Delivered by John Whitehead, Secretary to the Treasury, at a Breakfast Address to the New Zealand Institute of Directors on 28 June 2005.
Breakfast Address to the New Zealand Institute of Directors
I’d like to pass on my appreciation to the Institute for the invitation to speak today. One of the reasons for that appreciation is that it gives me the opportunity not only to talk to you, but to hear from you as well.
So, if you pick up on anything you’d like to raise, I hope you’ll feel free to discuss it at the end of the formal part of the talk.
What I’d like to do, firstly, is let you know what I will cover this morning.
For a while now the main focus of debate about the economy in New Zealand has been about how we improve the rate of economic growth. However, I think there is growing evidence we are now in a different economic environment. New Zealand’s growth performance has undeniably changed for the better over recent years.
That success, though, also means we are now facing some new challenges. And it is those challenges I would really like to focus on today.
Scanning the horizon, we will face important issues around population aging, climate change, access to global markets and the growing economic role of China to name just a few. But today I’d like to try and go beyond these and look for some issues that have received rather less attention.
One way to explore some of the possible challenges ahead is to look at other, similar, economies which have also had a strong growth path over the last decade or so and see what issues have arisen for them. These may provide us with some clues as to the sort of issues that New Zealand business and government may also face.
I’ll be particularly drawing on comparisons with Australia today, because I think in a number of areas there is a striking similarity in the challenges we face. While we dislike some of the lessons they have handed out to us in areas like cricket, I think we can learn a lot by observing how Australia is also coping with the emerging challenges of higher growth.
And when I say “we”, I’ll be cutting the discussion in terms of what it means for business as well as for government.
But the main message I want to stress today is this: it’s not premature for us to start thinking about the challenges raised by a growing economy and how we are going to deal with them.
In fact, some of these issues are just as demanding as those we’ve faced in our less prosperous past.
New Zealand’s recent economic performance
So how is the economy going? I’m not going to dwell on this as Treasury’s views are laid out in some detail in the Economic and Fiscal Update published with the Budget.
But here are just a few points to give some context.
Our annual GDP growth to the December quarter came in at 4.8%, one of the strongest growth performances in the OECD and much stronger than Australia’s at 1.9%. Last week’s data release (showing GDP growth of a slightly lower 4.2 percent to March) does not change this story.
- Slide 1: GDP growth
If you look over the last 30 years or so, our performance over the last decade has picked up considerably.
Inevitably, some of that most recent performance has been a result of a buoyant economy at the top of the economic cycle. But Treasury’s research work over the past couple of years suggests that quite a bit of this increase in performance represents a rise in longer term growth trend.
Our latest forecasts suggest that when the slow-down does arrive, New Zealand will only slip back to GDP growth of 2 percent and will quickly move to a more sustained rate of around 3%. There was a time, not so long ago, when even achieving our forecast low point of 2% would have been considered somewhat of an achievement.
I don’t think we have yet appreciated just how profound this enhanced performance has been and how it will affect the challenges of the future.
I am struck by the nature of domestic debate which seems often to be a recycling of debates of the past. While some economic themes are evergreen in nature, I worry that as a society we are not thinking enough about the new sets of challenges that confront us.
Put simply: we need to move from issues of how to get growth to issues of sustaining and enhancing growth.
There is a range of issues in the pipeline that are clamouring for government or business attention.
But when your frame of reference is shaped by three decades of poor economic performance, it is hard to appreciate the risks and opportunities of an environment where there is a reasonable prospect that underlying economic growth will be robust and enduring.
Comparisons with Australia
That is why I think it is worth casting our eyes offshore for possible lessons.
Of course, I don’t think that other countries provide us with off-the-shelf solutions. But I am constantly surprised to see how infrequently cross-country experience is used, particularly since in a globalising world other countries’ policies will become increasingly relevant to us.
- Slide 2: Comparison with Australia
A useful place to start is to look across the Tasman, despite some obvious differences in our economic structures. This chart shows Australia’s GDP growth rates compared with New Zealand’s. The trends in the two countries are very similar – both countries have seen a pick-up in their growth in the last 10 years or so.
But the strength of the Australian economy has been more pervasive and started from a higher base. Growth pressures are therefore likely to show up earlier and more starkly in Australia than New Zealand.
One of the implications of a growing economy is that once the policy fundamentals set by government are sound, it is the business sector that will have the lead role in sustaining and fostering growth. So I will talk both about the role of government and the role of business.
Let’s start with government first.
At the level of individual firms, the government domain can seem one step removed from day to day activities. I hope that’s true, because if it is, it’s a good indicator we’re getting policies roughly right.
Across the ditch, commentators attribute much of the Australian success to a much better policy and economic framework compared to their past.
The Australian economy is a dramatically different creature today from what it was 20 years ago. The fact that Australia weathered the Asian crisis, the global slowdown of 2001, the uncertainty from 9/11 and SARS, and now higher oil prices, is a function of the flexibility and adaptability of that economy.
Similarly, the New Zealand economy was also able to hold up well in the face of these external shocks, showing that New Zealand’s policy framework is functioning well.
A thought experiment for the sceptics: start with the Asian crisis and add to that not one, but two major droughts and ask yourself how the New Zealand economy would have performed in the past. Yet in the late 1990s, when these crises occurred, growth bottomed out at 0.5% and quickly rebounded to very acceptable rates.
The need for economies to respond to substantial shocks is one of the reasons that low saving rates by households has been such a prominent issue in Australia and in New Zealand.
But media commentary doesn’t accurately reflect the Treasury’s view on these issues. Our position is much more complex than the black and white interpretations I’ve seen.
While the evidence suggests that at the individual or household level there does not appear to be a systemic savings problem, it is not the end of the story. We know that in coming decades there will be a gap between taxes and spending. Individuals cannot be sure now how that gap will be filled, so it may turn out that they have not been making the best decisions about their own saving.
And we can’t forget that the sum of these individual decisions means that New Zealand has very high external debt levels – making us potentially more exposed to future overseas shocks.
All this means that it is prudent for government policy to reduce future uncertainty, strengthen the current policy framework and to err on the side of encouraging individual saving.
But these are policy challenges that have been at the front of our minds for some years. Stepping back, is it now not worthwhile to think about the new challenges for government in a growing economy?
A big issue here is rising expectations for government provision of public services. In one sense it is quite reasonable to have higher expectations. After all, the point of growth is to improve living standards and this includes the level of public services.
- Slide 3: Rising Expectations
And that is consistent with Australian evidence. There, survey data indicates that as the economy took off in the 1990s, the demand for public services – notably social services - increased markedly. So I would see the current rising expectations here as only the start of a trend.
The challenge both there and here is meeting those expectations in a way that is fiscally sustainable and does not constrain future growth rates.
There is a real risk that public expectations of what can be delivered are beginning to outstrip reality.
We have certainly moved from times when governments faced high levels of debt, and we have freed up fiscal space for key government priorities. However, the shift is not to a world of bottomless resources.
The current forecast for 2005/06 is for an impressive operating balance after valuation effects of around $7.5 billion. But that translates to a more modest cash surplus of only $30 million in 2006, and then we expect to start seeing cash deficits again - of $1.6 billion in 2007 and $2.8 billion in 2008.
In terms of fiscal policy more broadly - the focus is on managing gross government debt. Again, progress has been good. Gross Debt will stabilize at around 20% of GDP by 2008/09. But this flatlining of the debt track also tells us that unconstrained spending has the capacity to lead us back into fiscal difficulties.
In recent years, the average annual increase in health spending was 7.8% per annum; for education the figure was 7.6%. This next graph presents an example of this government spending for tertiary education. It has increased around 60 percent in the last five years.
- Slide 4: Tertiary Education Expenditure
A moment’s reflection will reveal that these growth rates in spending are faster than that of the economy as a whole, which is growing around 6% in nominal terms.
This means two things: first, these areas are becoming an increasingly bigger share of the economy; second, they are growing faster than the taxes required to support them.
The options are stark: to cut expenditures in other areas to sustain that social spending; to raise more taxes to fund them; to wind back some of the public expectations that have been built up in recent years; or to get more value for money out of what we do spend. Of course these alternatives are not mutually exclusive.
Business and Government
The next set of challenges applies to both business and government.
It is a long list, so instead I’m going to cover some, but not all, of the important ones. They fall into four main areas: labour, productivity, infrastructure and the environment. These alone raise some great challenges for business.
Looking back over the past few decades, the sort of skills that were required by the business sector have altered radically. In the 1980s, a profound change in the overall economic environment meant that many of the economy’s resources were in low productivity uses. The business skills rewarded were those that moved assets from low to high value uses. This led to some spectacular gains, but also a sense of euphoria brought down to earth with a thump by the 1987 stockmarket slump.
This phase was followed by a period over the 1990s of intensive pressure on businesses to cut costs as the impact of domestic and international competition took hold.
The businesses which did well in this period were those which found effective means to manage costs structures and thereby raise profitability. The experience of our banking sector with cost to income ratios falling to some of the lowest in the world is only one example of this phenomenon.
With the new millennium has come a demand to change business strategies once again. As we have become more confident that the structure of the economy - combined with sound macroeconomic settings - is capable of generating sustained growth, the challenge for business has turned to one of how to manage in a growth environment.
Just like in the government sector, this new environment will require new skills and new ways of thinking. And that means that some of the topics I am touching on are both exciting but all the more challenging.
Nowhere is this changed environment as obvious as in the labour market. It is this area that perhaps highlights most vividly the fact that we are not the economy we once were.
- Slide 5: Unemployment
Currently we have one of the lowest levels of unemployment in the OECD at 3.9% - a quite remarkable achievement given it was 11% in 1991. Apart from the profound social consequences this has had, it has changed our economic landscape too. We now have firms reporting substantial skill shortages, a huge change from the situation during the 1990s when both New Zealand and Australia had high rates of unemployment.
Australia, of course has had a similar labour market experience in the last few years, with the unemployment rate dropping to 5.1%.
- Slide 6: Participation
One significant difference is that New Zealand’s participation rate has lifted further and faster than in Australia. Nonetheless, in many ways both countries face a similar set of issues as it is becoming harder and harder to generate further economic growth from increasing labour numbers and hours.
In both countries we are increasingly looking at ways to improve economic growth and living standards by lifting labour productivity, although there is still some scope to improve labour utilisation.
In a recent speech given by my Australian counterpart Ken Henry, he identified four groups where effective policy action aimed at increasing participation may have the most promise – participation rates amongst older workers, females, the less skilled, and those on income support. These are exactly the same issues we are facing in New Zealand.
New Zealand has already been even more successful than Australia in increasing labour force participation. So, it is these non-traditional sources of labour that will become even more important in New Zealand.
The challenge is, and will increasingly be, how to make employment and employers more attractive to these groups. A lot of that challenge will lie with you, the employers.
Some would argue that increasing migration is a solution to the problem.
Undoubtedly it is, to an extent. But don’t forget that we have been a migrant rich country for some considerable time and this has not been sufficient to meet current labour demand.
In fact, New Zealand and Australia are among the very top countries worldwide in terms of foreign born population as a percentage of the total population. About 19.4% of New Zealand’s total population was born overseas, while a quarter of Australia’s population was born abroad, with another quarter made up of first-generation natives.
However one major difference between New Zealand and Australia can be seen in the net migration statistics.
- Slide 7: Migration Trends
As you can see from the chart, Australia has retained positive net migration since 1982, but New Zealand has significant periods of negative net migration.
This points to the fact that our economic performance has historically been a lot more erratic than Australia’s, but it could also indicate that we may start seeing more stable migration trends in New Zealand, as we see more sustainable growth patterns.
Given that Australia has historically been the next step for many New Zealand immigrants and a key country of alternative destination for New Zealand born, how we grow relative to Australia will have a crucial bearing on New Zealand’s migration patterns.
If you combine our unemployment rate with longer term issues like population aging and migration I think we are only just starting to see the start of some significant changes ahead in the nature of the employee/employer relationship.
The government too has a role in addressing the barriers, and considering options, to support increased labour supply. The example of increased participation in the workforce by women raises the challenge of whether we have sufficient quality childcare to ensure that it is not a barrier to increased participation. Likewise, strategies to assimilate migrants are not limited to the workplace.
The second area I want to cover is the all important area of productivity.
The drop in unemployment and the already relatively high participation rates for many groups brings us to the challenge of improving our labour productivity because there is a natural limit to what we can achieve through labour utilisation.
- Slide 8: Labour Productivity 2003
This graph provides a comparison of how our productivity performance rates against other members of the OECD. It is a pretty clear picture.
And what is noticeable is that all the OECD countries with higher GDP per capita than us have higher labour productivity, while all of the countries with lower GDP per capita have lower productivity (except Spain). It also shows that New Zealand’s labour productivity is only 78% of Australia’s, a major reason for our lower standard of living.
That demonstrates fairly clearly the importance of improving our productivity.
Sadly, solutions to the challenge are not so transparent.
But current opportunities are real. For the first time we have business, union and government leaders all recognising the need for higher productivity. Notably, initiatives like the tripartite talks between the three groups and the joint work on workplace productivity have been the basis for identifying considerable common ground.
There will be healthy differences on how to go about it, but agreement on a common goal is a tremendous opportunity.
Government can help create the climate to raise productivity, but fundamentally productivity is business driven.
One thing we do know is the importance of how much investment capital we have to work with. In New Zealand, the suggestion is that our levels are too low compared to other countries. That conclusion is possibly a bit simplistic. A straight comparison with Australia, for example, doesn’t account for the fact they have a large mining sector which requires considerable investment.
- Slide 9: Capital-Labour Ratio
This slide is another comparison with the OECD, this time the amount of capital per hour worked. It is clear that we are less capital intensive than other countries.
Will this change? Perhaps.
Recent Treasury research shows that the amount of capital per worker is consistent with the trends in wages and rates of return to capital. In both New Zealand and Australia capital per hour worked seems to be quite responsive to changes in these returns. New Zealand’s relatively cheap labour is one of the reasons why we have been absorbing so much labour and investing less in capital.
But looking forward, this trend is likely to reverse.
We have already seen pressure on wages to rise, and recent news on business investment suggests levels are climbing. So we may be coming to a point where we will begin to look more like Australia in terms of capital per hour worked.
The question for the business sector is whether it is anticipating these changes.
- Slide 10: Exiting Firms Labour Productivity
Another challenge for government is to address barriers to productivity improvement.
Work that the Treasury did last year showed that the firms that survive tend to have rising productivity, while firms that fail tend to have static or declining productivity.
This chart shows that firms that go out of business generally experienced static or declining labour productivity. In other words, productive firms are flourishing and those with poorer productivity are leaving the industry, freeing up resources for others.
So this data indicates that the dynamic picture of the entry and exit of firms is adding to labour productivity growth.
This seems to be a very similar trend to what is happening in Australia. For example, Martin Parkinson of the Australian Treasury attributes Australia’s strong labour productivity growth to the effectiveness of Australia’s labour and product market reforms. These, he says, allow resources to move toward those industries for which Australia has a comparative advantage.
But not only has this led to Australian growth, it is also part of the reason why Australia has started to climb back up the OECD rankings.
For example, Australian industries have made significant productivity gains relative to their US counterparts since the mid-1980s. In addition, the number of industries with productivity levels above their US counterparts has increased over this period.
The policy trick is to ensure that we maintain a regulatory environment that provides essential protections but does not inhibit the dynamic picture of firms entering and exiting business.
The evidence so far seems to be that, while there are still pockets where competitive conditions and functioning of markets can be improved, markets and regulatory conditions in New Zealand are on the right track. There may be some positive growth impacts such as those experienced by the Australians yet to come.
It won’t be a surprise to you that the next area I want to cover is infrastructure. Inadequate infrastructure can be a major bottleneck to growth.
One of the consequences of Australia’s long period of sustained growth is the stress it has placed on the country’s infrastructure.
Some of you may, for example, be aware of the crisis in Australia’s coal mining industry in recent years, as the surge in demand from China has highlighted inadequate capacity in both plant and machinery and infrastructure - such as port facilities.
Australia has implemented a number of major projects in both rail and roading, (like Sydney’s Westlink M7 motorway – Australia’s largest urban infrastructure project). Similarly, in electricity, Australia is facing issues in keeping up with demand – in particular, the interconnection of the electricity grids to form one national electricity grid.
So it’s not surprising that in a generally positive audit of infrastructure done in 2004 for New Zealand, energy and transport were also seen as the two big areas where there are grounds for further focus.
When it comes to energy, we are in a period of transition. Not only do we have to guard against a lack of energy becoming a barrier to growth, we have to do so in an era where we can no longer rely on an abundance of Maui gas and hydro capacity.
In the main, the response to that challenge is to look for opportunities for increased supply. Examples firmly on the agenda at the moment include moves to encourage gas exploration, the expansion of the Huntly station and examining the feasibility of LNG importation. But there are many other options - including energy efficiency, wind and solar power.
At a more general level, supply is too close for comfort to ever growing energy demand. There is also a real issue in the increasingly urgent need to upgrade and update our transmission network.
Turning to transport, if we were looking for classic case studies of the challenges a growing economy can present, Auckland, Bay of Plenty and Wellington transport would be a good places to start.
For government, the challenge requires a range of solutions. Concentrating solely on trying to build our way out of congestion won’t work, although we can do better with roading as the Auckland and Wellington roading packages show.
Traditionally, when it comes to roads, we have tended to focus on supply – that is, building more. Now we are reaching a point where we are thinking and trialling financial and non-financial measures to limit or spread demand.
For business that is going to mean choices about facing more congestion and more measures to manage demand. That in turn raises questions about where, how and when you operate.
Let’s turn now to the issue of the environment.
Traditionally, most New Zealanders do not believe that we face the same level of environmental stress faced by those in more densely populated countries. But it is becoming clear that this is not the case.
Looking back, our experience of over-exploitation of fish species such as rock lobster and orange roughy shows that even small countries like ours can face serious degradation in natural resources.
But further out, these challenges are going to become more diversified and more amplified.
One example is water supply.
As we all know, Australia is a very dry continent, so a key challenge there is the management of water in a sustainable way. What is less well known is that most of this pressure is coming from the agricultural sector – more than 70% of Australia’s water is used in irrigation. Excessive allocations to irrigation over most of the past century have caused extensive damage to river systems and groundwater resources, while increasing salinity is rendering infertile large tracts of productive land.
But this water supply problem is not just restricted to Australia.
- Slide 11: Irrigation Trends
One of the key emerging pressures in New Zealand is increasing demand for irrigation. That’s not that surprising given that the agricultural sector has grown on average a percentage point faster than the economy as a whole over the last 25 years.
We are already starting to see such constraints in Canterbury. And in the Waitaki we have witnessed the struggle between the competing uses of water. Australia began addressing these issues in the 1980s by implementing substantial water policy reforms - and there are undoubted lessons for us.
The environment is often highlighted as a loser when there is economic growth. What the Australian experience demonstrates is that this is not necessarily the case.
It is true that growth can mean more pressure on the environment, but the picture is more complex than a straight either / or proposition.
A framework such as the Resource Management Act is essential to manage the trade offs between development and the environment.
The challenge for government, both central and local, is to continue to monitor the Act to ensure it runs as smoothly and efficiently as possible. A variety of potential improvements are in train to that end and we have to ensure implementation delivers the benefits.
For business, the challenge will be to continue to recognise the trade-offs the Act is addressing and work within that framework. There is no way around it, the trade-offs have to be managed.
My aims for my address today have been to share with you some of Treasury’s thinking about the economic issues we see on or just over the horizon.
As I pointed out earlier, we all can get so buried in the day-to-day realities that we can miss some big emerging challenges. A growing economy raises new dilemmas, many of them no easier to solve than those faced over our less prosperous past.
I have touched today on only a few of those issues.
But I think it is important that we identify these early because to meet some of these emerging challenges will require new ways of thinking and new skills. Countries and businesses that address these issues most quickly will have a head start on their competitors – and we need to give ourselves time and space to devise strategies.
All this will apply to the business sector just as much as government.
To help me think about this I took a quick look across the Tasman to see if some of the issues arising over there give us some insights for our own future.
While I would be the first to argue against copy-cat policy making, when it comes to trying to predict an uncertain future I do think that we can learn from the Aussies’ efforts. Seeing how they tackle similar challenges provides us with some valuable lessons - and I hope that I have persuaded you that there is some insight to be gained.
Of course, it still doesn’t mean that they can play rugby. But I’ll leave that topic for a suitable speech in Australia.