What to do for prosperity

In an article in the Otago Daily Times on Friday 17 June 2011 Roger Kerr asks If We Know What To Do, Why Don't We Do It? In answer to this question Kerr writes,

It’s certainly the case that we know what makes for prosperity. For over two hundred years the essential nature of the ‘wealth of nations’ has been understood.

Adam Smith didn’t get everything right, and economics has been refined since his time, but his basic insights into the virtues of free markets and limited government have stood the test of time.

Modern economics confirms that the key to prosperity is the institutions (broadly the rules that govern economic and social interactions) and policies that nations adopt.

And Kerr is right, free markets ans, limited government and proper institutions are of major importance. But there must be more to it than just this. If not then why are we not at the top of the OECD? To a large degree we have gotten the institutions right and markets are freer today than they have been for much of the post war period. So what’s wrong? What is wrong with the policy mix we have adopted?

Part of what’s wrong is that we have done the easy, obvious things to increase productivity, growth and prosperity, This is what got us into the OECD in the first place. But to move up the ladder we have to start doing hard, less obvious things. The low hanging fruit have been picked.

To increase out productivity and growth we have to ask and answer harder questions. We have to look at how we deal with things like creative destruction, innovation, human capital, investment and competition, along with interactions between them.

By creative destruction I mean the exit of firms from industries, and the associated job losses, along with the development of new firms and markets. Entrepreneurs identify and realise new market opportunities, create investment opportunities and drive innovation. Maintaining free entry and exit to and from markets is an important issue if we wish to increase productivity. Accepting the exit of underperforming firms and, especially, the associated temporary loss in employment, is important to improvements in productivity. Trying to prevent such exit and loses will only prolong weak productivity growth. When considering the reasons for poor European productivity growth, the economic historian Nicholas Crafts has gone so far as to write,

“Politicians find it attractive to wax lyrical in support of the “knowledge economy” and rush to adopt targets for R&D spending and participation in tertiary education. This “happy-clappy” approach to addressing Europe's productivity growth shortfall keeps them in the comfort zone. More progress would be made if the dark side of productivity improvement implied by creative destruction – exit of established producers and re-deployment of labour – were accepted and facilitated. If only ministers could bring themselves to think (better still occasionally to say) “these job losses are good news”.”

How many ministers in New Zealand want to think such things, let alone say them?!

Questions that need answers include, Is it straightforward to start and run a business? How common are the types problems Ikea had in its attempts to find a site for a store in the North Island? How competitive is the business environment and how open is it to international competition? Are there barriers to entry in New Zealand’s industries? How competitive is the market for corporate control and how restricted is the flow of foreign investment? How large is firm turnover? Also we need to promote a climate that creates positive attitudes to risk taking, as Tim Harford implies with the sub-title of his latest book, “Why Success Always Starts with Failure”, we must be willing to fail, to succeed.

In terms of innovation note that innovators generate, adopt and adapt new ideas and create investment and entrepreneurial opportunities. Innovation increases productivity by increasing firms’ technological efficiency, it moves a firm’s production possibility frontier out. It can also introduce new products and services and thus help create new markets. But business R&D in New Zealand is low by international standards. The number of patents per million inhabitants is also low; suggesting that commercialisation of the research base is a challenge. Such issues need investigation.

Today human capital and skills are big players in productivity and growth. Higher skills increase individuals’ productivity and the productivity of others they work with. Skills have a dynamic effect on productivity growth by increasing the capacity to innovate and apply new ideas. Skills can enhance the returns to capital investment, and increase firms’ ability to adapt to new markets and competitive challenges. Productivity gains over the long term will come from improving the quality of early years education, and from targeting support to those children who are disadvantaged or at-risk. But this needs to be followed up by ongoing engagement in quality education and training both in school and after people enter the workforce.

In terms of human capital and skills issues arise at all levels of education. For example, at the tertiary level, the relevance and usefulness of graduates with regard to innovation requires attention. More importantly, in pre-tertiary education there is a large group of poor performers. We have a large variance in student achievement which needs to be addressed. Ongoing education for those already in the workforce is another area in need of attention. The relative importance of mechanisms by which education may affect productivity is the subject of debate. Are skills for imitation rather than new innovation more important in some cases?

Investment, rather obviously, improves and enlarges the capital stock; is an input in the entrepreneurial process; and increases the returns to skill acquisition. But care must be taken with policy changes since investment can be affected by policies in seemingly unrelated areas. Consider investment in ICTs in U.S. and Europe. Recent research argues that one reason for the lower productivity growth in Europe compared to the U.S., since the mid-1990s, is the lower investment in ICTs in Europe. One reason for this is the level of employment protection available there. Such protection raises the cost of exiting an industry if things go wrong and these exit barriers act as entry barriers. Badly designed bankruptcy law can have a similar effect in so much as it can raise exist costs and thus act as an barrier to entry.

Questions with regard to investment include. Are there problem with regime uncertainty? Are there are problems with the depth and breadth of New Zealand’s capital markets and with financial intermediation, along our reliance on foreign capital.

Competition is another player in productivity and growth. Consider as an example, Nicholas Crafts who argues that competition helped cure the “British disease”, which to a degree is now the “New Zealand disease”. There are several channels through which competition can affect productivity: (1) Stimulating innovation to sustain rents close to the technology frontier; (2) Acting as an antidote to corporate governance problems arising from weak shareholders and the separation of ownership and control; (3) Acting as a discipline which leads to better management practices; and (4) Removing the basis for low-productivity effort bargains between firms and their workers. Of course competition can come from two sources, local – governed largely by competition policy; and international – governed by how free people are to trade with other countries. It is commonly accepted that trade liberalisation can increase productivity. An interesting question is, How? Which of points 1-4 apply. The early literature emphasises the role of firms “learning” to be more productive, whereas recent studies suggest that more productive firms are “stealing” market share from less productive ones, thus raising overall productivity. One very recent study based on India’s trade liberalisation since 1991 finds support for both, but argues that learning outweighs stealing.

Things to think about with regard to competition would involve issues such as: Are there barriers to competition either locally or to competition from foreign firms? Are there negative, unintended, consequences from decisions of the Commerce Commission or other regulatory bodies? Is the Commerce Act itself adequate? Policy should aim to keep barriers to competition at low levels, does it?

But a word of caution with all of this: two considerations to keep in mind when thinking about policy approaches to New Zealand’s particular circumstances are geographical location and size. With four and a bit million people, the population of New Zealand is smaller than many cities overseas and with 10,000 kilometres to the U.S.A. or China and even a couple of thousand kilometres to Australia, New Zealand is a considerable distance from its main trading partners. While it’s clear that the cost of transporting goods, services and ideas has been declining and this has allowed for greater levels of trade and financial flows, evidence suggests that distance and size still play an important part in determining New Zealand’s prosperity. Research suggests that countries that are smaller and further away from international markets are likely to be poorer than countries that have larger domestic markets and are closer to international markets. New Zealand’s relatively small domestic market limits the extent to which firms can exploit internal economies of scale, benefit from product market competition and gain from specialisation. Aspects of this will be less of a problem in a comparison with Australia as it too is along way from its markets, but it still has a larger economy than New Zealand.

So Roger Kerr is right that there are easy, obvious, sensible things that can be done to increase the prosperity of a country. But New Zealand has done most of these and what we have to do from now on isn't so obvious and could come at a high political cost, so isn’t easy.