"Wellbeing" is a term that is much bandied about in Wellington these days. But policymakers should never be allowed to forget that the key to sustainably raising living standards is to lift our game on productivity. It is as simple — and as difficult — as that.

Right now we are going backwards. In the year to the end of March, hours worked rose 3.1 per cent on the year before, while gross domestic product rose 2.7 per cent. Output per hour, therefore, fell.

In a recent paper, the Productivity Commission's director of economics and research, Paul Conway, gives us a trenchant and wide-ranging analysis of our weak productivity performance and where public policy needs to focus to enable it to improve.

New Zealand's labour productivity is only about two-thirds of the average level of the top half of the OECD. Incomes and the size of the Kiwi diaspora reflect this.


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It is elementary that labour productivity has two drivers: how much capital is invested per worker, and multifactor productivity, which reflects how effective firms are at extracting value from the labour and capital at their disposal.

New Zealand firms are capital-shallow by international standards and since the recession the capital-to-labour ratio has flat-lined.

One obvious reason for the capital shallowness is that capital is relatively expensive. New Zealand's real interest rates have been stubbornly high for decades and that may partly explain, via the effect on the exchange rate, why exports as a share of gross domestic product are low for a small country and have been trending down to levels last seen in the 1980s.

We really need to figure out why real interest rates are so high, Conway says.

One explanation is that they reflect the risk premium demanded by foreign lenders — on whom we depend because of our lousy saving rates.

If so, the distortions in a tax system which discourages saving and encourages borrowing (provided it is to pay ridiculous prices for housing) really need to be addressed.

Another explanation, associated with economist Michael Reddell, is that higher interest rates are principally the result of persistent demand pressure in the economy threatening to outstrip the supply side's capacity. Reddell's thesis is that rapid migration-fuelled population growth is the underlying cause of these persistent demand pressures.


"If low investment constrains the ability of the economy to produce housing, infrastructure and business capital, then reducing high labour force growth would be an important key in lifting capital intensity," Conway writes.

"Reducing inward immigration from currently very high levels is the only practical way of doing this." At least until productivity gains have lifted the supply side's capacity to handle stronger inflows of people.

A third possible explanation of capital shallowness is that the very small firms which make up the bulk of the economy are just too small to justify significant capital outlays.

"This mix of a real interest rate premium, small firms operating in small markets, relatively widespread government influence and an abundant supply of labour encourages New Zealand firms to grow by investing relatively little in capital and taking on additional workers [instead]," writes Conway.

Perhaps the most troubling chart in his paper shows that firms below the median for multifactor productivity provide most of the jobs and have tied up most of the capital.

It is the top quartile of firms for multifactor productivity which have the smallest share of the workforce and capital. Ideally it would be the other way round, with the lion's share of those resources going to the firms which can make the most of them.

"Small insular markets that suffer from weak competition are a big part of this," Conway says.

New Zealanders may not be any smarter or more enterprising than anyone else but we are no less so either.

Competition policy could be doing more to enhance competition, he says, so legislation before Parliament to give the Commerce Commission power to proactively undertake market studies of the competitive health of particular industries is welcome. "Shifting to an effects-based test in the abuse of market power provisions [of the Commerce Act] is the obvious next step."

Another part of the reason the most productive firms are not employing more of us may be that the education and training systems are not delivering enough people with the skills required.

"Foreign-owned firms tend to have higher productivity than domestically owned firms so just having them in the economy improves our performance. We should be encouraging of them," Conway says.

But we can be strategic in the type of foreign direct investment (FDI) we encourage.

"What are we good at? What is our place in the 21st century global economy? And can we gear migration flows and flows of foreign capital to help us make the most of those opportunities?" The current regime for approving FDI proposals is a bit opaque and there is a lot of scope for discretion, Conway says.

"Let's have the conversation about what are the 'strategic assets' we don't want foreigners to get their hands on and ring-fence those and where is it that we are looking to encourage financial flows, accompanied by new technology and new ways of doing things."

For all the challenges, Conway is optimistic about New Zealand's ability to transition from employment-led to productivity-led growth, especially as technology mitigates the tyranny of distance and knowledge-intensive products and services grow in economic importance: "Increasing export diversity and a growing high-tech sector, including strong growth in the market capitalisation of various ICT firms, suggest improved international connection in some areas. By building on these developments, policymakers have a good shot at finally breaking free of the economic constraints that have kept productivity low for so long."

Or to put it another way, New Zealanders may not be any smarter or more enterprising than anyone else but we are no less so either. These trends should enable us to claim our fair share of the business to be had based on what people have between their ears.