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Productivity: Innovation, Diffusion and Markets

Published 2 Dec 2015

Speech delivered to the Productivity Hub Symposium by the Secretary to the Treasury, Gabriel Makhlouf, 1 December 2015.

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The speech is available in Adobe PDF and HTML formats. Using PDF Files

Good morning everyone.

I'm very pleased to be here and even more pleased to be delivering the first of today's keynote addresses alongside my friend and colleague Dave Ramsden.

When I spoke to the inaugural Productivity Hub symposium, I noted how a cross-agency body like the Hub models the right approach to understanding productivity and its challenges. I am confident that gatherings such as this – bringing many perspectives, experiences and values together – generate ideas that should be good enough to survive formidable intellectual examination and debate.  Of course, it's also important that good ideas are turned into action!

Since the symposium two years ago, the Hub has done a lot of work to unpick the so-called paradox at the heart of New Zealand's productivity: why do our very good policy settings, combined with our immense natural capital, our skilled and energetic workforce and our reputation for innovation and agility in business leave us with persistently low productivity growth compared with other OECD countries?

Productivity of course matters.  As Paul Krugman said – over 20 years ago now – "Productivity isn't everything, but in the long run it is almost everything.  A country's ability to improve its standard of living over time depends almost entirely on its ability to raise its output per worker."

And it's important that we're clear on some other things that also matter.  I hope it won't be a surprise to anyone in this room if I say that it remains a fundamental truth that successful economies need, among other things, a stable and sustainable macroeconomic framework, sound monetary policy that delivers stable and predictable prices, a prudent fiscal policy and debt that's under control.  And it remains true that a well-regulated financial system matters, that properly functioning markets matter, that price signals matter and that incentives matter. 

Facts: what we know, and what we might not know

But first let's turn to some facts.

In terms of official productivity statistics, average annual labour productivity growth has been 1.0% over 2008-14.  Multi-factor productivity growth has averaged 0.1% per annum over the same period, so that capital deepening contributed the remaining 0.9% per annum.

There has been a slowing in average labour productivity growth over recent growth cycles to around 1.3% per annum. Amidst the global improvement in trend productivity associated with the benefits of ICT technology, New Zealand's per capita income gap with the OECD average did not materially reduce during this period.  This despite the fact that New Zealand's average real GDP growth was 2.6% over the 1995 to 2013 period.

We have a productivity challenge and all sectors of the economy need to respond to it.  The public sector is a big part of the economy and has a big role to play in continuing to improve its own effectiveness.  That's a road we've been travelling on and will continue to travel.  And business needs to play its part too.  In fact how business responds is at the heart of the productivity challenge.

StatisticsNZ has just released their Business Demography statistics showing that as at February 2015, New Zealand had 502,170 businesses, up 1.9 percent from February 2014.

These businesses had just over two million paid employees, up 2.3 percent from February 2014. Of the 502,000, 353,000 have zero employees.  Of the remaining 149,000, 90% have fewer than 20 and 97% have fewer than 50.     

We know that rich data about these businesses helps us understand current productivity levels and identify where improvements can be made.

The firm-level work the Hub has been doing - and the new insights this is generating on New Zealand productivity - is making a significant contribution in this area.  As recent work has indicated, firm-level data is giving us unprecedented insight into the specific, local forces at work on productivity across the country.

It can, for instance, reveal significant variability in performance between individual firms, even within the same industry.  And like in so many other areas of the economy, data helps us to understand elements of productivity that may otherwise remain obscure.  Good data sets, and deep analysis of them, give us a picture of productivity performance and skills at the level of individual firms and even individual workers.

Taken together, the firms for which we have this kind of data (about skills, pay level, hours worked, age, and gender) make up the majority of New Zealand employment. With careful application, this material becomes a solid foundation from which we – all of us – can address future challenges.

At the same time, it's important that we ensure we can indeed capture all productivity data. 

Productivity in production tends to be what we focus on, but there is a far bigger game, involving how and what we consume – whether it's provided by the public or private sectors – from technology-enabled services in transport and electricity, to broader forms of infrastructure planning such as telecommunications and to services more generally.

As Robert Solow said, back in 1987, "you can see the computer age everywhere but in the productivity statistics."  There remains a strong suspicion that our current data sets are not capturing the immense impact that ICT – and digitisation in particular – has had on our lives. Nor that we're capturing all services productivity data.  This measurement challenge is faced by StatisticsNZ and by its peers around the world.

Innovation and diffusion

That brings me to an important theme that I want to talk about, innovation and the pace at which it spreads or diffuses throughout the economy.  It is the key to lifting aggregate productivity.

The Productivity Commission has been working on a productivity narrative which is important for continuing to build our collective understanding about the possible drivers of New Zealand's productivity performance and where policy responses may lie. 

I'll draw on a number of conclusions of that work here. 

There are a number of reasons why such technological diffusion may not work particularly well in New Zealand.

First, weak international connections may limit the extent to which new technology diffuses from the globally most productive firms to the most advanced New Zealand firms.  Second, small and insular domestic markets may reduce diffusion to firms within New Zealand further away from the frontier, so-called 'laggard' firms.

So 'fixing the diffusion machine' is a key policy challenge.

The broader policy challenge is to cement-in the dynamic policy gains that lift productivity growth. With rapid technological change continuing, future gains in GDP per capita will become more dependent on skills and investment in innovation and other forms of knowledge-based capital.

Ongoing  technological  change  also  implies  a  focus  on  diffusion  as  a  key  source  of productivity growth and policy focus.

The diffusion of new productivity-enhancing technology from high- to low-productivity firms is a key driver of productivity growth.

As the world's most productive firms innovate and push out the global technology frontier, they create space for the most advanced firms nationally to adapt and adopt frontier technologies to local conditions. In turn, this allows 'laggard' firms to use this technology in their production processes.

But technological diffusion isn't a smooth process and much can go wrong along the way.

During the 2000s productivity growth for the world's most productive firms was much stronger than for the laggards and substantial productivity gaps have opened up, particularly in services.  So while technological advances proceed apace at the global productivity frontier, the 'diffusion machine' appears to be broken, especially across firms in the services sector.

There are a number of possible reasons why technological diffusion has slowed but weak investment in knowledge-based capital such as innovative property, digital information and managerial capability are all potential explanations for weak diffusion, among others.

In particular international connection – via trade, capital, people and idea flows – is a key channel for the diffusion of new technology.  In small economies, access to international markets – in all its forms and whether through trade, foreign direct investment, outward direct investment, employment of skilled migrant labour etc – also allows productive firms to grow and benefit from scale and specialisation while at the same time maintaining – or even increasing – competitive pressures.

It follows that limited international connection prevents leading domestic firms from growing and adopting frontier technologies.

This is consistent with the characteristics of New Zealand firms that are internationally connected via trade and investment flows versus those that are not.  Specifically, internationally engaged firms tend to have relatively high productivity levels and growth rates and be considerably larger in employment terms than firms focused solely on the domestic economy. 

Knowledge-based capital – which includes assets such as product design, inter-firm networks, research and development and organisational know-how – is more conducive to productivity growth than other capital assets.  And given the nature of new technologies, the positive productivity impact from investing in these assets is greater than for more traditional types of capital.  Recent research highlights its importance in 21st century economies where new ideas and knowledge are the key engines of growth.

As well as being important in pushing out the technological frontier, knowledge-based capital is also critical in facilitating technological diffusion.  Adopting new technologies developed elsewhere requires hard work on the part of firms, including investing in the complementary assets that facilitate diffusion.

If 'lagging' firms under-invest in these assets, they will struggle to adopt new technologies and lift their productivity growth.

Markets

Productivity is not only about embracing the new, as if new challenges demand the exclusive use of new tools.

To improve productivity we also need to recycle and up-cycle: adapt the old, reconfigure the old, re-examine and find new uses for the old in the face of change. Change is the only constant; being smart about the use-value of new tools and how they will interact with older mechanisms and levers will be a great advantage.

It is important that our frameworks for understanding contestability are dynamic enough to enable new ways of doing things, and new markets, rather than holding us to old and established understandings of 'productivity'.

Part of this is about understanding markets from the perspective of the end-user, the consumer, rather than simply looking at how concentrated the existing competitive playground looks.

Debates about market power in New Zealand tend to be polarised, with some suggesting (on one hand) that we are so small and isolated on the global stage that we should emphasise economies of scale as much as possible, and others pointing at our smallness as a reason for using policy to promote competition more actively, ie, to drive efficiencies.

As I said earlier, properly functioning markets matter and there is a continuing need to detect and prevent anti-competitive conduct, even when the market is seemingly competitive.  It does appear from the Commerce Commission's work in the construction sector, for instance, that the meaning or impact of damaging collusive behaviour is not well-understood.Two weeks ago the Government released an issues paper calling for submissions on potential reforms to Section 36 of the Commerce Act, including reforms to the market power prohibition and the potential introduction of market power studies for the Commerce Commission.  I urge anyone interested or concerned with these issues to read the paper and make a submission.

And the question of properly-functioning markets isn't simply about whether big or small firms can compete.  It's about all markets and whether they are functioning well.  For example, do our skills and labour markets operate efficiently?  Do our professional and vocational qualifications operate to promote the competition and innovation that could make a difference to productivity?

It is accepted wisdom that our policy settings are right and are working well but perhaps some of them may no longer be fit-for-purpose.  We should keep an open mind and avoid the risk of becoming complacent about the quality of our policy-settings.  That might be part of the explanation of the so-called 'paradox' when we look at our productivity performance.  We may need to challenge accepted paradigms if we want to ensure that our markets are functioning well and encouraging the competition, entrepreneurship and innovation that make a difference to productivity and, ultimately, our living standards. 

The structure of firms

As I noted earlier, most of our firms are very small.  And one response to some of the disadvantages of size has been the development of co-operatives.  Although they are most prominent in the primary sector, the co-operative form is widespread throughout New Zealand business, including in retail, insurance and finance.

Co-operatives meet some obvious interests and provide some real advantages in the New Zealand context.  They provide a strong sense of control for members, an effective mechanism for spreading risk, and better ability to weather cyclical downswings in revenues.

However, there are also certain disadvantages: co-operatives are typically less transparent in performance reporting; owners are more motivated by growing the value of their own businesses than providing for the growth of the co-operative; usual market disciplines faced by conventionally structured entities tend to be less visible and effective for co-operatives; and governance is also often less transparent and more challenging.

So given the centrality of co-operatives to the New Zealand economy, are the advantages of this corporate form sufficient to outweigh any disadvantages?  Or to put it another way, do cooperative structures support innovation and promote increased productivity?

People

Technology has certainly aided businesses in communication and data collecting and agility of implementation but at the core of business lies the human element. How do we marshal our common understanding and sense of purpose?

While technology may help greatly with improving elements of manufacturing, distribution and design, its use-value for people in workplace of all kinds (for operating and building, for analysing and compiling, and for connecting with each other) remains its greatest attribute.

Whether it's fostering new relationships in new markets, or improving efficiency in existing processes, or attracting fresh thought and talent to business, people hold the key to improving productivity.

Productivity is not only, as we're sometimes told, about scale.  To me, it's also about being smart and embracing the human element in all its diversity is important, too.  Diversity of thinking drives innovation. It helps identify opportunities quickly and inventively. Diverse thinkers illuminate blind alleys and uncover new pathways.

International connections

Let's get back to the issue of distance.  New Zealand remains challenged by being a small market far away from large trading partners.

As a small and distant economy, we have to work harder to be at the cutting edge.

Technology has not yet eliminated distance completely but it has brought us closer than ever before to the rest of the world.  I remain positive about the potential for technology to bring us even closer but the reality is that – in terms of productivity – the challenges of distance still loom large.

We have not been able to benefit from agglomeration of economic activity in our particular location to the same extent as, say, countries of similar size that are in or close to the EU. But while we are far from European markets we are part of the fastest growing region in the world.

So the question we should be looking to answer is: how do we deepen our integration into the Asia-Pacific region?  How do we take advantage of our increasing closeness to the global centre of economic activity?  How do we take advantage of that closeness to improve our productivity?

Conclusion

The Government's efforts to support improvements to New Zealand's productivity are concentrated around the Business Growth Agenda, underpinned by sound management of the nation's finances and a State Sector that is focused on delivering outcomes and improving its own productivity.

But meeting the challenge of improved productivity is a task that we all have to face up to, public or private sectors, big or small firms.  If we had all the answers, I wouldn't be making this speech today.  We need to share experiences, build agile and resourceful innovation, promote its diffusion, deepen our international connections and make sure we use all of New Zealand's diversity of talent and ideas.

Thank you to the Productivity Hub for inviting me here today.

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