down of the rate of decline.)

4. The secular deterioration in the terms of trade for pastoral products which dominated New Zealand exports in the first half of the post-war period, and remain important in the second.

In addition In Stormy Seas identified two shocks which sharply lowered the relativity.

5. The (permanent) collapse of the price of wool in late 1966; and

6. The overvaluation of the real exchange rate from the mid-1980s, which slowed down the growth of exports, the engine of growth of a small open economy, while encouraging imports to wipe out much domestic production.

A decade’s further research gives no reason to change the conclusions.[6] Indeed events since then support the account. We turn now to some other international comparisons from the Maddison data, which fill in some of the story.

Export Performance

In Stormy Seas placed considerable stress on the weak export performance of the New Zealand economy as the reason for the poor overall performance of the New Zealand economy. Regrettably the Maddison (merchandise) exports data base is not very detailed.[7]

New Zealand’s merchandise exports made up 1.33 percent of the OECD total by value in 1950, falling to .61 percent in 1973, .36 percent in 1990, and .30 percent in 1998. This is a far more dramatic fall than the GDP per capita decline, but consistent with the general theme of In Stormy Seas. It is the tradeable sector which has mattered.

Productivity

At the simplest, productivity may be measured by output (GDP) per worker, or by output per hour worked. In brief, the conclusions were:

– New Zealand employment as proportion of the population in New Zealand was slightly higher than the OECD average in 2000. That means its relative level of output per worker was a fraction lower than output per person.

– However it appears that New Zealanders work slightly more hours a year than the OECD average. Hence the relativity for output per work hour is lower than GDP per capita. In 2000 output per hour worked was 74.1 percent of the 27 OECD countries for which there was data, in comparison to percent for 77.1 output per person (and 75.4 percent for output per person employed).

So New Zealand productivity is certainly worse than the OECD average.

Australia

The most obvious country to compare New Zealand with is Australia. How did they compare in the relative GDP per capita stakes?

Australia too, began above the OECD average, and declined – on the whole more slowly than New Zealand through to late 1980s or early 1990s. Since then, it has expanded faster than the OECD, and is back at the level of the early 1970s. The impression is that, other than this acceleration in the 1990s, there are not the abrupt changes in its trend that New Zealand experience, nor is the cycle around the trend as strong. In 2002 Australia was in its 11th successive year of perceptibly faster growth than the OECD average, which suggests that there has been a significant turn around (which may be halted by the drought of 2003).

New Zealand’s GDP per capita was just ahead of Australia through the 1950s and early 1960s. In effect the output of the two economies were growing at the more or less the same per capita rate. The 1996 wool shock changed the relativity, depressing New Zealand, so that it was now 6 percent below the Australian GDP per capita level.[8] The constant relativity between the two resumed until the mid 1980s. At that point the New Zealand GDP per capita stagnated so its relativity against the OECD fell sharply. Meanwhile Australia’s genteel decline eased back. The result was the New Zealand to Australia relativity deteriorated, through to about 1998, although perhaps New Zealand has grown fractionally faster since. Today, New Zealand’s per capita GDP is about 75 percent of the Australian level, lower than the OECD relativity because Australia is above the OECD average.

The broad conclusion is that New Zealand and Australia grow at the broadly the same trend rate in most periods, except for the impact of the collapse in the price of crossbred wools in the late 1960s, and in the late 1980s and early 1990s when New Zealand was experimenting with its economic reforms. The 1980s must have laid the foundation in Australia, for the perceptible improvement in its relative growth. Why its moderate economic transformation policies worked and New Zealand’s extreme ones did not is yet another important issue unaddressed by the conventional wisdom.

Prospects for the New Zealand Economy

That the GDP relativity does not seem to have deteriorated during the last decade suggests that the New Zealand economy is again growing at about the same rate as the OECD as a whole. Moreover, most of the factors which In Stormy Seas identified as giving poor relative growth of the New Zealand economy do not all apply.

1. The war recovery is long completed.

2. New Zealand population growth is slower, and while still higher than some OECD economies, the ageing effect is not so pronounced.

3. Being below the OECD average means the convergence effect now favours New Zealand. In practice that means there are gains from importing foreign technologies.

4. While the secular deterioration of the terms of trade of pastoral products may continue, they are now a lesser share of total exports. It is not obvious that the terms of trade for the remaining (and largely new) exports are subject to a secular decline (although they will fluctuate with world economic conditions), while the optimist may hope for some gains in pastoral prices from world trade liberalisation.

5. External shocks of the magnitude of the wool price collapse peculiar to New Zealand are not very likely (although one could think of circumstances in which they might occur – such as local outbreak of foot and mouth disease).

6. However, undoubtedly there remains a danger that the exchange rate will remain overvalued, especially as a means of fighting inflation, and that will inhibit economic growth.

In summary, the apparent stability of the relativity is understandable. (Arguably it would have been stable from the late 1970s, if the exchange rate overvaluation from the mid 1980s had not occurred).

Can New Zealand lift its OECD relativity further than implied by the above. Much of the rest of the book addresses the problem, albeit in the context of a better quality growth. It may be argued that there is little New Zealand can do to recover its lost relativity – after all everything it can do, the rest of the OECD can do just as well. Even so the policies are probably necessary for it to retain its place. And perhaps with a little bit of cunning – using the peculiarities of the New Zealand economy – quality growth can be accelerated.

Endnotes

1. I have adjusted for the 1977/8 year for which, following careful analysis, I conclude overestimated the volume contraction by 1.5 percentage points. In Stormy Seas p.281-283. The adjustment makes little change to the shape of the story being told, but it can affect some quanta.
2. In Stormy Seas discusses a measure bias .3 percent from not allowing for sufficient quality change in the service (including the public sector).
3. In Stormy Seas p.73-88, 139-168.
4. A professional statistician would avoid using rankings, not only because they provide less information than the relativities, but because an ordinal scale is more difficult to work with than a cardinal scale. The popularity of the rankings, given that the relativities are as easy to derive, provides a clue that the users are not professional statisticians. But the same applies for economists. While the Treasury reports New Zealand’s GDP standing in terms of place in the OECD, when it comes to assessing the prospects, ranking gets abandoned and its analysis (rightly) is in terms of the actual GDP and the extent to which its growth can be accelerated.
5. This point escaped Treasury economist, Peter Mawson, who dealt exclusively with rankings, and then wrote ‘Brian Easton states that “The economy lost its placing following two major shocks – in the late 1960s when the when the wool price collapsed, and the late 1980s when there was a grossly overvalued real exchange rate” as already discussed, the first of these explanations is to some extent apparent in the data displayed in [Mawson’s] Figure 1.The latter explanation is not really supported …’ It is clear from the text – indeed all my writing – that I am referring to the relativity not the ranking.
6. There may be a caveat to point 6. The addition of the new countries to the OECD data set suggests that the 1973 oil price shock may have been more important – although In Stormy Seas explored the hypothesis and found little evidence for it.
7. Providing broad statistics for only 1870, 1913, 1929, 1950, 1973, 1990, 1998, and in little country detail.
8.Australia was not hammered in the way New Zealand was, partly because wool only half as important in its exports, but mainly because its fine wools for clothing did not suffer the big price drop that New Zealand crossbred wool for carpets experienced.

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Third draft of Chapter 1 of Transforming New Zealand. Comments welcome. (Second Draft).

Keywords: Growth & Innovation;

In recent years the focus of economic policy has been on increasing GDP, which is a measure of the material production of the economy. The shrillest cries were that New Zealand should accelerate its GDP growth rate to rejoin the top half of the OECD on a per capita basis. As one business journalist, more noted for her rhetoric than her insight asked ‘what could be simpler than that?’ And she was absolutely right for the simple minded who had little conception of what constituted GDP or of how it might be accelerated.

Those with a more sophisticated turn of mind, might ask whether per capita GDP is the right indicator, and were it whether policies which accelerated it relative to other OECD countries were successful, why the others would not pursue the same policies and so neutralise the relative advantage. (They might notice too, that the proposed policies had little analytical or historical justification, but they certainly advantaged the advocates and their employers.) But the relevance of GDP is the first issue.

As every first year economics student knows GDP has numerous fundamental deficiencies as an indicator of national welfare. The public knows too because there are numerous books on the topic. The deficiencies are summarised in the appendix to this chapter. What must be reiterated is that GDP was devised for one purpose – the macroeconomic management of employment and inflation – where to this day it remains a powerful and useful measure. However the measured also became used – on far more tenuous grounds – as one of national welfare.

But is it? Nothing in the construction of the index is going to tell us how it relates to the lives of ordinary people. At issue is the empirical relationship between them. So what is the evidence?

GDP and Wellbeing

Nineteenth century economists tended to focus on material output, assessing how well off someone was by the amount they could consume. Given the much higher levels of hardship of their day, that notion was perhaps justifiable. But it still dominates today’s economics. Pushed, an economist might say it is better to have more material goods and services than less, and if all the other things which make up human happiness are assumed as given, higher material consumption is better.

Economists – or at least the good ones – have been aware of the importance of the assumption, but until recently they were not able to evaluate it in any scientific way. Now that we can, we find that ‘more means better’ proves to be only marginally correct, and that it is not nearly as important – directly anyway – as economic policy assumes.

A major source of evidence comes from an official US survey which each year asks whether each of the 1500 odd respondents were ‘happy’. (The question is motivated by the US Declaration of Independence that among ‘certain unalienable rights’ is ‘the pursuit of happiness’.) Since the questions have been asked over a number of years (together with a whole range of other personal variables), it is possible to study the trends and associates of happiness. Of course, happiness is not quite the same as personal wellbeing (consider a person on a psychedelic high). But the survey raises serious doubts about the importance of material consumption (and hence GDP) as a good indicator of wellbeing.

For instance, US citizens are no happier today than they were in 1972, when the survey began (or even back to 1946 according to older surveys), despite major increases in material consumption and GDP per capita over the period. There are differences between groups is even more puzzling. Men report themselves less happy than women, but over the period they have been getting slightly more happier and women slightly less happy (so the gender difference is converging). This is an astonishing finding, given the social changes over the last three decades are generally thought to favour women. No one is sure why. A cynical possibility is that ‘women’s liberation’ is making women as unhappy as men. Another non-obvious outcome is that happiness changes over a lifetime, initially decreasing as one gets older, hitting the bottom in the thirties, and rising thereafter.

But surely the most surprising finding – to those who think GDP is important – is that while real incomes have risen over the quarter of a century, average happiness has not. If we look at any point in time (‘cross-sectionally’, as the jargon says, rather than ‘longitudinally’, over time) we find that there is a very slight improvement in happiness for those with higher incomes in the community. The effect is small. By comparison consider the advantage of extra income to the advantage of being married, for respondents report being married is a much happier state than being widowed, separated, divorced or never married. (That is an average, of course. As Jane Austin reminds us, ‘happiness in marriage is entirely a matter of chance.’) Economists calculate being average married generates the same additional happiness as an additional income of $US100,000 a year. These figures apply for the US, but some less comprehensive European data generally supports the broad conclusions. (The annual sum capitalises to at least a $1,000,000. Look at the (average) spouse and think ‘you’re a million dollar baby.’)

Economic variables over which the government has some influence, and which give a much better increase of happiness than income, is the more years of education the happier. It is also happier to have a job (for the same income). This last result is intriguing, for it suggests that work is valuable in itself, and that job creation may generate greater happiness, even if that reduces average incomes. (However I would not jump to the conclusion that make-work schemes or low paid jobs are necessarily a good thing. Other studies suggest that work has to be seen as socially valuable. )

More recently the World Values Study asked people in many different countries ‘are you happy’ and ‘are you satisfied with life’. In 1998 (not a year of outstanding economic performance) 95 percent of New Zealanders said they were ‘happy’, which put them second equal in the world with Switzerland and Sweden, just behind Iceland. Some 84 percent said they were satisfied with their life. That is 14th in the world –– in the middle of the OECD. The divergence is intriguing suggesting that there are a lot of New Zealanders who are happy, but striving for better.

That New Zealand ranks higher on these measures than it does on per capita GDP is perhaps no surprise given the deficiencies of the measure. There is not a very good correlation among the rich OECD countries: The responses of New Zealand and the US are much the same even though US per capita GDP is about 40 percent higher than New Zealand’s.

Intriguingly there is a relationship between material production and happiness for those countries whose per capita GDP is less than 70 percent of New Zealand’s. It would appear that economic growth in poor countries increases happiness and life satisfaction. As a country gets richer, growth does not. This suggests that the nineteenth century equation of additional consumption being directly associated with a better quality of life may have been correct. But many economies have grown well pass that condition.

While there does not seem to be any connection among high income countries between wellbeing and measures of civil liberties and political rights (perhaps because the differences are too subtle to catch by statistical indicators), those in poorer countries with democratic institutions seem to be happier. Not surprisingly being in a Communist nation depressed the responses, although (sadly) happiness and satisfaction deteriorated when they threw off their Communist regimes. Regrettably the studies have not yet investigated the extent to which high employment and low unemployment affect happiness and life satisfaction. An eyeball over the data suggests there may be a statistically significant correlation, although the effect of superior labour market conditions may not be strong.

Would changing the material output measure from GDP to one of the host of proposed alternatives such as Net Economic Welfare (NEW) or the General Progress Indicator (GPI) change the conclusion? Probably not. Their focus remains on material consumption valued in a particular way. The indications are the richer nations have moved on past the simple utilitarian equation of more goods and services means more happiness. What is it to be replaced with?

An Alternative to Material Output: Functionings

The economist with the high standing who has written most about alternatives to material output is Amartya Sen who starts with the notion of ‘functionings’ which summarise the life a person might lead. Some functionings are elementary: being well nourished and disease free. Some are more complex: having self respect, preserving human dignity, taking part in the life of the community.

The list has echoes of Abraham Maslow’s hierarchy of needs:

High level needs
– need for cognitive understanding;
– need for self actualisation;
– esteem needs;
– needs for belongingness and love;
– safety needs;
– physiological needs.
Low level needs.

Observe that measures of material output such as GDP only directly address the lowest – and possibly the second to lowest – needs on the hierarchy, again warning us that we should not get obsessed with GDP.

Sen then introduces the key notion of ‘capability’ which refers to the alternative functionings (‘life choices’) a person might have. His notion of wellbeing is not what you consume (‘opulence’ as Sen calls it) but the choices (or ‘capabilities’) the individual has. These are:

(1) Political freedoms: ‘the opportunities that people have to determine who should govern, and on what principles, and also include the possibility to scrutinize and criticize authorities, to have freedom of political expression and an uncensored press, to enjoy the freedom to choose between different political parties, and so on.’

(2) Economic facilities: ‘the opportunities that individuals enjoy to utilize economic resources for the purpose of consumption or production or exchange.’

(3) Social opportunities: ‘the arrangements that society makes for education, health care and so on.’

(4) Transparency guarantees: ‘the need for openness that people can expect: the freedom to deal with one another under guarantees of disclosure and lucidity.’

(5) Protective security: ‘needed to provide a social safety net for preventing the population from being reduced to abject misery, and in some cases even starvation and death. Its domain includes fixed institutional arrangements such as unemployment benefits and statutory income supplements to the indigent as well as ad hoc arrangements such as famine relief or emergency public employment to generate income for destitute.’

So material consumption is only a part of the totality of capabilities.

Like the New Right, Sen talks of ‘freedom’ and ‘choice’. But unlike the New Right, Sen does not assume that if everybody has ‘freedom’ (in the New Right sense) in a ‘free’ market they will all be better off. Sen is an expert on inequality, and he knows ‘free market’ outcomes will have some people worse off (as happened in New Zealand in the 1980s and 1990s). But the capability approach also diverges markedly from the New Right when it concludes that government spending (on education, on health care, on other things such as the environment, culture and recreation facilities) can enable individuals to do and be so much more.

The logic of Sen’s approach led to the World Bank developing a Human Development Index’ (HDI), which is intended to replace GDP per capita as an indicator of the state of progress of a nation. It combines per capita material output with measures of educational and health achievement. Thus a rise in life expectation increases the HDI even if GDP per capita goes down (because the same output has to be shared among more). Literacy is there because the capability markedly affects our ability to flourish and enjoy life. The index has to be simple, because most countries do not have complicated statistical bases. Had it been practical, Sen would have wanted a measure of the differences between men and women, which can be grotesque.

Sen’s concerns are illustrated by Kerala, one of the poorest states of India, nonetheless has a life expectancy of over 73 years, not too different from the New Zealand’s 76.9 years. In contrast, US Afro-Americans, living in some of the richest cities in the world, have a shorter life expectancy than those in Kerala. Despite its material limitations, Kerala has organized itself – especially its education and health systems – to give its residents substantial freedoms.

New Zealand is 19th in the world on current HDI standings, three above its GDP per capita ranking. (The biggest divergence in the country rankings is for South Africa, whose HDI ranking is a whopping 44 places below its GDP per capita ranking, a terrible indictment on apartheid’s record on health and education, that will take generations to repair.)

However, the World Bank’s interests are poor countries, and the index is not be very good at discriminating between rich countries. How might we elaborate the HDI approach for rich countries?

At the very minimum we might want to add two further diversity for choice; and leisure to the World Bank’s three of material consumption, health, and education.

Choice is key to Sen’s account of human wellbeing. Health, education and leisure all enhance choice, but we need a measure which directly indicates the possibilities. There is no diversity component in the HDI, because it is difficult to measure even in rich countries. Relevant are such factors as ethnic and religious diversity. Opportunities for women and the disabled are good tests too. Richard Florida proposes a ‘bohemian’ index based on the ‘number of writers, designers, musicians, actors and directors, painters and sculptors, photographers and dancers’. Perhaps we should be less precious and extend his bohemian index by include sportsmen. Whatever, choice is hard to measure, although we would miss the point of human development were it left out.

American workers work 1867 hours a year, Dutch ones work 1347 hours, some 28 percent less. In fact hourly labour productivity in the Netherlands is higher than the United States (by almost 17 percent) even though GDP per capita is lower (by 23 percent). The Dutch have chosen to take out their higher productivity with more worker leisure, rather than more material consumption. It is a valid choice, and needs to be included in any index of human development. Ideally hours worked should include travelling time to and from work, and adjust for forced leisure from involuntary unemployment. (New Zealanders seem to work slightly longer than the OECD average, so unless involuntary unemployment is low – probably not – and travelling time to work is low – possibly – New Zealand’s leisure is not especially high.)

However, while such extensions may be useful we should not forget that Sen also assumed that some basic conditions – effective civil rights; personal security; national security; environmental sustainability – were also attained. In respect of some New Zealand must already be well above the OECD average.

Rawles’ Approach

The American philosopher, John Rawles, added the further requirement that we should judge society by how it treats its weakest. He argues that if we were choosing the best society from behind the veil of ignorance when we did not know whether we whether we would be rich or poor,, able-bodied or disabled, white or black, man or women …, we would choose the society which gave us the best deal if we ended up among the worse off, fearing that state more than the benefits from the being in other states much better off. (Many people find this exercise in empathy – Adam Smith’s term – difficult, as when an affluent able-bodied Pakeha male cannot comprehend the situation of a poor disabled Maori woman. It is worth asking oneself when you are being harangued, whether the sermoniser has any conception of life other than the one they have lived.)

Even so, practically applying the principle is problematic. Just who is worse off? An affluent elderly woman about to be robbed and terrorised may be worse off on that day than the poor young burglar.

The Rawlesian principle may seem to result in everybody have the same material standard of living. Leaving aside that it is difficult to compare the needs of different people, the principle also allows inequality – that is people on higher standards of living than the poorest – insofar as it is in the poorest’s interests. The reward of higher incomes is an incentive to work more, to invest more, and to innovate more. Thus from one’s veil of ignorance one may prefer a society in which the highest incomes are $1000 a week, or whatever, if that means that the lowest income is $200 a week, rather than the $100 a week if there are few incentives to produce more so the top income is $300 a week.

Insofar as the Rawlesian critique has force, any index or well being – even GDP per capita – should be adjusted to reflect the situation of the worse off. It would undoubtedly lead to a very different ranking among OECD countries.

The Alternative: The Vision Thing

But trying to construct an index which gives a unique non-controversial assessment of how well a country is doing may be, or how well it compares with other is the sort of impossible task the small minded take on, never realising its fundamental impossibility. For various reasons such indexes may be helpful, but they are not definitive.

An alternative approach is to settle on a non-quantitative vision, which describes the sort of society that is wanted. Of course it will be harder to assess whether it has been attained, but that is because it captures nuances which no index can. The current New Zealand government’s Vision for New Zealand was set down in the 2002 document Growing an Innovative New Zealand and repeated in the 2003 document New Zealand Sustainable Development Programme of Action.

The Vision for New Zealand

• A land where diversity is valued and reflected in our national identity.
• A great place to live, learn, work and do business.
• A birthplace of world-changing people and ideas.
• A place where people invest in the future.

We look forward to a future in which New Zealanders:

• celebrate those who succeed in all walks of life and encourage people to continue striving for success
• are full of optimism and confidence about ourselves, our country, our culture and our place in the world, and our ability to succeed
• are a nation that gains strength from its foundation in the Treaty of Waitangi and in which we work in harmony to achieve our separate and collective goals
• are excellent at responding to global opportunities and creating competitive advantage
• are rich in well-founded and well-run companies and enterprises characterised by a common sense of purpose and achievement, which are global in outlook, competitive and growing in value
• derive considerable value from our natural advantages in terms of resources, climate, human capital, infrastructure, and sense of community
• cherish our natural environment, are committed to protecting it for future generations and eager to share our achievements in that respect with others
• know our individual success contributes to stronger families and communities and that all of us have fair access to education, housing, health care, and fulfilling employment.

My only grumble about this vision is that it does not incorporate the vision the 1972 Royal Commission on Social Security who wanted a society in which ‘within limitations which may be imposed by physical or other disabilities, that everyone is able … to feel a sense of participation in and belonging to the community’. Their view is closely realted to the Rallesian view. I think it a pity it is not there, and in truth, I suspect also does the majority of the cabinet and the majority of New Zealanders.

Let me, however, not climb onto the pulpit and preach. Rather this technician proposes to accept the current vision, and write a book about how it might be implemented, albeit mainly from the perspective of economics policy. We shant ignore indicators such as GDP. But we will not build a policy focussed solely upon them.

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Prologue of Transforming New Zealand. Comments welcome.

Keywords: Growth & Innovation;

After this book had gone through its first draft, the Growth and Innovation Advisory Board, which provides a private sector policy perspective to the government’s economic strategy (and of which I am a member), released its ‘Growth Culture’ study which described the public’s attitudes to economic growth. The report is rich in detail but its main findings were the public was not enamoured with the notion of growth as a key policy objective, and was tired of being told that they had to make sacrifices to increase the economic growth rate.

The conclusion was somewhat of a shock to the economic elite who have been advocating policies to increase economic growth. Don Brash, economist leader of the National Party and past Governor of the Reserve Bank, sorrowfully concluded that New Zealanders did not understand that growth delivers them the things they want. In a similar vein Simon Carlaw, then Chief Executive of the lobby Business New Zealand, remained committed to economic growth, grumpily remarking that ‘it may seem strange not to be able to talk directly about economic issues, and to recourse to speaking about values in order to talk about them’ (a view which, incidentally, this book rejects).

Other responses from the policy elite more thoughtfully responded to the public’s concerns . Apparently a large proportion of them did not like the current economic discourse. It was not merely that they did not like the policies that were being contested: the public objected to the framework, particularly the dominance of GDP – the economist’s main measure of material production – as the primary economic goal. There seemed to be two major issues.

First, the public had little faith that GDP actually measured what they valued, believing it included ‘bads’ (such as traffic congestion) as well as goods. Thus they were not objecting to growth of something – to having more rather than less of things they valued. At issue was what was in the package that defined the something. A revealing insight was there was a widespread belief that economic growth would not increase spending on the health and education services which the public valued.

Second, they were tired (I think that was a fair summary of their tone) of being told they had to abandon what they valued in order to accelerate the growth of GDP. For instance, calls that lower taxation was necessary for higher economic growth, implied the public would have to reduce the public spending on things it valued and wanted more of. This may be where the disjunction between growth in output and growth in health and education spending came from, for they had been told that public spending on these had to be cut back to generate further economic growth.

Perhaps there was a third concern. The policies that were being articulated were descendants of policies which had been implemented in the previous two decades. Yet the historical record had been of a relative decline per capita GDP (and an absolute decline for five successive years). The demand to return New Zealand to the ‘top half of the OECD’ ignored that New Zealand had been there in the early 1980s. The wish to repeat the policies associated with the decline, without confronting their apparent failure, gave the public little confidence in the advocates. Moreover, and rather blatantly, the implementation of the policies gave their advocates (or their employers) immediate gains at the expense of the rest of the public, but only promised the wider benefits at some stage in the future, promises which had been rarely fulfilled in the past. The advocates were asking the public to make short-term sacrifices but were not expecting the same of themselves.

We have then a major disjunction between the policy elite and the public, one which had been evident enough to those policy advocates who came down from the bully pulpit and listened to their parish. In a curious way economics has been a religion of the late twentieth century insofar its practitioners thought it provided a sort of moral guidance as to how to behave socially. It was a hell and brimstone approach. If one did not take their advice the eternal damnation was poor economic performance. And just as the past clergy seized ignorantly on an unconnected event – such as the plague – to justify their advice, today’s policy advocates make tenuous links between events such as poor economic performance and their particular preference for, say, lower taxation or privatisation. At least the ancient priests were not direct beneficiaries of the moral direction they gave their flock.

Does this disjunction mean we have a standoff? Ultimately the policy elite will have to bow to the wishes of the democracy as political parties – but not all politicians – learned in the 1990s. But the tensions in the interim will be great, and result in – if one may use the term – ‘inefficient’ policy outcomes, that is practically possible outcomes inferior to that desired by the elite and the public. In particular the public’s antipathy towards the proposals of the policy elite may result in our throwing the baby out with the bathwater.

Undoubtedly there are among the policy elite those who are adapting their policy stance to one more in line with what the public want. Some may be doing so merely by changing the words – the wrappings around their package. Others will be assessing the package itself.

In one sense, this book might be thought of addressing the policy advocates, but it has a wider purpose. It has always seemed to me that the public deserves to – and needs to – understand the economy better. There are rules about how economies work – rules, I add, which are not always accepted by those in the policy elite. There are also options and directions available for we have choices albeit, so the rules tell us, not unlimited ones. A better understanding should mean better policies and better – in the sense of ‘more desirable’ for the public – economic outcomes. Thus this book is intended to improve public understanding of the economic policy debate and to enable them to contribute to it in a constructive way.

So what it its stance in regard to the Growth Culture’s findings? First it accepts agree that GDP is not a very good objective for economic policy. I set this argument out in the next chapter, but to summarise GDP is a poor indicator of the quality of life, especially in a rich economy. If an policy which increases in material production (which is what GDP measures) involves a reduction in the quality of life then I would eschew that policy. As I will suggest we really need a better measure of what we mean by economic growth, but there is no really acceptable one on the horizon.

But I am committed to economic growth if we define it properly. Quite frankly we have no option. Well – it is never quite true there is never any option. In this case there is perhaps the option of isolating New Zealand from the rest of the world, and refusing to admit new technologies or of generating them ourselves. Not only is this impractical, but the economy would not just stagnate but regress, because we would find it increasingly hard to pay for the imports that we need.

The practicality of such isolation is so low, that it is not worth exploring the scenario. Mentioning it however, underlines that at the core of economic policy is change over which economists have little control. Not just technological change in the narrow sense of what science and engineering generates, or even in the wider sense to include the social technologies of the way we organise society. There is also demographic change, social change and changes in taste and fashion. Sometimes political changes – war or peace, boundary changes – are important, although fortunately they have had little impact on New Zealand in the last half century.

Many – but not all – of these changes impact on the economy, so it is continually accommodating to them. As it happens, the changes are often beneficial with the consequence that the economy is able to produce more goods and services with less resource inputs. Sometimes the changes are detrimental to the economy and to society. The invention of nuclear weapons was a technological change that could hardly be described as beneficial., even were its consequences substantial. One can think of numerous technological and other changes of somewhat smaller magnitude with benefits offset by detriments. I have yet to be persuaded that the rise in the demand for whale oil in the nineteenth century was in the interests of whales.

The perspective here is a rather different one from that which is thundered from the pulpit. It sees economic policy largely about dealing with these external changes and their consequences. But there is a need for principles to guide the responses. Economists generally operate on the basis that the aim of policy is to make people better off, albeit with the caveat that we getting a bit vague when some people are better off and some worse. A very crude measure of whether people will be better off is the quantity of material production, of which GDP is a measure. Thus there is a sort of convergence between the growth advocates and this approach. Each is concerned with increasing material output.

However there is a limit to the convergence. The growth advocates’ rhetoric is that growth is a good thing, and should be strenuously pursued. The approach here is that growth is a consequence of responding to the technological and other changes which impact on society. Moreover the growth may be assessed in different ways from the two perspectives. The rhetoric of growth advocates accepts uncritically that material outputs measures such as GDP give an unequivocal indicator of success. The alternative approach has that the material output indicators are useful but not decisive.

A major divergence between the two approaches is that the growth advocates are always promising that the adoption of their policies will accelerate economic growth. Not that they deliver. (One is reminded of the woman who sued for divorce from her economist husband on the grounds on non-consummation. ‘He would stand naked at the end of the bed promising that things would get better but nothing else happened.’) The alternative sees that much policy is simply about trying to keep up with change, without any promise of there be an increase in the growth rate.

For example, I have been marginally involved in the proposals to reform the 1960 Archives Act. It will not add to economic growth, nor reduce the demand for inputs. The justification is that archives knowledge and circumstances had changed in the 40 years since the act was passed, the most noteworthy change being the plethora of electronic archives.

Or consider the Credit Contracts and Consumer Finance Act 2003, where again I was marginally involved in its replacement of the Credit Contracts Act 1981 and Hire Purchase Act 1971. A score and more years after they were passed they had become increasingly obsolete. Again I make no claims this would accelerate economic growth measured by GDP. But I hope it gives people on the margins better access to credit. (The credit markets for those with adequate assets were working fairly well. One design problem was how to avoid raising the compliance costs in that market and maintain its responsiveness and flexibility, while giving those with poor security a better deal.)

Of course, sometimes a policy change may contribute to an acceleration of economic growth, but that is rare. More often, if there is not some sort of change the economy will slow down, missing opportunities that other economy’s will seize upon. So economic policy is usually about maintaining existing levels of economic growth, not accelerating it. An even more pernicious claim is that it will accelerate it faster than other countries. But if the policy is so successful, why wont other economies also adopt it?

In many ways being in a modern economy is like riding a bike. If one does not go forward, one is likely to fall off – with severe repercussions. But note this. No, I write BUT NOTE THIS:

While the cyclist and the economy must go forward, there is a choice of where to go forward.

Those who say there is but one way to go, with them on a comfortable saddle steering the operation (while the submissive rest of us provide the power to turn the pedals for little reward) are either dishonest, if they know there are alternatives, or, if they do not know, they are incompetent. There is a role for the honest competent economist to help control the bike, and of course he or she will have their own views as to where it should go. But they have no special expertise in deciding where the bike should go, even if they can say that some options are not available, such as trying to stay where we are.

What worries me is that there is an undertone in the responses to the Growth Culture survey which suggests that some people would rather the economy stagnated – the bike fell over – than go down the route of the growth advocates’ rhetoric. Fortunately there is more choice. Most of the respondents showed a willingness to engage with the economy, to ride on a bike going somewhere, providing they had some say in its direction, some contribution to its performance rather than just the hard grind, and some actual – rather than promised – benefit.

Understandably many respondents expressed a considerable nostalgia for the past. Of course the bike went along some pleasant routes, although we often forget the hardships. But we cannot circle back, and ultimately most of would not want to (other than the desire to live our life over again) because we value so many of the changes that have happened since. Ideally, but unrealistically, we would like to be able to select the bits from the past we valued and the bits form today we valued, and the possibilities from the future that we expect to value. That, sadly, is not an option, but the nostalgia needs to be understood and respected. Sometimes it will influence the direction and speed of the bike, as when we resist the destruction of a heritage building or a valued environment in the name of progress.

The difficulty with choice of paths, is that the road map plus the pedalling and steering directions are complicated by the options. So here is what the book is going to do. First it has to decide on a general direction. The next chapter does this by starting with the path of increasing GDP and explaining why it may not be the best choice. After looking at other single indicators it selects the approach of the current New Zealand government as to the objectives of economic (and broader public) policy. It does that because the government choice has been derived by a democratic – albeit imperfectly democratic – process, but also because the principles seem to be consistent with the New Zealand public’s core beliefs as uncovered by the Growth Culture survey.

After that chapter the book uses the writer’s expertise to suggest what economic (and sometimes other) policies might be helpful in pursuing that goal.

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