INTRODUCTION TO THE NEW ZEALAND ECONOMY

GDP is not a complete measure. It is an estimate of the total value of final goods and services produced in the New Zealand economy over a particular time period, say a year. However, GDP does not measure people’s wellbeing, happiness or wealth.

In 1970, real GDP per capita was around $19,000, and in 2010 it was around $31,000 – an increase of 63 per cent over the period. This increase in real GDP per capita is caused by two factors: the increased production of goods and services (often via productivity improvements); and the availability of additional resources (human and physical).

The first driver [of GDP] is population. The working population contributes directly to national output through employment and the total population also influences the final demand for goods and services in the economy.

World prices of New Zealand exports and imports also affect GDP growth. As discussed earlier, oil prices and other import price rises cause GDP per capita to grow more slowly or even decrease. In contrast, rising world prices for New Zealand exports tend to increase real GDP per capita.

The import and export price effects are combined in a single indicator called the terms of trade, Graph 1.4. The terms of trade measures the ratio of New Zealand export prices to import prices.

World capital markets are another important external influence on the New Zealand economy. Because New Zealand borrows foreign savings on a regular basis, interest rates prevailing in world financial markets set a floor (minimum) on interest rates in New Zealand.

One of the interesting features of the production structure of the New Zealand economy, for a higher-income country, is the large agricultural (farming) sector. Farming represents 4.4 per cent of total GDP. This is two or three times the size of the farming sectors in many other high-income countries. The New Zealand farm sector is concentrated in the production of animal products (milk and meat), and as a result our largest manufacturing industry is food processing. Animal products usually need more processing before they can be traded internationally. By contrast, the food-processing sector in large agricultural-producing countries such as the United States, Canada and Brazil represents a much smaller share of manufacturing. The large food-processing sector in New Zealand is the result of New Zealand’s rather unique pattern of comparative advantages.

While GDP is the preferred measure of economic activity and a proxy for the standard of living, it has many other limitations. For example, in GDP measurement the cost of an oil spill is not counted but the clean-up is. A country’s black economy and unpaid work are not counted. And though factors such as income equality, health, educational attainment and happiness have an important bearing on the actual success of an economy, they are not explicitly captured in GDP either.

New Zealand is a small open economy. Being small, it is heavily influenced by global events and forces, but local institutions and government policies are also important drivers of its economic performance. Net migration, commodity prices and interest rates are key influences on the economy.

NEW ZEALAND'S LONG-TERM ECONOMIC PERFORMANCE

This chapter expands to four key indicators which macroeconomists often use to summarise the performance of an economy. They are income per capita, the inflation rate, the unemployment rate and the current account balance.

The first turning point for New Zealand relative per capita incomes came just after 1840. Wool was a highly valued commodity and the expansion of sheep farming from 1840 led per capita incomes in this country to rise – along with Australia – to a peak of 40 per cent above US levels in 1880. Australasia had the highest per capita incomes in the world. This was a remarkable achievement, because the US economy was also growing fast.

New Zealand import protection was temporarily reduced in the 1950s and again in the 1970s only to be reversed under lobbying pressure from manufacturers (Rayner and Lattimore, 1991). This protectionist policy insulated many manufacturing industries from global competition. As a result, many firms did not innovate and invest to follow global productivity trends.

During this period, New Zealand and many other countries had signed on to a fixed exchange rate system administered by the newly created International Monetary Fund (IMF) in 1945 (the Bretton Woods Agreement). The monetary anchor for this IMF system was the US guarantee that it would sell gold at US$35 per ounce to the central banks of participating countries in return for participants agreeing to fix their exchange rates, directly or indirectly, to the US dollar. The payoff to the US from this system was that it encouraged the use of its currency in global commerce and its use in other countries as foreign exchange reserves – the US Treasury could print dollars for a fraction of a cent and other countries would buy and hold them for a dollar. This payoff is called seignorage.

Employment policy from the Great Depression until 1984 involved not just setting wages but also some job creation. People who found themselves unemployed might be assigned jobs in the Forest Service, Post Office or the Railways, for example. As a result, the unemployment rate often sank below 1 per cent in the period up until the late 1960s. Ministers of Labour would joke that they knew all the unemployed on a first-name basis.

In the absence of a liberal import regime, such firms would tend to dominate the local market. In particular, they would have the market power to ration supplies and push prices up. This is the natural strategy of a monopolist. Such firms are constrained in these actions when importers are able to operate freely in the New Zealand market. Accordingly, imports complement the activities of the Commerce Commission in ensuring that New Zealand markets remain competitive.

From 2002, deficits began getting larger as banks imported foreign savings for borrowers speculating in the property market.

GLOBAL ECONOMIC DEVELOPMENT

Most governments continue to restrict full and open globalisation through tariffs or quotas on imports, subsidies for exports, exchange rate manipulations, other regulatory interventions and prohibitions on the movement of goods, services, capital and people between countries.

INDUSTRIAL DEVELOPMENT AND POLICY

While the primary sector – which includes agriculture, forestry, fishing and mining – resonates most strongly with the New Zealand image, it accounted for only 7 per cent of the economy in 2006, down from 26 per cent in 1953.

Before ANZSIC was implemented, the New Zealand economist A.G.B. Fisher, in the 1920s, aggregated industries into sectors based on the level of processing. The primary sector refers to industries that produce raw materials. Agriculture, forestry, mining and fishing are placed in this category. The secondary sector (also called the manufacturing or industrial sector) refers to industries that transform raw materials into consumer goods. The tertiary sector (services) refers to producers of intangible goods. It includes banking, real estate, retailing, hospitality, education, health and government.

Technological change in a particular industry alters the ratio of inputs to outputs and the ratio of capital to workers required for that industry to remain competitive. It can also alter the skill sets of workers required in a particular industry, and this factor, in turn, alters the relative value of workers with different skill sets and their wage rates

New Zealand’s position in this regard (as a high-wage economy) contrasts with that of China (as a low-wage economy), which tends to specialise in the final assembly of products – particularly electrical machinery and equipment. Accordingly, China requires a large number of wooden pallets and crates for its exports but land for trees is scarce. New Zealand has relatively abundant land for trees so it exports logs to China to be transformed into pallets and crates.

China is the world’s largest exporter, but its value added per unit of exports is low because it concentrates on final assembly – a process that can usually be carried out by unskilled workers with on-the-job training.

GDP. Recruiting and staff training is expensive, so firms usually do not dismiss staff when output first falls in a recession. At the other end of the cycle, firms usually do not re-hire staff as soon as output starts to trend upwards – they wait for confirmation of a recovery. This means that percentage changes in employment tend to be less than and lag behind changes in GDP.

A key macroeconomic indicator is labour productivity – a measure of how much we each produce per unit of effort. The economy will be more productive if it uses more highly skilled labour, better-quality capital and improved technology. A more productive economy will produce more output for the same amount of inputs or resources. Productivity is an important driver of output, value added, incomes and economic efficiency.

One problem with the overall labour productivity index is that some major industries like the government sector produce outputs that are not traded in markets. We know that the value added in these industries is not correctly measured. A second problem with the labour productivity index is that resource inputs such as capital equipment are excluded from the computation. The measured sector multifactor productivity index deals with both these issues.

The New Zealand government sometimes bypasses the Commerce Commission’s controls by allowing mergers under special legislation that regulates the behaviour of a firm. When two large dairy co-operatives wanted to merge to form Fonterra in 2000, for example, the government intervened to allow the merger. However, because Fonterra would be a virtual monopsonist – controlling over 90 per cent of raw milk purchases in New Zealand – conditions were imposed.

The Chinese government (and some other Asian governments) does not permit its currency to fully float. Over the past decade or so it has set its exchange rate against the US dollar at a rate where central bank reserves of US dollars have accumulated rapidly and to very high levels (around 2 trillion US dollars). The US and EU governments argue that if China allowed its currency to float it would appreciate against the US dollar and the euro, raising Chinese export prices and dampening the large flow of Chinese exports to the West. The foreign governments see the Chinese exchange rate policy as an implicit export subsidy – a trade policy stimulating exports.

LABOUR MARKETS AND POLICY

Up until 1967, many wage rates were determined by the Arbitration Court. In 1967 a fall in export prices for wool persuaded the Court that there should be no increase in wages. Labour unions would not accept the decision and the arbitration system essentially broke down. Unions and employers returned to direct bargaining.

INTERNATIONAL TRADE AND CAPITAL FLOWS

Mechanical machinery and electrical machinery are significant exports as well as major imports. Exports of these products provides an interesting example of New Zealand focusing on niche export products with shorter production runs while importing ‘commodity’ machinery items requiring long production runs.

Import prices are mainly influenced by oil price volatility and a longer-term downward trend in manufactured products tied to globalisation and the rise of Asia. Export prices are mainly influenced by movements in agriculture commodity prices, New Zealand’s main exports. These are influenced by weather patterns, global supply and demand, and foreign policy settings.

CAPITAL MARKETS AND MONETARY POLICY

There are elements of ‘moral hazard’ in financial markets – situations where people change their behaviour because the risks associated with their actions are carried by somebody else. For example, holders of fire insurance policies are likely to be less careful about lighting fires.

Controlling inflation requires, at least in the short term, a trade-off with unemployment. The Phillips Curve, discovered by the New Zealand economist Bill Phillips, shows that when inflation rises, unemployment falls in the short term, and vice versa. Too much inflation is undesirable, as discussed above. However, if inflation is reduced by choking economic growth, this will lead to a temporary rise in unemployment. Accordingly, the Reserve Bank is implicitly charged with the delicate task of balancing inflation and unemployment.

GOVERNMENT SECTOR AND FISCAL POLICY

The demand for government programmes and policy can be thought of as emanating from lobby groups and public opinion while the supply of policy and programmes arises from the benefits to politicians – usually buffered by ministry advice. It is a form of supply-demand analysis but one that is different from the supply-demand framework used to explain market behaviour.

There are three areas of government expenditure where over a longer period governments have been unable to find a sustainable political consensus: pensions, health and education. The political conflict in these areas has led to almost continuous policy change in the government programmes involved. This vacillation has resulted in government expenditure in these areas trending upwards in an unsustainable fashion – unsustainable because the root causes of the issues involved are not being dealt with.

This universal access policy receives strong political support because it combines the influence of lobbies for the poor with the median voter lobbies – the latter being the political power brokers in a democracy (Hotelling’s Law).

Universal government programmes might be egalitarian in the view of some but they tend to redistribute income from the poor to the rich. The power of the median voter is a major challenge for social development.

A BRIEF RECAP OF THE KEY DRIVERS OF THE NEW ZEALAND ECONOMY

Before we get down to the nitty-gritty of forecasting the economy through the business cycle, let’s recall the key drivers of the economy. The economy responds to many influences, but these can be boiled down to three main factors:

1. Monetary policy – Monetary policy works through interest rates and their impact on savings, borrowing, consumption, investment and exports (through the exchange rate). Every six weeks the Reserve Bank decides on changes in interest rates.
2. Fiscal policy – Fiscal policy works through two channels. First, government investment in roads or tax cuts, for example, provides direct injections of money into the economy. Second, government sets the long-term agenda by moulding the incentives to invest, consume and work. The government typically announces policy changes in the May Budget.
3. Global growth – We live in a globalised world. The health of the global economy dictates how much we export and at what price, it influences our cost of credit and access to capital and it influences net migration into New Zealand.

An assessment of where the economy is at the time forecasts are being prepared requires a forecast of the current position. Economic data from Statistics New Zealand takes some time to be compiled. For example, GDP data takes around three months – so the March quarter data is released at the end of June. Accordingly, an analyst making a set of forecasts on the first of June has to make an assessment of economic performance from January to May of that year without an official estimate. The forecast will therefore be done by looking at partial and leading indicators to understand the current state of the economy.

1. House sales – House sales are a good indicator of household spending, which accounts for around two thirds of total expenditure. If house sales are weak, this generally reflects weak household spending on most goods and services. National house sales data is released by the Real Estate Institute of New Zealand (REINZ) in the first week of the following month.
2. Net migration – Accelerating net migration boosts population growth which leads to demand for housing, jobs, goods and services. Higher net migration tends to support stronger growth. Net migration data is compiled by Statistics New Zealand and is typically released in the third week of the following month.
3. Business and consumer confidence – Confidence is a necessary but not sufficient condition for businesses to decide to invest, hire and expand. Similarly, consumer confidence can shape people’s decisions to buy houses and goods and services. There can be periods of divergence between levels of confidence and actual decisions. This can be the result of a number of factors, including a lack of access to finance to fund investment plans. Monthly business confidence data is released by the National Bank of New Zealand at the end of each month. A more comprehensive survey, the NZIER Quarterly Survey of Business Opinion, is released in the first week following each calendar quarter. Monthly consumer confidence data is released jointly by Roy Morgan and the ANZ Bank. A longer-running quarterly consumer confidence index is published jointly by Westpac and McDermott-Miller.
4. Commodity prices – Some rising commodity prices provide a long-term boost to the economy. New Zealand mainly exports agricultural commodities, such as dairy, meat, forestry and horticulture. It is important to note that in the short term only the 10 per cent of the workforce that is employed in the agriculture sector benefits from higher commodity prices while the other 90 per cent of the workforce pays higher prices for their milk, timber, cheese and meat. But commodity prices eventually benefit the wider economy through spending in local communities and taxes paid to government. The ANZ Bank releases a monthly commodity price index in the first week of the following month.
5. Stock market performance – Equity market performance is an excellent indicator of growth. Equity markets tend to rise strongly when the economy is booming and vice versa. For example, equity prices plunged during the GFC, reflecting falling confidence in economic growth. Equity or sharemarket price performance data are freely available from global sites such as Yahoo! Finance and Google Finance, and they are also published in newspapers.