Putting Productivity First

Delivered by John Whitehead, Secretary to the Treasury, at the Icehouse, Auckland on 3 April 2008.


John Whitehead, Secretary to the Treasury
The Icehouse, Auckland
3 April 2008

Hello everyone, thank you for coming today.

While it’s usual to start at the beginning, I thought I’d start way back at the very beginning and ruminate about the origins of the universe. There are a lot of theories about how the world was created. According to Hindu beliefs, the world came about through the act of churning an ocean of milk. This involved a team of gods, a bunch of demons, a giant serpent and a large tortoise toiling away for a thousand years. The traditional Judeo-Christian view is that God created the world in six days before resting on the seventh. And in Maori mythology, Tane pushed his father Ranginui away from his mother Papatuanuku and planted posts to keep them apart, wrapping up the whole job in a matter of moments.

As an economist considering these stories in terms of productivity levels – here output per hour worked – the Maori story has some attractions. It shows that we kiwis have the potential to be among the very best in productivity.

We need to fulfil that potential to be world-class. Because if there’s one point I’d like to make above all else today, it’s this: productivity performance is critical to raising the living standards of New Zealanders.

Long-term productivity growth is not yet meeting our aspirations, which means many of our aspirations for a better quality of life are going unmet. Let me emphasise the words “long term”. New Zealand’s poor productivity performance is not a brand-new problem with quick-fire solutions. We need to take a long-term view about what matters for productivity and what we can do to improve it.

That’s what I’ll be focusing on today. I want to talk about the importance of productivity performance and what New Zealand’s productivity challenges are. I’ll be discussing the key drivers of productivity and their influence on our farms, factories and firms. And in particular, I want to take a closer look at three of the factors that matter most for New Zealand right now: investment, skills and international connections.

Paul Krugman of Princeton University made the observation that “productivity isn’t everything, but in the long-run it’s nearly everything”. Our capacity to raise our standard of living depends on our ability to raise output per worker – the amount of goods and services each worker produces and the value they add. It comes back to the old adage about working smarter rather than harder.

Lifting productivity isn’t just about making kiwi companies more internationally competitive and profitable. Remuneration is linked to the productivity of the workers in those kiwi companies; a more productive workforce leads to higher wages and ultimately higher living standards.

Right now we have challenges and opportunities ahead of us that make it even more important to lift New Zealand’s productivity performance.

Globalisation and the shifting centre of economic gravity towards Asia are increasing our potential markets while also testing the ability of New Zealand firms and individuals to remain competitive. The growth in skills supply in huge developing economies such as China and India means they are no longer competing on just labour costs, but on their ability to combine relatively cheap skilled workforces with deep capital bases, and leverage off growing internal markets. New Zealand now faces international competition on previously non-traded goods and services through global supply-chaining and communications technology. The opportunity for New Zealand is to apply ourselves to areas of non-routine work that deliver higher returns, areas that earn a premium for highly skilled innovation.

Demographic changes are also making the productivity challenge more urgent. New Zealand has an aging population and increasing dependency ratios, which means we need greater output per worker to sustain the same income per capita.

Natural resource scarcity is another critical factor. The environment is fundamental to New Zealand’s way of life and to the country’s economic well-being, with land and sea-based primary production and tourism sectors generating about 17 percent of our GDP. Yet despite the importance of a high quality environment we persist with some low quality practices. Water is a particular concern both in terms of quantity and quality. And of course tackling greenhouse gas emissions has become a national priority. 

The link between high productivity and high living standards has been recognised at the political level, and over the years governments have introduced agendas and policies to improve New Zealand’s productivity performance. Unfortunately, we still get a ‘could do better’ report card. The Treasury’s view is that our country’s long-term trend of productivity under-performance is the biggest economic challenge for governments of any political persuasion in New Zealand. That’s why the Treasury’s policy advice puts a lot of weight on the question “will this initiative help or hinder productivity?”.

Slide 1 - Real output per hour

New Zealand’s under-performance problem became entrenched during the disco era – though I’ll let you be the judge whether there’s a causal relationship. In the 1970s, annual labour productivity growth across the whole economy was close to zero. Since then we’ve dragged the annual average up to around 1.5 percent, largely due to policy changes and structural changes in the economy leading to better productivity and greater economic resilience.  

Slide 2 - GDP per hour worked in 2006

Nevertheless in 2006 New Zealand’s level of labour productivity ranked 22nd out of 30 nations in the OECD – around 25 percent below the OECD average, 30 percent below Australia’s level, and 44 percent below the United States’ labour productivity. We’re not at the back of the field, but the pack of countries behind us is going faster than we are.

The main issue here is not recent productivity performance. The key point is that our long-term productivity growth rates have not been enough to meet our living standard aspirations or to raise our productivity level to match other developed countries.

I find it encouraging that there are a broad range of voices – from politicians and business groups to economists, academics and unions – who are talking about productivity and what should be done to get our performance up to speed. That includes the performance of the public service, a topic I talked about a few weeks ago. What we should seek to avoid is the substance of this debate being limited to silver bullet solutions delivered in six o’clock sound-bites.

We also need to look beyond the current over-emphasis on perceived political solutions – the view that a few policy changes alone could fix the bulk of our productivity performance problems. I don’t wish to understate the very important role that government plays in creating an environment in which productivity may flourish or flounder. But I believe that if we want to see what can be done to lift long-term productivity growth, we have to look at what makes a difference at the firm level – the level where boots get dirty, hands get greasy and mouse-clicking fingers get achy.  

So what are the factors that influence the growth of firms and productivity performance? Productivity is a complex challenge, but taking a broad perspective it can be thought of in terms of five interlinked drivers, all of which have a part to play in providing the conditions to enable firms to thrive. These drivers are enterprise, innovation, skills, investment and natural resources.

Today and over the coming weeks the Treasury will be releasing a series of productivity-focused papers that will provide an in-depth look at these drivers, so I will just describe them briefly here to give you a sense of how they are inter-related and mutually supporting.

Enterprise is about seeing a market opportunity and making it happen. Innovation is about developing or coming across a new idea or way of doing things and putting it into practice. Skills is about having the right people who can create or identify these ideas and make them work. Investment is about putting money into bricks, mortar and steel - or these days ICT. And natural resource management is about ensuring the clean water, fertile land, and climate is used sustainably - now and into the future.

What it boils down to is this. By investing in new capital, increasing skill levels, introducing new innovations, encouraging entrepreneurial activity and promoting natural resource management, New Zealand can achieve productivity growth, higher incomes and a better standard of living.

Growth is a dynamic process that hinges on firms and individuals and the decisions they make. New Zealand has around 463,000 firms competing locally, nationally and internationally to get ahead. Some will be adaptive, find a smarter way of doing things and be successful. Others will start out with a good idea but don’t know how to make the most of it – hence the importance of the work The Icehouse is doing. Firms may lack the necessary business savvy, management culture and capability, and ultimately fail. In the wider scheme of things failure isn’t always a negative phenomenon – when poorer performers exit it raises the average performance of the economy and frees up resources to be used in more productive areas.

As I mentioned, this business activity takes place in an environment shaped to a large degree by a range of government policies, actions and decisions. Within this mix some issues are already under a floodlight of scrutiny and I don’t believe they require intensive illumination from me on this occasion.

Taxation falls into this category. Tax is sometimes prescribed as a cure-all for our economic performance ills. While it is a significant factor that drives incentives for firms and individuals, it’s by no means the only one. Suffice to say, tax is already the subject of robust debate and the government has budget announcements just a few weeks from now.

Regulation is another area which can be over-simplified and packaged as a panacea. Regulation can play an important role in achieving economic and other objectives, but it’s the quality that determines its impact. People making business decisions want regulation to be certain, stable and simple. This requires a strategic approach to regulation – being careful about how and when we regulate, and making sure that regulatory institutions and the overall regulatory environment improves over time.  Regulatory quality is particularly significant for New Zealand because of our small size, geographical isolation, and with that, the importance of deep international connections.  It’s vital that New Zealand's regulatory environment assists rather than hinders our global linkages and international competitiveness.

So how does the quality of our regulation stack up internationally? By most measures, the answer is “very well”. But other countries are improving the quality of their regulation and chipping away at our advantages.  We’re also not so good at systematically assessing the impact of regulation on the decisions of firms and individuals, and with that, the impact on productivity and economic performance. 

A good regulatory management system requires robust quality assurance processes for assessing the impact of new and existing regulation. This isn't easy. A single piece of regulation can cut across many areas of business, and affect different businesses in different ways. And while regulatory and compliance costs for individual pieces of regulation might be light, the combined weight of regulations might be enough to sink a proposed investment. It follows that a robust review process needs to ensure regulation is not having any unintended consequences. The importance of a good regulatory management system will not be new to most of you, and a number of government agencies, Treasury included, are looking at options for strengthening the existing system.

But rather than continuing to dig over the already well-dug ground of regulation and taxation, today I want to focus attention on three key issues for improving our productivity performance: investment, skills and international connections.

Capi1tal investment is a major component of labour productivity. Investment by firms, or in some cases by the government, directly influences how much a firm can produce. It’s not just the height of the stack of cash that’s important; it’s also about where the money goes and how it’s used. The quality of investment is influenced by innovation, the decisions of entrepreneurs and the process of competition.

Phil and Ted’s Most Excellent Buggy Company is a most excellent example of the impact of quality investment. When Campbell Gower first invested in Phil and Ted’s, the operation was producing two or three buggies a week out of a house in Wellington. He made an initial investment in 1997 and bought ownership of the company a year later. This injection of funds, along with Campbell Gower’s vision for the company, paid for the research and product demonstrations and led to the redesigning of the original buggy that has become the centrepiece of the business. New products have also been added to the range and Phil and Ted’s Most Excellent Buggy Company now sell in over 40 countries with exports accounting for 95 per cent of sales.

Slide 3 - Total fixed investment as % of GDP

Overall there is a low stock of capital in New Zealand. Our total fixed investment as a share of GDP slipped during the nineties, and while investment has picked up to around the OECD median since the turn of the century it is still below some of the higher-performing OECD nations. Lower investment rates have led to lower levels of capital per worker compared to the well-equipped employees in many wealthier countries, and this contributes to our labour productivity gap.

So why is our investment lower than it could be? Well, a key element in the challenge of raising investment is boosting the productivity of capital in New Zealand.  Compared to most OECD countries, we have low multifactor productivity — that is, we don’t tend to get as much output from our use of resources as other countries do.  This depresses the returns to capital and makes investment less attractive.  There is potentially a virtuous cycle arising from innovation, skill development and improvements in managing enterprises raising productivity and increasing the incentives to invest in more capital equipment.

Another likely factor is that the long-term cost of capital appears to be high in New Zealand compared with some countries. This is a significant problem with no quick and easy solutions.

It is linked to our low domestic savings and high external indebtedness – an issue the Treasury pushed quite strongly last year and which remains important to us. Having considered recent data, evidence and analysis, on balance we think that it is sensible to encourage more private saving. Our judgement rests on a least regrets approach in light of data uncertainties, macroeconomic imbalances, and the possibility that individuals are basing savings decisions on long-run expectations that could turn out to be mistaken.

In New Zealand we don’t save enough to fund our own investment, and have built up large external debts that are also likely to be pushing up the cost of capital. Initiatives such as KiwiSaver aim to improve this situation but it will take a long time to turn our savings record around. If we succeed in boosting our domestic savings, this would increase the funds available for domestic investment and deepen our financial markets. It could also help overseas investors to make green-fields investments in New Zealand.   

There are a few other factors at play in our investment environment. For example, risk aversion, regulatory uncertainty, or macroeconomic concerns may also inflate the return that potential investors require before committing funds to projects.

One final point about investment I’d like to touch on is the underdevelopment of New Zealand’s equity and venture capital markets. Lack of venture capital means that profitable investments are not undertaken, and even the young fast-growing firms that do get funded lose out on financial expertise. 

A well functioning financial market is critical to getting quality investment by ensuring that savings – both domestic and foreign – are directed to the most productive investment opportunities.  Overall, we think that a lack of development in certain parts of New Zealand’s financial system is probably imposing a moderate constraint on the growth and performance of New Zealand firms. 

I’d now like to turn from investment capital to human capital and talk about the importance of skills for New Zealand’s productivity performance.

You may wonder about the need to discuss skills when both main political parties have recently thrust skills into the foreground with major policy announcements.

I’ve decided to take a deeper look at skills because new macroeconomic evidence shows that they are even more critical for productivity and the rate of growth than we thought. Globalisation will only make the importance of skills even stronger.

Skills matter for a variety of reasons. Advanced skills in particular have a dynamic effect on innovation rates, the ability of firms to develop or adopt new technologies, and the development of market opportunities. We’re not just talking about boosting the capability of so-called knowledge workers; it’s apparent that improvement in skills at all levels can make a difference. Broad workforce skills matter for the ability of firms to adapt, and for the productivity and competitiveness of a wide range of businesses.

Sometimes there is a concern that the development of workforce skills to increase productivity might be too narrowly focused on vocational and technical skills at the expense of a well-rounded education. This is a false dichotomy. In a knowledge economy, the attributes of a productive worker include soft skills such as interpersonal communication, creativity, problem-solving and personal responsibility.

We know that skills development is a lifelong process and not just confined to the years spent in formal education. At one end, early childhood development is the most critical stage. Investing in quality teaching and support in the early years has potentially the greatest pay-off, especially if we can detect and respond to risk factors for children. In schools, what matters most for students’ learning is quality teaching – not just what teachers know, but how they teach it and how well they engage with students to make learning happen. The education sector’s debates about how to improve teaching practice are really critical to New Zealand’s future skills and productivity, as long as those debates lead to conclusions and actions. After the school years, we can lift productivity performance through the ongoing development of skills by adults in the workforce and improving the utilisation of those skills by firms.

On some measures the quality of our education in the years between kindergarten and a career appears very good. On average New Zealand’s 15-year-olds are near the top of the OECD for science, mathematics and reading literacy scores, and we rank among the best in our proportion of students achieving at the very highest levels. Clearly the capability of our teenagers goes well beyond their mastery of eye-rolling and sarcasm.

However, we also have a large tail of poor performers both in the classroom and later in the workforce. Among OECD nations we have one of the lowest participation and training rates for 15 to 19-year-olds. These young people are disengaging from education at a stage in their lives when we know it is important for them to continue building their skills. And of course for New Zealand, a long-term lift in our productivity and standard of living depends on improving the flow of skills from young people entering the workforce.

Evidence on helping this group indicates that interventions at a young age are most effective, provided they are followed up. Targeting the 15 to 19-year-old age group is critical while they are at the transition point between leaving school and entering tertiary education or the workforce. There is solid international evidence that supports keeping students in education or training for longer and providing them with flexible learning options to keep them engaged. For example, studies in the United States and Canada suggest that even if all we do is raise the school leaving age by a year or two, the students held in school longer would end up with higher lifetime incomes, less risk of unemployment, and better outcomes in other areas like health and offending rates. Those studies underscore the importance of the current focus in the political arena on increasing young people’s participation in education.

The final key area for productivity I’d like to look at is international connections. I talked earlier about the challenges and opportunities provided by globalisation. And while New Zealand is an open country, we are not necessarily as globally connected as we could be – or indeed as we need to be. We face a difficult job to convince others that a place at the bottom edge of the map can be at the cutting edge of business. New Zealand has to work harder than other countries to get noticed and accepted as a good place to establish business connections.

That puts an onus on Treasury and other policy advisers to ensure we take a global linkages perspective to policies that are the most crucial for improving productivity – to consider what might be best practice rather than just common practice, looking from the outside in.    

International connections are particularly important to New Zealand. First, there’s the small size of our domestic market. A lack of scale within New Zealand means we risk missing the benefits of higher competition, greater firm specialisation and the economies of agglomeration.

Slide 4 - We're a long way from the action

Then there’s New Zealand’s distance from other economies. Evidence has become clearer that proximity to other individuals and firms is positive for productivity – particularly the benefits of tacit knowledge and relationships – but a quick glance at a world map shows that New Zealand doesn’t exactly get a lot of foot traffic. Within a three and a half hour flight from Auckland we can access 0.4 percent of the world’s population and one percent of world GDP. Compare that with Hong Kong, where a flight of similar length would put you in reach of 58 percent of the world’s population and 37 percent of world GDP. The OECD estimates that distance from markets accounts for around three quarters of New Zealand’s gap in GDP per capita versus the OECD average, or around a 10 percent reduction in New Zealand’s per capita GDP.

New Zealand firms are changing how they do business in the increasingly globalised world economy. International Jade Software for example creates and exports products that are effectively "digitalised skilled labour" – software and services for sectors such as logistics, education and human resources. This internationally connected company is 80 percent based in New Zealand but uses a really broad recruitment pool – hiring experts from around the world, with 75 percent of its capital and 50 percent of its revenue coming from overseas.

The challenge for New Zealand is to achieve internationally competitive firms, supported by a set of domestic policies and international linkages that enable them to succeed.

Efforts to address this challenge have seen a strong focus on trade. Freeing up and developing trade links for our exporters has long been a priority for governments and by extension the Treasury, and there is no doubting trade’s importance. But international connections are about much more than trade. Global linkages are a key lever to improve performance in areas that really matter for productivity. They are about being open to – and being integrated with – global markets.

In essence we need a more sophisticated understanding of the New Zealand firm in the context of globalisation. On the domestic front, we have the sound policies needed to open our doors for international business, but we can't assume the rest of the world will go out of its way to drop by and start spending. Others may not know what New Zealand has to offer, or the relative costs and potential returns of finding out what we're offering might not be worth the effort. Allied to this is the need to understand better what the international market wants. We have to sell the opportunities in New Zealand in a way that matches the needs and aspirations of firms and individuals that are potential economic partners.

Looking abroad, New Zealand has put a lot of energy into removing barriers at and behind other countries' borders. This is really important stuff. Again, however, we can't assume that better access means greater success for New Zealand firms entering foreign markets. It's not easy expanding from our relatively benign market and making a successful go of it on the world stage, and there may be a case for focusing more on easing the path for offshore growth. We might look at ways to help firms overcome their lack of size and proximity to markets, gain better access to local tacit information, and increase their capacity to learn from their own or others' experiences.

I believe there is a real opportunity for a small economy like New Zealand to make the most of international connections as a productivity springboard. We can reap the full range of benefits from trade, the flow of people, fresh ideas and international financing. In many ways New Zealand’s doors are open to the world – and there is scope to do better at encouraging goods, capital, people and ideas over the threshold.

I lead a team of people whose vision is to be a world-class Treasury working towards higher living standards for New Zealanders. In its broadest sense, I believe other New Zealanders share that aspiration for a higher standard of living and are willing to put in the work to achieve it. The important thing is that we work smarter rather than harder – that we use our brains to make our brawn go further. Improving New Zealand’s productivity performance will, more than anything else, help us to achieve bigger incomes and a better life. This has been – and will be – a long-term challenge involving complex issues with no fast and easy solutions. But I am certain that New Zealanders have the capability and commitment to take up the challenge and succeed. To end where we started: like Tane, we should move heaven and earth to ensure we do succeed.