Executive Summary
Introduction
In February and March 2004, the Ministry of Economic Development ran a series of seminars to provide training in the different – and sometimes contradictory - ways that different economists have of thinking about economic growth and economic policy. Each paper within this Occasional Paper presents the paper prepared by the economist giving the associated seminar.
The purpose of the seminar series was to expose analysts to a range of ways of thinking about the processes underlying economic growth. This purpose implicitly admits that there is no single "right" model, or way of thinking, about the factors driving growth. The growth process is context dependent, reflecting each country's institutions, endowments, individuals, firms, geography, and interactions with others beyond the country.
The presentation is non-technical and non-mathematical, so it should be accessible to someone without much economics training.
The reason that there are different ways of thinking about economic growth is that the economy is a complex system, and part of a broader and more complex world‑wide socio-economic system. As a result, to understand a particular economic phenomenon, we must abstract from irrelevant details, so we can better focus on issues that are most relevant to the phenomenon that we are interested in. That is, any way of viewing the economy that is tractable and useful is inevitably a simplification or a "model" of the real system that we are dealing with.
In this sense, none of the views of economic growth presented here are "right", but they all help us form a richer view of how the economy behaves and how economic growth occurs.
This set of papers is being published now to form a companion piece to MED Occasional Paper 08/08 which outlines how the editor thinks about economic growth and policy for influencing economic growth.
Paper 1: The Development of the New Zealand Economy
Author: Brian Easton (Economic and Social Trust of New Zealand)
This paper outlines the economic change and development of the New Zealand economy from its first settlement to the present day. Economic change is not just about increases in material output, but a variety of other changes including in the mix of sectoral outputs, the products consumed, the production technologies used, the way the economy and society is organised, and the way people live.
There have been major changes to the structure of Gross Domestic Product (GDP), including a substantial reduction of the share of agriculture in GDP over the last 80 years, a diminution of the manufacturing sector for about 20 years, and an expansion of the service sector. Likewise relative prices across sectors have changed. To understand economic development, we must understand these changes in structure, not just the change in aggregate GDP.
Over the period from 1861 to 2003, the average growth of per capita GDP has been about 1.6 percent per annum, a doubling of output per person every 44 years. There were rapid expansions in the 1890s and early 1900s, and rapid growth from 1935 to 1945. Since the Second World War, there appear to have been five stages in the development of the New Zealand economy relative to the OECD. These are an upswing from 1954/5 to 1966/7; a step down from 1966/7 to 1977/8; an upswing from 1977/8 to 1984/5, a step down from 1984/5 to 1993/4; and an upswing from 1993/4 that as at March 2004 was still continuing.
The step-downs were due to a couple of shocks. The first step down was caused by a 40 percent fall in the export price of wool in December 1966. In 1966 wool made up over 30 percent of export revenue. So agriculture, the single biggest tradeable sector, took a major reduction in its profitability, while capital and skills which had been sunk into the sector became valueless. As a result, the economy in the 1970s went through a spectacular export diversification. When growth returned to OECD levels, the level of GDP had fallen 18% relative to the OECD.
The second step down was from 1985 to 1993, and GDP per capita actually fell for 6 years – the worst historically recorded experience. What caused this? There is a left wing view that the stagnation was due to the general liberalisation, but it offers no account of why liberalisation should generate stagnation. A middle view is that poor policy sequencing led to a financial liberalisation which distorted the economy, leading to a temporary economic boom, and then the crash of 1987. The right wing view claims that there was going to be a severe contraction or even an economic crash in the 1980s and that the liberalisation may have been associated with the stagnation but it prevented a far more serious occurrence. Regrettably there is no evidence of this possible crash.
Over this period from 1985 to 1993, New Zealand had an inferior economic performance compared to the OECD. Most of all, New Zealand had a poor export performance (despite some Think Big exports).
Why did exporting do so badly in the late 1980s and early 1990s? Crucial to any sector's performance is its profitability. A good proxy for export profitability is the real exchange rate – or rather its inverse. The higher the exchange rate the lower the profitability of the export sector.
New Zealand had a leap in real exchange rate in the late 1980s. The New Zealand government had no view on what the exchange rate should be and thought the market would set the appropriate rate. It did not appreciate that its macroeconomic stance tended to push the real exchange rate up. The government was running a large budget deficit in the 1980s, which meant that the economy had to suck in overseas savings, and that tends to push up the exchange rate. An even greater influence may have been the disinflationary policies implemented by the Reserve Bank.
A high – "overvalued" – exchange rate means that the profitability of exporting (and import substituting) was compromised. As a result various parts of these sectors expand more slowly, contract or even close down.
The liberalisation which took place after 1984 did not lead to the stagnation, but the poor quality macroeconomic management of the period did.
A key lesson from this paper is the need to think sectorally. Different sectors grow at different rates. Sectors that grow faster than the economy as a whole (say around seven percent per annum) and are big enough to drag the rest of the economy along with them are the key sectors in economic growth.
Growing tradeable sectors at these sorts of rates seems to be the only broad growth and development strategy available to New Zealand. That is the lesson of the "step-downs" of the post-war era, for on both occasions poor economic performance was associated with a poorly functioning exportable sector. The first occasion – from 1966 into the 1970s – was through an event over which New Zealand had little control. However, the second occasion has all the hallmarks of our own fault. We ignored the key requirement for successful growth of an industry: that it has to be profitable.
Paper 2: Endogenous Growth Models
Author: David Mare (Motu Economic and Public Policy Research)
This paper provides a non-technical overview of some key strands of the endogenous growth theory (EGT) literature, providing references to key articles and texts.
The starting point for the survey, as for EGT itself, is the neoclassical growth model. In this, the primary focus is on the growth of productive inputs (labour and capital). To this model, EGT adds a more developed treatment of the process of innovation. As we will show, modelling the process of innovation is not as straightforward as it might seem, and in general requires some tricky technical methods to generate defensible models.
These models are unavoidably complex, so the discussion focuses on the common‑sense intuition about innovation that the models endeavour to capture. Essentially, the models assume that something can grow without bound, but in a way that does not generate explosive growth, and in a way which can be sustained in a market economy. Such assumptions are necessary to combat the "ever present threat of diminishing returns".
Key points that this paper makes are that:
- Accumulation of capital and labour, as well as innovation, matter for growth.
- Diminishing returns can extinguish growth.
- Models are only as good as their assumptions.
- All growth models assume that something can grow without bound.
- Ideas and knowledge are obvious candidates for sources of spillovers and scale effects necessary for ongoing growth.
- EGT is important because of modelling methods as well as because of specific growth insights.
- Modelling a mechanism doesn't make it true.
- It may or may not occur.
- It may or may not be as strong as in the model.
- Changes in the level of GDP, rather than unbounded growth effects, may be good enough to explain observed growth.
Paper 3: Austrian Economics
Author: Frederic Sautet (Mercatus Centre, George Mason University)
Austrian economists understand economics as a multidisciplinary research programme, which sees the economic problem as a problem of coordination of individuals' plans under radical uncertainty. In this context, institutions, culture, anthropology, law, history and political economy are fundamental to understanding the nature of the socio-economic system.
This paper provides a brief view of growth and social change taken from the perspective of the entrepreneurial process and Austrian economics in order to establish the following chain of argument:
- Economic performance (i.e. growth) depends on capital accumulation.
- Capital accumulation is the result of entrepreneurial profit discoveries.
- Entrepreneurship is a function of the institutional makeup of a society.
- Institutions (or rules) will foster entrepreneurship if their adverse effects on (a) the noticeability and (b) the exploitability of profit opportunities are limited over time.
- In order to limit the effects on the noticeability and exploitability of profit opportunities, institutions must constrain the government from the possibility of reneging on its commitments.
In his 1974 Nobel Lecture, Hayek warned us against the "scientistic error". This is the view that economists should imitate as closely as possible the procedures that we learn in the physical sciences. Knowledge of physics has helped us develop the practice of engineering and the design of complex machines. The fallacy is the idea that the same should be done with economics: it should inspire the engineering of society.
Because it reduces the noticeability and exploitability of profit opportunities, "interventionism both increases the level of discoordination within the system and makes it more difficult to eliminate this discoordination". What matters is the speed and responsiveness of the market to discoordination situations: the market is an error-correcting mechanism where entrepreneurs tend to spot overlooked opportunities.
What the entrepreneurial understanding of the economic system teaches is that we cannot engineer growth. Growth is the result of a spontaneous order that cannot be designed.
The institutions that foster entrepreneurial incentives are those of a free market system traditionally understood based on the rule of law. These institutions are subsumed under the laws of property, contract and tort in traditional English Common Law (i.e. abstract and general rules), to which one should add the idea of monetary responsibility.
Paper 4: An Evolutionary View of Technology Driven Long-run Growth
Author: Kenneth Carlaw (Associate Professor, Department of Economics, University of British Columbia and the Department of Economics, University of Waikato and UBC)
We live in a world of rapid economic and social change. Any one change typically causes others, which in turn cause others, and so on in a concatenation of linked causes and effects. For example, the invention of the dynamo in 1887 allowed for the practical generation of electricity. The use of electricity allowed a separate power source to be attached to each factory machine (rather than being driven by a single central power source as in the steam-powered factory), allowing production to be reorganised as in Henry Ford's assembly line.
Such change is best understood as an evolutionary, historical process driven by endogenous innovative activity. Indeed, the evolution of technology drives much of the economic, social, and political change that we experience. Consequently, in our research we pay much more attention to technology than is usual. This is in contrast to most growth theorists, who most often focus on economic growth rather than economic change.
A full understanding of the causes and consequences of long-run economic growth requires an appreciation of the qualitative changes induced by technological innovations. Technological advance has not only increased our incomes many fold; it has also transformed our lives through the invention of new hitherto undreamed of products that are made in new hitherto undreamed of ways.
Humans are technological animals. Through many millions of years of biological evolution, technology has been fundamental in making us the physical beings that we are today. What distinguishes us from all other animals is our routine use of a wide range of tools and our ability to invent new tools consciously and persistently in the face of environmental challenges and also driven by our own latent curiosity.
New technologies largely result from activities of profit motivated agents, making technological change significantly endogenous to the economic system. Furthermore, scientific and technological knowledge is cumulative. Today's knowledge could not have been discovered or invented in the absence of many earlier discoveries and inventions. To understand where the system is today, we need to know where it has been in the past. In the study of innovation and economic growth, we need explanations that contain an arrow of time, explanations in which past history does exert an influence on the present - explanations and theories in which history matters.
Paper 5: Conclusions
Author: Arthur Grimes (Motu Economic and Public Policy Research, and University of Waikato)
Each of the preceding contributions emphasises the importance of knowledge creation in the presence of uncertainty; they also emphasise the role that the profit motive plays in guiding the knowledge creation process. Policies that reduce the ability to spot unexploited profit opportunities, and/or reduce the returns from doing so, can be detrimental to growth outcomes.
Many policies will impact on the profit search process. For instance, bankruptcy penalties that are imposed on those who take risks but fail need to be carefully balanced so as to create incentives for responsible behaviour without unduly discouraging risk-taking. Policies that support those who would not take risks (unless underwritten externally) may also water down the search for opportunities with the highest profit prospects. The profit search process may be affected by policies that affect firm scale decisions and/or a firm's (or investor's) choice of activity.
While the previous contributions provide cautions for policy, they also provide insights about types of policy that may assist the growth process. Policies that assist the knowledge creation process by raising capability and/or by raising the rewards to knowledge creation are consistent with key elements of each of the approaches. These policies may include promotion of educational attainment and promotion of research activities by tertiary and similar institutions. Broad-based promotion of research and development, and of staff training, in private sector firms is likely to facilitate the profit search, investment and thence growth. Support for investment in capital equipment embodying new technologies may also facilitate the profit search since staff are likely to "learn-by-doing" through using the new equipment, taking this knowledge beyond the boundaries of an individual firm.
These types of policies are, in the main, broad-based. Knowledge that underlies development of new projects and sectors is inevitably fleeting. By the time it is processed centrally and then disseminated it is often out-of-date. Those with the incentives to obtain and process the information are generally best placed to decide whether and how to make use of it. Support for the generic profit-search process is a key role that policy can play in order to assist the achievement of higher rates of sustainable economic growth.
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