Can the Kiwi Economy Fly? (2000) PDF - Economist

Economist.com http://www.economist.com/business/PrinterFriendly.cfm?story_id... Can the Kiwi economy fly? Nov 30th 2000 | WELLINGTON From The Economist print edition Recent claims that New Zealand’s economic experim...

Economist.com http://www.economist.com/business/PrinterFriendly.cfm?story_id... Can the Kiwi economy fly? Nov 30th 2000 | WELLINGTON From The Economist print edition Recent claims that New Zealand’s economic experiment has failed, and that it therefore needs to change course, do not stand up NEW ZEALAND, a small, far-off country of which most people know little, has attracted disproportionate interest from economists over the past two decades. It was once one of the most protected and regulated economies in the developed world. But in the 1980s and early 1990s it became the liberalisers’ darling, as it pursued market reforms more dramatically than any other economy—including Margaret Thatcher’s Britain. New Zealand was hailed with promises that it would change from “the Poland of the Pacific” into another Hong Kong. Yet today, 16 years after the reforms began in 1984, the economic rewards seem disappointing. Several recent articles have gone so far as to conclude that the reforms were misconceived. For instance, John Kay, a British economist, argued in the Financial Times that “the New Zealand experiment has failed” and that “liberalisation has left it poorer than before”. On the surface, the justification for such claims is strong. Since 1984, the growth in New Zealand’s GDP per head has been the slowest in the developed world (see chart 1). And, even more embarrassingly, the country’s nearest neighbour, Australia, which for years was lambasted by commentators (including The Economist) for not pursuing reform with the same vigour as New Zealand, has actually experienced much faster economic growth over the past decade. Most New Zealanders accept that some reform was necessary, but many feel that it went too far and too fast; and some think that the social cost, notably through increased inequality, has exceeded any modest economic gains. Indeed, since last December, a Labour-led coalition government has started to reverse some of the previous reforms. Trade unions have been given more power in wage negotiations; the top rate of income tax has been raised from 33% to 39%; workplace accident insurance has been renationalised; further privatisation has been ruled out; and the government is considering tougher regulation of business. In practice, the government’s new measures only modestly reverse the reforms of the previous decade and a half. But they have created the perception that the government is anti-business. Business confidence has plunged on fears that the government plans to do more to undo the reforms. Consumer confidence has also dived, and GDP fell in the second quarter of this year. 1z5 22.11.2008 11:04 PDF created with pdfFactory Pro trial version www.pdffactory.com Economist.com http://www.economist.com/business/PrinterFriendly.cfm?story_id... Who called Roger? Yet the current gloom needs to be compared with the conditions that led to the reforms in the first place. In the 1950s, when it functioned largely as Britain’s larder, New Zealand was the world’s third-richest country. By the mid-1980s, it had dropped to around 20th; and its GDP per head had fallen from 20% above the OECD average to one-third below. The country suffered two severe blows in the 1970s. Not only did oil prices soar, but Britain’s entry into the European Community meant that New Zealand lost its preferential access for farm produce into the British market (then 35% of its exports, now 6%). The government of Robert Muldoon responded with massive fiscal expansion, including big subsidies for industry and farming, and heavy public investment in industrial projects. As inflation soared, the government froze wages, prices and rents. By 1984 New Zealand’s economy was on an unsustainable course, with enormous budget and current-account deficits (8% and 9% of GDP, respectively) and mounting inflationary pressures that were masked by price controls. It was also the most distorted economy in the OECD. Almost all its prices, which in market economies are supposed to send signals to firms and individuals, were controlled, and high trade barriers shielded inefficient producers from competition. Enter Roger Douglas, finance minister of the Labour government after 1984. “Rogernomics” consisted of both microeconomic reform and macroeconomic stabilisation. The exchange rate was floated, foreign-exchange controls were scrapped and financial markets were deregulated. Trade tariffs were slashed and import licences abolished. The top marginal rate of income tax was cut in half, to 33%. Subsidies to farming and manufacturing were eliminated, and many government activities, which then spread far and wide, were privatised. Although Mr Douglas subsequently fell out of favour with his party and lost his job in 1988, the National Party government that took office in 1990 continued with the reforms he had begun. Their most important measure was the Employment Contracts Act of 1991, which decentralised wage bargaining, putting contracts on an individual basis between the worker and employer. At the same time the framework for macroeconomic policy was radically reformed. In 1989 the Reserve Bank won full independence to set monetary policy, with an explicit inflation target. This model has been widely adopted elsewhere, as has the Fiscal Responsibility Act, which helps to impose budgetary discipline by making policy more transparent and making governments take more account of the future implications of today’s policies. After two decades of double-digit price rises, New Zealand’s inflation rate has averaged just under 2% over the past decade. The government has run a budget surplus since 1994, reducing its ratio of net public debt to GDP from 50% to 20%. A few myths about these reforms should be laid to rest. Although they were radical in their speed, their extent can be exaggerated. New Zealand is often portrayed as undergoing a decade and a half of non-stop change. In fact reform occurred in two brief waves: “Rogernomics”, under the Labour government of 1984-87, and “Ruthanasia”, under the National government’s finance minister, Ruth Richardson, in 1990-91. In both cases, after an initial spurt, reforms stalled during their governments’ second terms of office. The reforms also appeared more radical because the economy was so tightly regulated to begin with. New Zealand required much more extensive restructuring in 1984 than did other developed economies, such as Britain’s in 1979. British politicians and civil servants used to visit New Zealand to seek tips on economic reform, yet the country remains more regulated in several ways than Britain, let alone the United States. Take, for instance, agricultural producer boards, which act as monopoly sellers of produce in foreign markets—at a high cost to the economy. With no competition, the dairy board, which accounts for one-fifth of exports, has little incentive to innovate and shift to higher value products. Another myth is that New Zealand’s welfare state was largely dismantled. In the early 1990s, benefits were cut and stricter eligibility rules introduced. But government spending still accounts for more than 40% of GDP, higher than the OECD average and well above Australia’s 32% (see chart 2). By international standards, New Zealanders still enjoy generous state pensions. Even today, New Zealand is hardly a test-case of the economic benefits of small government. The scorecard Judged by average growth since the reforms began, they might appear to have failed. Since 1984 GDP per head has grown by an average of only 0.9% a year, even slower than the 1.5% average in 1971-84. But it is 2z5 22.11.2008 11:04 PDF created with pdfFactory Pro trial version www.pdffactory.com Economist.com http://www.economist.com/business/PrinterFriendly.cfm?story_id... unfair to judge the reforms over the whole period since 1984. One of the biggest reforms, labour-market deregulation, did not occur until 1991. The urgent need to reduce inflation and government borrowing also depressed growth during the early years. Between 1984 and 1991, the economy broadly stagnated. But since 1992, GDP has grown by an average of 3% a year and GDP per head by 2.2%—slightly above the OECD average (see chart 3). The OECD reckons that New Zealand’s potential growth rate has risen to 2.5% a year, compared with about 1.5% before the reforms. New Zealand’s income per head has stopped falling relative to other economies, after doing so continuously since 1950. Unemployment, now 6% of the labour force, is roughly the same as in 1983, but over the past decade New Zealand has seen one of the fastest rates of growth in employment of all OECD countries. To make a proper assessment of the reforms one needs to consider what would have happened had New Zealand stuck with its previous policies. And the truth is that those policies were unsustainable. Underlying problems were hidden by subsidies, protection and price controls, but public-sector debt and inflationary pressures were exploding. Eventually they would have had to be corrected—and the longer the delay the more painful the adjustment would have been. Critics point out that New Zealand’s labour-productivity growth has actually slowed since its reforms began. That is true, but it partly reflects a big increase in hiring after the 1991 labour-market deregulation, which reduced labour costs for lower-skilled workers. In any case, a better gauge of productivity performance is total factor productivity (TFP), which measures the overall efficiency with which inputs of both labour and capital are used. And the most comprehensive study of this finds that, if TFP is measured on a comparable basis to that in Australia (ie, excluding certain hard-to-measure sectors), TFP growth in New Zealand spurted in the 1990s, broadly matching productivity growth in Australia. Moreover, official GDP figures almost certainly understate recent gains in New Zealand, because they fail to take full account of improvements in the quality of products, which have been much bigger than elsewhere. Since opening up to foreign competition, New Zealand has enjoyed huge gains in the quality of goods and services, along with a vast increase in consumer choice. Restaurants, telephone services and air travel have all improved out of recognition. The scrapping of import controls has given New Zealanders access to foreign (and typically better-quality) goods that once they could only dream of. There used to be only two sorts of refrigerator on sale, made by the same manufacturer and to the same specifications. If you wanted a foreign car, you faced a long waiting-list. New Zealanders even had to get foreign-exchange-control approval to subscribe to The Economist. Inflated expectations It is nonsense, therefore, to argue that the reforms have failed and that New Zealand is worse off than it would have been had they never happened. Doing nothing was not an option. And growth in output and total factor productivity have increased, not fallen. Nevertheless, it is true that the rewards of the country’s reforms have failed to live up to their promises. The OECD, in its latest economic report on New Zealand, forecasts average annual growth of 3% over the period 2000-06. But because of rapid population growth, that would imply no significant narrowing of the large gap between New Zealand’s income per head and the average for all developed countries. One lesson is that initial expectations from the reforms may have been too high. Indeed, international hubris about the Kiwi experiment may have exacerbated a financial bubble in the 1980s that left the economy horribly vulnerable when global stockmarkets crashed in 1987. There is a parallel here with Thatcherism in Britain, whose effects have also been more modest than many had hoped, and which also was associated with a financial and asset-price bubble. Britain, like New Zealand, has halted its relative decline, but it has not experienced the economic miracle that some were looking for. With hindsight, it takes a long time for an economy to change. One reason is that the economic pay-off does not flow direct from the reforms themselves, but rather from companies that take advantage of the new opportunities they offer. And after decades of protection and state coddling, it is bound to take time for managers to learn new rules. This is one reason why comparisons between New Zealand and Australia may be unfair. New Zealand started off far more regulated and protected than Australia. Nevertheless, New Zealand’s reformers made some serious blunders, which must carry some of the blame for the economy’s performance. The biggest mistake may have been that the reforms were done in the wrong order. The exchange rate and financial markets were set free before the budget deficit and inflation had been 3z5 22.11.2008 11:04 PDF created with pdfFactory Pro trial version www.pdffactory.com Economist.com http://www.economist.com/business/PrinterFriendly.cfm?story_id... brought under control, and before product and labour markets had been deregulated. The failure to eliminate the government’s enormous budget deficit early meant that interest rates had to be pushed even higher in the late 1980s to hold down inflation. With capital controls removed, foreign money flooded in, resulting in a massive appreciation of the exchange rate. This savaged many industries that might otherwise have benefited from the reforms, and it also discouraged investment in new industries. Increased competition certainly drove out inefficient producers, but few new industries sprang up to take their place. Worse, because the labour market was not yet deregulated and wages, set by a national system, continued to rise rapidly, unemployment soared, deepening the recession of the late 1980s and early 1990s. With better sequencing of the reforms, the costs of adjustment could have been smaller. As it was, the overvalued exchange rate during the 1980s and much of the 1990s largely explains New Zealand’s poor export performance. Since the early 1980s New Zealand’s volume of exports has grown at only half the pace of Australia’s. Many economists (especially in Australia) reckon that another serious policy error was made by New Zealand’s Reserve Bank during the Asian crisis. In 1997 the bank adopted a “monetary conditions index” that combined interest rates and the exchange rate into a single measure of monetary tightness. As the New Zealand dollar fell in response to the problems in Asia (the destination for one-third of New Zealand’s exports), this forced the bank to raise interest rates sharply. Yet this happened at the very moment when demand was being squeezed by the slump in exports to Asia. In contrast, the Australian Reserve Bank left interest rates unchanged even though its currency also sank. Unlike Australia, New Zealand dipped into recession in 1998. The extent to which monetary policy was to blame for New Zealand’s recession is debatable, however. After all, during the Asian crisis, New Zealand’s farmers were also hit by two successive years of drought. Nevertheless, the argument suggests that it is as important to get macroeconomic policy right as to introduce microeconomic liberalisation: indeed, if the first is wrong, it can dilute any beneficial effects of the second. A third explanation of why the growth dividend from the reforms has disappointed is that New Zealand suffers such huge inherent disadvantages. In theory, free trade and deregulation should boost growth by encouraging a shift of resources to industries in which the country has a comparative advantage. The snag is that New Zealand’s main comparative advantage lies in agricultural produce (two-thirds of total exports), and trade barriers in global markets prevent New Zealand from fully benefiting from it. New Zealand’s small population and geographic isolation from large markets also limit its scope for exploiting economies of scale. As “the last bus stop on the planet”, New Zealand is at a disadvantage compared with other small economies such as Ireland or Finland. A circle with a radius of 2,200 kilometres centred on Wellington encompasses only 3.8m people and a lot of seagulls. A circle of the same size centred on Helsinki would capture well over 300m people. Even if New Zealand had the best economic policies in the world, its isolation would probably still constrain its growth rate. Unfinished business To the extent that the mis-sequencing of reform and New Zealand’s inherent disadvantages may have reduced the growth dividend so far, the country’s relatively disappointing performance should not be seen as a verdict on free-market economics. It does not, in short, prove that the model is wrong. But other changes may be needed to improve New Zealand’s performance. Michael Cullen, Labour’s finance minister, accepts that the reform programme was necessary to open up the economy to competition. But he says it was not enough by itself. He favours a more active industrial policy to promote growth, along with government measures to address structural problems, such as education standards (New Zealand performs badly in international tests) and low saving. Thanks to inadequate saving, New Zealand still has an alarmingly big current-account deficit (almost 7% of GDP in 1999), which leaves it vulnerable to the whims of foreign investors. The country’s net foreign liabilities amount to a horrendous 90% of GDP. To reduce the deficit New Zealand needs to boost private savings or run a bigger budget surplus. Instead, the budget surplus has fallen. If Mr Cullen is really worried about skill levels and saving, he should pay more heed to the latest reports on New Zealand from the IMF and the OECD, both published during the past month. The IMF warns that the recent increase in top tax rates could accelerate New Zealand’s brain drain and further reduce the incentive to save. It also frets that there is a risk that new labour laws and increased regulation could reduce flexibility of labour and product markets. The OECD also reckons that recent policy has moved in the wrong direction, making New Zealand a less attractive place in which to invest. The current gloom about the “New Zealand experiment” is, however, overdone. The reforms could have been better managed, with better results, but the economy would today be in a worse state had the reforms never taken place. It is alarming, therefore, that the government believes that some reforms need to be reversed. If 4z5 22.11.2008 11:04 PDF created with pdfFactory Pro trial version www.pdffactory.com Economist.com http://www.economist.com/business/PrinterFriendly.cfm?story_id... anything, New Zealand should do the reverse: press on with reform, as most other economies around the world are now doing. New Zealand’s smallness and remoteness mattered less when it produced mainly for the British market and when people had less choice about where to work and invest. But in today’s more integrated world it is a serious handicap. As the OECD points out in its report, to offset its natural disadvantages, New Zealand needs to have better economic policies than other countries, if it is to be an attractive location for investment and for skilled workers to live. As other countries, notably in continental Europe, continue to liberalise their own economies, New Zealand’s policies are no longer so exceptional. By reversing its reforms now New Zealand could snatch defeat from the jaws of victory. Copyright © 2008 The Economist Newspaper and The Economist Group. All rights reserved. 5z5 22.11.2008 11:04 PDF created with pdfFactory Pro trial version www.pdffactory.com