Chapter of TRANSFORMING NEW ZEALAND. This is a draft. Comments welcome.

Keywords: Growth & Innovation;

It is dangerous to focus – as the last chapter had to – solely on the aggregate economy. Being excessively aggregate means that some of the most important features of the economic transformation are ignored, especially how a small part of the world economy – New Zealand – can grow at a different rate from the world as a whole. The growth occurs in businesses, and so we need to think about how businesses grow. However being too disaggregated can also lead to misunderstandings. Some businesses grow at the expense of others, as they increase their market share. But we need not be detained by such activities despite their being important in terms of inter-business competition, indicative of business striving.

Sectors in Economic Growth

The useful level of disaggregation is economic sectors, which is a part of the economy with certain common characteristics so that the sector can be treated as unity for the particular analytic purpose. Since the purpose will vary there are a whole range of possible sectors. As the highest level the division is sometimes between the primary, manufacturing and service sectors. But for some purposes the primary sector may be divided into agriculture or farming, fishing, forestry, mining, …. The farming sector itself can be divided into pastoral, horticultural, cropping, farm services … In turn the pastoral sector can be divided into dairying, sheep, cattle, dairy, goats, horse … And so on. The term ‘sector’ is thus very flexible: its importance is that we can think of all the sector’s businesses (or divisions of businesses, where one overlaps sectors) functioning in a similar way. (Sometimes the text will refer to ‘industries’, a term usually interchangeable with ‘sector’. If there is a distinction, it is that industries tend to be smaller than sectors.)

The fundamental point, overlooked by the aggregate analysis, is that different sectors grow in different ways, under different circumstances, and at different rates. Aggregating them together, as the theories of the last chapter did, obscures these differences, losing the heart of the growth process.

These sectoral differences become overwhelmingly important in regard to the difference between those which mainly supply the domestic economy and those which export. The growth of the retailing sector will primarily be determined by the growth of the domestic spending of New Zealanders (tourists make a small difference), which will be primarily dependent upon the growth of their incomes, or overall economy. On the other hand the film-making sector sells mainly overseas, so its growth will depend upon film demand in the world economy. It hardly matters to the film making sector whether New Zealand stagnates or grows at 10 percent p.a.. The same applies to the dairy sector, which is dependent upon the growth of overseas’ accessible markets. But it also is limited by biological constraints in its production of its base raw material milk. (It can add more or less value to the milk – as when it strips out some chemicals from the milk to create pharmaceuticals.)

The term ‘tradeables’ is sometimes used to describe those sectors (or products) which are primarily involved in the external sector of the economy and ‘non-tradeables’ for those more domestically oriented. The tradeables can be divided into ‘exportables’, that is exports and home supply of export like products such as butter, and ‘importables’, which compete against imports or supply from overseas. Historically importables – the import substituting sectors – were an important part of New Zealand’s economic growth. But over the last two decades, their protection from overseas competition (particularly by the use of import controls and tariffs) was stripped away and today the importable sector is much less significant. That does not mean importables should be totally ignored, and certainly they should not be unnecessarily discouraged. But in today’s New Zealand the tradable sector is primarily about exports.

If the growth of non-tradeables is dependent upon the growth of the economy as a whole, then non-tradeables cannot determine the economy’s economic growth. There is a sort of ‘bootstrap’ approach which says that if we can get the non-tradeable sector to increase its growth rate that will lift the overall economic performance. (It is like climbers lifting themselves by pulling on their bootstraps.) The difficulty is that higher domestic growth sucks in imports, but fails to provide the wherewithal to pay for them. So bootstrap strategies generally come unstuck. The imports of larger economies can stimulate enough growth in the countries exporting to them, to result in almost enough exports to pay for the imports. Additionally, if they are the US, and perhaps increasingly the European Union, they can issue the currency to pay for the extra imports. Alas, there is not the same world demand for the New Zealand dollar.

(Advocates of bootstrapping tend to support protection in order to prevent imports from flooding in. The protection issue is discussed in a later chapter – the main point being whatever its merits, it is not a very practical option. Moreover, the growing domestic industries in a bootstrapped – or indeed any – growth usually require imports as vital inputs, which limits the suppressing of importing via protection.)

If small economies such as New Zealand wanting to accelerate their growth rate are handicapped in bootstrapping their growth, they have an advantage on the export side. A small country can more easily increase its share in foreign markets. Not all of them. New Zealand is unlikely to markedly increase its market share in Pacific Islands or Australia for the share is already high. But the country’s exports to the enormous and rapidly growing Chinese market are minuscule. New Zealand businesses could double them, and hardly anyone would notice. Nor would the rapid growth drive the sales price down against the New Zealand supplier.

So a consequence of disaggregation is that it draws attention to that not all sectors are equal for they have different roles in economic growth. As a general rule the sectors which can accelerate the growth rate of a small economy are the tradeables ones – usually nowadays exportables, but sometimes importables. They can grow faster than the world GDP by increasing their share of foreign markets and at the same time contribute to the funding of the imports the domestic sector needs.

But if the tradeable sector can accelerate economic growth, poor performance in the non-tradeable sectors can hold it back Poor productivity growth means they can absorb resources that the fast growing tradeable industries need for their expansion. Poor quality service by those which supply the tradeable sector (e.g. the telecommunications sector or the financial services sector) can undermine the ability of the faster growing sectors to respond to overseas market changes. One has to think of the different sectors as a team, with different requirements. But not everyone scores, but the grinders have as important a role on a racing yacht as the skipper and tactician. .

The Political Economy of Growth

There is one further implication of this disaggregation into sectors compared to the standard growth theory. Uncomfortably for the political process, the balance between sectors changes. The whole point of an economic transformation is that economy is different as a result. but the political process tends to favour the established sectors over the growing ones, and indeed the established and slower growing ones have the incentive to use the superior political position refelcting their past importance to pursue policies which benefit them in the short term, at the expense of the economy as a whole in the long term.

Even more fundamentally, successful political leadership is dependent upon a well functioning relationship with the existing political economy – and hence with the well established but slower growing sectors. Yet a growth strategy means they have to disturb that cosy balance, in effect undermining the very political bastions on which they depend. The easy solution is to articulate economic policies based on the aggregate growth theory of the previous chapter, since that obscures the fundamental structural changes that are required. The consequence is an unsatisfactory growth performance.

We saw this in the Muldoon era. Its growth performance, following the adjustment to the wool shock in the mid 1960s, was not bad – averaging about the same as the rest of the OECD. However Muldoon was reluctant to take the more-market measures necessary as the economy got more complex. It was partly because he was more comfortable with an older paradigm and which was more distrustful of the market, but he was also reluctant to disturb the political forces which had given him power. Since these forces tended to be the established sectors, Muldoon tended to be backward looking.

Muldoon’s dilemma is not unique, for it is faced by every political leader who has any ambition to stay in power. The short term tendency is to minimise political disruption, while long term success requires the politically disruptive transformation of the economy and the political actors which reflect it. Not surprisingly then, the political rhetoric tends to be ambiguous, and to require some subtlety of interpretation a subtlety which New Zealand political commentators are not noticeably good in identifying. Meanwhile the politician has the skilled task of walking away from the old political economy towards the new one with out alienating the old. As I argued in The Nationbuilders, the great political leadership in New Zealand came from both the left and right, but it controlled the centre while progressively moving it.

National-Sectoral Projections

Once upon a time, New Zealand economic management was very explicit about the role of sectors in the growth process. It sort of arose out of indicative planning, which was a popular notion in the 1950s and 1960s, but it probably still has a role to play today. The last major attempt was a ‘national-sectoral’ projection published in 1991. Here is a simplified account of what was done.

The economists asked each sector of the economy what was its sustainable growth rate. Typically, the domestically oriented sectors said they could grow at virtually any rate if the domestic economy did. Some asked for subsidies – they always do. Some drew attention to government policies which were practically inhibiting their growth. (For instance, today the biotechnology sector might say that the regulatory framework had high compliance costs compared with key overseas competitors).

The export sector responses were more restrained. Some said their sustainable growth depends upon the growth of world markets. (If one is exporting to saturated markets in Australia, then the exports are likely to grow at about 4 percent p.a. at most.) Others – notably farming, fisheries, forestry – mention the practical biological limitations on their supply side. Some sectors cite supply restraints from other sectors – energy supply may prove to be a bit of a problem in the future, while the tourist sector worries about the availability of hotels and the capacity of airports. And, of course, there may be specific labour shortages – not all skill deficits can be quickly resolved – in addition to a total labour constraint. Similarly there may not be sufficient investment to meet all the requirements. (Can we build the power stations, hotels and airport extensions in time?)

The economists then took all these various sectoral projections and used a quantitative model to assess to what extent they were consistent with each other and an economy as a whole. (Would there be enough labour, enough investment, enough savings? Would the assumed prices ensure that sectors would be profitable?) After some iterations – going back to sectors where they seemed over-optimistic or unnecessarily pessimistic – the study ended up with an overall economic growth rate.

We can see this today in the projections for the energy sector. As I write (in mid-2003) they are predicated upon the growth of the economy of 3 percent p.a. (about the average growth rate over the last decade), and there are worries that there will be electricity shortage in ‘dry years’ (years in which the hydro lakes do not get filled as much as normal). Meanwhile the government hopes to accelerate the growth rate to, perhaps, 3.5 or 4.0 percent p.a. Not only is there an inconsistency between the two projections but it seems possible that if the weather is unfortunate, energy shortages may slow down the economy. Additionally, those who advocate higher growth rates – sometimes higher than the government thinks possible – ignore that with the running down of the Maui field, there will be a change to primary energy sources (coal will be used in some gas fired stations, others are to be closed down), but the petrochemical industry based on Maui will be closed and there will be a lost of export revenue. Another concern is if the energy sector meets the supply that the growth requires, there are going to be major investments. How are these going to impact on the economy? There does not seem to be any systematic analysis of these changes, and the focus on aggregate growth ignores a lot of the complications contending underneath.

Do not place too great emphasis on the precise quantitative growth rate of the projections. If targets worked, the Soviet Union would have been an economic success. But the exercise does assist thinking systematically and practically about economic growth. It does so by focussing on the different sectors, and their diversity of circumstances. It identifies practical policy issues which can be addressed. This is sometimes called bottleneck planning, that is identifying the obstacles which are retarding key growth sectors. Bottleneck planning does not require a national-sectoral projection framework, but the systematic analysis helps focus on the relative magnitude of the obstructions, and the potential return from addressing them.

There is a further advantage from developing national-sectoral framework, which if political should not be underestimated. By bringing the sectors together – that is business people, unionists, those involved in the social sectors, government officials, and politicians – it gives a sense of national purpose and direction. In the past the very activity of the players in different sectors coming together within sectors (as when business and unions work together to progress their joint sector) and between sectors (for the various business may not know a lot of what is going outside their sector) has social and national benefits. It is almost ironic that the focus on the disaggregated sectoral economy, leads to an aggregate unity, as the business community works together. It is a reflection of the more general phenomenon of aggregation (such as the centralisation by dictators) being intolerant of diversity resulting in a repressed social fragmentation and potential unrest. To an extent a market economy avoids this because it allows diversity through market expressions (if one has sufficient income to express oneself), but only where the market acts reasonably effectively.

Perhaps it should be added that these benefits are likely to arise most in small societies. As the society gets larger it is harder to maintain social cohesiveness. Thus the dominant economic paradigm tends to underestimate the political and social gains, from approaches such as national-sectoral projections, which can ultimately be converted into economic ones. It reflects the practicalities of large economies like the US, rather than small economies like New Zealand.

How Fast Can New Zealand Go?

A further advantage of a National-Sectoral Projection is that it anchors expectations about growth in a reality, since businesses can look at how reasonable the outcomes are – whether their markets can expand that fast, whether they can attain the productivity assumptions made of them, whether the investment projections look realistic. Even so the projected growth rates have tended to be on the optimistic side, although not as outlandish as those who do no calculations or depend only on aggregate calculations which hide a multitude of assumptions which can be tested.

Instructively, the 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. Perhaps the growth targets were over-optimistic, perhaps the government’s policies inhibited their attainment.

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. Economies can also be like that. 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. 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.

One does not know what the conclusions of a National-Sectoral projection exercise would come to today. But 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 turn a boom into a bust.

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Chapter 3 of TRANSFORMING NEW ZEALAND. This is a draft. Comments welcome.

Keywords: Growth & Innovation;

As in most human endeavours, a historical perspective is invaluable, especially since economic thinking on growth has evolved over the last forty odd years. Historically, economists concerned with economic growth focussed on the accumulation of capital. But in the 1950s there were two major developments in economic thinking about growth. The first, which had a microeconomics focus, was concerned with the allocation of inputs into production and the outputs that were produced. The second was concerned with the more aggregate (macroeconomic) concerns of technical progress. Each has an important role for capital accumulation, but it had a less important role in economic growth than in earlier theories.

The Neo-classical Theory of Markets

Practically one can see the transition from capital to allocation in the quarrel over the ‘Think Big’ energy intensive installations of the late 1970s and early 1980s. The chief advocate, Robert Muldoon, came from the old school with its focus on capital investment. The vision he represented was that the major projects were a marvellous opportunity to contribute to economic growth in New Zealand by increasing capital intensity.

The populace tends to support this major investment approach, but Muldoon was so unpopular the other side of the argument obtained some political leverage, even if their analysis was more subtle – sometimes to the point of obscurity. Essentially their (allocationist) ‘neo-classical paradigm of market behaviour’ amounted to questioning whether the Major Projects were the best way to commit the nation’s resources. (In fact the failure of ‘Think Big’ proved to be more about the manner in which the risks were allocated between the public and private sector when world energy prices fell. It was a classic case of the privatisation of profits and the socialisation of losses.)

The debate over Think Big resulted in a new generation of allocationists swept aside the old economics in 1984.. (The extremist allocationists are generally known as ‘economic rationalists’ but in New Zealand they tend to be called ‘rogernomes’. Of course not all advocates of ‘more market’ are extremists.) In the previous three decades economist had 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 (GDP). 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.

Providing it is not pushed to an extreme, there is much to be said for this approach. A properly working market system is a signalling device, in which the resource content of potential transactions are embedded in the price. It is a self-enforcing system, because a purchase involves exchanging money which represents a power to acquire resources for a product which has these resources. Thus there is an incentive for purchasers to go ahead only if they value the product more than the money they are outlaying. Such transactions involve an improvement in material welfare of each of the transactors – and in a sense for the economy as a whole.

But there are all sorts of problems with this analysis. Many will become apparent as the book progresses, but important ones are prices may not embody all the resources of social value (such as environment, culture or life itself). Moreover is the system need not be fair. On the other hand the alternatives to the complete elimination of the market system are not that attractive either. In the end we combine a market system for many areas of the economy with the more bureaucratic management for others. Many of the market liberalisations which occurred in the 1980s made good sense from this perspective although some were unnecessary, to be justified by ideological extremism.

What is astonishing is the poor growth record following the market liberalisation of the 1980s. In fact the New Zealand GDP per capita relativity to the rest of the OECD dropped 15 percent. The reason why is crucial in any debate on the economy, especially where further market liberalisation is being advocated. If the extremists got in wrong before, how can we be sure they wont get it wrong again?

While some of the more extreme market liberalisations may have damaged the economy, a moderate supporter of market reform might defend the reforms by accepting its allocative gains were small, probably in the order of one percent at most. (Some extremists talked of them giving a twenty percent boost to GDP.) The real justification for the reforms were more:
– 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. (The 1990s might illustrate the point for the economy seems to have operated more smoothly that in earlier years – although the big test is likely to be in the next decade.)
– they simplified the disinflation (the rate of inflation falling from around 15 percent p.a. to 2 percent p.a.) making it even less painful than it proved to be.

These are useful gains, which however have to be offset by many people appearing to be worse off as a result of the changes. For many of the changes also affected the distribution of income (and jobs). It seems that the market liberalisations generally had an enormous but erratic impact on the distribution of income, but the tax and benefit changes systematically favoured the rich over the poor. Moreover some jobs are less secure than they were before 1984 (especially in the public service) but other (typically private sector) jobs may be more secure, because they were not so vulnerable to being taxed out of existence to protect public sector jobs. (Central to the political economy of the growth process is that those who suffer from a change are almost always much more vociferous than those who benefit. When clothing tariffs were reduced, many garmentmakers found themselves redundant and publically bemoaned their distress. The public at large did not publically celebrate their cheaper clothes.)

These benefits and caveats, do not explain the economic stagnation. As this book (and elsewhere) argues, insufficient attention was paid to the external sector which is the engine of growth in a small open economy. More fundamentally, the neo-classical market paradigm is not particularly concerned with growth. All it was offering was a one-off boost from improved efficiency (which proved to be very small). Because policy focussed exclusively on market liberalisation and ignored the other prerequisites for growth policy (especially a viable exchange rate), the economy behaved exactly as the theory predicted. It stagnated.

The Neo-classical Theory of Economic Growth

About the same time as the neoclassical theory of markets evolved, a parallel but separate neo-classical theory of economic growth also developed. The growth theory assumed the conditions of the market theory, but it was not as static. As well as the theory’s elaborate mathematical analytics is an empirical finding due to Bob Solow published in a seminal paper published in 1957.

Solow’s central finding, replicated for many other data sets, for other periods and for other countries – including by Bryan Philpott for New Zealand – can be summarised as follows. Suppose the amount of capital and labour increase in an economy by 10 percent over a period. Then we might expect the economic output to increase by 10 percent too. In fact it increases by more than that 10 percent – significantly more. So there must be something else which is increasing output over time on top of the additional labour and capital and so on.

The paper described the other source of output, and hence the main source of economic growth, as ‘technical change’, a term which is often misused in such expressions as ‘80 percent of economic growth can be attributed to technology’. Solow defined his concept:

‘I am using the phrase ‘technical change’ as 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)

In fact the technical progress – today it is measured as ‘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 often 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. If it does, I think we can draw some crude but useful conclusions from the results.’

‘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’.

Exogenous Technical Change

There is an empirical feature of the research which has led to the notion of ‘exogenous’ technical change. Over time, after allowing for fluctuations caused by the business cycle, the growth of this mysterious residual (sometimes called ‘total factor productivity’) seems to be relatively constant – apparently constant enough to treat the change as exogenous and over which policy had no influence. There are data series which, perhaps tenuously, suggest the underlying growth may be constant over decades and even as long as a century. Of course there are caveats, some of which will appear as the argument develops, but it was almost as if the situation could be described in the following ways.

Think of ‘technology’ as a series of blue prints – plans which tell how to combine labour and capital to get an output (a metaphor owed to Joan Robinson). The amount of output for any given amount of capital and labour will vary. (Although the blueprints makes one think of the sciences based on physics, chemistry, biology and so on, the technologies they illustrate may also included social possibilities including such important social technologies as money, the market mechanism and property rights.) We then rely on the market mechanism (as analysed in the neo-classical theory of the market) to chose the blueprints – the technologies – which gives the highest output. They do so, because they give the highest return on the inputs.

However, at any point in time not all the relevant the blueprints can be known. The ‘exogenous’ technical change model might be thought of as someone at a counter regularly handing over blueprints for new technologies from a warehouse. Not all the blueprints handed over are used (since they may be less efficient than others), but in this story businesses snap them up, and the process of market competition means the most productive ones get implemented reasonably quickly. It would appear that the rate of release of blueprints are such that the residual increases at a fairly constant rate over long periods, although implementation processes and costs probably smooths any short term fluctuations. It may have been that in earlier eras – say before the industrial revolution – the flow of new blueprints was much slower. Possibly the industrial revolution depended upon the unlocking the counter which provides the blueprints.

This is a very simplified account of the implicit process of technological change which underpins the original neo-classical growth 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. And it seems to have the implication that policy can not influence the rate of technical change – that it was practically exogenous.

Endogenous Economic Growth

However at the micro-economic level – 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.

This insight has resulted in a model of ‘endogenous’ technical change and growth, in which the rate of technical progress can be altered. In the blueprint fable, assume there is no manned counter at the warehouse, which is instead an enormous labyrinth, with the unexplored parts badly lit, and piles of blueprints of technology which prevent access to more advanced blueprints. The process of technological progress involves individuals and firms going into the unexplored part, identifying potentially interesting blueprints, understanding them and implementing (commercialising) them.

The picture presented here 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; 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’ but the mind set probably involves the attitude of the community 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 instances those US metropolises which are more tolerant have a better economic performance.

Knowledge as a Pure Public Good.

Sitting behind this account of technology is the implication that because of the very nature of knowledge, it is not possible to regulate it entirely by the market mechanism. Not all knowledge can be given useful commercial property rights. (The rogernomes seemed to be antagonistic to intellectuals – something they shared with Lenin who said that after the revolution ‘first kill the intellectuals’ – because most of an intellectual’s output cannot be commercialised.)

It may even be a good thing that knowledge cannot be commercialised. Much (almost all?) is what is known as a ‘pure public good’, in that 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. (The term ‘good’ is being used here in its standard economic meaning as something which bestows some utility or benefit to its possessor. Thus a ‘good’ in this sense need not be tangible – it could be a service or idea. Nor need it be ethically ‘commendable’. Heroin is a ‘good’ in this sense.)

Consider a poem I much enjoy. But you can enjoy the poem too, without in any way infringing on my enjoyment. (Contrast a can of juice: if I drink it, 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 it.) It is important for these purposes to distinguish the artefact which represents a poem – say a page of a book – from the idea of a poem. The idea is different from the artefact, which is not a public good.. For instance the idea can be represented by another artefact, or can be carried in one’s mind, or voiced in the air – as was the tradition of the minstrel. (As a – possibly pregnant – aside, knowledge is the primary constituent of philosopher Karl Popper’s ‘third world’ of ideas, whereas the artefacts are in his ‘first (objective) world’ . His second world is the world inside the mind. It may be that the third world is (entirely?) made up of pure public goods. There are pure and impure public goods in the first world, as well as private goods.)

Insofar as knowledge is a pure public good the 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? Copyright payments via the artefacts which publish the poems provide some rewards, but in practice most countries have a variety of non-market rewards such as grants, subsidies, and prizes (which may be provided from public or private sources) to enhance the supply. Thus we need not be surprised that for knowledge creation there can be considerable non-market interventions to increase its production.

That this is not trivial is illustrated by what is currently happening to popular music. The world wide web and the CD means that the traditional means of pop stars funding themselves via royalties on recordings is collapsing, for their fans can digitally copy their works without payment. How the industry will develop is not at all obvious – but one suspects that measured by the monetary value of sales it will be a diminished one and the royalties for recording less. It may be that ultimately the fans will be worse off – unless some non-market interventions are instituted.

Much of economic growth policy is about the practicalities of interventions to provide and implement the knowledge – the technology, the blue prints – to enhance economic growth. There are particularities in New Zealand circumstances.

The Implications for New Zealand

Most of the economic growth debate has occurred from the perspective of the US economy. which is treated as the whole world. (In some respects it is, for it is so large and there are strong feedbacks between it and the rest of the world.) Thus the technology warehouse/labyrinth story refers to all the world and not just to a small country like New Zealand.

So how does the theory of endogenous growth and the difficulty of commercialising ideas apply to New Zealand? There are a lot of countries wandering around the technology warehouse. Much of what they find cannot be charged for. That can be true even when the ideas are embodied in artefacts. For instance, New Zealand has been a beneficiary of the computer hardware revolution – in particular the import and utilisation of increasingly powerful but nevertheless cheaper computers – even though it has not contributed much to its development.

The favourable terms which gave New Zealand these benefits are primarily the result of competition driving down the price. Producers cannot keep all the benefits of their innovations to themselves, even in the medium run. As a general rule technological innovation tends to benefit consumers in the long run, although in the short run the beneficiaries are often – but not always – the innovators, the producers, and the owners of relevant assets and human capital.

This has a very important consequence for growth rates of different countries. There is a tendency for lower per capita GDP countries, in the OECD anyway, to grow faster than the top income countries. 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 cost. because it is more expensive to find them in the ‘warehouse’ than it is to copy the finders. So countries lower in the technological pecking order have an advantage. in terms of the cost of access to technology, which enables them to catch up if their other conditions are right. Not surprisingly, the United States has been the most vigorous nation in the pursuit of the imposition of rigorous intellectual property rights in the international economy. Even were it fully successful it would slow down rather than stop the convergence process.

But as we saw, possession of the blueprints is not in itself sufficient. There is the task of implementing them, and that requires various other conditions such as the right labour force, and also intellectual property rights to protect the local innovator, issues to be considered in later chapters.

Nevertheless one might expect New Zealand research and development to be more concerned with technology transfer and less with technology creation than the US. In some sectors where there are particularities to New Zealand circumstance – 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. Thus the technologies cannot be imported. Indeed those industries where New Zealand leads the rest of the world have to have the most advanced technologies in the world.

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Appendix 2 of TRANSFORMING NEW ZEALAND. This is a draft. Comments welcome. (Some of this may be too technical to publish)

Keywords: Growth & Innovation;

Appendix I: The Maddison-OCD Data Base

Angus Maddison has provided a annual data base for production and population of the world economy between 1950 and 1998 (with some data going back to the beginning of the Common Era, but not continuously). [A. Maddison (2001) The World Economy: A Millennial Perspective (Development Centre Studies, OECD]

This date base differs from that used in In Stormy Seas as follows:
* the OECD has now expanded to include the Czech Republic, Hungary, Mexico, Poland and South Korea. In addition the German economy includes that which was East Germany before 1991. A further problem is that the data for the Eastern European Countries is provided annually from 1990 only, although it is possible to interpolate the data back to 1950.
* Individual estimates are not provided for OECD members Iceland and Luxembourg, but they are included in an aggregate of 13 smaller Western European Countries (most of which are minuscule). All 29 countries are included in the aggregate series described here as OECD.
* the data is available only to 1998, and was updated to the end of 2002 using the estimates and forecasts in OECD Outlook (a procedure similar to that used in In Stormy Seas).

Maddison provides two primary series: population in the middle of the year and GDP for the calendar year for the period from 1950 to 1998. The GDP is measured for all countries in the same common prices (purchasing power parity) based on the 1990 year, so the volume GDP series of different countries comparable. This is similar to using the same prices for GDP from different years, which enables in the volume of production (real GDP) to be compared through time without being obscured by changes in prices and inflation.

The database also gives the ratio of the two series as GDP per capita. This ratio is often used as a measure for economic performance. A high figure indicates more output per person (but not necessarily per worker, since the employment to population ratio varies [B.H. Easton (2002, forthcoming) New Zealand’s Growth Post-war Performance: Adjusting for Employment. Also In Stormy Seas, p.189-193]. As a general rule the ratio rises most years, indicating that output per person is growing.

The Maddison GDP series does not correspond exactly to the official New Zealand GDP series, although the fit from 1977 to 1996 may be as close as rounding errors. Before then the error appears erratic rather than systematic. After, they are the consequence of recent revisions. The official series was used here instead, with the following changes.
* Maddison follows the OECD convention of treating GDP for March year X+1 as the GDP for calendar year X, a misalignment of three months arising from New Zealand using a different standard year from the OECD. This study, like In Stormy Seas, estimates the OECD data for the March year as a weighted average of calendar years X and X+1.
* there are no New Zealand volume GDP official data earlier than 1954/5, although there is a Treasury series, and also an alternative. [B. H. Easton (1990) A GDP Deflator Series for New Zealand: 1913/4-1976/7 (Massey Economic Papers, B9004) p.83-103.] Both are problematic. This study uses the Treasury series, but cautiously interprets the early 1950s.
* In Stormy Seas adjusted the official New Zealand series for some data problems. Only the adjustment for the inventory mismeasurement in 1977/8 is made here.

Given this enhanced Maddison data base, it is possible to calculate the GDP per capita for New Zealand and the OECD (as it was in 2002). The ratio of the two series gives a measure of production per capita in New Zealand relative to that for the OECD as a whole. The ratio is shown in the graph below. (Its table at the end of this article.)

Appendix II: A Periodisation of the Post-war New Zealand Economy

The graph shows six separate periods as trends. They are identified with the problem of the coincidence of business cycles in mind. Where they are out of phase (as in the case of the New Zealand upswing in 1993 preceding the worlds boom) the ratio may experience a temporary blip. Fitting a trend requires some assessment of the cycle. It is a common rhetorical devise to chose the end points of a period to give the story that suits the teller’s predictions. The following are my best assessments, but the tabulation of all the data allows the reader to check my assessment and tell a different story if they wish. After the description of the period I give a brief account in italics of what I think was happening during it.

1950/1-1959/60

Over this nine year period the ratio fell from about 147 percent of the OECD to 130 percent, a 12 percent fall, or 1.1 percent p.a..

Although hostilities formally ended in 1945, the next years were a period of rapid economic growth in the war devastated OECD economies. The handful which were not invaded did not experience the same recovery. The war recovery so dominates the comparisons that it is common for economists to see the war period ending in 1959/60. [In In Stormy Seas I concluded that the New Zealand economy had not really recovered from the war before 1954/5.]

1959/60 to 1966/7

Over the next seven years the ratio fell from about 130 percent of the OECD to 122 percent, a 6 percent fall.[The 1950/1 figure is the trend estimate not the actual, because of the problems of the pre-1954/5 data.] This means the New Zealand economy was growing a fraction over .9 percent a year slower than the OECD average.

There can be little dispute that the rate of decline slowed down. In my view the ratio is near stable, the measure being depressed by the aforementioned measurement error. The remainder of the decline might be explained by New Zealand’s population was growing faster than the OECD’s (see below). Another depressant is the convergence issue, again discussed below.

1966/7-1968/9

In the two years the relativity fell 8.5 percent. This was not due to a reaction to an earlier cyclical upswing

In late 1966 the New Zealand economy experienced a major (and ultimately permanent) external shock when wool prices fell sharply (by around 40 percent). The consequences of this shock is a central theme of In Stormy Seas. The shock appears, in this series, to have impacted on the growth rate for only two years, with the New Zealand economy contracting while the world economy boomed. The next period discusses this change of intepretation.

1968/9-1986/7

The slower decline resumed, with the relativity falling 12.6 percent, from 111 percent to 97 percent. The rate of decline was a fraction more than .7 percent a year (about two-thirds of the rate of decline of the first period). There is a cycle peaking in 1975 and troughing in 1979. By the end of the period New Zealand had moved from being above the OECD average to just below it.

The reworked Maddison data is largely consistent with the account in In Stormy Seas, despite the revised data base and the addition of more countries to the OECD list (and more recent years). One apparent inconsistency between the two accounts might be that the 1966 wool price shock seems to have had a shorter impact (of two years) in the reworked data compared with the In Stormy Seas account which argued it took at least ten years for the price downturn to work through the economy. However any inconsistency is resolved by noting the In Stormy Seas account is based not only on this series but on the structural changes evident in the 1970s, and that divergences between the New Zealand and World economic cycles which have to be taken into consideration when short term comparisons are being considered.

Even so, this author of In Stormy Seas is not uncomfortable if the preferred explanation is a short sharp fall after 1966 followed by a slow decline, in contrast to the book’s account of a longer fall and then a flattening of the relativity from the mid-1970s to the mid-1980s. Either option discounts the conventional wisdom’s belief that the entry of Britain into the European Union in 1973 was the key element in the path of the post-war economy. It was one of a myriad of changes.

1986/7-1992/3

This is the second rapid decline – and a longer one. The New Zealand GDP per capita relativity to the OECD fell from 97 percent to 84 percent, a 14.3 percent fall in six years. This is an annual fall of 2.5 percent p.a. which means that the relativity fell more in the six years than in the 18 years from 1968/9 to 1986/7 and almost as much as it did in the 15 years from 1952/3.

The decade from the mid 1980s merits some comment, as the pattern becomes clearer. The introduction of new members to the OECD in the 1990s lowered the average GDP per capita, When all the new members are included New Zealand was close to the OECD average in the early 1980s. In the 1984/5 year it was about 100 percent of the average, although there is a margin of error.

By 1992/3 the level was about 85.5 percent, a fall of about 14.5 percent in seven years. As the level is still about 85.5 percent in 2002, the arithmetic says that as New Zealand being below the OECD average is entirely due to the fall which occurred in the seven (or slightly fewer) years.

Why this fall? In Stormy Seas details the poor export performance of the period, attributing that to the overvalued real exchange rate (a conclusion bolstered by the high rate of importing during the period). [In Stormy Seas p.231-250. Also B.H. Easton (1999) The Whimpering of the State: Policy After MMP (Auckland University Press) p. 49-62.]

After 1992/3

It is too early to identify the trend of the 1990s. The graph shows a flat trend, with a strong cycle. (9) But it could be argued that the trend has been slightly up. Whichever, the effect was very small compared to past trends.

Appendix III: The Ranking Race

The figures here based on Maddison with some interpolations for countries he does not report, using the official New Zealand series. The details are in the table.

1950: FIFTH
The following (OECD) economies (in probable rank order) already had a higher GDP per capita than New Zealand in the early 1950s.
United States; Switzerland; Luxembourg(?); Canada;
So New Zealand was ranked fifth. [Because the NZ series has not been adjusted for the secular measurement error, this ranking places New Zealand above Australia, rather than marginally below it as occurs in In Stormy Seas p.27.] New Zealand was then about 148 percent of the OECD average. [The trend rather than actual ratio is used here.]

1960: FIFTH
No additional OECD country’s GDP per capita rose above New Zealand by 1961. So New Zealand was still fifth, but it was now only about 31 percent above the average.

1970: ELEVENTH
In turn, the following six OECD countries’ GDP per capita became higher than New Zealand’s between 1961 and 1970 (in addition to the earlier four).
Denmark; Sweden; Australia; Netherlands; France; Iceland (?)

By 1970 New Zealand was 11th , and its GDP per capita was about 111 percent of the OECD average.

1980: NINETEENTH
In turn, the following eight OECD countries’ GDP per capita became higher than New Zealand’s between 1975 and 1980, additional to the earlier eleven.
Belgium; Germany (West & East combined); Norway; Austria; United Kingdom; Japan; Italy; Finland

By 1980 New Zealand was 19th , and its GDP per capita was about 96 percent of the OECD average.

1997: TWENTIETH
In 1997 Ireland’s per capita GDP passed New Zealand’s. So New Zealand became 20th , when its GDP per capita was about 86 percent of the OECD average.

The following OECD countries had per capita GDP figures less than New Zealand.
Spain, South Korea, Portugal, Greece, Czech Republic, Hungary, Poland, Mexico, Turkey,.

Notes: In the late 1990s the Spanish GDP per capita has come close to the New Zealand level. In the early 2000s New Zealand drew slightly away from the Spain.)
Slovakia (with a per capita GDP between the Czech Republic and Hungary) has recently joined the OECD.

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Chapter 2 of TRANSFORMING NEW ZEALAND. This is a draft. Comments welcome.

Keywords: Growth & Innovation;

This chapter looks at New Zealand’s post-war economic performance via the measure of GDP per capita. It does not consider the relevance of the measure – the topic of the next Chapter – but we note here that Gross Domestic Product (GDP) is the standard international measure of output, in which the net value production of each market sector of the economy is aggregated together and (for international comparative purposes) valued at a standard set of international prices (a phenomenon which is indicated by the expression ‘purchasing power parity’ (PPP) prices). The effect of using the same prices for every year is that year to year changes measure the volume of production (or real output) independently of inflation.

Useful comparative international data became available in the 1980s. Previously the focus has been on relative economic growth rates which gave no level of relative output. Insofar as such comparisons were made, the nominal GDPs of the various countries were converted by using the exchange rate – a procedure which was obviously faulty because when a country devalued (as New Zealand did by 19.45 percent in 1967) adjusting by the new exchange rate suggested a major fall in output overnight (that is by19.45 percent in 1967) whereas common sense suggests there was no such fall (in fact real GDP rose by 3 percent in the two years across the devaluation from 1966/7 to 1978/9).

I brought together my findings in In Stormy Seas: The Post-War New Zealand Economy [1].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. [2]

New Zealand versus the OECD

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

* excludes the Slovak Republic.

The overwhelming message of Table 1.1 and Figure 1.1 is that the ratio of New Zealand to OECD per capita has been falling. [3] 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.[4] 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. [5]

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.[6], [7]

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 also shown in Table 2.1.

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.[8]

There is a grudging acceptance of the wool price explanation of the first major decline.[9] 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.[10] 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.[11]

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 [9]

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.[12] 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.

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Endnotes
1. B.H. Easton In Stormy Seas: The Post-War New Zealand Economy (University of Otago, 1997).
2.
3. 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.
4.
5. In Stormy Seas discusses a measure bias .3 percent from not allowing for sufficient quality change in the service (including the public sector).
6. In Stormy Seas p.73-88, 139-168.
7. 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.
8. 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.
9. A mere quarter of a century since it was first published. (e.g. Easton
10. 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.
11. Providing broad statistics for only 1870, 1913, 1929, 1950, 1973, 1990, 1998, and in little country detail.
12.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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Appendix 1 of TRANSFORMING NEW ZEALAND. This is a draft. Comments welcome.

Keywords: Growth & Innovation;

The growth debate in New Zealand assumes an appropriate economic target is per capita Gross Domestic Product, or GDP. This appendix pays little attention to the population dimension of the target, but it looks at, as intensively as space allows, GDP. Initially it explains what the concept is, what was the measure’s original purpose – understanding the business cycle, and how it became interpreted to have a broader meaning – as a measure of welfare. Then the chapter looks at some of the criticisms of the measure – most notably its coverage and its distribution. However far more important is the extent to which it actually measures a nation’s welfare. The evidence is that it does not.

What is GDP?

GDP is intended to measure the total market activity of the production of goods and services in a domestic jurisdiction (such as New Zealand). It is the production which occurs in a time period, typically a year.

There are a number of ways of calculating it, but the simplest to understand is that it is the sum of the New Zealand products which are bought by households and invested by businesses. In addition the output of the public sector (such as education, health care, military services and so on) is included, valued at cost. Some New Zealand products are bought by foreign households and businesses, and so are a part of GDP. Conversely the outlays of households and businesses which are produced overseas and imported are not a part of New Zealand GDP.

There are a number of complications to this story, most of which can be avoided in this exposition. Importantly double-counting is avoided so that the milk produced by a farmer, is only valued when it is sold as cheese or whatever.

The biggest market omissions from GDP are financial transactions, because it only concerned with goods and services. Thus a transaction involving the purchase of a $100m of foreign exchange or government bods does not appear in the measure. Money spins around much faster than goods and services, so these transactions exceed are substantial. If it is not obvious why they are excluded from GDP, consider buying an appliance with your credit card, and paying the card company out of your cheque account, having transferred money from a savings accounts to do so. That means the financial transactions amount to three times the cost of the appliance, but it would be meaningless to include them all in GDP. (Insofar as the credit card company and the bank charge you for the convenience of using their services, that does appear in GDP.)

The ‘gross’ in GDP refers to there being no deduction for the wearing out of capital goods (depreciation). It might be more sensible to deduct the depreciation, but it is harder to calculate, so Net Domestic Product is not as reliably measured. (However, as Keynes said ‘it is better to be vaguely right, than precisely wrong’.) As it happens the ratio between GDP and NDP remains roughly constant over time and between countries so it is the distinction is not so important.

The ‘domestic’ of GDP refers to production in a region (typically a country). However not all the product of a country may be produced by its nationals, as when the profits are owned offshore or a passing through rock star receives a performance fee. Then again the residents of a country may receive profits from their investments overseas and fees. A better measure for nationals is Gross National Product (GNP), or better still NNP which is called ‘National Income’. The reasons that the domestic measure is used is because it can be defined more rigorously. (However Tommy Balogh complained about economics that suffered from rigour to the point of rigour mortis.) The ratio of GDP to GNP varies between countries, so the distinction matters. Moreover, a country could increase its GDP by a lot of foreign investment without as much impact on GNP – so that it produced more but its residents did not have correspondingly higher incomes.

In one sense this is all very boring – and it gets worse with the detail in the centimetre thick manuals which set out the exact rules. (In my time I have got tangled up with what one did about exploratory oil wells which proved to be dry, or how one treated floating oil rigs coming to and leaving New Zealand). What the reader needs to know is that GDP is an exactingly defined concept, but an increase may not always translate into local improvement, however it is defined.

There is one further complication that needs attention. What prices are the products to be valued in. If they are in the prices of the day, then the production is measured as ‘nominal GDP’ (or ‘GDP at current prices’). If it is measured in the same set of prices in different years it is ‘constant price GDP’, or ‘real GDP’ or ‘volume GDP’ (which is my preference). When people talk about GDP growth they are usually referring to changes in volume GDP.

This approach is not without its hazards, since it assumes that one can make comparisons through time. But how does one value a car today compared to one of a decade ago, given the changes in accessories and reliability that have occurred. And what about new products? A decade ago there was hardly any mobile phones. Any procedure is likely to underestimate the benefits from the convenience and opportunities of the innovation. Statisticians try to allow for such changes over time, but some economists think that they still underestimate the benefits of the quality improvements (by as much as 2 percent p.a. some say, but that seems to me to be extravagant). However, presumably these quality generally apply to all countries (or to all rich ones) so it is not so important for inter-country comparisons, providing all statisticians make the same quality adjustments (they probably dont).

Since different currencies have different prices and different currency units, international comparisons involve some common pricing standard. Once upon a time, for want of anything else, the conversion was on the basis of exchange rates – that is the ratio between the value of the domestic currency on the foreign exchange markets and, say, the US dollar. It was a very unsatisfactory method since the rates could change quickly – a devaluation might reduce a county’s comparative GDP by 20 percent overnight. Today (effectively starting about two decades ago) individual prices are carefully collected for each product from a range of countries, averaged, and applied to the products in each country to calculate GDP at a common purchasing power parity (PPP). The averaging is important, and it may be that it is less fair to smaller countries such as New Zealand. It is these PPP figures which are sued for the international comparisons.

The Purpose of GDP

Estimating the total activity in an economy has a long history going back over three hundred years. However the systematic development goes back only about three quarters of a century. There were many reasons for calculating the figure – perhaps initially no more than curiosity – but by the 1940s the prime concerns were business fluctuations (the trade cycle), unemployment and financing the Second World War with a minium of inflation (exemplified by Keynes How to Finance the War). To this day GDP, and the accounts which underpin it, are crucial for the government setting its fiscal policy and the monetary authority (the Reserve Bank in today’s New Zealand) setting monetary policy.

This was a time when economic growth was not in the public agenda in the way it is today. That really only begins in the 1950s, in part with the systematic attempts to measure economic activity (and perhaps from Krushev’s famous – and ineffective promise – that the Soviet Union would ‘bury’ the Western economies). Previously economists had tended to think that while an economy would grow in the medium term (and there would be fluctuations around the trend) eventually it would stagnate. (Keynes talked about the ‘euthanasia of the rentier’ which occurred when there was no more investment opportunities, so there were no rewards for saving). In fact, as best we can measure and caveats abound, there has not been a marked growth trend for the majority of human time. Growth as we know it is less than two centuries old. What made the difference – invalidating thus far the prognostications of such great practitioners of the dismal science as Keynes and Marx – is the creation of new technologies. If there is a stagnation level of economic output, then recent experience is that it keeps being lifted by innovations. Whether there is a limit to them, and hence a long run cap on the stagnation level I dont know. My guess is that humankind may be seeking new ends before that occurs.

If macro-economics (cycles, unemployment, and inflation) was the initial purpose of the new measure, subsequently – the key paper is due to Paul Samuelson in 1949 – it was shown that under some assumptions (which include that the economy can be represented by a single consumer) a higher National Income (not GDP, you note) represents an increase in consumer welfare. This uses standard consumer theory, which assumes that more consumption makes a person better off. We will explore this assumption below.

Even without Samuelson’s paper it seems likely that the populists would have latched onto GDP per capita as some measure of welfare, simply because the statistics were there. We have already seen that there are numerous caveats to the claim that GDP is associated with wellbeing, but there is a tendency to cling on to an available statistic like a drowning man clings to flotsam (even if it takes him over the falls).

Problems with GDP

The Distribution of GDP

Earlier we mentioned, almost as an aside, that a key assumption which relates GDP to welfare amounts to an assumption that the economy could be represented by a single consumer. I propose not to go through the complications of this assumption but, rather, point out the implications if there are numerous consumers who have different incomes.

In particular some may be rich and other poor. An increase in GDP does not distinguish between whether the extra income and consumption goes to the rich or to the poor. Indeed suppose GDP were to increase as a result of taking income from the poor and giving it to the rich (perhaps the lower taxes on the rich give them a greater incentive to produce more, while the poor also work longer to make up some of their lost income). Does that mean the nation is better off?

Economists have got into a muddle over this, when they say that the increase in GDP means that the poor could be made better off without the rich being worse off. But suppose they are not (suppose – as in the previous paragraph – the increase arises because the poor are being made worse off). One could say that the rise in GDP had the potential to be a rise in the nation’s welfare – but that does not mean it has actually happened.

There is another oddity as far as distribution is concerned over the living. Suppose everyone over working age – say 65 years – were to drop dead overnight. There would have to be some adjustment as individuals moved from industries which support the elderly (rest home care; providers of food) but in simple terms GDP per capita would rise (by almost enough to get New Zealand back to the OECD average). Would that be a good thing?

What to Do with Bads and Inputs

Consider a country which suddenly comes under military threat. It immediately diverts a lot of its productive activity into defending itself. Workers and the unemployed are recruited by the forces, which order various military equipment and requisition civilian goods and services. GDP may even go up as more of the unemployed diminish and the remaining workers work longer hours as a part of their war effort. Is the country better off? The higher GDP might suggest it is, but in fact it is worse off because of the military threat, and people’s material standard of living diminishes – evident by the higher taxation and the cutting back of civilian public services in order to finance the war.

The same applies for other threats. Consider a new health threat such as HIV-AIDS. Again the country will deploy resources to combat it, and possibly GDP rises, but is it better off? The same applies for the threat of crime.

Or consider two countries, one of which has a benign climate while the other requires airconditioning and central heating for a reasonable life style. Since the cooling and heating involves market transactions (equipment purchase, energy, maintenance) it adds to GDP. But does the higher GDP actually say the country with the inferior climate is better off.

A recent paper by (American) economist Robert Gordon compares the GDP per capita figures for the US ands the EU. The official measure is that the US OECD per capita is 23 percent higher. However after adjusting for inputs differences (including transport disadvantages from the sprawling US metropolises) and for greater European leisure and choice, Gordon concludes the difference amounts to only 8 percent. People in some European countries are almost certainly better off in terms of an adjusted GDP per person, than the US average.

There is an enormous amount of judgement in these comparisons, but the basic conclusion is probably right. Comparing living standards on the basis of GDP per capita between countries is not very satisfactory and may be subject to great error. The 15 percent difference which Gordon identifies between the US and Europe due to quality and input differences is also the difference between the NZ per cap GDP and the OECD average. This does not mean that NZ is really at the OECD average, but it illustrates just how inaccurate the statistics are for valid comparison purposes.

Note however that these criticisms apply mainly to inter-country comparisons. They are not as significant for comparisons through time.

Non-market Activity

Gordon’s adjustment for leisure occurs because people get value from not-working and having time for leisure. Suppose someone choses to retire early, going onto a lower material standard of living for ‘life style’ reasons. GDP goes down even if this person’s well being goes up (in their judgement).

This is one example of a non-market economic activity. Another important one is all the production that goes on in the home. Suppose neighbours were to take in each other’s washing and mow each other’s lawns for which they pay each other the same amount. GDP, that is the market value of production, would go up, but economic activity would not. All that has happened is that some has been transferred from the informal non-market sector to the formal market sector. It is not evident that this has made anyone better off.

This transfer from the non-market to the market sector has been underway for a long time. Parents use child care rather than leaving the child with the mother; households eat out rather than cook at home; rather than washing at home they use a dry cleaner; many purchases of commodities (easy to prepare foods, household equipment ) reduce housework. The issue is further complicated by whether the change results the houseworker entering the paid workforce (in which case it boosts GDP) or in more leisure (in which case it does not). It seems likely that the tendency has been to boost GDP (that is market production) faster than total production including non-market production.

A common demand is that the GDP measure should be extended to include non-market activities. Leaving aside that the required data base does not exist, it is far from clear what should be included (sexual services between consenting adults?) or at what price. In any case if the primary purpose of GDP is to assess business cycles, unemployment, and inflation in order to assist macroeconomic management, it is unclear what use the extended measure would be.

The international statistical community which governs the System of National Accounts (SNA) which measures GDP encourages the development of supplementary tables to cover non-market (including environmental) phenomenon. The idea is to allow countries to experiment, and then when enough experience is accumulated, to set international standards. (As someone who has puzzled over the relationship between non-market and market economic activity for three decades, I suspect they we are still some distance from a comprehensive theory, and that the best will be to extend the market economy into certain non-market activities without getting the peculiarities of non-market activity.)

However even this approach cannot cover some of the things we value most. Following the end of the communist regimes, the GDP of Soviet Bloc countries fell dramatically, but how are we to value the switch over to a time when an early morning knock at the door was from a postman and not a policeman? We take such things for granted in the West, and while there are variations between countries – my judgement is that New Zealand is one of the most secure in terms of improper repression by the state – providing we are comparing those whose civil society is based on due process and respect of citizen rights, there would need to be little adjustment to the relative economics.

Another phenomenon which the market may not properly value is choice. The Gordon paper mentions readily accessible French shops with over 200 kinds of cheese, contrasting their easy choice with the rarer US gourmet supermarkets with comparable choice and the lesser choice elsewhere. GDP comparisons do not properly catch this contrast, although the importance of varieties of cheese is another matter.

Environmental Issues

Sometimes one economic actor’s market activities are to the detriment of another economic actor, who may be incurred costs. The traditional example is the smoke from a factory which dirties the washing of local householders, but water and soil quality as well as air quality may also be affected by these ‘externalities’. Presumably any environmental deterioration should be deducted from GDP, although like other non-market measurements that is easier said than done. A further curiosity is that later on, when the damage is cleaned up GDP rises, even though the community may have less access to material goods and services because some is being diverted got the remediation.

Another concern has been the depletion of resources. Some of the highest GDP per capita rates are in oil producing countries, but for the most cases the reserves are being depleted rapidly. One way of thinking about this is that the depreciation component of GDP is unusually large, because it should include the value of the depreciation of the reserves. (This means GDP is the same but actual National Income is lower than as conventionally calculated.) Another is to treat the depletion as an inventory run down. (GDP would be lower than as conventionally calculated, and National Income the same as in the previous method.) . A third is to note that the reported GDP is not sustainable. There is no obvious best practice.

While the problem of depletables is evident for the oil producers and some other economies over-dependent upon them (e.g. Naru on phosphate), it applies also to New Zealand and other more conventional OECD economies. New Zealand has an economic history of resource depletion – sea-mammals, birds, minerals, forests, soil, ecologically sensitive environments – and some of that depletion continues. In a few years New Zealand GDP will be (slightly) decreased by the Maui gas field running out and some of the large petrochemical instillations being closed down.

A Conclusion

Recall that GDP was originally designed for one purpose – evaluating the state of the macroeconomy – and was kidnapped for another – evaluating welfare. It does this second purpose not at all well.

One might conclude that GDP should be confined to its macro-economic purpose, and some new indicator of economic welfare should be constructed. There have been various proposals such as ‘Net Economic Welfare’ (NEW) and ‘General Progress Indicator’ (GPI). However while they may patch up some of the defects described above, they introduce other difficulties, especially arbitrary assumptions that the Samuelson theorem draws attention to. In my view the approach is deeply flawed because it assumes that it is possible to rank countries on some single dimension of economic welfare.

This assumption is all the more ironic because for over half a century economies have eschewed person to person comparisons, because they are not ‘scientific’. Why should country to country comparisons be any more valid?

However the public wants measures, and we might as well stick to GDP per capita, as the internationally measured and available indicator of material output. One recalls as Bob Solow quoting the addicted gambler using a crooked roulette wheel ‘because it is the only game in town’.

Even so, as Chapter 1 argues material output is not a single compelling goal for a nation, although we may have to enlarge material output in order to pursue vigorously our other goals.

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Chapter 1 of TRANSFORMING NEW ZEALAND. This is a draft. Comments welcome.

Keywords: Growth & Innovation;

The Purpose of Policy

Asking about the purpose of public policy is only a little less frustrating than asking about the purpose of life. But if we dont ask either question we may lock ourselves into paths which are patently wrong. There is a danger of New Zealand doing this, if public policy focusses exclusively on maximizing material output, as measured by GDP or one of its related indicators.

As Appendix I reports, GDP has a number of fundamental deficiencies. There has been a number of attempts to modify GDP for these weaknesses, but they miss the point. The connection between wellbeing, or any other plausible purpose of public policy, is tenuous. Basically material goods and services are a means to an end, not the end in itself. If we focus too much on them, we may miss the whole purpose of life. However, once this is recognised, it makes sense to increase material goods and services – perhaps indicated by GDP, but subject to caveats – in pursuit of the higher goal.

Throughout this chapter I am going to refer to NNP (net national product). This is GDP less depreciation (that is consumed capital), which converts the ‘gross’ to the ‘net’, and less the (net) income of foreigners in the country, which shifts the measure from a ‘domestic’ to a ‘national’ basis. The use of NNP (a.k.a. National Income) is to remind the debate not to get too obsessed with GDP.

Focusing on NNP (or GDP) sets the economic perspective of transforming New Zealand. Much of this book is about how to increase material output. Of all the intermediate targets of the good life, it is the one scientists (albeit economic scientists) know most about. But it is always in the context of the wider aims, of using the additional economic activity to transform New Zealand for a wider purpose.

Perhaps that wider purpose might be described as ‘wellbeing’. To begin with the little we know about
wellbeing and material output.

GDP and Wellbeing

The assumption which underlies much of the economic policy debate is that New Zealand should aim for higher real incomes and production, measured by GDP. The difficulties with GDP as a measure of material output are analysed in appendix I of this book. Here we accept the indicator at face value, as does much of economic policy, and ask the more fundamental question, what is the evidence that material output contributes to some higher objective of 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 NNP) 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 NNP 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.

Even more surprising 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’) we find that there is a very slight improvement in happiness for those with higher incomes in the community. The effect is small, as is evident by a comparison of 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.’) The 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. 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 (and adequate remuneration is a signal that it is).

More recently the World Values Study asked across many different countries ‘are you happy’ and ‘are you satisfied with life’. (There is a translation problem. Is the word ‘satisfied’ in English equivalent to ‘satisfait’ (French), ‘sodisfatto’ (Italian), or ‘zufrieden’ (German)?. However the Swiss response is substantially higher than their counterparts speaking the same languages in France, Germany and Italy, which suggests the study is measuring behavioural, and not language, differences.)

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. Apparently 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 NNP is no surprise given the deficiencies of aggregate material product as a measure of wellbeing. 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 NNP is about 40 percent higher than New Zealand’s. There is a relationship between material production and happiness for those countries whose per capita NNP is less than 70 percent of New Zealand’s (perhaps justifying the nineteenth century focus on material prosperity as a measure of wellbeing). In poor countries economic growth increases happiness and life satisfaction. As a country gets richer, growth does not.

Among the factors which depress the responses are being in a Communist nation, although (sadly) happiness and satisfaction deteriorated when they threw off their Communist shackles. While there does not seem to be any connection among high income countries between wellbeing and measures of civil liberties and political rights, poorer countries with democratic institutions seem to be happier. 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.

In summary then NNP, or other measures of material production and consumption, do not seem to be particularly relevant to the promotion of social welfare as indicated by happiness and satisfaction – directly anyway. This chapter will argue that NNP contributes indirectly to some of the other factors which make up wellbeing.

Alternatives to Material Output

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 NNP 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 NNP.)

Sen then introduces the key notion of ‘capability’ which refers to the alternative functionings (‘life choices’) a person might have. His notion of well being 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. This is partly because Sen is an expert on inequality, and he knows ‘free market’ outcomes will have some people worse off (as happened in New Zealand). 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’s ‘Human Development Index’ (HDI), which is intended to replace NNP 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 NNP per capita goes down. 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 expectancy of 76.9 years. In contrast, 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 – including its education and health systems – to give its residents substantial freedoms, including that of longevity.

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

Constructing a Human Development Index for Well-off Nations

However, the World Bank’s interests are poor countries, and the index is not be very good at discriminating between rich countries. Their literacy and longevity are much the same. So should we go back to NNP per capita which shows bigger variation?

Not necessarily. The big gap between New Zealand and the US in per capita NNP terms does not reflect relative happiness, and probably does not reflect the difference in average wellbeing either. Instead, let us try to elaborate the HDI approach for rich countries, with an index which has five (rather than three) primary components: material consumption; health; education; diversity for choice; and leisure. However, with Sen, we assume that there are some basic conditions which are already attained:
– effective civil rights;
– personal security;
– national security;
– environmental sustainability.
We shall see that they affect the other measures.

Material Consumption: It would be easy to measure material consumption by per capita NNP. But we need to recognise that some elements of NNP contribute to civil rights, personal security national security, and environmental sustainability. Since there are considered prior to the measure, they should be deducted from NNP to get a better measure of material consumption. Moreover spending on health, educational attainment and creativity should also be deducted, because they appear directly or implicitly in the other three components of the index.

Health: The HDI uses longevity to measure health. Countries with better statistical systems are beginning to be able to adjust each of year of life for its quality. (The competing measures are QALYs – quality adjusted life years – and DALYs – disability adjusted life years. )

Educational AttainmentThe HDI gave a weighting to literacy and years of schooling. Richer countries might still want to use literacy measures in their index (although the more sophisticated ones of the ….), and also the proportion of the adult population with university degrees, and the hours they experience through a life time of post-secondary education including tertiary, vocational and continuing. Various institutions such as libraries, galleries and museums are also a part of this.

Notice the measure does not include numbers currently in educational institutions nor the attainments of the current crop of graduates (except as a part of the whole of adulthood educational attainment). That is because they are additions to the stock, not the stock itself. It would be as inappropriate to measure the stock of investment by the plant and equipment being installed.

Diversity for choice 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. We are interested in real choice – a problematic notion since who would think a plethora of cheeses was a real choice (unless they were French)? Sen is more concerned about life paths, and that might be better measured by indicators of diversity and creativity. Heterogeneity is important.

There is no diversity component in the HDI, because it is difficult to measure even in rich countries. Perhaps 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’ – he means people who describe their occupation in these terms. Perhaps we should be less precious and include sportsmen, in part because we have a different agenda to Florida. (He is trying to find measures of economic performance: we are trying to measure the choices which promote a quality of life.) It is a hard one t measure this one, but we would miss the point of human development were it left out.

Leisure:

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 NNP 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 rather the hours worked should include travelling time to and from work. And probably some adjustment needs to be included from forced leisure from involuntary unemployment.

(We will find that New Zealanders 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.)

It is not proposed here to create a human development index. That is technically a very big job, especially if it is done for a number of countries. The point of this section is to emphasise that NNP per capita is not the sole criteria human development, nor the sole objective of a nation.

The point of NNP

Now it may seem that by this stage the significance of NNP has been reduced to almost nothing, or at least to the point with which it is hardly worth bothering about. In fact the conclusion is exactly the opposite. Material output is needed to attain the other ends. It is necessary to run the institutions which give us civil rights, personal security, national security, and environmental sustainability. It not only gives the wherewithal for material consumption, we need it in the pursuit of health of education of diversity and of leisure (allowing that high productivity makes leisure more feasible).

So even if NNP does not contribute directly to national welfare, or only to a small extent directly, it contributes indirectly in very important ways. NNP is lower in the hierarchy of national goals, but it is a means to higher ones, and to some extent we know a bit about enhancing NNP, getting it to grow, so it is worthwhile pursuing it, but not by compromising higher goals. Recall that Ceausescu’s Rumanian abrogated civil rights, screwed back consumption, discouraged leisure and so on to maximise NNP growth. It was not successful, thank the lord. Otherwise there would be more others arguing for such policies. When we pursue NNP (or whatever measure of material output) we must always check that we are not compromising what we really care about.

The great thing is we know a little about how to enhance NNP, of getting it to grow. This is what this much of this book is about.

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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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