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The Challenges of a Growing Economy

Delivered by John Whitehead, Secretary to the Treasury at Reuters 85 Fleet Street London, on 11 May 2005.

Good evening and welcome. To start I’d like to pass on my appreciation to Simon Walker and Reuters and Greg Andrews from the High Commission for the efforts that have gone into organising today’s event.

One of the reasons for that appreciation is that it gives me the opportunity not only to talk to you, but also to hear from you a perspective on New Zealand and the issues I’m discussing that I don’t often get.

So, if you pick up on anything you’d like to raise, I hope you’ll feel free to discuss it at the end of the formal part of the talk.

Can I also say what a pleasure it is to be in the UK, and to observe the confidence and positive spirit there is in the place, despite the issues you undoubtedly face. A country whose per capita income has recently passed that of Italy, France, Germany and Japan must be doing something right.

In 2000 John Kay wrote a piece in the Financial Times on the “failed New Zealand experiment” suggesting that we’re “the new Argentina”.

I thought that today, while they’ve briefly let me out of the laboratory, I’d provide an update on how the New Zealand economy is performing, admittedly with the benefit of a few more years’ hindsight.

And 20/20 hindsight is a wonderful thing. I’m not looking to labour on John Kay’s article, but one point he made is that, prior to the economic reforms of the 1980s, New Zealand had low unemployment, although many of those jobs weren’t productive. Perhaps, he suggested, that was better than putting people out of work.

I’ll pick up on our unemployment record soon. But really the comparison should have been with what would have happened to unemployment had we not undertaken the changes we’ve seen over the last 20 years.

New Zealand was living on borrowed time, very heavily borrowed. he status quo simply was not sustainable. For those not familiar with New Zealand’s economic past – we saw two waves of significant reform. The first was under the Labour government of 1984 to 1987, led by Finance Minister Roger Douglas. This period involved both microeconomic reform and macroeconomic stabilisation. A second wave of reform followed under Minister Ruth Richardson in the early 1990s, and included, amongst other things, fundamental reform of the labour market. In between times, and subsequently, there has been more measured change, but the fundamental direction has been maintained, and more recently reinforced through a focus on growth and innovation.

Well, I think there is strong evidence that there has been a significant change and New Zealand is now in a different economic environment. Compared to the 1980’s our growth performance has certainly changed. We have moved up a gear – or two.

That success though means we are now facing some new challenges. Some of those challenges need to be addressed fairly soon, while others require a longer term focus.

And these challenges are what I want to concentrate on today. In doing so I’ll be drawing on comparisons with the UK, because I think in a number of areas there is a striking similarity in the questions we face.

New Zealand's economic performance

So how is the economy going?

Slide 1: GDP growth
Slide 1: GDP growth

Real GDP growth in New Zealand for the year to December 2004 was 4.8%, one of the strongest growth performances in the OECD.

That growth was supported by solid world growth, and a high terms of trade, due to strong prices for New Zealand 's exports, including those here in the UK .

As well as this, a stronger labour market, rising house prices and increased wealth have underpinned increasing consumer confidence.

Over the same period , the UK economy has grown by just over 3%. One of the stark differences in performance has been the strength of private consumption in New Zealand, whereas growth in consumption has been more muted in the UK. The UK housing market cycle appears more advanced than NZ, with price growth in the UK having slowed more than in New Zealand.

Last year's strong performance follows a trend which has developed over the last few years.

Slide 2: How have we been doing?
Slide 2: How have we been doing?

Some of this recent performance is the product of New Zealand going through an upswing in our business cycle over the last few years. To a degree we have been favourably out of sync with much of the rest of the world.

However, if you look back over the last 30 years or so, our performance over the last dozen years in particular has picked up considerably. Cyclical influences aside, enough time has now elapsed for us to see it won't all come crashing down again.

This graph provides a longer picture , and takes out cyclical fluctuations as it shows 11 - year moving averages. Having said that, an update with the latest OECD data would see the New Zealand line drop a bit because, as the previous graph showed, we had a big cyclical dip in 1993. Nevertheless the line remains above the OECD average.

Treasury’s latest forecasts suggest that when the slow-down does arrive we will only slip back to GDP growth of around 2 ? percent. There was a time, not so long ago, when growth of that level would have been considered a real achievement, even near the peak of the cycle.

Slide 3: GDP growth
Slide 3: GDP growth

The economic outlook


I’ve touched on some of the factors that have contributed to New Zealand’s recent strong growth performance. However, as I’ve said, that growth has slowed over the second half of 2004 and we look to be entering a period of more moderate growth.

The current high exchange rate is beginning to affect exporters' revenues and is likely to constrain export growth in New Zealand, particularly for services and manufactured exports. Recent interest rate increases and easing net migration will take some of the heat out of consumption and the housing market.

The economy is also running up against resource constraints, particularly in the labour market , where reported difficulties finding labour are at high levels. All of these factors point towards a period of slower growth. Our latest assessment for growth is in the range of 2¼ to 2½ percent in the next couple of years, before we rebound to 3 to 3½ percent.

I note that recent Consensus forecast of activity in the UK points to growth of a similar rate in the next 12-18 months, but clearly not coming from the same strong level of growth as New Zealand, with market commentators anticipating weaker growth in household spending in the short term.

Slide 4: OECD Per Capita Income
Slide 4: OECD Per Capita Income

The challenges


There has been a lot of discussion in New Zealand about returning our income per capita to the top half of the OECD.

Perhaps a more positive option is looking to take some steps up the ladder. I note that in this regard the UK gives us something to aspire to, slipping in at 13th out of the 30 OECD nations, and climbing in recent years. For someone who was in the UK in 1979 after the Winter of discontent, and then again in the late 1980s/early 1990s, it’s very encouraging to see the impact of generally good economic policies played out over a longer period of time, with the UK overtaking Italy, France, Germany and now Japan in per capita income and becoming, by some measures, the world’s fourth largest economy.

There was a period, particularly during the 1970s, during which our income per capita ranking in the OECD dropped dramatically. Over the last few years , we have arrested that decline. However the trip down the rankings took some time and the trip back up is not going to be a quick process either.

Looking at the picture, having gone up one step on the ladder in the last year , there is now a big step up to the next group of countries. So while we may continue the trend of the last dozen or so years of growing faster than the OECD average, it may be a while until we take the next step.

Moving from the “what” to the “how”, the key to sustained growth is a need to re-examine the horizon and assess how we need to respond. Some of the challenges we will face will be more transient than others. There are certainly some that we have to get better at identifying and addressing in the long run.

Government

The first group of challenges I'll cover are those in the government's domain, primarily around fiscal policy.

To put this in context, experience shows that when countries are hit by unfavourable conditions like a drop in trade, if the government's own finances aren't in order then the economy as a whole doesn't cope well either. New Zealand in the 1980s was a case in point.

The significant change in our fiscal policy framework is a fairly well- told story and the fundamentals of sound fiscal management - such as the budgetary discipline required under the Fiscal Responsibility Act - have been critical to our success in recent years.

But make no mistake, the number one rule must be to strengthen, not weaken, these fundamentals .

So what are the challenges for fiscal management in a growing economy?

A big issue is rising expectations for government provision of public services. In one sense , it is quite reasonable to have higher expectations. After all, the point of growth is to improve living standards and this includes the level of public services.

The challenge is about forming expectations that are reasonable and meeting those expectations in a way that is sustainable.

There is a real risk that public expectations of what can be delivered are beginning to outstrip reality.  If we take this too far, then the goose will stop laying golden eggs and die of exhaustion.

We have certainly moved from times when governments faced high levels of debt, and had to shake out the piggy bank for spare change for lunch.  However, the shift is not to a world of bottomless resources.  The current government, under Finance Minister Michael Cullen, has a long-term fiscal policy based on running operating surpluses - on average over the cycle - in order to make contributions to the Superannuation Fund, meet capital pressures and manage debt.

The operating balance for the 2004/05 year is likely to come in at around $5.6 billion or about 3.7 percent of GDP. It is then forecast to rise initially in 2005/06 before falling over the rest of the forecast period.

In our December forecasts the cash position for 2004/05 was a $1.4 billion surplus. Based on year-to-date figures the final figure is likely to be higher than this.  This cash is already ear-marked for future capital spending over the next few years and , after that, we expect to start seeing cash deficits again.

Of course the focus of fiscal policy is more long term with gross government debt acting as the anchor for fiscal policy in much the same way as seeking to reduce my mortgage impacts on what I do with what I’ve got in my wallet right now.


Again, progress has been good. Gross debt was 36.6% of GDP in 1996/97, and went below 30% in 2001/02. It is expected to keep falling to around 19.6% of GDP by 2008/09. Net debt has fallen in parallel, and allowing for Super Fund payments should fall to zero in that time period. This is another area where it is easy to forget the real progress New Zealand has made.

There's a difficult balance to be struck in ensuring that gross debt continues to track down in this way, consistent with the government’s goals and making sustainable spending choices.

I saw a story in the Economist a few weeks ago that looked at the UK fiscal position, and again the similarities with New Zealand, particularly the pressure on future spending following a time of relative plenty, struck a particular chord with me.

If I think about my own spending habits – it’s not a good long-term plan to spend all the cash I have now when I know that my house needs substantive maintenance, and also that the amount of cash available is going to be less in the future.

Health is one area often cited as an example of spending increases that simply cannot continue into the future. That’s a matter of mathematics rather than an economist being deliberately provocative. Health spending simply cannot keep growing at 5 percent real per annum, as it has been in recent years in New Zealand, unless the economy expands at least the same rate.

Slide 5: Tertiary Education Expenditure
Slide 5: Tertiary Education Expenditure

This graph presents a similar picture of government spending on tertiary education. This spending has increased by around 60 percent in the last five years. Growth at these levels is clearly outstripping growth in the economy and therefore the nation’s ability to sustain those increases. Overall, spending in the most recent years has been kept within the growth of GDP, but my point is that sooner or later, spending increases at this rate in health and education will crowd out other spending and become unsustainable.

Another aspect we have to face is the outlook, not over future years, but future decades. We know there will be big pressures in areas like superannuation and health.

Picking up these pressures, next year the New Zealand Treasury will be producing long - term fiscal projections, looking out another 40 years or so.

Demographic changes will be important in these projections, but the picture is broader than that. The health increases referred to above for example have resulted from technology and price increases, in many respects before the demographic spike has kicked in.

These projections will help us think about how to tackle questions around sustainable spending now, rather than being faced with a cliff sometime in the future.

Business and Government

The next set of challenges I'll cover apply to both the private and state sector. It is a long list, so I'm going to cover some, but not all, of the important ones. They fall into four main areas: labour, productivity, infrastructure and the environment. I can only skim the surface here, but I'm happy to expand a little at the end if you have questions on particular areas.

Labour

First is the question of the labour market. It is this area that perhaps highlights most vividly the fact that New Zealand is not the economy it once was.

Currently we have the lowest level of unemployment in the OECD at 3.6%, a quite remarkable achievement given that it was 11% in 1991. Apart from the profound social consequences this has had, it has changed our economic landscape too.

Slide 6: Labour Force Participation and Unemployment
Slide 6: Labour Force Participation and Unemployment

Labour force participation has lifted, employment is up strongly and the unemployment rate has dropped, including long-term unemployment. We now have firms reporting substantial skill shortages, a huge change from the situation during the 1990s when NZ, and the UK, had high rates of unemployment.

The UK, of course has had a similar labour market experience in the last few of years, with the unemployment rate falling to around 4.7% here.

As in New Zealand, employment in the UK has grown strongly and labour force participation has lifted. In many ways both countries face a similar set of issues as it is becoming harder and harder to generate further economic growth from increasing labour utilisation.

In New Zealand's case we are increasingly looking at ways to improve economic growth and living standards by lifting labour productivity, although there is still some scope to improve labour utilisation.

The Prime Minister's speech at the opening of Parliament this year covered the subject of further improving our already high levels of participation. Getting our rates across the population up to those in the top five OECD countries could increase our GDP per capita by around 5%.

That is a big call, but worth the effort if we're serious about the objective of returning income per capita to the top half of the OECD.

Of course there are countless other ways to contribute to society other than contributing to GDP. The key will be to provide people with options so they are better placed to make choices that help meet their goals.  

If you combine our unemployment rate with longer term issues like population aging I think we are only just starting to see the start of some significant changes in the nature of the employee/employer relationship. There will need to be more emphasis on thinking about the increasing role that women, people currently on benefits, people classed as “older” and migrants can play in the workforce.

The government too has a role here, such as addressing the barriers and considering options to support increased labour supply. For example, there have been a number of policy changes in New Zealand aimed at getting people off benefits and into work and also addressing the barriers to mothers with children moving back into the workforce.

But the challenge isn't just about the number of people; it is just as much, if not more, about the quality of labour supply and what it does.

On quality, the government is continuing to increase funding for industry training and is examining the tertiary system to ensure that it is focusing resources on creating the graduates with the skills firms need. There is also work going on with various industries to find ways in which firms themselves can better build and retain the skills they need.

A shortage of available skilled labour means that firms are getting smarter about the way they use the people they have. This includes things like flexible hours of work, improving productivity through innovative uses of labour, and providing support to parents trying to balance work and family responsibilities.

This also means that firms are on the look-out for smart people with new ideas, and also ideas from overseas about how they can improve current practices.

Productivity

This brings us back squarely to the all-important issue of labour productivity. The drop in unemployment reinforces the challenge of improving our labour productivity because there is a natural limit to what we can achieve through labour utilisation.

It is a huge topic and I'm not going to try to do it justice today, although many of the areas I'm going to cover do have a role in lifting productivity.

Slide 7: Labour Productivity
Slide 7: Labour Productivity

This graph provides a comparison of how our productivity performance rates against other members of the OECD. I think it paints a pretty clear picture.

Many New Zealanders still think of productivity in terms of cut backs and working longer hours, the idea that higher productivity comes from working harder. We have to get past this perception.

Productivity of course is about making better use of technology and the resources you currently have, and getting more out of them.

Government can help create the climate to raise productivity, but fundamentally productivity is business driven.

Going back to the slide, all the OECD countries with higher GDP per capita than New Zealand have higher labour productivity. All of the countries with lower GDP per capita have lower productivity.

A nice coincidence perhaps, but it illustrates quite clearly the importance of improving our productivity. Sadly, solutions are not so transparent – far from it.

Slide 8: Capital per Hour Worked (2002)
Slide 8: Capital per Hour Worked (2002)

One thing we do know is the importance of capital per worker. In New Zealand the suggestion is that our levels are too low compared to other countries. That conclusion is possibly a bit simplistic. For example, a straight comparison with Australia (as strangely we often tend to do in New Zealand!) doesn’t account for the fact they have a large mining sector which requires a higher investment ratio than many other industries.

However, some recent work we have done in Treasury comparing Australia and New Zealand suggests that despite these factors, there is still something to the capital shallowness story.

This slide is another comparison within the OECD, this time the amount of capital per hour worked. Even taking into account the point about trying to do straight comparisons, this slide paints a vivid picture for us, and a challenge.

Again, just to reinforce the similarities between the UK and New Zealand, you are three steps ahead on the productivity rankings and one step ahead on the capital per worker rankings.

The recent news on business investment in New Zealand has been positive. In some senses, our weaker investment performance in recent years may be the flip side of our extremely good employment performance. If so, it potentially puts us in a very strong position.

But the challenge certainly is not exclusively for the private sector. For example, the Treasury is currently looking at the way New Zealand’s financial markets are working to see if firms’ access to finance is being constrained, and if that may be affecting their investment decisions.

The Minister of Finance has also said that he is keen to pursue initiatives in the Budget this month that are linked to the cost of capital and business investment in areas such as changes to depreciation rates and taxation of financial intermediaries. Also announced recently were simplification measures such as streamlining the Fringe Benefit Tax regime.

The government also has a supporting role. Last year a group of business, industry, union, academic and government representatives reported on ways to improve workplace productivity. They highlighted a range of initiatives based on the government continuing to work in partnership with those other sectors.

At the end of the day, however, we need to remember that productivity will ultimately be determined at the level of individual firms.

Infrastructure

The next area I want to cover is infrastructure. Inadequate infrastructure can be a major bottleneck to growth. An audit of New Zealand’s infrastructure done in 2004 confirmed that, with a couple of fairly specific exceptions, our infrastructure is not an area of major concern.

But of course, the faster we grow, the faster the demands on infrastructure increase, and we need to be forward looking rather than steering via our rear-vision mirror. Two big areas where there are grounds for further focus are energy and transport.

When it comes to energy, we are in a period of transition. Not only do we have to guard against a lack of energy becoming a barrier to growth, we have to do so in an era where we can no longer rely on an abundance of gas from the Maui field and other known reserves. All this is also happening under the influence of the Kyoto protocol.

In the main the response to that challenge is to look for opportunities for increased supply. Examples firmly on the agenda at the moment include moves to encourage gas exploration, expansion of the existing power stations and examining the feasibility of LNG importation. But there are many other options including energy efficiency, wind and solar power. I know you are facing parallel issues in the United Kingdom.

If we were looking for another classic case study of the challenges a growing economy can present, transport would be a good place to start. In Auckland in particular we are having to look at many of the questions you’ve faced here for some time, although thankfully our issues on a much smaller scale.

Simply trying to build our way out of congestion won’t work, although we can certainly do better with our roading investment. However, we are reaching a point where both financial and non-financial measures – such as tolls or improved public transport – to limit, or spread, demand are imminent.

Environment

The environment is often highlighted as a loser when there is economic growth. It is true that growth can mean more pressure on the environment, but the picture is more complex than a straight either / or proposition.

Growth generates wealth, and that wealth provides the opportunity for trade-offs between environmental, social and economic goals. In other words, wealthy countries can afford to make choices on higher environmental standards that poor countries cannot. A casual observation around the world suggests they do make these choices.

Of course it isn’t even that simple. Countries differ and when you get down to the detail, addressing complex trade-offs between the environment and development is going to be difficult. Growth will mean these are challenges we will continue to face, and perhaps more often.

I believe that New Zealand has a good framework in which to face those trade-offs.

There are however some bigger questions that we are not so well-placed to address. New Zealand, like many countries, is inevitably moving into a world where allocation of some resources is going to be more explicitly based on price.

Slide 9: CO² Emissions Since 1990
Slide 9: CO² Emissions Since 1990

Thinking about more global environmental management, the Kyoto protocol came into force earlier this year.

The profile of New Zealand’s carbon emissions shows an interesting picture. Note that the data stops at 2002. We know that under the first commitment from 2008 to 2012, our forests provide us some degree of comfort. Perhaps we are a little too comfortable, since hidden behind this picture is the fact that we are one of the fastest growing carbon emitters in the OECD.

Our economic growth has driven much of this increase, particularly in areas like road transport. If you look out to what continued growth could do to our profile in 2012 it suggests that like most countries we will face some big questions.

Similarly we are starting to address the fallacy that all parts of New Zealand have unlimited access to water. Already we are seeing pressure in some areas – for example Canterbury – and demand is only going to go one way. Options such as transferable water rights are currently on the agenda. They are one possible way to ensure, that in areas of scarcity, water ends up in the highest economic use.

Conclusion

My aim today was to give you an overview of how New Zealand’s economic landscape has changed as we move from an economy struggling for growth, to one facing challenges resulting from it. And they aren’t challenges we can simply spend our way out of.

Linking back to John Kay’s article, I’d suggest that the thrust of the changes New Zealand has instituted are now considered to be fairly orthodox.

The clear lesson of the New Zealand experience is that those policies are necessary, if not sufficient, fundamentals for a successful modern economy. I hope I have painted for you a picture of an increasingly successful economy; one that is much more robust than it used to be and a country that is increasingly confident of its direction and place in the world. At the same time I hope I have given you a sense of some of the weaknesses, both current and potential. But these in the main are problems of success – they are the sort of problems we should prefer to have.

It goes without saying that the picture is not static and there are future challenges to face. I have touched on some of the main challenges. There are certainly more, and others will inevitably arise.

The thing they have in common is they show us that we have to lift our sights, not only because the challenges are so all-encompassing, but also to ensure we are prepared before the next set appears. I think that too often we focus debate about our future direction on yesterday’s problems.

I’m not suggesting there are easy answers; they would have been found by now if there were. We also need to recognise that New Zealand is different and we need to develop solutions within our own context.

Having said that, one of the things that is apparent is the many similarities between the experience and issues facing both New Zealand and the UK. That in part is why I stressed at the beginning that I look forward to your questions and discussion.

Thank you.

ENDS

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