Brian Fallow 's Opinion

The Economics Editor of the NZ Herald

Brian Fallow: Missing pieces surface in productivity jigsaw puzzle

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OECD economists take hard look at NZ's relatively poor performance

Our R&D spending is one of the lowest among advanced economies. Photo / NZ Herald
Our R&D spending is one of the lowest among advanced economies. Photo / NZ Herald

They call it the New Zealand productivity paradox.

When the likes of the OECD look at our structural economic policy settings and compare them to what has worked in other countries, they reckon we should be doing a lot better than we are.

We should be out-performing the OECD average in terms of per capita output, as the Australians do, but instead we languish well below.

"Given its generally favourable policy settings GDP per capita in New Zealand should be 20 per cent above the OECD average rather than 20 per cent or so below," three OECD economists, Alain de Serres, Naomitsu Yashiro and Herve Boulhol say in a recent paper released by the Productivity Commission.

Could the explanation be that we are under-investing in physical and human capital? Apparently not.

When they compare our record for investment in physical capital (plant and equipment, infrastructure and the like) as a share of GDP and for average years of schooling against a selection of English-speaking and Nordic countries, they find that neither can explain the widening gap in labour productivity.

Instead they point to knowledge-based capital, also known as intangible assets.

This includes such things as investment in software and databases, research and development, design, market research and brand equity, worker training and organisational change.

Good data on some of these kinds of investment is scant in New Zealand's case.

But where we do have a handle on what is happening, in R&D spending for example, the picture is not good.

R&D spending, relative to the size of the economy, is one of the lowest among advanced economies, the OECD economists remind us, "slightly behind southern European countries and a good distance from Australia, Canada and Denmark".

They also note a 2012 study which found New Zealand ranks relatively low in managerial quality.

They argue these forms of investment explain more and more of the difference in productivity performance. But why are we falling short in these areas?

Westpac chief economist Dominick Stephens says: "I hear a lot around New Zealand that we don't do much R&D and we are poor at managing our firms, so we need to do more R&D and manage our firms better. No one asks why it is that thousands upon thousands of individual decision makers are choosing low investment in R&D and in management.

"What is it about New Zealand that has people making different choices to similar people operating in the United States, say, who opt to invest much more heavily?

"The OECD paper comes back to the pay-off to R&D or better management being low because we are so small - so we don't have much competition - and because we are isolated."

Or as the Productivity Commission's director of economics and research Paul Conway puts it: "Why innovate seriously when the prize is the New Zealand market? It makes a lot more sense to do that if the prize is an international market."

The stock response to the view that much of New Zealand's underperformance can be explained by being small and distant from markets is that the country was once among the richest per capita in the world, when it was even smaller and located exactly where it is now. So that can't be the problem.

"I don't buy into that, because the nature of global trade flows has changed," Conway says.

Trade in goods is increasingly characterised by value chains which cross borders multiple times.

The sensitivity of trade flows to distance has increased as countries increasingly source intermediate goods and services from neighbouring countries.

"The international fragmentation of production stages tends to happen regionally because the co-ordination of global value changes often requires intensive interaction and just-in-time delivery," the OECD economists say.

A country's participation in global value chains can be partly measured by how much of its exports are made with imported intermediate inputs and by how much of its exports are used in other countries as intermediate inputs to make their export goods.

In a 2011 study New Zealand ranked lowest on this measure among 27 OECD countries Overall, de Serres et al calculate that just over half of the productivity gap vis-a-vis the OECD average can be explained by reduced access to markets and suppliers, and another quarter (give or take) by weak investment in R&D.

So what do they suggest we do about it? Not much, really. They are rather tepid about the prospects of public policy changes in the R&D area doing much to narrow the productivity gap.

"While R&D tends to be concentrated in manufacturing, the bigger payoff might be from boosting innovation in the much larger services sector."

The Productivity Commission is in the throes of an inquiry in the services sector and its preliminary view is that one way services firms could lift their game is by investing more in information and communications technology - provided they are also willing to adapt their business practices.

"If a firm wants to make the most of new technology it has got to be able to adapt its business model, not just buy a computer, stick it in the corner and hope for the best," Conway says.

"Firms need to turn themselves inside out to make the most of new technology."

Corporate managements are more likely to do that if they are under competitive pressure.

Unfortunately being small and distant reduces the likelihood of that.

The OECD economists say that somehow, poorly managed firms are able to survive to a greater extent than in countries such as the United States. "Insufficient competition in the domestic market could be an explanation."

Also, pressures on managers from the financial system may not be very strong, compared with the US, they suggest.

"Insofar as one of the benefits of international trade is to heighten pressure from competition, it is important for the authorities to ensure that other barriers to competition be lowered as much as possible, starting with those arising from product market regulation."

In particular they see scope for regulatory improvement in the airline, transport and telecom sectors.

"One area where distance-related costs have fallen to the point of being no longer significant is international telecommunications. In principle this should have reduced New Zealand's geographic disadvantage, in particular for trade in services."

But Conway points out that services exports, measured against the services sector's share of GDP, have in fact fallen over the past 20 years or so. It suggests there is seldom any substitute for local knowledge, face-to-face contacts and a commercial presence in the market.

- NZ Herald

Brian Fallow

The Economics Editor of the NZ Herald

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