Back to normal isn’t enough
Even before Covid-19, New Zealand was near the bottom of the class for productivity. What’s holding us back?
Getting the economy back to normal should not be the national goal at this stage. We need to set our sights higher than that.
And not just because normal — in the sense of the status quo before Covid-19 — has delivered shameful levels of child poverty and environmental degradation.
Back to normal would also mean settling for being at or near the bottom of the class internationally in terms of productivity and therefore incomes. The relevant class is the set of small advanced economies like Denmark and Singapore.
What prompts these observations is an insightful paper by expatriate economist David Skilling, whom people may remember from his days at the Treasury and then the New Zealand Institute.
It was prepared for the Productivity Commission, which has embarked on an inquiry into “maximising the economic contribution of New Zealand’s frontier firms”.
“Frontier”, in this context, means being in the top 10 per cent, say, of firms ranked by productivity.
Skilling has made a speciality of the economics of small countries. He points out that not only is New Zealand’s labour productivity, or output per hour worked, about a third lower than Australia’s, but the gap is wider still compared with small advanced economies as group.
The reasons for this have been analysed for years to the point of exhaustion: weak business investment; low spending, especially by the private sector, on research and development; and a stubbornly low level of exporting as a share of GDP.
Policy responses, from the Knowledge Wave to the Business Growth Agenda, have failed to move the needle.
“This is partly because the incentives to lift labour productivity have been relatively weak, including a relatively high cost of capital and an abundant supply of labour (high participation rates, good demographics and strong net migration inflows) as well as the small domestic market,” Skilling writes.
While New Zealand has some world-leading firms — a2 Milk, Xero, Weta Digital — their conspicuous rarity makes them exceptions that prove the rule. As a rule, New Zealand’s frontier firms are not performing as well as their international peers.
Skilling points to three key characteristics of prosperous small economies.
● One is the importance of internationally oriented sectors, given the limitations of small domestic markets.
● A second is the importance of large firms, as they tend to do more capital investment and R&D, are more likely to innovate, and pay higher wages.
● And the third is a focus on a limited number of world-class clusters in internationally oriented sectors that provide the critical mass of knowledge to foster and sustain frontier firms.
On international orientation, New Zealand’s ratio of exports to GDP is only about half the average level for small advanced economies, while outward direct investment is more like a tenth of the peer group average. We do not seem very good at investing abroad, with Fonterra only the most gruesome example.
The conventional excuse for a low export share is that it is combination of being small and remote that is the challenge. It is okay to be small if you are conveniently located in Europe or on a major maritime route like Singapore, or remote if you are the size of Japan, but the combination of the two is problematic.
But fatalism about remoteness is a cop-out, especially when digital technology is at least mitigating the tyranny of distance. Weightless exports, Skilling suggests, is an obvious area to focus resources on.
The primary sector is the other. But the dominance of co-operatives in pastoral farming does not help, he argues, constraining risky investment and skewing the product mix towards commodities.
“Bluntly stated, there aren’t enough large firms exporting at scale and too few smaller firms that are growing rapidly by expanding strongly into international markets,” Skilling writes.
“New Zealand does not have the strong pipeline of high growth firms required to make a material difference. As a matter of arithmetic, 100 per cent annual growth in 20 $100 million turnover firms is required to match 10 per cent annual growth in a $20 billion turnover firm like Fonterra.”
The policy response Skilling advocates would focus resources on strategic clusters where New Zealand has some comparative advantage. An ideological aversion to picking winners should not get in the way of backing winners.
“The risk of a level playing field approach that ‘lets a thousand flowers bloom’ is that it yields a thousand dead flowers, because firms do not have the topsoil of a surrounding cluster in which to grow to become frontier firms.”
Skilling calls for a substantially stepped up investment in skills and innovation and that it should be specifically focused on clusters in areas of strategic advantage.
“Otherwise investing in a country’s most mobile factors of production (skilled people, innovative firms) may simply lead to a greater risk of exit from New Zealand.”
R&D spending, at 1.4 per cent of GDP, is only about half the level of high-performing small advanced economies. Remedying that would mean sustained investment in research institutions and universities, so they are able to undertake worldleading research and education, particularly in areas that relate to New Zealand’s strengths, as well as financial support to firms through tax credits or direct grants.
But a shift in mind-set in the private sector is also needed, Skilling argues. “The record of New Zealand firms expanding into global markets is not good, with numerous high-profile examples of shareholder value destruction.” It is seen as easier to generate good profits and dividends in less competitive domestic markets.
“As a consequence, boards and management teams tend to be cautious about international expansion, and capital markets tend not to be supportive of financing international expansion.” And the opportunities for on-the-job training in running or growing an international business out of New Zealand are correspondingly limited.
But while the challenges are daunting, the international experience of small economies is an optimistic one, Skilling concludes.
“It is not the case that small economies need to accept more modest outcomes in terms of frontier firms because of their small domestic market size.”
The risk of a level playing field approach that ‘lets a thousand flowers bloom’ is that it yields a thousand dead flowers.
David Skilling