Beyond 2010 - Preparing for Tomorrow's Economic Challenges Today

Speech#

Thanks for having me here today.

I often feel that the best thing about being at events like this is the opportunity I get to step away from the day-to-day business of the Treasury and take a good breath of ‘big picture’ fresh air. I can open the window a little wider, if you like – and let the breeze blow through!

Like many organisations, the Treasury often gets caught up in meeting the short-term needs and the preoccupations of the present. As you’ll be aware, being the government’s lead economic and fiscal advisor means we have many immediate and pressing responsibilities across a large number of areas of public interest.

We do, however, also have an over-arching organisational vision of ‘improving living standards for New Zealanders’ – and an obligation to ensure that all economic and fiscal advice we offer does help the government achieve that long-term objective.

So a big part of our job is to be scanning the horizon continually for emerging challenges and trends which may affect New Zealand’s future economic well-being – and to help governments ready the country for that future.

Over the next 20 minutes or so I want to do just that: to step back from the short-term and take a speculative look at the future. I have chosen five challenging issues to explore which are likely to have a profound and pervasive impact on New Zealand and its economy.

As I go, I hope to outline in broad terms what responses are required: from the Treasury and wider government, from business, and from society more broadly.

Of course any speech about the future is fraught with danger – not least for an economist such as myself. It’s often said that all economists are pessimists: after all they've predicted 8 of the last 3 depressions.

Well according to that view, I’m a rarity - an optimistic economist. Yes; I am going to outline a future that will hold challenges. But, more importantly, as I hope you will see, it is a future that offers immense opportunities for New Zealand.

The present#

Before I talk about the future, I do want quickly to touch on the issues that dominate the present, to set a bit of context.

As we know, New Zealand is coming off a period of very strong economic growth. This strong growth has put considerable pressure on resources and we’ve been running at near full capacity. Indicators of this stress are rising inflationary pressures and a very sizeable current account deficit.

I don’t think it’s any secret that a cyclical slowing of the economy has been occurring for some time. This is a period of inevitable rebalancing and readjustment in the economy.

In fact, I think that ‘rebalancing’ point’s been lost in some of the current coverage of New Zealand’s economy. For example, Time magazine recently described us as “the canary in the coal mine of the new global economic order”.

Well, for the record, we’re a fairly healthy bird: yes, a slight sniffle here and there, but no flu-like symptoms from where I sit.

Our underlying fiscal position is judged to be very strong by informed analysts like the OECD and ratings agencies. We are one of only a handful of countries in this fortunate position, and we should rightly feel cheered.

My point is that in many ways we are in a much better position to weather this period precisely because of the past investment we made as a country in tackling longer term issues.

If some see this as making us a canary – that’s fine. It’s better than thinking our goose is cooked: a leap of logic some seem to make.

Ensuring New Zealand can take maximum advantage of the opportunities provided by a changing world puts a premium on protecting the hard-won improvements we have already made. These include continued macroeconomic stability and increased flexibility and productivity in the economy – all ongoing priorities on the Government’s agenda for Treasury.

And it is worth emphasising that there is now broad agreement in the Parliament about these matters. Those of you past a certain age will remember the sometimes fierce disagreements about the direction of policy. Yesterday’s disagreements are today’s consensus.

At the same time, rising to the challenge requires an innovative and tailored mix of policy. I’d suggest that our recent economic history has left us as a country in a half way house: seemingly averse to expanding the government’s role in the economy, and yet equally wary of market solutions. We can’t afford to stay here, trapped by our own uncertainty.

And just so we’re clear, I am not here to propose specific policies. That is quite correctly the right and the role of Ministers.

Where I do want to focus today is where I see critical preparation needed for the New Zealand of tomorrow — where the answers are far more difficult, the choices more complicated and the discussion and debate has yet to be had.

I am going to cover the following five broad areas:

Future fiscal challenges
Globalisation
The primary sector
Climate change
The inclusiveness of our economy
Clearly they’re not all areas for which the Treasury has primary responsibility. But they are each areas with pervasive or very significant implications for the economy, and therefore of vital interest to the Treasury.

As you’ll see, the five are interconnected — if not entwined — and I’ll try to draw out those connections as we proceed.

Future fiscal challenges#

Let’s take a look at that fiscal position I have already mentioned – but take a step into the future.

You may be aware the Treasury recently published our first Statement on New Zealand’s long-term fiscal position, looking forward 40 years and assessing our future fiscal situation under a range of possible scenarios.

What the statement showed was that while New Zealand’s current fiscal position is very strong, if you extrapolate current trends and policy settings a number of years forward, a potentially worrying scenario is revealed. We are looking at an eventual and unsustainable rise in debt.

Clearly the impact of demographic change – essentially, an ageing population - is one big contributor to the worrying debt scenario outlined in the statement. But another insight is that choices about the extent of government-provided services are critically important.

Changes will be required over the coming decades. The good news is that thanks to the efforts of successive governments over the last 15 years, future governments will have some choice about how they respond to the fiscal pressures that could arise.

While time is also on our side, it is also clear that small changes, taken sooner rather than later and applied consistently, will reduce the need for potentially more disruptive change later.

Slide 1: Impact of health spending

This graph, taken from the statement, illustrates this nicely. It shows the longer-term impact (assuming nothing else changed) of health spending growing each year at just over half a percent slower than the recent average.

It is worth remembering at this point that demographic change is also about a lot more than the fiscal position. Our ageing population will bring shifts in how we work and in spending and consumption patterns among a host of goods and services — those provided by both the public and private sectors. The public sector is starting to think about the economic and fiscal trade-offs required. The private sector will also need to do the same, if it hasn’t already.

But I don’t want to talk in too much detail about demographic change and its impact today, as it is a topic where discussion and debate is well underway.

And, at times, I believe we are in danger of forgetting that increased longevity and reduced mortality is something to be celebrated, not regretted.

Globalisation#

Now I want to move on to that over-used term “globalisation”.

Some of the discussion I see around globalisation implies that it is a choice – that it is a tap that we in New Zealand can turn off or on.

That simply isn’t true. The forces of globalisation are so pervasive and strong that they will inevitably continue to have a profound impact on New Zealand. Our real choice is how we approach these forces, and whether we see them as risks or opportunities.

First: what is globalisation? Put simply, it is the intensification of interconnections between societies, institutions, cultures and individuals on a worldwide basis. This includes flows of ideas, capital, people (both short- and long-term), foreign direct investment, and trade.

Globalisation is not new. But the most recent wave of globalisation is inducing more fundamental changes in many more economies than ever before.

What’s driving this? Factors involved include:

• multilateral trade liberalisation, which has promoted trade growth and raised growth potential
• technological progress – which has reduced the costs of transport and communications and increased the range of products and services traded; and
• the rapid growth of key economies – notably China and India – after the opening up of those economies.

Often it is the perceived negative aspects of globalisation that receive attention: the loss of certain jobs, of human capital, and ownership of the capital stock by foreigners.

But what is typically neglected is that the globalisation does allow greater choices for consumers and more opportunities for our firms. Foreign investment brings with it new technologies, market links and specialised know-how. There does appear to be some agreement that these globalisation flows are wealth enhancing.

I’d like now to reflect a little on what some of these trends may mean for New Zealand.

First, with the sustained rapid growth in Asia, the mass of global activity is moving closer to New Zealand. The fall in transport costs, together with revolutions in ICT, will facilitate the transmission of people and ideas between New Zealand and key fast growing economies, further reducing our remoteness.

Changes in remoteness over time

This slide shows how the distance to the rest of the world’s GDP has fallen for Australia since 1950. The story for New Zealand will be no different. You can think of it as showing how far away the rest of the world would be if the entire world’s GDP were in a single country. [The small tick upwards in 1998 is related to the impact of the Asian financial crisis, which affected the GDP of several of the countries that are relatively near to Australia.]

Second, trends in outsourcing will move increasingly into new areas. Most outsourcing to date has been in manufacturing. But the real impact is likely to be global shifts in the production of services.

Here’s an example of both these trends: a Calcutta newspaper recently reported that a leading bank in India is setting up a call centre in Belfast. That’s right – an Indian firm outsourcing call centre operations to Europe. The same article noted that inward Indian investment in the UK now exceeds new UK investment in India.

A third trend is increasing amounts of trade, not between countries, but within industries and firms located all over the world. Countries which are most linked into these international industry and firm value chains will be major beneficiaries of globalisation.

Fourth, flows of people will increasingly become part of the globalisation story. Global markets for skilled labour will extend into new occupations, much as over recent decades occupations like medicine and teaching have become global.

In turn, this means that there will be upward pressure on wages for skilled labour in countries like New Zealand – and corresponding downward pressure on the wages of the less skilled. It suggests a widening of income gaps between the high skilled and less skilled, a trend that will perhaps be moderated by burgeoning numbers of graduates worldwide.

Finally, globalisation will carry with it some challenging issues for New Zealand’s national identity. We’ve already seen examples of this: unique New Zealand images on a cigarette brand sold in Israel and, more recently, the use of a haka in advertisements for an Italian car.

At one level, the global reach of New Zealand’s brand is a positive development. At another level, it creates some very real challenges for us in managing and protecting our brand image in a global world.

This evolving dynamic will mean that we need to decide as a society what we permit to be modified by increasing global interaction and what should remain unique to New Zealand.

Do we, for example, continue to use international standards to control the safety of medicines? Do we maintain our own New Zealand specific school educational standards? Issues like these may involve some uncomfortable choices.

Role of the primary sector

What I want to explore now is what these forces of globalisation mean for the sectoral composition of New Zealand’s economy; and for the primary sector in particular.

I think a common reaction to the challenges of globalisation is a call for New Zealand to move away from producing and exporting commodities towards higher value-added products and services. A general theme is that New Zealand should (somehow) “create” its own Nokia.

But as my colleague from MED Geoff Dangerfield noted when he spoke at this forum in April, New Zealand’s best path may be to play to its natural advantages while remaining alert to opportunities that arise.

This is not to say that we should discourage new industries. I’m simply suggesting that we should not undervalue the ability of the primary sector to act as a catalyst for such higher value industries.

I think this point is underscored if we look at Finland. The forestry industry (wood, pulp and paper) remains one of the largest industries in Finland. And in recent years, the forest industry has accounted for around 25% of Finnish exports, a higher share than Nokia’s.

In fact, the development path of a number of rich, small, open, resource-based economies such as Finland and the other Nordic countries, as well as Australia and Canada is remarkably similar. New, sophisticated industries have emerged from traditional sectors such as forestry, fishing, agriculture, mining, and shipbuilding.

In other words, while these economies do possess high tech industries, they have developed on (and continue to rest on) major low and medium tech activities which are shared by New Zealand. These industries are not stagnant or declining – they are characterized by innovation and growth, and offer long term development potential.

Moreover, the growth in demand for all commodities – including agricultural commodities – in the rapidly growing world will act to hold up prices (although not forever). In addition, demographic changes will lead to a reduced number of farmers in some industrialised countries, lessening resistance to the opening up of agricultural markets.

Meeting the challenges of globalisation will require a greater transformation of New Zealand’s primary commodities to create new higher value-added goods and services that are branded and marketed in more complex and sophisticated ways.

The primary sector, as commentator Rod Oram has noted, is the only one in New Zealand that has all of the crucial attributes required to do this - including cost and quality competitiveness, international scale, an extensive science base and established channels to market.

In addition, recent work by Treasury suggests that, over the past 20 years, the primary sector has had one of the best productivity records in the economy.

But it is already abundantly clear that New Zealand’s primary sector faces considerable challenges in all of these areas.

Firstly, there is increasing competition from developing nations such as China, Chile and Brazil. These countries are already adding value and rapidly moving up the supply chain and technological spectrum. With low labour costs, limited environmental protections, cheap land and low exchange rates these countries can beat New Zealand on price.

Combined with the rapid growth of other economies such as India, their growth may also make it more difficult for New Zealand to secure the shipping we need to import essential inputs, let alone for exports – further affecting our ability to compete on price.

Secondly, pressures on our natural resources such as water, soil and our oceans are becoming severe in some places. And the effects of climate change are likely to make life increasingly hard for many of our producers, requiring careful investment decisions at home and abroad.

‘Cleaning up’ the unintended impacts from our primary sectors and taking leadership in combating the effects of climate change, pose huge political and economic challenges. Foreign markets and international instruments are likely to penalise New Zealand producers increasingly for weaknesses in these areas.

EU producers are already well awake to this strategy and doing whatever they can to differentiate their products on this basis. ‘Food miles’ (accounting for carbon usage of shipping goods across the world) are becoming topical in the EU. And in recent weeks, as some of you will know, a UK dairy company has launched an advertising campaign targeting Anchor butter specifically in this way. This is the advertisement that appeared in the UK.

This targeting will only grow in a carbon-constrained world and we need smart ways to counter this; not least because this will act to our advantage in competing against low-cost competitors.

And thirdly, to move beyond a focus on competing on cost, we need to lift the value of our products. To achieve this will require strategic and sustained change across the entire sector, and accompanying investment in innovation in high value products and markets.

It will also require a renewed focus on governance and performance. Even a cursory glance at our top 200 companies shows that many of our largest firms are local branches of multinationals, or are government-owned.

Ownership structure of top 200 NZ firms by industry

As you can see, in the primary sector, agricultural producer co-operatives (the bright green colour) and other forms of collective organisations dominate. The longevity and success of some suggests that there are lessons still to be shared in this sector in competing in rapidly changing world markets.

This is not to suggest that policy should focus on “making” more large New Zealand firms. But I do suggest that our firms may need to think differently and constructively about collaboration and coordination.

A recent initiative entered into by Rissington Breedline and Affco with UK retail giant Marks & Spencer illustrates this well. Carcasses will be partly processed by Affco before shipment; on arrival in the UK they will be processed into individual cuts, labelled with the Marks & Spencer brand and the name of the New Zealand farmer who provided the original carcass.

In part, this responds to growing consumer demand in high value markets for ‘safe’ products that stem from sustainable farm management techniques. Our competitors in these same high value markets will increasingly seek to use concerns about animal welfare, environmental impact, socially responsible production and food safety as non-tariff barriers to our goods.

But, as the Affco example shows, challenges can also be catalysts for innovation and transformation. There are opportunities to be taken.

I’d argue New Zealand is better placed than just about any country to market and differentiate ourselves in this way.

Climate change#

The fourth major theme — and I’ve touched on this already — is climate change.

Much of the debate in New Zealand on climate change has focused on Kyoto obligations, about whether climate change is happening, and whether it is human induced. It is too often regarded as a phenomenon that will have limited consequences for New Zealand.

It is my contention that these are yesterday’s discussions.

There are a large and growing number of peer-reviewed scientific papers dealing with climate change; and the overwhelming consensus of these is that human activity is increasing the concentrations of greenhouse gases is the atmosphere, and causing warming.

Climate change is undoubtedly an environmental issue, but it is also one that potentially has serious economic implications. The Treasury's strong involvement in this policy issue reflects the environmental / economic nexus involved, and the complexity of the challenges it presents.

At the Treasury we see climate change as a much broader and longer-term issue for government and for business than simply meeting New Zealand’s international obligations to 2012. Policy actions now will only have limited impacts in the foreseeable future. It places a premium on actions for mitigation and for adaptation.

So whether you believe climate change represents carbon chickens coming home to roost or merely a change in local weather patterns — we believe, for New Zealand, doing nothing is not an option.

It’s not an option because of the obvious direct climatic effects which may affect where we live, the risks that we face – from biosecurity to extreme weather events – and what we do.

And doing nothing is not an option because, increasingly, the views and actions of multinational firms and sectors, and of other governments, are likely to be a major force shaping how New Zealand adapts to climate change. In fact, in this area, domestic policy may be affected by international events that, at first glance, seem unconnected to New Zealand affairs.

For example, leading international insurance companies now regard climate change as a major risk. For New Zealand, the end result may be that insurance premiums in some areas rise substantially and some domestic risks become no longer insurable.

The point is that local companies reinsure offshore, and reinsurers may refuse to cover risks regardless of what local companies think. In fact, Lloyd’s of London now suggests directors risk shareholder action if they fail to take climate change into account.

From an economic standpoint, we do need to be prepared for a future in which consumer preferences may shift towards low-carbon goods and services. It’s not difficult to imagine the “food miles” campaign I referred to earlier extending beyond a focus on Anchor butter, to the carbon footprint of any New Zealand produce.

Guardian “how far has your food travelled?” campaign

In fact, this on-line report from the Guardian has been around since 2003. It calculates the “food miles” travelled by a basket of 20 common UK food items (collectively it’s 100, 943 miles). New Zealand wine gets a mention.

Increasingly, we will also be affected by the actions of other governments. The European Parliament recently voted in favour of introducing a tax on jet fuel for flights within the European Union, and is actively talking about bringing emissions from international aviation into their Emissions Trading System.

The impact of doing this would be felt by the whole industry — all those who fly into and out of the EU.

And there would be pressures for countries outside the EU to introduce similar measures. For a country like New Zealand which is highly dependent on air travel this could have a major effect. Tourism is an obvious example.

New Zealand's air travel “wing print”

Our dependence on air travel is shown in this rather unusual world map. The territory size shows the distribution of aircraft take-offs, measured by the aircraft’s territory of registration. Note how big New Zealand appears. In fact we’re 7th in the world on departures per thousand people per year. [Antigua & Barbuda, Monaco, and the Seychelles are the top three].

There are precedents for similar rapid shifts in consumer preferences. They include the rapid rise of organic food, the move to unleaded petrol, and the banning of CFCs. I think, despite the challenges, we are potentially well placed to take advantage of these shifts and to differentiate our products to appeal to premium markets.

If we had to, reducing emissions from agriculture would be a major challenge: but our primary sector is one which has a worldwide reputation for innovation. There may well be opportunities from developing new technologies. One scenario would have New Zealand take the lead internationally on this issue – which affects both developed and developing countries, and which is one of the key differences between these groupings.

We in the government sector need to support the transition by designing sustainable and cost-effective policies which provide long term certainty about the direction New Zealand will take. And the Treasury has a major role to play in this.

But as I suggested earlier, it’s not just an issue for government.

Firms also are going to have to think about how products are marketed and differentiated in response to a potential change in consumer preferences — and to the use of protectionism disguised as consumer preference.

The inclusiveness of our economy#

The final topic I’d like to cover is about the effect the previous four – globalisation in particular – have on the inclusiveness of our economy.

In other words: how do we ensure that our economy does not increasingly exclude groups of people? How do we make sure the benefits of growth are spread in a way that is seen as fair; and in so doing, helps the development and acceptance of long term solutions?

Much of what I’m about to say will be familiar to those here who have followed the Treasury’s work on the inclusive economy, since its initial release some five or six years ago. The intersection of economic and social policy illustrates well the challenge and complexity involved in making long term choices of the nature that I have raised here today.

I’ve already said that the world of the future will be characterised by increasing returns to skills and the replacement of unskilled labour with capital and cheap labour in developing countries. As a consequence, there is the potential for a more marked widening of income gaps between the high skilled and less skilled — individuals and countries.

New Zealand already has a wide income distribution. This chart from the OECD may surprise people who think of New Zealand as an egalitarian society.

Income inequality

This is where we were at in 2000: slightly higher income inequality than the OECD average, than in Australia, Ireland and the UK for that matter.

Growth in income inequality

As you can see in this chart, measured income inequality in New Zealand grew markedly between the mid 80s and mid 90s – in fact it grew faster than in any other OECD country.

The reasons for the New Zealand increase in inequality are complex, well-studied and only partially understood. A key contributor was the very low growth New Zealand recorded over the 1980s and early 1990s which saw unemployment rise to more than 11%. Other factors include technology change (which has displaced low-skilled workers), deregulation, changes in household composition, and increasing returns to education and skills.

It is true that this rise in inequality stabilised from the late 1990s. But it is worth reflecting on the causes for a moment. This happened at a time of very strong employment growth. Those at the bottom moved from benefits into work, while those at the top had marked increases in wages.

More importantly, a prolonged slow down in our economy or structural change involving an increase in job losses could easily reverse those recent gains.

We must avoid getting overly focused on a given snapshot of the income distribution. Some income inequality is inevitable — after all, different people will have different skills, abilities and preferences and be at different stages of their careers. The ability to get into a job and then into a better one is at the heart of the patterns of incomes we see across the community.

But there may be good grounds for alertness to the developing patterns.

First, if parts of the population are not participants in economic development there will be less social consensus on how we as a country should tackle the big challenges facing us.

Secondly, what if income inequality reflects more than differences in innate ability, effort and preferences? What if it reflects marked differences in opportunity between individuals –- for example between children growing up in different kinds of family and community?

There are good reasons to believe that big differences in opportunity will exist. A glance at the distribution of educational outcomes, or a visit to some of our most disadvantaged communities, will confirm this. Disadvantages can persist across generations, as the children of disadvantaged parents become disadvantaged parents themselves.

As a country we cannot afford to waste the talents of individuals – not least, but not only, because to do so is economically inefficient.

Looked at in this way, the passive redistribution of income does not tackle the root causes. The real challenge is to break cycles of disadvantage — the compounding impacts of weak employment, of poorer health and justice outcomes, and of family circumstance — so that children from all backgrounds are able to succeed in the economy and in society.

We must therefore focus on improving skills and educational attainment — including of those at the bottom who are, in the shorter term, most threatened by globalisation — and on tackling these compounding factors.

A critical element in any long-term response must also be protecting the hard-won improvements New Zealand has made in the flexibility and strength of its economy. One thing that the last decade shows is that getting people into work is a key part of the solution. So policies that help firms expand and create jobs, and policies that support people into work are central to an inclusive economy.

Ultimately, the economic reality is that workers need to be healthy enough, have the right skills, and have enough confidence in our laws and institutions to compete in a globalising world.

And we need to ensure that there remains broad social consensus about our overall economic trajectory. If there is a large group of people who don’t share in the benefits we won’t get such a consensus.

The Treasury’s role – how it is changing and adapting#

I’ve spent some time today focusing on five challenging and far-reaching trends and forces which may have a profound and pervasive impact on New Zealand. Others may come up with a different list.

But that, I believe, would not alter my main theme, which has been that there is an important and influential role for all of us; for government, business and others — and for the Treasury as the government’s primary economic and fiscal advisor — in shaping New Zealand’s response.

Ensuring that New Zealand is long-term in its view will require all of us to revisit assumptions and to take a broader view of our interests.

On some of the issues I’ve outlined today the Treasury will continue to lead, developing our understanding of the issues and their implications, and working with Ministers and other agencies to take them forward. The long term fiscal position is an obvious example. On others, we expect to see others leading.

But, as you have seen, these five issues are not distinct and un-related discussions. And effective and enduring solutions need to work on the ground so to speak – which is why I see a role for business and for society more broadly.

So, beyond its role as the government’s lead economic and fiscal advisor, I believe the Treasury has an important, over-arching role in looking out for the broader interests of economy in a way no other government institution in New Zealand is in a position to do.

The new UK Treasury secretary, Nicholas Macpherson, has described his organisation as ideally performing the role of ‘strategic friend’ to the UK economy – ‘small, focused on the big challenges, able to adapt rapidly to changing circumstances and alert to risks and opportunities’.

I think the New Zealand Treasury is also on this path.

We have moved from being an organisation that fifty years ago focused on managing the government and its finances to one whose over-arching goal is making a real difference to New Zealand’s ability to achieve its growth and welfare ambitions.

Critical to the Treasury’s future success – and the success of New Zealand’s economy in anticipating and adapting to future challenge and change – will be a productive and informed dialogue between all sectors of the economy.

 

Conclusion#

In summary then, New Zealand finds itself on the edge of a region that contains substantial valuable natural resources, and is experiencing stronger growth than the rest of the world.

Against a backdrop of rapid global change — economic, environmental and societal change — this offers us as a nation immense opportunities, and profound challenges.

Finding appropriate responses, those that are long-term, enduring, and broadly supported, requires all of us – not least the institution I lead – to lift our sights beyond the preoccupations of the present.

And I want to make it clear once more that I’m on the side of the optimists here.

Looking back, the British entry to the EU presented challenges of similar orders of magnitude to those we are now facing. We managed that. It was painful at times, but I think the New Zealand we now have is very much the better for it.

We are now a Pacific nation, with a much more international focus, and with friends around the world. We are no longer simply an outpost of empire, with the comfort of assured markets. Instead, we are a confident and respected player in international markets and politics. We’ve got a good base.

Now we need to invest in ideas, capital and people to meet and overcome new challenges - like those that I have outlined today — as well as we have in the past.

ENDS