What comes to my mind when someone mentions New Zealand is that the country is literally at the end of the world and that there are more sheep than people. It has a small population of only around 4.5 million people – living mostly on its North Island – and Australia is often seen as New Zealand’s ‘big brother’ in terms of land mass, population size or the size of the economy.

However, despite its rather isolated location New Zealand is a high-income OECD country. What is more, it currently ranks second in the Doing Business (DB) Ranking by the World Bank (2016a), just behind Singapore. It is number one in starting a business, registering property, getting credit and protecting minority investors. That is quite impressive in international comparison; the US for example ranks 7th overall. Only in trading across borders New Zealand is performing relatively poorly being 55th out of 189 countries. This excellent DB performance is a sign for New Zealand’s good regulatory and institutional quality. This is also confirmed by high scores in all of the six World Governance Indicators measuring for example the rule of law, control of corruption, regulatory quality or government effectiveness (World Bank, 2015). This excellent institutional setting is even amplified by low inflation and unemployment rates.

In sum, everything points at strong economic performance comparable to other OECD countries. So how has New Zealand performed? Take for example the UK and Australia as benchmark in the diagram above. New Zealand still has strong economic ties to the UK through the Commonwealth and Australia is in geographical proximity. The diagram shows the countries’ GDP per capita at PPP (in constant 2011 international $) from 1990 to 2014 and indexed to 1990=100. In 1990 New Zealand’s output per capita was around $24,000 and the UK’s output per capita was a little higher at $26,000. Australia already was at $28,572, therefore more than $4,500 higher than in New Zealand. Until 2014 this gap widened considerably as Australia reached a GDP per capita of $43,257 while New Zealand stood at only $33,846 in 2014. Hence the gap widened to more than $9,400, that is the gap more than doubled over this period. The diagram also shows that both the UK and New Zealand were hit hard by the global financial crisis. It took New Zealand more than 5 years to recover to 2007 GDP per capita levels while Australia only experienced a period of stagnation from 2008 to 2010 but no real fall.

This leaves us with some kind of a puzzle: New Zealand has been outperformed by comparable OECD peers but pursues best practice in many regulatory and institutional areas, as assessed by the Doing Business and World Governance Indicators. This phenomenon is also known as New Zealand’s productivity paradox. It has attracted a considerable amount of research in the past and is certainly crucial to be addressed by the country’s policy makers to avoid a further fall back in income relative to other OECD countries with all its negative side effects such as migration of New Zealanders to Australia. To do so the so-called 2025 taskforce was set up in 2009 with its goal to close the income gap with Australia by 2025 (2025 Taskforce, 2010). However, this can only be achieved if one can identify its sources and even then, finding a cure is likely to be even harder (we stick to identifying potential sources today).

So what are the theories in the existing literature for explaining New Zealand’s under-performance? One of the most plausible ones was formulated by Philip McCann (2009) in his paper Economic geography, globalisation and New Zealand’s productivity paradox. He argues that it is likely not regulation, taxation and institutions as focused on by the 2025 taskforce that drives the productivity paradox but New Zealand’s economic geography. This sounds rather logical; if you are ahead of your peers in terms of sound institutions and regulatory quality, this is unlikely to be the cause of slow productivity increases and therefore long-run growth, because New Zealand actually has the capacity to grow. What McCann argues is that New Zealand’s position in the international marketplace has worsened in the globalisation era in which the world has become flat. The cause for this worsening is New Zealand’s unusual economic geography compared to other advanced economies. What do we mean by ‘unusual’? Hendy (2010) names four indicators for New Zealand:

Low population density Large share of primary/ agricultural goods in exports for an advanced economy Low export diversity compared to other advanced economies: New Zealand’s Export Diversification Index were at 2.28 in 2010 (IMF, 2014) High geographical isolation

Let’s look at this in more detail. Where is the link between these indicators and the productivity paradox? For McCann this stems from the fact that there are low value-added and high value-added goods in today’s international marketplace. For the former he assumes falling spatial transaction costs in the era of globalisation. For high value-added goods, however, spatial transaction costs have actually increased coupled with increasing economies of scale. This is due to factors like timeliness, speed, variety, customisation or service quality that have become more and more relevant in high value-added manufacturing according to McCann. If this is true then it follows that cities which allow for clustering and agglomeration of high value-added manufacturing become crucial. They pool human and physical capital, innovation etc. to fuel a country’s productivity.

Manufacturing Economies of scale Spatial transaction costs 1) Low value-added/ low knowledge-intensive Constant returns to scale Falling 2) High value-added/ high knowledge-intensive Increasing returns to scale Increasing

(based on McCann, 2009)

So based on this understanding New Zealand’s unusual economic geography matters a great deal in explaining the productivity paradox. In the first category competition has become tougher, for example in production of commodities. This category, however, is really the driving force of New Zealand’s exports with goods like milk powder, butter or cheese. In the second category New Zealand suffers from a lack of scale due to low population density and skyrocketing spatial transaction costs due to geographical isolation. This ultimately dampens high value-added manufacturing and limits the country’s potential to nurture such a sector. This is worsened by the country’s relative proximity to Australia, which – as the big brother – can offer both. In sum this seems to be a compelling theory to why New Zealand’s economic geography is the driver of the observed under-performance even in today’s flat world.

I want to conclude today’s post with a remark on why low export diversification might not only play an important role in the explanation of the productivity paradox but might also explain New Zealand’s susceptibility and volatility in performance over the last decades. For this let’s look at GDP per capita growth of New Zealand and Australia:

The data is taken from the World Bank’s World Development Indicators (2016b). It is graphed over the period from 1996 to 2014 showing GDP per capita growth (in annual %). Furthermore, on the secondary axis I highlighted the difference in growth rates calculated as New Zealand’s minus Australia’s growth rate. A positive difference would therefore represent a year in which New Zealand outperformed Australia and a negative difference would represent a year in which New Zealand was outperformed by Australia. One can clearly see that in the first three years New Zealand performed poorly and this again occurs during the period from 2007 to 2009 (GFC). In the remaining years New Zealand mostly outperformed Australia in terms of GDP per capita growth (to be clear here: this is not in terms of GDP per capita at which we looked earlier). However, the positive growth gaps are considerably lower than the negative ones and over the complete period New Zealand’s per capita growth is more volatile with growth as high as 4.96 percent in 1999, and as low as -2.45 percent in 2008. In comparison Australia’s maximum lies at 3.81 (1999) and minimum at -0.26 (2009). This is where low export diversification might come into play. Being reliant on primary commodity exports might not be the best strategy due to abundant supply from other countries to satisfy global demand as well as high interrelationships of markets transmitting crises from abroad into the country. One good example in terms of New Zealand might be dairy. The dairy industry benefits from high demand for milk powder in Asian countries in general. However, it suffers from extremely volatile dairy prices which are currently very low constraining New Zealand’s dairy production. Furthermore depressed short-term demand from the two main trading partners China and Russia dampens the industry’s performance (Ministry for Primary Industries, 2015). I think this might be of importance because the relative importance of primary commodities in New Zealand’s exports and its low diversification might reinforce the productivity paradox.

That’s me for today. I did not have time to address potential solutions but McCann proposes several in his paper if you are interested. Overall, I hope you enjoyed today’s post and thanks for reading!

Jasse

2025 Taskforce, 2010. Focusing on Growth: The Second Report of the 2025 Task Force. [pdf] Available at: http://purl.oclc.org/nzt/r-1252 [Accessed 18/04/206].

Hendy, S., 2010. New Zealand’s productivity paradox: Part III. [online] Available at: http://sciblogs.co.nz/a-measure-of-science/2010/03/31/new-zealands-productivity-paradox-part-iii/ [Accessed 18/04/2016].

IMF, 2014. The Diversification Toolkit: Export Diversification and Quality Databases (Last Updated: May 28, 2014). [online] Available at: https://www.imf.org/external/np/res/dfidimf/diversification.htm [Accessed 18/04/2016].

McCann, P., 2009. Economic geography, globalisation, and New Zealand’s productivity paradox. New Zealand Economic Papers, 43(3), pp. 279-314. Available at: http://dx.doi.org/10.1080/00779950903308794 [Accessed 18/04/2016].

Ministry for Primary Industries, 2015. Situation and Outlook for Primary Industries 2015. [pdf] Wellington: New Zealand Government. Available at: https://www.mpi.govt.nz/document-vault/7878 [Accessed 05/03/2016].

World Bank, 2015. Country Data Report for New Zealand, 1996-2014. [pdf] Available at: http://info.worldbank.org/governance/wgi/c168.pdf [Accessed 18/04/2016].

World Bank, 2016a. Doing Business Economy Rankings. [online] Available at: http://www.doingbusiness.org/rankings [Accessed 18/04/2016].

World Bank, 2016b. World Development Indicators. [Data] Retrieved from World Development Indicators (WDI) database: http://databank.worldbank.org/data/reports.aspx?source=world-development-indicators&preview=on [Accessed 11/04/2016].