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Cullen To NZ Association of Economists Conference

Opening address at NZ Association of Economists Conference

Hon Dr Michael Cullen, Minister of Finance

Embargoed to 0930

Wednesday 26 June 2002

James Cook Hotel, Wellington

I was very pleased to learn that the theme of the conference is “Back into the top half of the OECD: New Zealand’s long run economic performance’. The title is presumably based on the target I articulated in relation to the growth and innovation framework released by the Prime Minister in February.

This is a critically important area of inquiry and certainly something that my colleagues and I have been thinking a lot about. It is essential that research economists in this country apply themselves to the task of understanding the various processes by which sustained growth occurs in a global, knowledge-based economy, and in particular how a small country, isolated geographically, but with a literate, mobile and skilled workforce, can best position itself for that kind of growth.

Raising the sustainable growth rate to 4 per cent within the next five years is a first step towards returning New Zealand’s real per capita income to the top half of the OECD.

That is an ambitious target, certainly in excess of New Zealand’s historical and projected economic performance. Treasury is forecasting annual real GDP growth to average about 3 per cent over the next four years. Achieving 4 per cent will require a substantial lift in productivity.

However, this is not an impossible dream. Consider, for example, the Australian growth experience. Over the 1993-2000 period, Australia has averaged real GDP growth of 4.2 per cent. Several other OECD countries, such as Ireland and Finland, have sustained much higher growth rates than this. I do not buy the notion that New Zealand is condemned to a low growth trajectory. The challenge for all of us is to consider how New Zealand’s growth rate can be lifted. What are the mechanisms that will achieve this, and what are the levers that government, business and individual communities can use?

I don’t want to open up a technical debate, and certainly not in this forum, but it is worth sketching out the broad parameters of the growth arithmetic that can contribute to achieving an average GDP growth rate of four per cent a year.

An economy will grow if it uses a greater quantity of capital, and/or a greater quantity of labour and/or increases total factor productivity.

The standard theoretical advice is that the only permanent method to achieve this is through an ongoing increase in total factor productivity. The logic is that in the absence of this an increase in the quantity of capital will result in a decline in the return on capital and hence a decline in the rate of investment.

I’m not totally convinced about this, and I am also not totally convinced about where it otherwise leads policy. The danger is that it leads away from attempts to boost the stock of capital and the size of the labour force.

What theory cannot tell us is how long an increase in the growth rate can be sustained through capital deepening - through more investment. The big unknown is when returns to extra investment will start to decline. As new market opportunities expand, partly through new trade agreements and partly because of expanding world demand, it is possible for profitable expansion to continue for some considerable time. That time can be extended by the effects technology has in sustaining profitable expansion.

There is also little empirical understanding about how extra investment, and an increase in the labour supply though a mix of an increase in net immigration and the participation rate can stimulate productivity growth, and reinforce another round of capacity growth.

If we start to unscramble the arithmetic, the growth equation looks a little like this:

- Achieving a long-run potential growth rate of 4 per cent requires the total factor productivity growth rate to rise from an historical level of just over one per cent to two per cent. Changes of that magnitude, or to that level, are not that rare. Recent examples are Australia, Finland and Ireland.

- 4 per cent growth would be achieved if the rate of growth of the capital stock increased from an historical 2.7 per cent per annum to around 6.5 per cent. How long that would last is a theoretical unknown. While this looks relatively achievable, it does in fact represent a large increase in the rate of growth of investment.

- In a mixed scenario, a small increase in total factor productivity - from 1.1 to 1.4 per cent per annum, an increase in the rate of labour force growth from 1 to 1.5 per cent and investment increasing the capital stock by 4.5 per cent per year would also combine to generate 4 per cent growth.

The broad conclusion is that the target is achievable, but gets harder and harder if there is too much emphasis on any one contributor to growth. This leads me strongly away from magic bullet solutions that focus, for example, on increasing investment on its own. (Even if a cut in the company tax rate, labour market deregulation and weaker resource management controls led to increased investment, which is arguable, there is no plausible scenario that would have them achieving the totally implausible growth rates that opposition parties are throwing around with loose analytical abandon.)

The broad front approach mixes things like education and training, active labour market programmes, immigration policies, expanded trade agreements, inward investment attraction, business incubation, industry and regional development assistance, venture finance provision, deeper capital markets and science and innovation promotion. Together they expand the quantity of capital, the quantity of labour and increase the rate of growth of productivity, and that underpins the next cycle.

Each contributing its bit is what achieves the required expansion in the growth rate.

Of course, at the oppositie end of the spectrum to the magic bullet approach, there are those who see economic growth as the enemy of the environment or of their particular take on social justice. While it seems curious to have to set out the reasons why economic growth is important, in light of some of the antediluvian policies being put about by some of our opponents, it is important to remind ourselves of why we need to grow.

First, without growth, we are less able to provide public goods and services. Growth expands the tax base, which means that more can be spent on health, education, infrastructure and so on.

As I noted in the budget speech, there is generally a very close relationship between GDP per capita and the proportion of GDP spent on health per head. New Zealand is, and has been for some years, pretty well exactly on the trend line. What this suggests is that if we want to provide for ourselves an even higher standard of heatlh care, we must either increase substantially the proportion of GDP spent on health (with all the difficult trade offs that would entail), or we will need to lift our sustainable growth rate.

Continuing to provide first world public goods and services is heavily dependent on the ability of the New Zealand economy to generate first world rates of economic growth. Over time, faster rates of growth in other countries will enable them to offer more generous public health care and higher quality public education systems which give their citizens a head start.

Second, a growing economy is important in terms of the provision of returns and opportunities to New Zealanders who stay here. We want New Zealanders to have the option of pursuing a career, making investments and so on, in New Zealand rather than being forced to exit to larger, more successful economies.

The recent turnaround in migration appears to be due in part to our improved economic performance. An economy that is growing offers competitive returns to investors and opportunities for skilled people. This becomes self-perpetuating.

But the lesson to be taken from the positive migration flow is that people are mobile, and the flow could just as easily turn negative if the economy fails to continue growing. This in turn could become self-perpetuating; as more capital and talent leaves New Zealand, the incentive for the remaining stock to stay in New Zealand diminishes.

Another reason why we need to grow is that growth disparities also reduce the extent to which global connectedness happens - itself a crucial input into future growth. If New Zealand incomes do not keep pace relative to cost structures in other countries, it will be harder for New Zealanders to travel overseas, and for New Zealand firms to move into export markets.

The key message here is that New Zealand’s economic performance relative to other countries is an important consideration, over and above changes in the absolute rate of growth. Clearly the key relativity is between Australia and New Zealand. There has been a large and widening gap; in 2000, the OECD estimated that Australia’s real GDP per capita, as measured using purchasing power parity, was 33 per cent ahead of New Zealand’s real per capita income ($24,708 v $18,630, in 1995 US dollars). This gap needs to be closed.

So while it is true that growth is not the only objective of government - and that social and environmental goals are also important contributors to welfare - increasing growth is an immediate priority. Given New Zealand’s current position, our ability to achieve our social and environmental aspirations is heavily contingent on an improved growth performance.

There is no basis to the contention that there is a direct trade off between higher growth and achieving other goals - in particular, social and environmental goals. As mentioned above, money is needed to finance health, education and environmental priorities. Growth also helps to increase the amount of employment in the economy and lifts wages, which is likely to have a positive effect on the distribution of income.

The government’s initial thinking on how to improve growth was articulated in the growth and innovation framework (copies of which are available on the Prime Minister’s web site). This framework outlined the various policy settings that we felt were important for increasing New Zealand’s growth rate. These elements are well attested in theory and in econometric analysis as contributing to growth.

The first element of the framework consists of a set of “policy foundations’, important institutional and infrastructural building blocks. In this regard, we have identified a stable macroeconomic framework, an open, competitive micro-economy, a modern cohesive society, a healthy population, sound environmental management, an educated population, a globally connected economy, and a solid research and development framework.

Successive governments have made significant investments in policy foundations over the past two decades, and this has had a positive effect on economic performance. This government has made further advances since 1999, and we continue to receive favourable comment from the IMF and OECD on these policy settings, which in turn has a positive flow on effect for our international credit rating.

However, a sound set of foundational policies is unlikely to be sufficient to generate high growth. Indeed, other countries, with what are from an orthodox perspective less transparent foundational policy, have generated higher rates of growth than New Zealand.

Good foundations are a necessary but not sufficient condition for growth for a country with New Zealand’s characteristics. They are the fulcrum, but we also need effective levers. We see three major levers for growth: innovation, skills and talent, and global connectedness.

First, we need to encourage and reward the creation and commercialisation of good ideas. We need to improve the efficiency of the networks that link the innovators and the entrepreneurs, so that more of our R&D spending leads to commercial benefit.

It is often said that innovators and entrepreneurs work in a disjointed fashion in New Zealand. What we need then is better articulation. To give just one example, we need a thicker capital market - either on-shore or through better access to foreign sources of venture capital - to assist small to medium sized businesses with potentially world-beating products and services to access the capital they need to increase the scale of their operations.

In the area of skills and talent, we have recognised two areas of need. We need a well educated population, with a high average level of skills, in order to attract and retain businesses. And we must also develop, attract and maintain a solid core of exceptionally talented people who will be leaders in the development of new products. This will involve growing more talent through the education system, attracting overseas talent to live and work in New Zealand, and utilising the “Kiwi diaspora’ living in other countries.

Thirdly, global connectedness. For a small country of 3.8 million people, economic integration with the rest of the world is critical - this is not just in terms of access for our exports, but also in terms of being able to readily access skilled people, capital, ideas and knowledge.

In the past, connecting with the global economy has been made more difficult by our physical location. Arguably, those impediments are much less important now. We are beginning to see companies such as Fonterra and Zespri International develop strategies and alliances whereby a distinctly New Zealand brand is “virtually” located on the doorsteps of major world markets.

We need to find ways of doing this with the whole of the export oriented sector. This is part of the reason why the government intends to focus on export promotion, increased foreign direct investment promotion to strengthen domestic capacity, and developing a national brand for New Zealand.

We also have to consider the question of the degree of “focus’ in the economy. We hamstring ourselves when resources are thinly spread, and we need to examine how to create the critical mass that is required for our industries to excel globally. For this reason, the government intends to focus its policy interventions, particularly those that relate to innovation, skills and talent, and global connectedness, on a few key parts of the economy.

In the first instance, the government has chosen to focus on biotechnology, information and communications technology and the creative industries. These are not so much industry sectors as key competencies that can increase productivity across the economy, thereby creating the potential for a material improvement in growth. They are also areas in which New Zealand firms have existing or potential competitive advantage. The idea to is follow the market and simultaneously gain greater leverage from our existing strengths.

I do not suggest that this set of policies is the last word on the economics of growth. Even after decades of research on growth, there are many questions that we do not understand well. This can make us vulnerable to uni-dimensional solutions, and various forms of economic snake-oil. One might argue that New Zealand fell into that trap in the 1990s, when the economic rationalists (using logic kindly donated by the Jesuits) convinced us that purity by itself is the surest precursor to fertility.

The truth is more complex than this, and for this reason we need an ongoing evidence-based debate on the best growth strategies for New Zealand. This must recognise that New Zealand differs from other OECD economies in terms of its history, its economic structure (particularly, the importance of agriculture), our small size and distance from major markets.

Also, as a government that believes in its role as a partner in the economy, we believe in the need for research into the most effective forms of engagement and partnership between the public and private sectors in the joint pursuit of economic growth.

I would hope that this conference will contribute to this debate, and I would personally be very pleased if future editions of the New Zealand Economic Papers were to contain thoughtful and scholarly discussions of New Zealand’s economic performance and what might be done to improve it. I can assure you that they would find a very eager audience within the government.

Best wishes for a successful and enjoyable conference.

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