KEY POINTS:
The economy seems to be caught in a trap of low productivity and a high cost of capital, with each reinforcing the other.
It is a vicious circle. Low productivity means we hit the inflationary wall earlier than we otherwise would and interest rates go up in response.
High interest rates, in turn, tend to discourage the investment needed to increase the amount of physical capital workers have to work with. Without that investment, labour productivity is liable to stay low.
This line of argument begs two questions. Just how bad is our productivity performance? And why are our interest rates persistently so high?
Productivity is a slippery thing to grab hold of and measure. Statistics New Zealand provides figures for the two-thirds of the economy where it is not too hard to measure outputs independently of inputs. This under-represents the services sector.
It shows labour productivity growing at an average rate of 1.2 per cent a year between 2001 and 2006 (inclusive). That is a sharp decline from the average 2.8 per cent in the 10 years before that.
You can get different numbers by taking different periods but they all show a significant decline from the 1990s to the past few years.
ANZ National Bank in its submission to the select committee inquiry into monetary policy says we can't dismiss such a deterioration as cyclical, given the magnitude of the fall and the period covered.
It said if labour productivity growth had been a mere 0.2 percentage points higher per annum during the past five years, expanding the supply side of the economy, interest rates would be at least 50 basis points lower and the dollar well south of US70c.
The Reserve Bank and Treasury expect to see some improvement in labour productivity growth over the next few years but only to the 1.5 per cent to 2 per cent range.
They base this on a pick-up in business investment encouraged by labour scarcity and a high exchange rate which makes imported capital equipment cheaper.
A tight labour market looks like being a long-term feature of the economy; the high dollar - let's hope - is a temporary phenomenon.
But business investment growth will need to stay high indefinitely if we are to make much impression on the gap between the level of labour productivity and one of its key drivers, the ratio of capital to labour.
That gap is reflected in the fact that New Zealand's gross domestic product per capita languishes at 15 per cent below the OECD average, 20 per cent below Australia's and 40 per cent below the United States'.
Some economists argue that our relatively low capital-to-labour ratio is what you would expect when labour has been comparatively cheap and capital expensive, making it cheaper for firms to expand by hiring more people than by investing.
As the economy adjusts to chronic labour shortages that should change.
There is also a view, supported by some IMF research, that a surge in employment of the kind experienced in recent years reduces productivity growth in the short run because new workers are generally less productive, at first anyway, than existing ones.
But the Reserve Bank, in its submission to the select committee, is prepared to acknowledge another possible reason for our low level of capital per worker: the fact that real interest rates have been persistently higher than those in other OECD countries.
The good news is that real interest rates since 2000 have been about 1.5 percentage points lower than in the seven years before that.
The bad news is that they have been at least one percentage point higher than Australia and three percentage points higher than the US.
For multinational companies operating here that may not matter so much if they can access funding at their global cost of capital.
But for home-grown enterprises, it is the local cost of capital that matters.
Should they blame the Reserve Bank or the monetary policy framework it operates within?
No. If the bank had been erring on the side of running policy too tight, inflation out-turns would have been towards the low end of its target band.
Instead, it has been cutting things fine on the high side.
And the target itself, with a mid-point of 2 per cent, is in the mainstream for central banks.
Could it be a consequence of being a small and open economy?
But how then would one explain the fact that other small countries like Singapore, Switzerland and Norway enjoy lower interest rates, and higher incomes, than we do?
The bank sees the explanation of our persistently high interest rates in households' avid appetite for debt, which to a large extent has to be met by importing foreigners' savings.
New Zealand borrowers are willing to pay interest rates that foreign savers find attractive, even allowing for the inherent riskiness of lending to a country whose international indebtedness, relative to the size of the economy, is extremely high.
The Swiss and the Singaporeans, conversely, are significant exporters of capital and have low domestic interest rates.
The bank warns the willingness of foreign savers to shift their funds around the world is not limitless.
So our high demand for credit results in persistently high interest rates and, to some extent, crowds out business investment.
It suggests changing the tax laws so that real, rather than nominal, interest is taxed or deductible.
If the first 2 per cent of a saver's interest income escaped tax that would boost his returns by 0.8 per cent (if he is in the top take bracket).
Conversely, a property investor would not be able to deduct the first 2 per cent of the interest rate he pays.
Whether the finance and expenditure select committee goes for this helpful suggestion remains to be seen.
But the onus is on the politicians to address the broader regulatory impediments to business investment and tax-based distortions to investment decisions.
ANZ argues for the establishment of an independent Productivity Commission, like Australia's, to examine how Government policy decisions could impact on the economy's productivity performance.
That seems like a good idea.
Policymakers are generally focused on fixing some particular problem.
They are likely to be indifferent to the broader question whether the measures they come up with will make the economic boat go faster or slower.
