4. Summary
High and rising levels of material well-being – the key objective of economic policy ‑ result from an evolutionary process of transformation of the economy – the creation of new and better products, processes, business models, organisational forms, markets etc. Thus transformation of the economy is fundamental to economic growth.
Economic development is driven by entrepreneurs in business. They operate in an environment that is so uncertain that it precludes objective optimisation. Using their knowledge and imagination, they grope forward in this radically uncertain environment seeking out profit opportunities. In doing so, they develop profitable new products and methods of producing and marketing them ‑ i.e., they innovate.
Entrepreneurs are motivated by the intrinsic satisfaction innovation yields, by social approval and by material rewards. In particular, profit provides entrepreneurs with the incentive and means to focus on socially valuable innovation and so to add to real output and income per capita. A succession of innovations leads to successive increases in income per capita – in other words, leads to economic growth.
Entrepreneurs are influenced in what they do and how they do it by the natural and institutional environment in which they operate and the capabilities that it provides.
In a modern economy even relatively simple products depend on a complex web of knowledge, institutions, skills, networks and other capabilities for their production. These are highly differentiated and product specific, so that countries that look alike in their resource endowments actually produce different products.
Adapting the production structure to produce a new product requires the development of new knowledge and capabilities. This is difficult, even when the capabilities required to produce the new product are similar to those used to produce existing products. Producing products that need multiple new capabilities is just about impossible.
Thus, when they innovate, entrepreneurs build off the complex web of existing capabilities, and in innovating, create new somewhat different knowledge and capabilities. This in turn creates a new higher foundation of capabilities and knowledge, laying the foundation for more innovation and economic growth. These capabilities are interdependent, so that development of each depends on development of others.
As a result, economic development is systemic in nature and path dependent. It results in an evolutionary transformation of a country's product mix and production structure.
There are two implications of this analysis. First, the highly differentiated nature of products and capabilities means that areas of comparative advantage will be highly differentiated. This means that even a tiny country like New Zealand can realistically aspire to retaining and developing a sustainable comparative advantage in a few areas.
Second, where a country has developed a comparative advantage, it is likely that it has developed a myriad of related, difficult‑to‑replicate, world‑class, capabilities and resources. It is also likely in future that it will develop new world‑class capabilities in products adjacent to its current comparative advantage, creating clusters of businesses with a comparative advantage. These capabilities will be difficult for a country without a similar comparative advantage to replicate.
For New Zealand, this implies in particular a set of capabilities related to the natural resource based industries, together with their related and supporting industries.
Two broad classes of capabilities can be distinguished – those that relate to individual economic agents (such as skills), and systemic capabilities that relate to the interaction between agents. Both are important to innovation. They are summarised in MED's productivity model (Annex 3).
One important systemic capability is a well-functioning market. The market mediates the process of economic development. It integrates the interests of the various actors in an economy. It resolves the enormously complicated problem of aligning the activities of all the actors in the economy and across the world.
However, in any modern economy the market is neither natural nor perfect. Instead, the market and the institutions that underpin it are a human construct. Government action is necessary to create a market which fosters socially productive innovation by giving entrepreneurs the incentive to compete on those margins, and those margins alone, that are socially desirable. And this structure must evolve with changes in the world.
Thus the real question for the government is not whether it should intervene in the market, but where, how and in what circumstances it should intervene.
The objective of and touchstone for intervention should be to facilitate innovation by enhancing the ability, connectedness or incentives of entrepreneurs to spot and pursue socially worthwhile outcomes and by discouraging them from pursuing socially undesirable outcomes.
In order to intervene appropriately, we need to know how a new intervention will impact on productivity growth. Two key ways of assessing the need for intervention are:
- Empirical studies identifying what capabilities are conducive to growth.
- Theoretical analysis of how markets and the institutions underpinning them may fail to deliver good outcomes.
Empirical studies can identify at a broad level the capabilities that are associated with high income levels and growth rates. While these studies are not without their difficulties, they have the virtue of directly assessing the impact of various interventions on material well-being.
Where such evidence is not available, an analysis of how markets differ from the theoretical ideal posited by neo-classical theory may give us some clues as to where intervention may be appropriate. The particular characteristics include:
- Uncertainty
- Incentives
- Spillovers
- Path Dependence
- Information Asymmetries/ Missing Markets
- Coordination Failures
- Non-rationality
This analysis must be undertaken judiciously, recognising both that some neo‑classical market failures are necessary for innovation and that neo-classical theory will not highlight all areas where capabilities may be deficient – notably the need for mechanisms to promote networking, co-ordination and knowledge flows. It turns out that innovation is particularly problematic – it is replete with characteristics which mean that government action may enable markets to better foster entrepreneurial activity and so economic development.
The New Zealand economy, like any modern economy, has in place a complex web of government interventions – taxes, publicly provided goods, regulations governing social and economic behaviour, enforcement mechanisms etc.
Much of the complex web is aimed at addressing income growth. In addition, governments intervene for a variety of other economic and non-economic reasons. The New Zealand government for example has a heavy hand in health, education and welfare. And it has to finance these and other interventions through the tax system. The design of these interventions also has the potential to impact on growth.
At any point in time, there may be situations where further or different interventions will better provide people with ability or incentives to spot and pursue socially worthwhile outcomes.
While ongoing government action to maintain and improve the working of the market is necessary and inevitable, it is not without its costs. In addition to the resource costs that any such action may impose, it raises the potential for rent-seeking, either by those in government or by those who can influence the government. The latter in particular risks diverting entrepreneurial effort away from socially productive innovation. In addition, in making and implementing policy, those doing so face the same uncertainty as do entrepreneurs. If they do not adduce appropriate evidence, or if they lack the competence to design and implement effective policy, there is a risk that the potential benefits of policy may be forgone.
Thus an assessment of whether and how to intervene in any particular case involves an assessment of the costs and benefits of intervening.
For broad-based economy-wide policies, like competition policy, there is often independent statistical evidence (cross country studies etc) on the potential gains from intervention. In addition, because any business looking to rent-seek faces a free‑rider problem (its competitors benefit from any rent-gaining intervention it manages to promote), the risks of rent-seeking are relatively manageable.
On the whole, New Zealand's broad-based policies are regarded as approaching best‑practice. However, the Economic Indicators Report 2007 (Ministry of Economic Development et al 2007) provides some evidence that further significant improvements are likely to be possible. Because even small policy improvements add up across the economy as a whole, they should continue to be pursued.
For more fine-grained policies, the opportunities for rent seeking tend to be more sharply focussed on a smaller group of businesses, making rent seeking more profitable. There is often little statistical evidence of the benefits of a particular policy. And the government is not close to the market. As a result, the government suffers from an even worse problem of radical uncertainty in implementing fine-grained policies than entrepreneurs do in pursuing profit opportunities. In order to get more robust information, it must engage with the businesses that are close to the relevant market and elicit information from them. This provides businesses with further scope for rent‑seeking behaviour.
The risk of rent-seeking behaviour can be reduced (but not eliminated) by establishing and following a set of principles that take account of uncertainty and apply transparent and market‑based incentives to the process of intervention.
Furthermore, implementation of fine grained policies often requires a case by case assessment of the likely economic benefits from intervention and design of policy to realise them. This requires a good understanding of the nature of the economic benefits and of the part of the economy to which the intervention will be applied. This is likely to be a complex task, and the skills available to undertake it are likely to be in short supply.
These considerations suggest caution in undertaking more fine‑grained intervention.
At the same time, the benefits from these fine-grained policies are potentially substantial, and may outweigh these and other costs of intervention. In particular, as discussed earlier, the multiple capabilities required for achieving comparative advantage will be highly specific. Business can be expected to develop the capabilities within its purview, but exploiting the opportunity may also need government action ‑ for example, to deal with issues (e.g., inappropriate regulation or missing institutions) that can only be addressed by the government. These issues can often only be identified and dealt with at a more detailed level than broad-based policies typically address.
In addition, direct engagement with the relevant businesses makes coordinated action possible, allowing both parties to achieve gains that each individually could otherwise achieve. For example, if the government simply reacts passively to transport demands, and businesses make their decisions on demand for transport infrastructure based on their projections of that response, solutions which better serve business needs may be neglected.
Stiglitz 2005 (pp27-29) summarises the need for and design of industry policy and other more fine-grained policies well.
"In some sense, this means that the government cannot avoid addressing issues of industry policy. The government plays a central role in the economy. In addition to [a] large role …in finance, it is pivotal in research and education as well. Infrastructure is another area….Decisions it makes in these areas – which areas of research to support, how to design the curriculum, where to build roads and airports, help shape the economy and its competitiveness. It is better these decisions be made with a view to where the economy is going….
Modern industrial policy is not involved in micro-management of the economy. Critics of industrial policy say the government is not in a position to "pick winners". And it should not do so. But this misses the point, in two respects. The government intervenes in the market not because it does not have faith in the market's ability to pick winners…but rather because it recognizes that there are market failures of the kind noted earlier. By the same token, modern industrial policy is often "broad gauged" and, so far as possible, attempts to employ market-like mechanisms in its implementation….
A key part of this broad-gauged policy will be working to enhance the economy's flexibility….
Modern industrial policy may entail "negative" policies as much as positive, recognising that speculative real estate may contribute less to employment and growth than other sectors, and may expose the economy to greater instability. Thus it may make sense to restrict the extent of bank lending.…
While broad-gauged policies reduce the necessity of the government "picking winners", there is no way that the government can avoid forming a "vision" of where the economy is going".
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