Catch Australia? Only if We’re Ready to Pay.

Business Herald, 26 March 2010.

Keywords:  Growth & Innovation;

While accelerating the rate of GDP – even catching up with Australia – may be an official aspiration it is not simply a matter of trebling productivity as one businessman airily explained to me; he changed the topic when I asked how his firm is going about it. There are laws of thermodynamics, and the there are parallel economic tradeoffs which cannot be avoided.

One of the simplest is that if we wish to grow faster we are going to have to invest more. The tradeoff is that we are going to have to consume less, at least in the short run. Here is a simple example.

To produce an extra $1 of output each year we are going to have to invest an extra $4 so there is the capital to produce the output. That means in the first year we have to reduce consumption by $3 in order to get the growth. After five years (public and private) consumption will be ahead but initially there will be lower consumption.

We can make the example a lot messier, by having a regular increments in output  rather than a one-off one, and for allowing for such things as depreciation, lags (since production does not come on stream immediately) and overseas borrowing. Overseas borrowing may seem to be a way to avoid the drop in consumption but given New Zealand’s very high level of borrowing that would seem to be unwise.  In effect we would be borrowing for consumption. In the end the analytic conclusion which comes out of the modelling is that we will have to reduce consumption for a number of years in order to accelerate the economic growth rate.

This result has been known for fifty years at least. Indeed earlier, the Soviet Union had accelerated its growth rate by focussing on investment and failing to supply consumption goods to its people, causing great hardship. When I was young the strategy was known as ‘Stalinism’, but such rhetoric only obscures the laws of thermodynamics.

In the last fifty years we have learned that it takes more than capital investment to increase the growth rate. An economy also has to invest in education and training and in research, science and technology. Unfortunately noone knows how much investment, but the likelihood is a lot. Even if it was only a quarter of the investment in physical capital it would put off the breakeven from four to five years.

Note that I have not said how much public consumption has to be cut back and how much should be from restraint of private consumption. Many advocates of accelerating the growth rate argue that the cutbacks should be of government spending. That is a political decision. But there is an implication. Cutting government spending to make room for more capital investment does not enable offsetting income tax cuts, unless all the additional private income is saved.

At the moment the economy is spending too much relative to production (evident by our high overseas borrowing). The government has been reluctant to cut back aggregate spending vigorously. Instead it is squeezing government spending, perhaps because it does not want to precipitate an economic crisis like the Richardson measures of 1990 and 1991 did. Accelerating the growth rate requires even more vigorous cuts to public and private consumption.

Critics of the government strategy who aspire to markedly accelerate economic growth need to acknowledge that their approach initially involves markedly cutting consumption, that is people’s standard of living. One of the most pervasive tradeoffs of economics is that there is no such thing as a free lunch.