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Author: Brian Easton (Economic and Social Trust of New Zealand)

This paper is a reduced (by over half) version of the paper for presentation to the Ministry of Economic Development Seminar Series: 25 February, 2004. The longer version is at http://www.eastonbh.ac.nz/?p=509.

Between them, Santayana and Marx famously said those who do not learn the lessons of history, are doomed to repeat them: the first time is tragedy, the second time it is farce. The New Zealand economic debate is woefully ahistorical, with little reference to our economic history. Future historians will look at some of our recent tragedies and think them quite farcical.

Mindful that the invitation to speak came from a ministry for development, and not just for growth, I will begin with a political economy account of the past, which emphasises that economic change is not just about increases in material output, but a variety of other changes including the mix of sectoral outputs, the products consumed, the production technologies used, the way the economy and society is organised, the way people live. I then describe the main outlines of aggregate economic output through time. Focussing on recent times, I shall look at New Zealand's aggregate performance compared to other countries, and finish with a quick summary of my own explanatory account of what happened, together with an indication of the policy implications.

1.1 The Political Economy of New Zealand's Economy Development

Political economy can be described through the metaphor of tectonic plates. The geologists' tectonic plates are great slabs of rock which shift about – pushing, crushing, and overriding one another. In a similar manner the economists' tectonic plates are systems of economic organisation, which over time change as new ideas and circumstances create new ways of organising the economy, while old organisations disappear subducted by the overriding new. The conflict between the political economy plates leads to political and social change.

The first such plate in New Zealand – the beginnings of an economy – began about 750 years ago when the first Polynesians reached these shores. They came from a very different tropical environment, to one rich in protein food sources from birds and the sea. Unfamiliar with the new environment and with inappropriate organisational forms, they exploited the available resources in unsustainable ways. The term for this unsustainable political economy based upon exhausting the resources is ‘quarry'. In the depleted environment, any surviving communities have to develop a new sustainable tectonic plate. This led to a new political economy – the ‘Classic Maori.' It was a closed economy without interaction with the rest of the world.

This changed just over 200 years ago with first the explorers and then the sealers and whalers. Just as those early Polynesians did not understand the environment they had come to, neither did the early Europeans. They quarried the natural resources too: whales, seal, timber, kauri gum, gold, other minerals, even soil was washed to the sea. So the first European political economy in New Zealand was what the French described as a "colony of exploitation" rather than a "colony of permanence". It is a world in which the visitor comes, exploits, and moves on.

But from 1882 new technologies transformed New Zealand: refrigeration, the steamer and telegraph came from offshore, while the grasslands revolution was largely indigenous. Over the next 80 years the political economy was based on producing grass, processing it into wool, meat, and dairy products, and selling them overseas in return for the desired imports.

This pastoral dominance ended in 1966 when the premium prices that farmers got for wool collapsed, never to return (except temporarily in the 1972-3 commodity boom), while meat and dairy prices were under pressure. The response was diversification – into horticulture, timber, fish, some minerals, tourism, and a little general manufacturing mainly to Australia.

Again the new political economy, which was based on the sustainable exploitation of primary resources, led to changes in the way New Zealand was governed and how New Zealanders lived. The story could be illustrated in many ways, but time allows only the example of the more market element of the 1984 economic reforms because the greater diversity of the export sector meant decentralisation of the economic mechanism became necessary.

Today there may be a new plate arising – that appears to be the intention of the Government's Growth and Innovation Strategy which I discuss at the end.

1.2 Changing Sectors

The political economy of tectonic plates is a qualitative story, which reminds us that development is not simply about a single aggregate output. Here are some few quantitative indicators which support this aggregate story.

Industry Composition

There have been major changes to the structure of GDP, particularly a substantial reduction of the share of agriculture in GDP over the 80 years, a diminution of the manufacturing sector for about 20 years, with the service sector expanding but not uniformly.

Table 1: Industry Shares in Nominal GDP

Deflators

Changing industry composition, means changing relative prices. This is nicely illustrated by comparing the Consumer Price Index (CPI) with the GDP price deflator (GDEF). The CPI covers what consumers spend, including production in New Zealand, and imports of consumer goods. GDEF covers only what is produced in New Zealand, including for export and what goes into investment as well as consumption, but it excludes imports. The difference (shown in a graph in the full version of this paper) is salutary. Aggregates operate on the basis that there is only a single product. Two such key prices diverging so markedly reminds us that an economy is about many products. The lesson is that the economist concerned with the growth of the economy cannot just look at aggregate GDP. Sectors are important; prices are important; and profitability and other factor prices are important.

1.3 The Course of GDP

This section, which looks at past periods of growth, is omitted.

1.4 The Long Run: 1861-2003

I have cobbled together the various GDP series, to give a 142 year run from March year 1861 to 2003, always using the better quality data. Chart 6, which uses a logarithmic or ratio scale, shows the stagnations in GDP per capita in the nineteenth century, and from the around 1908 to 1935, in the late 1940s to the early 1950s, and in the late 1980s and early 1990s. Remembering in a logarithmic scale graph,

steeper means faster, we observe that there were rapid expansions in the 1890s and early 1900s, and the rapid growth from 1935 to 1945, plus a steady growth, with the odd hiccough from the 1950s to the early 1980s. In summary the last hundred years have seen an average growth of per capita GDP of about 1.6 percent per annum., a doubling of output per person every 44 years.

Chart 6 also shows a trend line based upon a fourth order polynomial. It recognises the nineteenth century stagnation, but sees a strong upward trend in the twentieth. However notice that the trend bends down late in the twentieth century from about 1985. It may reflect the stagnation of the following years, an interpretation supported by that the fact GDP levels have been above trend in the past few years. Alternately it may indicate a slowing of the long run growth rate for New Zealand.

1.5 The Post-war Era

We can get an insight into exactly what happened by looking at the following graph of NZ GDP from 1954/5. I have omitted the earlier years when New Zealand grew slowly relative to those OECD economies severely damaged by the war, but so did the other war-ravaged economies. Chart 7 shows the path of New Zealand volume GDP from March year 1955, where it is indexed to 1000.

Over this New Zealand GDP path Chart 7 superimposes three OECD GDP paths. The first, on the left of the Chart, is set so that OECD GDP is set at the same 1000 in the March 1955 year. The middle path has the OECD GDP set at 820 in the March 1955 year, that is, 18 percent lower than the first OECD path. The third path, on the right, has the OECD GDP set at 730 in the March 1955 year or 11 percent lower than the middle path.

So the slowing down we saw in that long term trend was not continuous, but due to a couple of periods when shocks – which I discuss below – lowered the level of GDP relative to the OECD, rather like dropping a step or two on the ladder. Indeed in two thirds of the years – perhaps more – the New Zealand economy grew at much the same rate as the rest of the OECD. The Chart suggests five stages in the development of the New Zealand post-war economy relative to the OECD, although as usual the endpoints may not be precisely those chosen here.

1954/5 to 1966/7: Upswing

1966/7 to 1977/8: A Step-down

Then, in 1966 New Zealand suffered a shock which put it on a slower growth path for about ten years. The next section explains that the event was the collapse in the wool price at the end of 1966.

1977/8 to 1984/5: Upswing

In the following seven years, the economy broadly followed the OECD growth path again, but at a relative level that was 18 percent lower than the path of the 1950s and early 1960s.

1984/5 to 1993/4: Step-down

Then from 1985 New Zealand underwent another period of stagnation, through to 1993.

1993/4 - ? : Upswing

Since 1994 the economy has been growing at broadly the same rate as the rest of the OECD.

The new growth path is 11 percent below the path of the late 1970s and early 1980s. It is fatuous to say, as no less than the OECD did recently, that the New Zealand reforms are paying off. It is true that we appear to have returned to a growth rate comparable with the rest of the OECD but the reforms will not have ‘paid off', until New Zealand is above the 1977/8-1984/5 track.

1.6 The 1966 External Shock

In December 1966 the export price of wool fell about 40 percent. Except for a brief flurry during the 1971-1972 world commodity boom, it never recovered relative to import prices. In 1966 wool made up over 30 percent of export revenue. Add meat, and exports from sheep farming came to half of the total. So 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.

The immediate effect of such a shock was that the economy contracted. In 1967, there was – as there had been in the 1932 – a devaluation to share the burden of the commodity price downturn across the entire economy, rather than concentrating it in a leading sector. But instead of clinging to the weakened sector, as happened in the 1930s, the New Zealand economy in the 1970s went through an export diversification – into horticulture, forestry, fishing, mining, general manufactures, and tourism. The external diversification was spectacular. No other OECD economy compared. Even so the economy slowed down. When New Zealand recommenced upon its traditional growth path it was at a level some 18 percent below the previous one.

1.7 Explanation for the Slow New Zealand per capita GDP Growth

Among the explanations I have investigated and given some credence to are:

Post-war Catchup
Systematic Measurement Errors
Population Growth
The Convergence Effect
Terms of Trade

All seem to have slowed per capita New Zealand GDP growth in the post-war era to some extent. But none – except the terms of trade – explain the transition from the pre 1966 track to the post 1977 one, or the magnitude of the difference between the two paths.

1.8 Non-Explanations for the Slow New Zealand per capita GDP Growth

There are some popular explanations which hardly conform to any known scientific methodology.

Excessive Intervention: It was popular to argue in the 1980s that the New Zealand economic mechanism had been too dependent upon centralist interventions, which slowed down the economic growth rate. The policy prescription was that a major economic liberalisation, shifting the mechanisms to more-market, would accelerate economic growth. The evidence of the 1990s is that it did not. But here we evaluate the theory from an early 1980s perspective.

There was no attempt to demonstrate the connectedness of the proposition, or to measure it. In particular, was New Zealand more intervened in than the countries with which any comparison was (implicitly) being made? Additionally the account was ahistorical: it is not obvious interventions intensified in 1966. Moreover the period of fastest growth – from 1935 to 1945 – was a time when the economic mechanism was highly interventionist, much more so than it was in the 1970s.

Size of the Economy

The same problems apply here as apply to the market mechanism thesis described under heading 1.8 above.

Distance

The same non sequiturs apply. Indeed, if distance was an inhibition, one would have thought that the continued and remarkable reductions in the cost of distance in the post-war era ought to have speeded up New Zealand's economic growth rate.

1.9 Some Errors of Method

A therefore B

There is a tendency to connect unrelated facts, without any analytic account of how they are connected, or empirical verification. It is typically associated with the ignoring of facts which contradict the connection and alternative theories which might prove more robust.

Too Late a Period

Check before the period which begins the analysis that something did not just happen earlier.

Tautologies are Not Explanations

Relativities Not Rankings

Much of the New Zealand discussion has been in terms of its ranking measured by GDP per capita among OECD countries. Whatever the mathematical distaste for using an inferior measure, rankings have also misled researchers. Chart 8 shows both OECD relativities and rankings. Not only does the ranking pattern not closely follow the relativity, but for the first 15 years New Zealand hardly changed its ranking, although its relativity fell dramatically. The same applies to the last twenty years, when only Ireland passed New Zealand. Even so, New Zealand's GDP per capita fell from about the OECD average to just above 83 percent. A regrettable result from the focus on rankings has been the focus on the 1970s when New Zealand dropped nine placings, ignoring the problems of the post 1984 period. The earlier period is easily explained in terms of the 1966 terms of trade crash. The later period is more complicated to explain.

1.10 What Happened After 1984?

The graphs show that GDP broadly stagnated from 1985 to 1993. Indeed there appears to be six years in sequence when GDP per capita fell. There was no similar experience in the post-war era, or indeed in any known pre-war era. There is no obvious external shock in the mid 1980s of sufficient magnitude to explain all the stagnation. I looked at the third oil shock (in 1985 when the real price of oil fell) and the hike in real interest rates. While both impacted unfavourably on the New Zealand economy, neither seems to have been sufficient to explain the stagnation.

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. Australia went through a similar – albeit less extreme – liberalisation, but it did not experience a stagnation.

A middle view is that poor policy sequencing lead to a financial liberalisation which distorted the economy, leading to a temporary economic boom, and then the crash of 1987 (which seems to have been the most severe of all the sharemarket crashes in the OECD).

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. The one attempt to predict the medium term course of the economy in 1985 by Bryan Philpott contradicts the conclusion that the policies of the 1980s and 1990s made no contribution to the stagnation.

Rather than look for an external shock, we look for an internal shock which impacted on the external sector. That there was a problem in the external sector is evident from the following table which compares New Zealand's economic performance with that of Australia's and the entire OECD's over the 1985 to 1998 period.

As the table shows, New Zealand's economic performance was inferior to the rest, with poor GDP growth, poor productivity growth and high unemployment growth,

Economic Performance: Average 1985-1998 (% p.a.)

despite the most favourable terms of trade boost. The one success was the dramatic reduction in inflation. Most of all, New Zealand had a poor export performance – worse than its import growth.

The import growth is not surprising, given that border and internal protection had been reduced, although without the import substitution of the ‘Think Big' major projects it would have been even higher. Similarly the poor growth of the export sector is better than one might expect because it is boosted by some Think Big exports, and by the horticultural and forestry exports from plantings before 1985.

Here is the same table for the 1978 to 1985 period when the New Zealand economy grew much better. Indeed the whole economic performance was much better, except for inflation. In particular export growth was higher: more comparable to the rest of the OECD.

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.

Economic Performance: Average 1985-1998 (% p.a.)

Chart 9 shows a leap in real exchange rate 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 disinflation. The Reserve Bank targeted the Consumer Price Index, which being a measure of expenditure rather than production, has a large import – and therefore exchange rate – component. The easy way to depress the CPI was to hike the exchange rate.

A high - "overvalued" - exchange rate means that the profitability of exporting (and import substituting) was compromised. This has two effects. First, some parts of the tradeable sector contract and close down. This is most evident in the import substituting industries. Second, other parts of the tradeable sector would cease to expand: the mechanism is that the fall in profitability means there are fewer attractive investment opportunities, while sales are not generating the cash flow to fund the investment. Of course, this slowdown would phase in. The medium term outcome would be that the tradeable sector would slow down.

Eventually, the tradeable sector adjusts to the high real exchange rate, by eliminating all its activities which are unprofitable below that rate, at which point it begins expanding again, apparently at roughly the same rate as had occurred before the exchange rate hike. So economic theory says a step-up in the level of the real exchange rate will lead to step-down in the level of GDP with a lag, a transition path of a period of slow GDP growth or even stagnation. That is exactly what happened in practice after 1985. The liberalisation which took place after 1984 did not lead to the stagnation, but the poor quality macroeconomic management of the period did.

1.11 The Importance of Thinking Sectorally

There are many lessons in this paper. Here I want to focus on the importance of thinking sectorally. Suppose we wanted to think about the possibility of an annual GDP growth rate of 4 percent per annum. Those trapped in the aggregate GDP paradigm would write down a mathematical tautology, perhaps leading to a level of total factor productivity growth that had to be obtained. In contrast, a sectorally focussed approach recognises that different sectors grow at different rates. Let me group sectors into four.

The first sector category, perhaps called the tens, are sectors which are likely to grow at 10 percent per annum or more in volume terms. Typically these are very dynamic industries perhaps responding to a new technology or fashion. But "tens" are small industries. As their rapid growth makes them larger, they tend to slow down to join the second category.

The second sector category (sevens), are those which grow faster than the economy as a whole – say around seven percent per annum. Because they are big enough and fast enough to drag the rest of the economy along with them they are the key sectors in economic growth.

The third sector category (fours), are those sectors which grow about the same rate as the economy as a whole. They are not unimportant and can be quite dynamic. But they are not economic drivers.

In the final sector category (ones), are those which grow markedly below average. Not all sectors can grow above average. "One" industries often have productivity growth with demand stagnation. How do we shift their underutilised resources into the "sevens"?

What are the characteristics of ‘sevens'? A possibility unavailable in New Zealand is the ‘bootstrapping seven', a domestically oriented sector which can drag the entire economy along.

Import substitution might seem to be a bootstrapper but, like exporting, it is displacing overseas producers. The most common ‘seven' is a tradable industry – in today's circumstances an exporter. In the post-war era, OECD exports and imports grew faster than output. I will come back to why they did shortly. But there is a second reason why a small economy like New Zealand is likely to have ‘sevens' in the export sector. As a general rule, New Zealand is only a small exporter relative to market size so it can expand its share of the market without severely disrupting competitors. Thus its export sectors can grow faster than the domestic sector and, in doing so, drag the rest of the economy onto a faster growth path.

Tradeables as sevens 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 the poor economic performance was associated with a poorly functioning exportable sector. While the first occasion – from 1966 into the 1970s – was through an event over which New Zealand had little control, the second step-down has all the hallmarks of our own fault, when we ignored that the key requirement for successful growth in an industry is that it has to be profitable.

1.12 The Next Political Economy?

To finish with a little speculation about the future New Zealand political economy; while it has transformed from one dominated by the pastoral sector into a more diversified one, there is still an underpinning resource base for most of the major industries: tourism, dairy products, meat products, forestry, horticulture, fish products, wool minerals and energy.

If I have understood the Growth and Innovation Strategy aright, the government wants to accelerate the roles of human capital and creativity. To understand how this fits into the international trading pattern – I am now no longer describing the government's strategy but interpreting and extending it – recall that exports grow faster than output. Now there is nothing inherent about exports that means that their income elasticity of demand should be substantially greater than unity. What seems to be causing the rapid growth is the patterns of the location of production.

Today, about a quarter of the world's trade is in oil, a quarter in primary products, and a quarter in general manufactures which are traded according to the rules of comparative advantage. The final quarter of world trade involves intra-industry trades, which occur when the two countries trade broadly the same goods or services – say the French buying Volkswagens and Germans buying Renaults. There was negligible intra-industry trade immediately after the war, so this is the fast rising part of international trade.

Intra-industry trade is governed by the rules of competitive advantage not comparative advantage. This theory is a recent one. It is based upon products which are similar but can be differentiated by the market, it involves economies of scale in production and other advanced technologies, and it is driven by the falling costs of distance.

New Zealand has probably the poorest intra-industry trade record in the rich OECD. An issue is whether New Zealand can get into intra-industry trade – exporting pharmaceuticals to Europe, software to the US, films to Hollywood, while, of course, also importing pharmaceuticals from Europe, software from the US, films from Hollywood. A way of interpreting the ‘innovation' part of the Growth and Innovation Strategy is it aims to create industries involved in intra-industry trade which are tens, and grow them strongly enough to become the sevens. This upwelling of a new political economy tectonic plate need not subduct the diversified resource plate. There may be synergies between them – to mix metaphors.

Whether we are economic theorists or practical policymakers we are feeling our way about the significance of competitive advantage and intra-industry trade. Much of my research program over the next few years is trying to understand it. So I conclude with the more fundamental message which has pervaded this paper.

Economic development is different from economic growth. It is not simply about increases in aggregate output, but about the changes 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.