Economic growth within environmental limits

That was the title of a speech David Parker gave a couple of weeks ago.  Parker is, as you will recall, a man wearing many hats: Minister for the Environment, Associate Minister of Finance, Minister for Trade and Export Growth, and Attorney-General.  Since he was speaking to a seminar organised by the Resource Management Law Association, this speech looked like it might touch on all his areas of portfolio responsibility.

In passing, I’ll note that he clearly doesn’t live in Wellington.  He introduces his speech lamenting that New Zealand had just had its hottest summer on record.  Most Wellingtonians –  no matter how liberal (indeed, I recently heard an academic working on climate issues make exactly this point) – revelled in a summer that for once felt almost like those the rest of New Zealand normally enjoys.   The sea water was even enjoyably swimmable not just bracing or “refreshing”.

But the focus of his speech is on economic growth.

First he highlights some of New Zealand’s underperformance.

New Zealand has enjoyed relatively strong nominal economic growth over recent years, bolstered by strong commodity prices, population growth and tourism. More inputs, mostly people, have been added into the economy but, with population growth stripped out, per capita growth has been poor at about 1 per cent per annum.

That underperformance has been the story of decades now.   And poor as the growth in per capita real GDP has been, productivity growth –  real GDP per hour worked –  has been worse.  In one particular bad period, over the last five years or so, labour productivity growth has been close to zero (around 0.2-0.3 per cent per annum on average).

Parker is obviously aware of this, beginning his next paragraph “we also have a productivity problem”, but seems more than a little confused about the nature of the issue.

Capital has been misallocated, including into speculative asset classes such as rental housing, rather than into growing our points of comparative advantage.

But…….your government (rightly) keeps telling us that too few houses have been built, laments increases in rents etc.   If we are going to have anything like the rate of population growth we’ve run over recent decades (let alone the last few years) ideally more real resources would be devoted to house-building, not less.  Simply changing the ownership of existing houses doesn’t divert real resources from anything else, or even use material amount of real resources.

The Minister goes on

We aim to diversify our exports and markets as we move from volume to value. We want to change investment signals so more capital goes towards the productive economy rather than unproductive speculation.  Where we need immigration, it will be more targeted.

That last sentence sounds promising, even tantalising.  But it doesn’t seem consistent with the Prime Minister’s rhetoric, with Labour Party policy on immigration, or with the (in)action of the government on immigration policy to date.     Our large-scale non-citizen immigration programme runs on unchanged, complemented by the big increases in recent years in the numbers here on short-term work visas.    A reduced rate of population growth would reduce the extent to which real resources needed to be devoted to meet the –  real and legitimate –  needs of a fast-growing population.

The Minister also makes a bold claim

I am an experienced CEO and company director. I know from experience that we can achieve economic, export and productivity growth within environmental limits.

No doubt, as absolute statements, those claims are true. But surely the relevant question is “how much?”     After all, the message Labour and the Greens were running in the election campaign was that what apparent economic success there had been in recent years was built on “raping and pillaging” the environment –  water pollution, offshore oil exploration, emissions etc.   And yet, as the Minister notes, even that “economic success” didn’t add up to much: weak per capita GDP growth, almost non-existent productivity growth, no progress in closing the gaps to the rest of the advanced world.  And what of exports?

exports 2018The past 15 years have been pretty dreadful, and the last time the export share of the economy was less than it was in the March 2017 year was the year to March 1976 –  back in the days when (a) export prices had plummeted, and (b) the economy was ensnared in import protection, artifically reducing both exports and imports (our openness to the world more generally).

In the Minister’s own words

But economic management over recent years has put pressure on our social wellbeing and our environment. 

So how, we might wonder, is a greater emphasis on environmental protection going to be consistent with the economic growth, and the exports and productivity growth that David Parker says the government aspires to?

As Minister for Economic Development and for Trade and Export Growth, my priorities reflect the reality that our economic success will be underpinned by a more productive, sustainable, competitive and internationally-connected New Zealand.

It is great to see growth in the value of output from our productive sectors. The Government wants to work with them to ensure that the right conditions are in place for firms to thrive and trade, and that we maximise the value of the goods we produce, and encourage high-quality investment in New Zealand. We want our sectors and regions to realise their full potential.

Economic growth and trade helps us create a greater number of sustainable jobs with higher wages and an improved standard of living for all New Zealanders.

However, the Government is clear that economic growth cannot continue to be at the cost of the environment. This is not idealism: it is grounded in common sense. Protecting our environment safeguards our economy in the long term – our country has built its economy and reputation on our natural capital.

I’m not arguing against improving environmental standards, perhaps especially around fresh water.  Improvements in the environment are typically seen as a normal good: as we get richer we want (and typically get) more of it.  But those gains usually come at some (direct) economic cost.    Major change isn’t just wished into existence.

In some places, perhaps, these changes are easier than in others.  If the tradables sector of your economy is, in any case, in a transition  away from heavy industry to, say, financial or business services (perhaps the UK experience), you are naturally moving from industries that might otherwise tend to pollute heavily towards those that don’t.  And farming –  and land-based industries –  might be a small part of the economy anyway.

But this is New Zealand.  And in New Zealand probably 85 per cent of all our exports are natural-resource based, and total services exports (even including tourism) are no higher as a share of GDP than they were 15 or 20 year ago.  Not very many new industries seem to find it economic to both develop here, and then remain here.   We –  and the Minister –  might wish it were otherwise, but up to now it hasn’t been.  Instead, what export growth we’ve had has been in industries where the government is often –  and perhaps rightly –  concerned about the environmental side-effects.

In his speech, the Minister declares that as Minister for the Environment improving the quality of freshwater is his “number one priority”.  I might have hoped that fixing the urban planning laws was at least up there, but lets grant him his priority for now.    How does he envisage bringing about change?

In environmental matters there are only three ways to change the future – education, regulation and price. Of these the most important for water is regulation

And regulation comes at a cost, reducing the competitiveness of firms and industries that are no longer free to do as they previously did.  The best presumption then has to be that future growth in affected sectors will be less than previously, and less than it would otherwise have been.  Sometimes, regulatory and tax initiatives spark brilliant new technologies enabling industries to move to a whole new level.  But you can’t count on that.  You have to work on the assumption that regulation costs.  Those costs might be worth bearing, but you shouldn’t pretend they aren’t there.

The same will, presumably, go for including agriculture in the emissions trading system, however gradually.   Relative to the past, firms facing such a price will no longer be as competitive as they otherwise would have been.    And experts tell us that as yet there are few technologies for effectively reducing animal emissions –  other than having fewer animals.

And then, of course, there are the direct bans.  The ban on new offshore oil exploration permits hadn’t been announced when the Minister gave his speech, but it will –  by explicit design –  reduce output in the exploration sector and, over time, in the domestic production of oil and gas.    It might be –  as some of the government’s acolytes argue – “the thing to do”, “leading the way”, “this generation’s nuclear-free moment” [that one really doesn’t persuade if you thought the Lange government’s gesture was a mistake too], but it must come at an economic cost to New Zealanders.  An economy totally reliant on the ability to skilfully exploit its natural resources, consciously and deliberately chooses to leave some chunk of those –  size unknown –  untapped.

Again, over the course of the last 45 years –  the period of that exports chart –  we’ve had a lot of oil and gas development.  All else equal, our economic performance can only be set back without it – not perhaps this year, or next, but over time.  And it all adds up.

Reading through to the end of the Minister’s speech there is simply no credible story for how he, or the government, expects to be able to do all these things and still see some transformation in the outlook for per capita GDP growth, or growth in productivity or exports.  Indeed, there is nothing there to explain why the outlook won’t be worsened by the sorts of initiatives –  each perhaps worthwhile in their own terms.

It might be different if the government was willing to do something serious about immigration policy, rather than just carrying on with the bipartisan “big New Zealand” strategy.   When natural resources are a crucial part of your economy –  and everyone accepts they still are in New Zealand –  then adding ever more people, by policy initiative, to a fixed quantity of natural resource is a straightforward recipe for depleting the stock of resources per capita, and thus spreading ever more thinly the income that flows from those natural resources.

It is pretty basic stuff: Norway wouldn’t be so much richer per capita than the UK –  both producing oil and gas from the North Sea –  if Norway had 65 million people.  And if Norway decided to get out of the oil and gas business –  leaving underground a big part of their natural resource endowment –  they’d be crazy to drive up their population anyway.    But that is exactly the thrust of what the New Zealand government is doing between:

  • what is aspires to do on water,
  • its ambitious emissions targets, in a country with very high marginal abatement costs, and
  • the ban on new oil and gas exploration permits

even as it keeps on targeting more non-citizen migrants (per capita) than almost any other country on the planet, and as the export share of GDP has been under downward pressure anyway.

It is not as if there is a compelling alternative in which export industries based on other than natural resources are thriving, boosted immensely by the infusion of top-end global talent, in ways that might make us think that natural resource industries could easily be dispensed with and a rapidly rising population was putting us on a path to a more prosperoous, productive, and environmentally-friendly future.  Its been a dream, or an aspiration, of some for decades.  But there is barely a shred of evidence of anything like that happening in this most remote of locations.

It might all be a lot different if the government was willing to step aside from the “big New Zealand” mentality, or put aside for a moment fears of absurd comparisons with Donald Trump –  recall that (a) our immigration is almost all legal, and (b) residence approvals here (per capita) are three times those in the US (under Clinton/Bush/Obama).

If the government were to move to phase in a residence approvals target of 10000 to 15000 per annum (the per capita rate in the US), with supporting changes to work visa policies, we’d pretty quickly see quite a different –  and better –  economic climate.   We’d no longer have to devote so much resource (labour) to simply building to support a growing population –  houses, roads [rail if you must], schools, shops, offices.  All else equal our interest rates –  typically the highest in the advanced world –  would be quite a bit lower, and the real exchange rate could be expected to fall a long way.  I don’t think there is a mention in the whole of David Parker’s speech of the real exchange rate, but it is a key element in coping successfully with the sorts of transitions the Minister says he aspires to.   Farmers, for example, will be able to compete, even with tougher water regulations, even with the inclusion of agriculture in the ETS.  And more industries in other sector will find it remunerative to develop here, and remain based here.  We’d actually have a chance of meeting both environmental and economic objectives instead of –  as the government would see it –  having consistently failed on both counts.

Last year, I ran several posts (including this column) making the point that rapid population growth –  mostly the consequence of immigration policy –  was the single biggest factor behind the continued growth in, and high level of, carbon emissions in New Zealand over recent decades.  In other words, we had made a rod for our own back and then –  through the process of driving up the real exchange rate –  made it even more difficult and costly to abate those emissions without materially undermining our standard of living.  OIA requests established that neither MBIE nor the Ministry for the Environment had even explored the issue.

It wasn’t a popular view, but I stand by the argument.  In a country still very heavily dependent on natural resources, if you care about the environment, and about “doing our bit” on carbon emissions, it is simply crazy to keep on actively driving up the population.  Doubly so, if you think you can do so and still improve productivity, export growth, and overall economic performance.  The Productivity Commission is due to release soon its draft report on making the transition to a low emissions economy.  I hope they have been willing to recognise, and explicitly address, the integral connection to immigration policy in the specific circumstances New Zealand faces.  Not wishing to confront the connection –  an awkward one for the pro-immigration people on the left in particular –  won’t make it go away.

Our rather moribund economy

The quarterly national accounts data were out yesterday.  They made pretty underwhelming reading.

There was the (rather modest) growth in per capita GDP

pc GDP mar 18

This expansion –  dating from around 2010 –  has been quite a lot weaker than the previous two growth phases.  In the chart you can see that almost every peak for the last 25 years has been lower than the one before.   And for the last year – full year 2017 over full year 2016 – we managed only 0.8 per cent growth in real GDP per capita.   Growth has been slower than that only in the midst of the last two recessions.

At least real per capita GDP grew, you might say.  But hours worked per capita (whether measured by the HLFS or the QES) grew by a touch over 0.8 per cent over that same period.  In fact, there was no growth in labour productivity at all.

Here is my standard labour productivity chart, averaging the different possible combinations of QES and HLFS hours data and production and expenditure GDP data.

productivity mar 18

There has been no productivity growth at all in the last year, and in the last five years ( the grey line relative to the orange line) average annual labour productivity growth has been only around 0.3 per cent per annum.   And this in an economy that the previous government liked to boast –  and the new government seemed happy to concede –  was doing pretty well.  Productivity growth is the only sustained basis for long-term improvement in material living standards.   We have very little of it –  even as we start so far behind most other advanced countries.

Perhaps our firms have been managing more success in taking in world markets?

There was bounce in the terms of trade –  dairy prices were improving –  so nominal exports as a share of nominal GDP did improve.

x share of gdp

Unfortunately, it looks like another of those series in which each peak is a bit lower than the one before it.    And services exports –  the wave that was much talked of a year or two back –  look to be dropping away again.  Exports of services –  often talked of as the way of the future –  first got to the current level (share of GDP) in 1998.

I don’t often show charts of export volumes.  As a share of GDP such charts aren’t very meaningful.  But one can compare growth rates, in this case for the last decade, since just prior to the 2008/09 recession.

x and gdp real

Over the decade as a whole, export volume growth has barely kept pace with the unimpressive growth in real GDP, and even the services surge in 2014/15 only ‘made up’ for the severe underperformance of that sector in the previous few years.   Recall that, for a country with a small population, New Zealand’s export share of GDP is very low to start with, and over this decade there has been no progress in closing that gap (something probably an integral mark of any sucessful policy programme to close the overall productivity gaps).  The result isn’t very surprising given how out of line with relative productivity our real exchange rate has become, but it can be (soberingly) useful to see the hypothesis confirmed in the data.

And one last chart.  Here is the proxy for business investment spending as a share of GDP (total investment less government and residential investment).

business investment to dec 17

Yet another chart in which each peak seems lower than the one before it –  and this in a country where, with very rapid population growth at present, one might have hoped to see a temporarily larger than usual share of current GDP going to business investment, to maintain the capital stock per worker.   But no.    If anything –  and there is noise in the series so I wouldn’t make anything much of it – things may have been falling off again in the last few quarters.

These weren’t outcomes the previous government showed any sign of caring about.   In Opposition, Grant Robertson would regularly release statements when the national accounts came out lamenting the relatively poor performance.  In office, there was no statement yesterday.  And despite the occasional ritual obeisance to the idea of lifting productivity performance, there is no sign that government –  or their Treasury advisers –  has any serious idea how such outcomes might be brought about, or any very serious commitment to trying.

 

Exports in a cross-country perspective

Across the advanced world, exports have been becoming a larger share of most countries’ GDP.  This chart shows the median export share for OECD countries going back to 1971.

export % of GDP OECD

The OECD only has complete data for all its member countries since 1995, but in that time total exports as a share of total OECD GDP have risen from 19.5 per cent to 28.3 per cent.

There is some short-term variability –  I’m not sure what explains the 2016 dip –  but the trend has been pretty strongly upwards.  That’s encouraging: trade (imports and exports, domestic and foreign) is a key element of prosperity.

For quite a while, New Zealand’s performance was very similar to that of the median OECD country

export %

and then it wasn’t.    The last time New Zealand’s export share matched that of the average OECD country was around 2000/01, when our exchange rate was temporarily very low (and commodity prices were quite high).   At very least, we’ve been diverging for 15 years now, although it looks to me that the divergence really dates back at least 20 years to the early-mid 1990s.

Once upon a time –  well before these charts –  New Zealand traded internationally much more than most other countries.   With a high share of exports in GDP, and a high GDP per capita, a common line you find in older books was that New Zealand had among the very highest per capita exports of any country.    These days, not only is GDP per capita below the OECD median, but so is our export share of GDP.

Small countries typically have a larger share of exports in their GDP than large countries.  That isn’t a mark of success for the small country, just a reflection of the fact that in a small country there are fewer trading partners.  If your firm has a great world-beating product and yet is based in the US quite a large proportion of your sales will naturally be at home.  If your firm is based in Iceland or Luxembourg, almost all your sales will be recorded as exports.  US exports as a share of GDP are about 12 per cent at present, but divide the country into two separate countries and even if nothing else changes the exports/GDP shares of both new countries will be higher than those of the United States.   The median small OECD country currently has gross exports of around 55 per cent of GDP  (New Zealand 26 per cent).

On the other hand, we also expect to see countries that are far away do less international trade than countries that are close to other countries (especially countries at similar stages of economic development).   That isn’t just a statistical issue, an artefact of where national boundaries are drawn.  Distance is costly –  there are fewer economic opportunities for trade.     That has become over more apparent in recent decades as cross-border production processes have become much more important: in the course of producing a complex product, component parts at different stages of assembly may cross international borders (and be recorded as exports) several times.   This has been a particular important possibility in Europe, and has been part of the success of formerly-Communist countries like Slovakia.    Distance is an enormous disadvantage –  enormous distance (such as New Zealand suffers) even more so.

The OECD is now producing data on the share of domestic value-added in a country’s exports.  The data only go back to 1995, and are only available with quite a lag (the latest are for 2014) but you can see the difference between New Zealand’s experience and that of the median OECD country.

value-added

These opportunities (gains from trade that weren’t economically posssible a few generations ago) generally aren’t available to New Zealand based firms.  Then again, a widening in this particular gap isn’t the explanation for the divergence between New Zealand’s export performance over the last decade and that of the median OECD country (since the gap hasn’t widened further).

New Zealand has just been doing poorly.

Here is one comparison I found interesting.

nz vs fr

France has more than ten times the population of New Zealand and yet its foreign trade share now exceeds that of New Zealand.    The United Kingdom –  similar population to France –  also now has a higher trade share than New Zealand.   And the difference isn’t just down to components shuffling back and forth across frontiers in the course of manufacturing (eg) Airbus planes.  New Zealand’s exports have a larger domestic value-added share than those of the UK or France, but adjust for that and all three countries now have export value-added shares of GDP of around 21 per cent.  In a successful small country you would expect –  and would typically find –  a much higher percentage.

Remoteness looks like an enormous disadvantage for New Zealand, at least for selling anything much other than natural resource based products  (even our tourism numbers aren’t that impressive by international standards).   Here is the comparison with another small remote country, Israel  (it is both some distance from other advanced country markets, and made more remote by the political barriers of its location/neighbours).

nz vs israel

The Israel series is more volatile than New Zealand’s –  probably partly reflecting the extreme macroeconomic instability in the Israel earlier in the period –  but the overall picture is depressingly similar (and that in a country where R&D spending is now around 4 per cent of GDP).    The other similarity with New Zealand: very rapid immigration-driven population growth, into an economically difficult location.  As I’ve illustrated in previous posts, Israel has struggled to achieve much productivity growth and has a similarly low level of real GDP per capita.

Looking back over the last few decades, it is sobering to note that natural-resource dependent advanced economies are foremost among those that have struggled to achieve higher international trade shares of GDP.    It isn’t some sort of fixed rule: if, like Australia, vast new deposits of minerals become economically exploitable, a remote natural resource dependent economy can see its export share of GDP rise.  And if you have enough natural resources and few enough people, you can be very well-off indeed, even if the export share of GDP isn’t rising (Norway is the only OECD country where exports have’t risen at all as a share of GDP since 1971).  But if you are very dependent on natural resource exports –  and that dependence doesn’t seem to be changing –  then you’d probably want to be very cautious about actively using policy to drive up the population unless –  as with Australia –  there are new waves of nature’s bounty to share around.

New Zealand –  apparently structurally unable to secure rapid growth in exports based on anything other than natural resource –  looks not only like the last place on earth, but the last place in the advanced world to which it would make sense to actively set out to locate ever more people.  And yet is exactly what one government after enough does, apparently blind to paucity of economic opportunities here.    They might wish it was different, and perhaps one day it even will be, but for now there is just no evidence to support their strategies.  Every year, in following that course, governments make it harder for New Zealanders as a whole to prosper.

Oh, and what changed in the last 20 years or so –  to go back to that second chart?  After 20 years of quite low levels of immigration, active pursuit of large non-citizen immigration targets became a centrepiece of policy again.   Without great economic opportunities here –  already or created by the migrants –  that renewed population pressures just made it even harder, despite all the good work on economic reform in the previous decade –  for outward-oriented firms to succeed, and made the prospects of ever closing the income and productivity gaps to the rest of the OECD more remote than ever.

Looking for a successful outward-oriented economic strategy 

I could bore you with thoughts on (a) Supreme Court rulings on the duties of trustees to disclose material to members/beneficiaries, or (b) even more recondite rulings on severability (the conditions under which, having inserted an invalid and unenforceable provision into a deed, the discovery of that invalid provision invalidates (or not) the rest of the deed).  Doing so might help straighten out my thinking for a meeting this afternoon, but it would bore you witless.

Instead, I’ll just leave with a link to a piece I wrote that appeared on the New Zealand Centre for Political Research website over the weekend.

A month or so ago, on the day the new government was to be sworn in, I wrote a post here about the apparent tension between the government’s stated ambition to increase the outward-orientation of the New Zealand economy (including the appointment of a Minister for Export Growth) and various specific policies the new government seeemed committed to, which seemed likely to reduce exports as a share of GDP (all else equal).  In some cases, those policies represented overdue elimination of explicit or (more often) implicit subsidies.  In other cases, no doubt some sort of case could be made for each of the policies on their own merits.  Nonetheless, taken together they looked likely to continue to shrink the foreign trade share of the New Zealand economy (the actual outcome under the previous government, despite the regularly restated goal to substantially increase exports as a share of GDP.

In that earlier post, I included this chart, of exports and imports as a share of GDP, back to 1971/72.

trade shares

There are some data revisions due out later this week.  It would be very surprising if they changed the broad picture.  Foreign trade has been becoming less important as a share of New Zealand’s economy, even though every successful case of economic transformation I’m aware of has involved getting the preconditions right that result in more domestic firms successfully taking on the world market.

There are some unavoidable factors that explain a temporary diversion of resources towards the domestic economy: the repair and rebuild process after the Cantervury earthquakes being the most obvious. But the peak of that process has passed, and yet Treasury’s advice in the PREFU was that the downward trend (in exports/GDP) would continue.  The problems look structural.

A few days after that earlier post I was mildly encouraged to see references in the Speech from the Throne to the need to lift productivity in New Zealand.  Exports were highlighted in this paragraph

This means working smarter, with new technologies, reducing the export of raw commodities and adding more value in New Zealand. For example, by securing the supply for forestry processing, greater investment in fishing and aquaculture, increasing skills and training, and more research and development to add value to dairy and other products and to create new technologies.

I couldn’t track down old Speeches from the Throne, but it did strike me as the sort of stuff almost any government could have (and probably did) say for at least the last 50 years.   The previous government, for example, claimed to be keen on aquaculture, and removing regulatory roadblocks to it.  Forest processing as a big theme in the 1950s when the government led the formation of Tasman Pulp and Paper (and my old hometown of Kawerau).  And so on.

And yet, as the old line has it, if one does the same stuff over and over again, why would one expect a different result?  We’ve been drifting behind the rest of the advanced world –  and have had no productivity growth at all in the last five years –  and foreign trade as a share of GDP hasn’t been sustainably increased for 25 years now.

Muriel Newman, former ACT MP, at NZ CPR saw that earlier post and asked if I’d like to do something shorter, and a bit more policy-focused for their newsletter.    The result is here.

I noted that there are lots of things that could be dealt with to lift our economic performance

I hope that the new ministers are going to turn their minds pretty quickly to how they might achieve the sort of reorientation in the economy that their own campaign recognised is needed. Regional development funds aren’t likely to be the answer; in fact, over the last 15 years, “the regions” have generally done better than “the cities”.   Auckland has been the laggard (again in per capita terms).

There are plenty of things that could be done to lift the competitiveness of the New Zealand economy.  For example, we now have a company tax rate that is above that of the median OECD country.   Lower taxes on the returns to business investment are one of best ways of getting more such investment.   We also already have one of the highest minimum wages rate, relative to median incomes, of any OECD countries.  Reforming our land use and planning laws could markedly lower the cost of housing, and help ensure that people and businesses can locate in the best locations.

In response, Muriel Newman asked a bunch of other regulatory issues.  I noted that I agreed that there was plenty of room for improvement on many fronts

But it is worth remembering that things on the regulatory front are typically not worse here than in most other advanced countries (indeed, we often score a little better than average on summary measures).   There is a lot we could do to remove roadblocks in these areas, but if we are to understand why NZ has continued to do badly relative to other advanced countries, i think we need to focus on things that are different here than abroad.  As per the column, our company tax rate is now high, and our minimum wage is high (both relative to other OECD countries).  But we are also very remote, in an era when personal connections seem to matter more than ever, and we have an immigration policy that is very unusual by international standards.  Of other OECD countries, only Australia and Canada come close to our target inflow (and Israel will take any Jewis person who wants to come –  that is a different issue).

And to revert to the concluding paragraphs of the NZCPR article

Defenders of our very high target rate of immigration talk constantly about skill shortages.  But OECD data show that New Zealand workers are already among the most skilled around.  We don’t need more workers – skilled or otherwise.  In fact, because of how difficult it is to base internationally competitive businesses here, there is an almost irreconcilable tension between continuing to drive the population up, wanting to deal with the pressing environmental issues associated with natural resource exports, and still wanting First World living standards.  The best way to square the circle would be to cut back sharply on the target rates of non-citizen immigration.

There isn’t anything necessarily wrong, in principle, with a growing population.  But successive governments have been putting the cart before the horse – driving the population up in the idle hope that a bigger population might somehow spark higher productivity growth.  In a location that isn’t a natural home to lots of people, that was never very likely.  Instead, we need to focus instead on the able people we already have – and to heed the wisdom of the New Zealanders who’ve been leaving.   Without a change of course, we seem set to slowly drift ever further behind other advanced countries, increasingly unable to offer our people the world-leading living standards we once delivered and could, with the right policies, once again aspire to.

It is a shame that the new government shows no interest in tackling our anomalous, and deeply unfit-for–this-location, immigration policy (indeed, there are now reports they are in no hurry even to fix the manifest problems around student visas and associated work rights).  Unless they do so –  and in the process achieve a substantial sustained reduction in the real exchange rate –  it is very difficult to see a path through which the Minister for Export Growth will get to the end of his term and be able to point to a sustainable turnaround in performance, and a trajectory for exports (and imports) as a share of GDP that might offer some hope of New Zealand one day catching up with the rest of the advanced world again.

Is there a plausible economic strategy?

In the new government, sworn in this morning, David Parker will take up the renamed role of Minister for Trade and Export Growth.

Early in their term of office, the outgoing government adopted a numerical target for lifting exports (as a share of GDP).  It was, no doubt, well-intentioned, but has provided the basis for quite a few posts here pointing out that no progress was actually being made towards that target, if anything trade shares of GDP were falling, and the pre-election advice from The Treasury was that, all else equal, the trade shares would continue to shrink.  The focus on exports, in turn, seemed to prompt a willingness to use actual or implicit subsidies –  be it in the film industry, export education, irrigation, convention centres, or firms like Rocket Lab –  or unpriced externalities (eg around water) rather than focusing on the fundamentals in a way that might have seen firms themselves increasing taking up new foreign trade oppportunities, responding to improvements in opportunities, markets and incomes.

I stress “foreign trade” rather than just “exports”.   We don’t want policy to be guided by some sort of mercantilist vision in which the purpose of economic life is to sell us much as we can to others, only to store up treasure at home.   Firms export because they can, and because doing so enables owners and employees to earn incomes, which enable them to consume (including from among the abundance the wider world has to offer).  Successful firms invest more heavily too, and many of the investment goods will typically be sourced from abroad.    Trade is good, and generally mutually beneficial.  Ideally, we would see quite a bit more of it: New Zealand firms successfully competing in wider world markets, enabling them and us to purchase more of stuff firms in other countries specialise in producing.    And if New Zealand is ever to catch up again with the rest of the OECD –  whether in productivity or incomes – the process of getting there is likely to involve a materially larger share of local production being exported but –  especially in the transition (which could last decades) –  a lot more investment.  Current account deficits aren’t even problematic when they rest on firm foundations of rising productivity and market-led business investment.  It was the story of 19th century New Zealand (or Australia or the United States).  It was the story of emerging Singapore and South Korea.

So I really hope that the new Minister of Trade and Export Growth (who is also the Minister for Economic Development) sees his role as being at least as much about putting in place the pre-conditions for sustained stronger import growth, as about export growth.  In successful economies, the two go hand in hand.

Here is how we’ve been doing over the 45 years for which we have official data.

trade shares

The last few years’ data are still open for revision, but there is no credible prospect that trade shares of GDP will have been rising.

In interpreting the graph it is worth noting a few things.  The first is that the peaks in the 1985, 2001, and 2009 years simply relate to unexpectedly weak exchange rates.  Most of our imports and exports are priced in foreign currency terms, so when the exchange rate falls sharply there is an immediate translation effects –  both imports and exports rise in NZD terms, even if the volumes haven’t changed at all.   In each of those three cases –  the 1984 devaluation, the slump in the NZD (and AUD) at the end of the dot-com boom, and the sharp fall in the 2008/09 recession –  the exchange rate falls were pretty shortlived.

The second is to note that external trade as a share of GDP was trending up for some time.  The economic policies New Zealand adopted after 1938 had tended to reduce our external trade.  There was a focus on increasing local manufacturing to supply domestic markets in consumer goods (directly reducing imports), and the increased costs of that domestic protectionism undermined the competitiveness of our (actual and potential) export producers (thus, shrinking exports as a share of GDP).

But in the 1970s and early 1980s there were signs of progress, lifting both export and import shares of GDP, even though the terms of trade for New Zealand were pretty dreadful during that period.  There will have been a mix of factors at work: the real exchange rate was trending lower, import protection was being reduced and, less encouragingly, there was a substantial use of export subsidies, both for non-traditional exports and (latterly) support for farmers too.  One argument made at the time for that export support was to counter the adverse competitiveness effects of import protection.  Better, of course, to remove both sets of interventions.  And that is largely what happened over the following decade.    Trade shares of GDP didn’t fall back.

It is perhaps tempting to look at the chart and conclude that taking the last few decades together there is quite a lot of variability in the series, and overall nothing very much has changed since at least the early 1980s.  That’s largely true, but it is also largely the problem.  Successful economies have typically experienced quite material increases in their foreign trade shares (imports and exports) in recent decades.  New Zealand hasn’t.  New Zealand –  or foreign – firms simply haven’t found the profitable opportunities here to take advantage of.    Even services exports are now only around the same share of GDP that they first reached in 1995.   Amazingly (I hadn’t previously looked at this number), services imports as a share of GDP have been lower in the last year than at any time in the past thirty years.

services trade

Not exactly a picture of a successfully internationalising economy.

I don’t find these outcomes –  worrying as they should be, as symptoms of our economic failure –  that surprising.  It is very difficult for firms to compete successfully internationally from such a remote location, based on anything other than location-specific natural resources.  Not impossible, but very difficult.  And so it shouldn’t surprise us that there aren’t many of them.   For whatever reason, in the global economy personal connections on the one hand and integrated value/supply chains on the other have become increasingly important.  The last bus stop before Antarctica –  a long way even from the next to last bus stop – just isn’t a propitious place, no matter how skilled New Zealand workers might be, and how innovative and entrepreneurial New Zealand firms might be.

It is also difficult to successfully compete internationally from here when (a) real interest rates and, in turn, the real cost of capital, for New Zealand investors have averaged so much higher than those in the rest of the advanced world.  Those real interest rate gaps have shown no sign at all of closing  (and they have little or nothing to do with monetary policy).  People push back sometimes arguing that interest rates can’t make that much difference.   They do, through two channels.  First, the standard approach to identifying an appropriate discount rate for project evaluation starts from a risk-free interest rates.  Ours are, and consistently have been, well above those in other advanced countries (something like a 150 basis point margin is a reasonable approximation of the average difference).  And, second, high real interest rates here have been accompanied, causally, by a persistently high real exchange rate, out of line with our deteriorating relative productivity.   In combination, that mix makes investment here harder to justify, and particularly makes investment in the tradables sector harder to justify.  Combine that with the disadvantages of distance and it is no real surprise the foreign trade shares of GDP haven’t increased.  Successful economies have an abundance of new profitable opportunities in which their firms, or foreign firms investing there, take on the world.  It has happened to only a very limited extent here.

But what concerns me is that the new government appears, at this stage, to have no more of a strategy than the outgoing government did for turning around the dismal productivity performance, or the static (or shrinking) foreign trade shares.      There have been encouraging hints of a recognition of the issue: in her speech to the CTU yesterday, the incoming Prime Minister referred both to a need to “boost our productivity”  and to the need to gear the economy more towards “value-added exports”.     But it isn’t clear that they have any real idea of how to get from here to there.   There was nothing any more encouraging in James Shaw’s speech to the same audience.   Or looking through the areas prioritised in the agreements Labour has signed with New Zealand First and the Greens.   If anything, the risk looks to be that the tradables sector will shrink further.

  • The new government plans to adopt measures that will reduce the size of the export education sector.  To the extent that involves a removal of implicit subsidies I think (as I noted yesterday) that is a step in the right direction.
  • The new government plans to phase out government subsidies for irrigation schemes.  From what I’ve seen, that is welcome too.
  • The new government is clearly heading in the direction of reducing exploration for oil and gas in New Zealand and its territorial waters.
  • The new government is clearly intending to take a more aggressive stance around emissions reductions, including moving towards the inclusion of agriculture in the ETS.
  • The new government seems likely to move more aggressively on increasing water quality standards faster,
  • And the new government is planning to increase minimum wages –  already high, by international standards, relative to median wages –  quite considerably over the next few years.
  • The new government is planning (or hoping for) a major acceleration in housebuilding activity.

You might agree or disagree with some or all of those measures individually. But every single one will put the tradables sector under more pressure, to some extent or other.

Take minimum wages for instance.  I recommend you read Eric Crampton’s piece (which I largely agree with).   Here is the Prime Minister’s take.

I know most businesses want a fair set of employment policies.  They know that we need decent wages if they are going to have customers for their products. They know that we need to boost our productivity, and low wages are a barrier to that because they discourage investment in training and capital. They know that we need a government that invests in skills and education.

I simply don’t buy into baseless claims that paying people well means there will be fewer jobs. In fact, the overwhelming weight of evidence is that strong wages for all working people help to boost growth and create jobs.

Wishful thinking at best.  We all, I imagine, want a country in which strong economic performance and strong wage growth goes hand in hand, but there is little or no credible evidence that, at an economywide level, one can get that sort of lift in performance by, say, mandating higher minimum wages.  It is putting the cart before the horse.  And if it worked anywhere, surely New Zealand should be the prime example, given that we already have high minimum wages relative to median wages (a policy maintained and extended by the previous National government).

And here is Shaw

And our whole intent will be to flip climate policy from being seen as a threat and a cost, to being seen as an opportunity and an investment in the future.

And, as I say, that means we’ll be creating tens-of-thousands of new jobs, paying decent wages, for workers and families all over New Zealand.

Not just high-tech city jobs, but out in the regions as well.

Here’s one example: trees.

We are going to plant hundreds of millions of trees to soak up New Zealand’s greenhouse gas emissions.

These trees, we’re going to plant them in the cities. We’re going to plant them in the towns. We’re going to plant them in in the National Parks. We’re going to plant them in the regions.

That’s going to be tens of thousands of jobs. That means lower unemployment. Lower poverty. Lower crime. Cleaner rivers. More native species.

It would be worth doing even if we weren’t saving the world.

One pictures the seas parting and New Zealanders walking together across the Red Sea to the promised land.

Whatever the merits of mass tree-planting –  which until now firms have not regarded as economic –  it doesn’t exactly seem like a high productivity industry.    And in the short-term (trees take decades to come to maturity) resources that are used planting trees can’t be used for anything else.

Lower unemployment is a worthwhile goal, and I really liked the new PM’s line

we have unemployment stuck stubbornly at 5% when it should be below 4%

but (a) deviations of unemployment from long-term sustainable levels are mostly a matter of monetary policy (so find the right Governor/commitee, and specify the mandate well) and (b) however many trees you plant, higher minimum wages will almost certainly come at some cost –  perhaps not that large –  in higher long-term sustainable unemployment rates.    And for all the complacency there has been in New Zealand about our unemployment rate, when I checked there were already 12 OECD countries with unemployment rates lower than New Zealand.  We simply should be doing better.

Of course, the usual economist’s response when (eg) proposing stripping away subsidies is “the market will provide”.  For example, a lower real exchange rate will allow some firms to expand, and other firms not yet visible to economists to emerge.  But how likely is it that that provides the answer this time?

Of course, the exchange rate has fallen perhaps 3 per cent in the last few weeks since the election (against the AUD, the best guide to idiosnycratic New Zealand effects).  It isn’t a large move, and may not be sustained.  And even at these levels isn’t outside the range it has fluctuated within over recent years.     Between a somewhat more expansionary fiscal policy (than the previous government was running), the aspiration to a big increase in housebuilding, and a continuation of the high target rate of immigration, it is difficult to see why we should expect any near-term material narrowing in the margin between New Zealand interest rates and those in the rest of the world.

Thirty years ago, Grant Spencer –  then Reserve Bank chief economist, now “acting Governor” –  published a book chapter in which he described pre-1984 New Zealand economic management this way

“In particular, the maintenance of high levels of aggregate demand supported a buoyant non-tradables goods sector while exporters faced more depressed market prospects”

When I re-read that chapter last week, it was hauntingly reminiscent of the last few years.  But it isn’t clear why the next few will be any better, unless there is sort of near-term cyclical downturn Winston Peters was warning about last week.  As I’ve highlighted previously, in real per capita terms, the tradable sector of our economy is now no larger than it was 2000 – two whole governments ago.  The risk, at present, is of further shrinkage.

So I do hope that the new Minister of Finance and Minister of Economic Development (and Trade and Export Growth) are turning their minds pretty quickly to how they might achieve the sort of reorientation in the economy that is generally recognised as needed, and which they – and the Prime Minister –  have themselves highlighted as a matter of concern.  (And, hint, regional development funds aren’t likely to be the answer either.   And over the last 15 years, “the regions” have been doing better than “the cities”)

 

(On matters of the new government, I was interested to see Andrew Little, new Minister of Justice, observe – on Twitter and Facebook – yesterday that “As Minister of Justice-designate I want to state from that outset that “pretty legal” is no longer the standard this country operates to!”.     Admirable sentiments, and I have no idea what specifics he had in mind [oh –  Steven Joyce no doubt], but might I suggest that he and the Minister of Finance review how we came to have a pretty clearly unlawful appointment of a Reserve Bank “acting Governor” by the outgoing Minister of Finance. )

The tech sector…and ongoing economic underperformance

The 13th annual TIN (“Technology Investment Network”) report was released a couple of days ago.  I’ve largely managed to ignore the previous twelve –  breathless hype and all –  but for some reason I got interested yesterday, and started digging around in the material that was accessible to the public (despite lots of taxpayer subsidies the full report is expensive) and then in some of the New Zealand economic data.   Perhaps it was the seeming disconnect between the rhetoric from the sector, and its public sector backers, and the reality of an economy that has had no productivity growth at all for five years, and where exports as a share of GDP have been falling (and are projected by The Treasury to keep on falling).

The centrepiece of the report is an analysis of “New Zealand’s top 200 technology companies” (by revenue) where, as far I can tell, “New Zealand’s” here means something about the base of the company being in New Zealand, whether it is owned here or not.  I’m not quite sure either what the definition of a “technology” company is, and it is worth remembering that almost every type of economic activity uses technology in ways that were inconceivable even 50 years ago.  Often new technologies are developed and adopted inside companies that wouldn’t think of themselves primarily as “technology companies”.   No one doubts the important pervasive role that technology plays, in New Zealand and in any moderately-advanced economy.   But the TIN Report appears to focus on a pretty broadly-defined group of companies in biotech, ICT, and (more than half) in “high-tech manufacturing”.

Here are the top 10 companies from the list

Date founded Total revenue ($m)
Datacom 1965 1157
Fisher & Paykel Appliances 1934 1146
Fisher & Paykel Healthcare 1934 894
Xero 2006 295
Gallagher Group ca. 1938 232
Orion Health 1993 199
Douglas Pharmceuticals 1967 190
Tait Communications 1969 175
NDA Group 1894 175
Temperzone 1956 175

Perhaps most immediately striking was the gap between the first three companies on the list and the rest of them.   But I also realised that I’d visited quite a few of these companies (the Reserve Bank’s business visits programme), in some cases a long time ago.  Tait was one of the good news stories we used to tell in the 1980s –  economic times were tough, and we had a selection of (sometimes rather desperate) anecdotes of economic transformation.  So I dug out –  as best I could –  the dates each of these firms was founded.    Of the top 10, as many (one each) had been founded in the 19th century as in the 21st century, and only one more had been founded in the last three decades of the 20th century, even as the New Zealand economy was being liberalised.      It isn’t exactly the image one has of really top-tier technology companies.  Sure IBM and Hewlett-Packard have been round for a while now, but Google, Facebook, and Amazon all date from the last 25 years  –  and they’ve managed to dominate world markets, not just been big in New Zealand.

Actually, a somewhat similar point even found its way into the TIN press release

Companies with over $20 million revenue grew at twice the rate of companies below NZ$20 million.  The 90 companies with revenues NZ$20 million and over grew at 8.4%, compared to just 3.8% revenue growth for the 110 companies with under $20 million in revenue.

Nominal GDP in New Zealand grew by 5.9 per cent in the year to June, and yet the second tier of New Zealand based technology companies could only manage sales growth of 3.8 per cent in the last year (and even that number is subject to a form of survivor bias –  some firms that did worse will have dropped out of the list).  I was, frankly, astonished at quite how weak the revenue growth seemed to have been.

The headline TIN were keen to highlight was that the annual worldwide sales of the TIN 200 companies had now passed $10 billion (just a bit more than Foodstuffs supermarkets).   $10 billion isn’t a trivial sum of course, but New Zealand GDP last year was $268 billion dollars (and gross sales are higher than GDP) –  so worldwide sales of these 200 companies were just under 4 per cent of New Zealand’s GDP.    They were also keen to highlight 43000 people employed around the world.  Again, not a small number but just over 2.5 million people are employed in New Zealand at present.    In many of these companies, overseas employment –  an important part of making the businesses successful –  is quite a large share of the total.  For many of the companies, data aren’t easily accessible, but from Fisher and Paykel Healthcare’s latest annual report I learned that of its 4100 employees, 1800 are overseas.

Writing of the $10 billion revenue number, the TIN Managing Director noted

It is not just a number but a marker that indicates that our technology exporters are well and truly entrenched as a critical part of New Zealand’s economic growth

Perhaps he isn’t aware that there has been no productivity growth for five years?

But what of “exports”?  We are told that these 200 firms have “more than NZ$7.3 billion sourced through exports”.   They carefully describe that in their headline as “the equivalent of 10 per cent of all New Zealand’s exports”, but some media rather loosely translated this into a story that these tech companies now account of 10 per cent of New Zealand’s exports.

Without access to the full report, it is difficult to know quite how they calculate the number.  But almost certainly, a lot of that $7.3 billion –  perhaps total overseas sales –  will in fact be counted as other countries’ exports.  Chinese-owned Fisher & Paykel Appliances, for examples, manufactures in Thailand, Mexico, China and Italy.    Fisher and Paykel Healthcare manufactures in Mexico, and presumably most of that production goes to the United States.   And if, say, Datacom has big operations in Australia, much of the value-added from that operation will accrue to Australian employees.

I don’t have a problem with any of that.  It is how successful international businesses work.  In most cases, the relevant intellectual property is probably being generated in New Zealand, and the value of that should be captured by those doing the work, and the owners of the relevant businesses (in many, perhaps most, cases, New Zealanders).

But how does all this fit with the overall economic performance story.  One of the public sector funders of the TIN report was quoted in a Newsroom story yesterday

Victoria Crone, chief executive of one of the sponsors of the report, Callaghan Innovation, said technology was a key for growth in New Zealand’s economy. “Every dollar invested in the tech sector creates three dollars of growth in the New Zealand economy. Doubling or tripling the contribution of dairy or tourism by simply expanding these sectors is simply not practical given their respective demands on land, water and infrastructure.

“By contrast all the tech sector needs to expand is more brains, more ideas and more capital to bring them to market.”

Which might all sounds fine, but how have those tech sectors actually been doing?  Getting too deeply into the line items of our export data isn’t really my thing but (for example) SNZ publish a summary breakdown of merchandise exports, with a category of “elaborately-transformed manufactures” (not all of which would typically be thought of as anything like “technology exports”).    Here is how elaborately-transformed manufactures on the one hand, and primary products on the other, have done as shares of total merchandise exports, going back to 2003  (just before the first TIN Report was published).

share of merch exports

And over that period, total merchandise exports have fallen from 21.4 per cent of GDP to 18.6 per cent of GDP.

What about services exports –  the weightless economy and all that?

Again, it is a challenge to break out the things that most people will think of as “technology exports”, so I’ve erred on the side of including more items rather than less.   There is greater detail for the last few years, but to go back further the data are less disaggregated.    From the annual services exports data I summed four categories

Services; Exports; Charges for the use of intellectual property nei
Services; Exports; Telecommunications, computer, and information services
Services; Exports; Other business services
Services; Exports; Personal, cultural, and recreational services

The latter because the largest component of it appears to be film and TV exports (Weta workshops, Peter Jackson etc).

These components of services exports are, as one would perhaps hope, a larger share of total services exports than was the case 15 or 20 years ago.    Unfortunately –  and unusually for advanced economies –  services exports in total have not been growing as a share of GDP.    This chart shows these four components of services exports as a share of GDP.

tech services exports

It looks quite sensitive to the exchange rate (as one might expect), but whatever the reason the share in the most recent year is still around where it was in 2000 or 2001.  Even with, for example, those amped-up film subsidies.

Still on the trail of (overall) success stories, I thought I’d check out the investment income account of the balance of payments.  New Zealand shareholders will still be better off –  as I noted earlier –  even if there aren’t exports directly from New Zealand if their offshore operations are generating profits.  Whether those profits are remitted to New Zealand or reinvested in the business abroad, it is a gain for New Zealanders (and captured in the Gross National Income numbers, although not in GDP –  the latter is about production in New Zealand).   The published data in the investment income account isn’t broken down by economic sector, but there is data on different types of income.    I focused on two columns

Primary Income; Inv. income; NZ inv. abroad; Direct inv.; Income on equity etc; Dividends and distributed branch profits
Primary Income; Inv. income; NZ inv. abroad; Direct inv.; Income on equity etc; Reinvested earnings

Unfortunately, the data are patchy to say the least so I can’t show a time series chart.  And bear in mind that these profits are from direct overseas investment by New Zealand firms in all economic sectors.    But here are the total returns under these two headings for the five years to 2000 and for the last five years, both expressed as a percentage of GDP (over those five year periods).

profits on NZ inv abroad

Remember that these are profits from firms in all sectors, but if there are big transformative tech sector profits they must be pretty well hidden.

When, many years ago now, I read Brian Easton’s economic history of New Zealand since World War Two, one of the things I noted then was the evidence Easton had gathered for how the composition of New Zealand’s exports had changed rapidly in the past.

Back in the 1960s, in the Official Yearbook Statistics New Zealand reported a high-level table of the composition of our exports.  The traditional products were these

Meat
Dairy
Wool
Fruit and vegetables
Animal by-products

In 1962, these products made up 85 per cent of (estimated) total goods and services exports.  Just a decade later in 1972, those same products made up only 67 per cent of total goods and services exports.  Subsidies probably played a part –  counteracting the additional cost imposed by our own tariffs and import quotas.  Then again, film subsidies (or Rocket Lab subsidies) anyone?

In earlier decades, new technology  –  it was all technology that made it possible –  meant that dairy products went from being only for the domestic market to being our second largest exports in 30 years.

By contrast, the performance of today’s New Zealand based tech sector seems pretty distinctly underwhelming.  I’m sure there are plenty of good firms, and plenty of able people trying to build them –  New Zealand isn’t short of able people, or of a regulatory environment that makes it easy to start new businesses –  but in aggregate the results should really be seen as rather disappointing.  Vic Crone talks of how, in her view, “all the tech sector needs is more brains, more ideas, and more capital to bring them to market”.    New Zealand has never had a problem with any of those three.  It looks rather more as though the opportunities just aren’t here – in a location so remote –  to any great extent, and the challenges of remoteness are just compounded by a real exchange rate that has got persistently out of line with the deteriorating relative competitiveness of the New Zealand economy.

The taxpayer –  through Callaghan and NZTE – has been helping pay for this report, and the associated puff pieces made available to the public.  One can only hope that a new government (of whatever stripe) might start by asking some hard questions, of those agencies and of MBIE and Treasury, that look behind the hype.  I’m not optimistic –  all sides seem to have a stronger interest in believing the spin than in confronting the real and persistent underperformance.  Then again, the good thing about being a pessimist is that just occasionally one can be pleasantly surprised.

 

 

Exporting to a large communist state

One of the things that seems to worry establishment people in New Zealand is a belief that our economy is somehow very vulnerable to anything that disrupts the trade of New Zealand firms with China.  It is a more-than-slightly puzzling concern, since only around 20 per cent of our exports go to China, and exports themselves aren’t an overly large share of GDP in New Zealand.   For the firms involved –  even if not the wider economy –  there are clearly somewhat greater risks, since China has a demonstrated track record of being willing to use targeted trade sanctions for “punishment”.   Those are the risks you take, as a private company, when you choose to play in that particular sandpit.

For the world economy, of course, any serious dislocation of China’s economy is a significant risk.  With interest rates in most of the world not much above zero, any serious downturn in one of the world’s two largest economies could be quite problematic (as the US recession/financial crisis in 2008/09 was).      But such downturns generally do even more damage to the economy at the centre of the problems than to everyone else.  We all have a stake in a better-managed Chinese economy, even if the Chinese authorities are showing increasingly autarckic tendencies, and even if China isn’t anywhere near as internationally connected as the major Western economies are.  But that interest isn’t a good reason to orient foreign policy around deference to China, or to refuse to have an open debate about Chinese government interference in the domestic affairs of other countries.

One case study that sometimes get mentioned when people talk about the vulnerabilities of trade with China is Finland.   After a rather difficult time in World War Two –  gallantly losing to the Soviet Union in 1939/40, and then ending up on Germany’s side –  Finland spent the post-war decades in an awkward position.  A new word was added to the international vocabulary: Finlandization

the process by which one powerful country makes a smaller neighboring country abide by the former’s foreign policy rules, while allowing it to keep its nominal independence and its own political system.  The term literally means “to become like Finland” referring to the influence of the Soviet Union on Finland’s policies during the Cold War.

And largely, no doubt, just because of geography, much of Finland’s foreign trade was with the Soviet Union during those decades (it was a highly managed and regulated trade).  Eyeballing a long-term chart, over the post-war decades to 1990 around 20 per cent of Finland’s exports were to the Soviet Union. And in the 1970s and 1980s, total exports as a share of GDP averaged just over 25 per cent in Finland.   In other words, exports to the Soviet Union were averaging about 5 per cent of Finland’s GDP, pretty similar to New Zealand exports to China today.  (A century ago, by contrast, New Zealand exports to the United Kingdom in the 1920s were 20-25 per cent of our GDP.)

The Soviet Union ended messily, at least in economic terms.   Here is a chart, using Maddison data, of real per capita GDP in the (once and former) Soviet Union.

USSR GDP

In the slump, and associated disarray, imports plummeted, including those from Finland. In fact, in 1992 Finnish exports to Russia (the largest chunk of the former Soviet Union) were less than 1 per cent of Finnish GDP.

At the time, Finland itself was going through one of more wrenching recessions seen until then in post-war advanced economies.  The unemployment rate rose from 3 per cent to over 17 per cent in just three years, and real per capita GDP fell by 11 per cent from 1990 to 1993.

The collapse of the Soviet Union wasn’t the only thing going on at the time.  There were recessions in many western economies (including New Zealand and Australia) around 1991, but Finland’s experience was particularly savage (and also worse than the experiences around the same time of other Nordic countries).

One distinctive was house prices.

finland real house prices

Real house prices rose by about two thirds (across the country) in just a couple of years, and then more than fully reversed the increase.  The 50 per cent fall in real house prices involved a very sharp fall in nominal house prices, only matched in recent times in Ireland.

To some New Zealand readers it will all seem like just the sort of stuff they worry about.  Isn’t our economy heavily dependent on trade with China, which could easily but cut off or otherwise implode, and aren’t house prices extraordinarily high?  Isn’t the great Finnish recession exactly the sort of thing Graeme Wheeler and the Reserve Bank were warning of?

No doubt there are some similarities in what they were warning about.  But if Finland offers lessons for us, they aren’t about who our firms trade with, nor even really about house prices and housing lending exposures.  Instead, they are the (now) age-old lesson about the risks of severely overvalued exchange rates, with an overlay of a warning about the transitional risks of financial liberalisation (readers will recall that New Zealand and Australia also had a tough time in that transition in the late 1980s).

Finland had had quite high inflation even by the standards of many other European countries during the great inflation of the 1970s.    Persistently high inflation, in a fixed exchange rate system, is typically accompanied by a succession of devaluations.  We went through almost 20 years of something similar in New Zealand.   But in Finland in the 1980s they decided to break the cycle, and set out to maintain a “hard markka” –  the fixed exchange rate holding down imported inflation and, supposedly, imposing domestic disciplines that would lower domestically-sourced inflation.    Much of the advanced world was disinflating at the same time, and so for a while the approach looked pretty successful.  Core inflation was 12 per cent in 1980, and not much above 3 per cent by 1986.

But the Nordic economies, including Finland, were also liberalising their domestic financial systems in the 1980s.  And a necessary corollary of a fixed exchange rate system is that, with an open capital accounts, your country’s interest rates are heavily influenced by those abroad.   And German interest rates, which had been 7.5 per cent in 1980, just kept on falling –  the Bundesbank’s discount rate was 2.5 per cent by 1988.

In process –  fixed exchange rate, falling global interest rates – what followed was a massive speculative credit and investment boom in Finland. Lending and asset prices surged.  Inflation picked up, and Finnish industry became increasingly uncompetitive internationally.  That in turn created doubts about the stability of the exchange rate peg, prompting increases in domestic interest rates.

Here is what happened to the real exchange rate

fin rer

And a measure of real short-term interest rates

fin int rates

Real interest rates didn’t peak until well into 1992, two years after the recession began.  Why? Not because inflation was a particular problem –  it was back down to not much above 3 per cent in 1992 and falling fast –  but because of the extreme reluctance of the authorities to float the exchange rate.   There had been grudging periodic adjustments under pressure, but it wasn’t until September 1992 that the markka was finally allowed to float.

In the process –  the boom over the late 80s and the subsequent bust, both heavily linked to the fixed exchange rate  –  the Finns managed to bring on themselves a very severe domestic financial crisis.   And there had been huge shifts in the shares of various components of the economy.  Here was the export share of GDP.

exports finland

Investment as a share of GDP fell from around 30 per cent at the end of the boom, to around 19 per cent at the trough.

Floating exchange rates can be messy, but unless you economy is very closely aligned to –  and integrated with –  the currency of some other country, they are usually better than the alternative.  That was certainly Finland’s experience over the crisis of the early 1990s.

And what of the financial crisis?  Surely with house prices falling by that much, residential mortage losses must have been a big part of the story?  In fact, the overwhelming bulk of the problem loans were to businesses and although many residential borrowers did get into trouble –  rapid increases in unemployment and rising real interest rates in combination can be a toxic brew –   in the end only 1 per cent of household loans were written off.   That isn’t particularly surprising, is a point made in numerous studies, and is consistent with a survey of financial crises done a few years ago by the Norwegian central bank.  As they put it

We look at a wide range of national and international crises to identify banks’ exposures to losses during banking crises. We find that banks generally sustain greater losses on corporate loans than on household loans. Even after sharp falls in house prices, losses on household loans were often moderate. The most prominent exception is the losses incurred in US banks during the 2008 financial crisis . In most of the crises we study, the main cause of bank losses appears to have been propertyrelated corporate lending, particularly commercial property loans.

And thus it was in Finland (and neighbouring Sweden for that matter).  It is a point I’ve been making about New Zealand: when severe adverse shocks hit, provided your exchange rate is floating, not only does the exchange rate fall, but interest rates typically do too.  Those are typically very powerful buffers, especially in the case of an adverse shock that isn’t global in nature.

And what of the role of the collapse in Finnish exports to the (now) former Soviet Union.  I found various books and articles on my shelves about the Finnish experience –  it was one of the handful of defining post-war crises.  None of them regard that sudden drop as a particularly important part in the Finnish recessionary story.  For anyone interested, there is an interesting recent paper by a couple of Finnish researchers.  Their summary is as follows

It is shown that empirically, the strong credit expansion resulting from the simultaneous liberalization of the domestic financial markets and international capital movements has played the most important role in explaining the changes in real economic activity in Finland during the time period analyzed. In fact, over a longer time period (1980-2005) exports to Russia emerge as a countercyclical variable: slightly contractionary after the crazy years, and expansionary during the following depression [exports to Russia recovered somewhat after the first chaotic year or two].

Exporters were fairly soon able to find alternative markets for their products, helped –  after 1992 –  by the much lower real exchange rate.

And what of the overall Finnish economy itself?  After freeing the exchange rate and allowing real interest rates to drop sharply, the economy itself rebounded quite rapidly.  By 1997, real per capita GDP was already 4 per cent above somewhat flattering boom-exaggerated 1990 levels.

finland real pc GDP  And consistent with a story I’ve run here in various posts over the years, through all that disruption and dislocation, here is the path of Finnish real labour productivity (real GDP per hour worked).

fin real gdp phw

As was the case with the numerous US financial crises in the 19th and early 20th centuries, there isn’t much sign of any enduring damage to productivity (levels or growth) from the Finnish crisis.  That’s reassuring, if not terribly surprising.

(Finland’s economic performance in the last decade has been pretty shockingly bad, including a productivity performance that –  like the UK’s –  is even worse than New Zealand’s over that period.  But that is a story for another day.)