New Zealand Government Debt and Budget Balance 2003 – 2012

In today’s post I am going to look at the New Zealand government’s budget balance and debt over the period from 2003 to 2012. In particular, I am going to focus on changes in government debt in response to the global downturn of 2008/09 and some of the reasons for the country’s negative budget balance. In the last part of today’s post I will comment on the claim that the government did nothing in response to the recession.

Tax revenues and expenses, as well as central government debt for the period from 2003 to 2012 are graphed in figure 1. This is complemented with an overview on subsidies and other transfers (welfare payments) both in absolute terms as well as a share of government expenses in figure 2. Nominal data series are deflated to constant 2010 levels with the use of the CPI to account for inflation.

new zealand budget deficit 1
(Source: World Bank, 2016c)

New Zealand’s tax revenues and expenses were roughly balanced until 2008. Government expenses started at around 30.4 percent of GDP in 2003 and increased slowly to 32.9 percent of GDP in 2008. Likewise tax revenues increased slowly from 29.2 percent of GDP (2003) to 31.8 percent in 2008. The highest tax revenue was recorded in 2006 (32 percent). Over the same period government debt decreased by almost 11.8 percentage points to 36.4 percent of GDP in 2008. After 2008, however, the government’s tax revenues and expenses diverged significantly. While taxes fell to levels below 30 percent, government expenses increased by almost 13 percentage points within only one year. After stagnating in 2009/10, expenses increased further by 6.5 percentage points to an all-time high of 52.8 percent of GDP in 2012. This trend caused government debt to rise from 36.4 percent (2008) to 67.9 percent of GDP by 2012. This corresponds to an 86.5 percent increase in debt in only 4 years. In 2012, government expenses came down to 45.6 percent of GDP but are still considerably higher than in the early 2000s before the global financial crisis.

Figure 2 looks at the New Zealand government’s expenses more closely. In general, government expenses include (1) compensation of employees, (2) goods and services expenses, (3) interest payments, (4) subsidies and other transfers, as well as (5) other expenses. It can be shown that the spike in government expenses of 2008/09 was mainly caused by the fourth category. Thereby subsidies and other transfers are defined as “all unrequited, nonrepayable transfers on current account to private and public enterprises; grants to foreign governments, international organizations, and other government units; and social security, social assistance benefits, and employer social benefits in cash and in kind” (World Bank, 2016b). However, the lion share in this category are welfare payments made by the New Zealand government.

new zealand budget deficit 2
(Source: World Bank, 2016c)

While subsidies and other transfers remained relatively constant at a level of slightly above $20 billion from 2003 to 2008, they increased by more than $32 billion from 2008 to 2009. This is a 143 percent increase in government subsidies and transfers within only one year. It was mainly driven by increased government spending on family assistance to low income households. The lowest income decile in the population saw its transfers rise by more than 6 percent of disposable income while the second decile saw an increase of almost 10 percent from 2006/07 to 2009/10. Overall, 9 out of ten deciles benefited from an increase in transfers during this period. This includes Working For Families, NZS and Veterans pension, Income replacement and Housing Supplement (Ball & Ryan, 2013).

The second spike of 2010/11 was driven by the fifth category due to the two Canterbury earthquakes. The New Zealand government provided short-term income support, financed public infrastructure reconstruction and repairs and was liable for Earthquake Commission payments to households (Treasury, 2011). Earthquake Expenses were expected to accrue to a sum equivalent to 10 percent of GDP and the net cost to the Crown were estimated to be $13.5 billion in 2011 (Doherty, 2011).

new zealand budget deficit 3
(Source: World Bank, 2016c; own calculations)

Putting expenditures and tax revenues together, one can calculate the budget deficit of New Zealand for the period, as shown in figure 3, by subtracting government expenses from tax revenues. It should be noted though, that this is a simplified calculation of the budget deficit and differs from the cash surplus/deficit quoted in the World Bank database, which includes other revenue such as grants and deducts the net acquisition of nonfinancial assets in addition to expenses (World Bank, 2016a).

Figure 3 supports the findings from my analysis above, namely that New Zealand has been running large budget deficits since 2009 due to (1) the increase in welfare payments during the 2008/09 recession and (2) the costs related to the Canterbury earthquakes in 2010/11. Hence the claim that the government did nothing in response to the crisis does not hold if one looks at the numbers. The New Zealand government did respond with an almost 2.5 fold increase in welfare payments, especially to poorer households through family assistance. The government also had to bear higher costs in terms of unemployment benefits as the eligible population increased from 18,000 in June 2008 to 62,000 working age people in June 2010. It introduced a Youth Opportunities package including initiatives like the Job Ops or the Community Max programme as well as Youth Transition Services to tackle long-term unemployment through training and jobs funded or subsidized by the government (Ministry of Social Development, 2010).

I hope today’s post provided insights into how New Zealand reacted to the global recession of 2008/09 with the goal to shed light on the magnitude of the government’s spending increases and tax decreases over that period.

Thanks for reading!

Jasse


References

Ball, C. & Ryan, M. (2013). New Zealand Households and the 2008/09 Recession (New Zealand Treasury Working Paper 13/05). Wellington: The Treasury. Retrieved from: http://www.treasury.govt.nz/publications/research-policy/wp/2013/13-05/twp13-05.pdf

Doherty, E. (2011). Economic effects of the Canterbury earthquakes (Research Paper December 2011). Wellington: Parliamentary Library. Retrieved from: http://www.parliament.nz/resource/en-nz/00PlibCIP051/ccd96733060e8e3a1769b3a4ef3017e3de45df83

Ministry of Social Development (2010). Ministry of Social Development Annual Report 2009/2010. Wellington: New Zealand Government. Retrieved from: https://www.msd.govt.nz/documents/about-msd-and-our-work/publications-resources/corporate/annual-report/annual-report-2009-2010.pdf

Treasury (2011). Economic and Fiscal Impacts of the Canterbury Earthquakes. Budget Economic and Fiscal Update 2011, 95-101. Retrieved from: http://www.treasury.govt.nz/budget/forecasts/befu2011/befu11-whole.pdf

World Bank (2016a). Cash surplus/deficit (% of GDP). Retrieved from: http://data.worldbank.org/indicator/GC.BAL.CASH.GD.ZS

World Bank (2016b). Subsidies and other transfers (% of expense). Retrieved from: http://data.worldbank.org/indicator/GC.XPN.TRFT.ZS

World Bank (2016c). World Development Indicators: New Zealand [Data file]. Retrieved from: http://data.worldbank.org/country/new-zealand

Two Measures of Inflation in Theory and in the Context of New Zealand

Today’s post takes a closer look at two common measures of inflation, namely the Consumer Price Index (CPI) and the GDP deflator. The first part looks at key differences between inflation measured by the former and the latter indicator. In the second part I take a closer look at CPI and GDP deflator inflation in the context of New Zealand from 2000 to 2014 and the Reserve Bank of New Zealand’s performance in inflation targeting. This was part of a bigger assignment for my Macroeconomics in the Global Environment class. However, I think that it is valuable content for a blog post.

Two common measures of inflation are (1) the Consumer Price Index (CPI) and (2) the GDP deflator. Over the long-run they tend to move together. However, they can diverge for two reasons due to the way they are constructed.

Firstly, the CPI is based on a basket of goods and services, which proxies for the consumption of an average household. Because consumers do not only consume domestic goods, the CPI does include foreign consumption goods. The GDP deflator, on the other hand, only tracks domestic produce, because GDP measures all goods and services produced within a country. This also includes things like investment, which are not considered in the CPI, so that the composition of the baskets differs significantly. Overall, the CPI can rise due to price rises in imported goods while the GDP deflator can only rise if prices of domestic goods and services, investment etc. increase. This matters especially for small open economies which export most of their produce but import most of the goods and services consumed domestically. A good example is oil. When a country relies mostly on oil imports, then oil and oil-based products make up a much larger share of the CPI than of GDP. Therefore oil price changes weigh more on the CPI than the GDP deflator in this case (Mankiw, 2008).

Secondly, the components of the CPI basket are fixed, exogenously determined by Statistics New Zealand, while the GDP deflator’s basket can change over time. This is because the GDP deflator compares the prices of currently produced (domestic) goods to the prices of goods produced in the base year. Its basket is a unit of GDP, no matter what the GDP contains (Thoma, 2008). This can cause the CPI and the GDP deflator to diverge if the GDP deflator basket adjusts over time and the prices of the goods do not change proportionally (Mankiw, 2008).

The context for the following analysis of CPI inflation and GDP deflator inflation in New Zealand from 2000 to 2015 is that the Reserve Bank of New Zealand has officially pursued CPI inflation targeting to maintain price stability since the Reserve Bank of New Zealand Act 1989. This Policy Targets Agreement (PTA) set out a CPI inflation band of 0 to 2 percent per year. The PTA was last changed in September 2002 to a band of 1 to 3 percent per year. In the short-run, inflation is allowed to exceed the band but for no longer than 12 months (RBNZ, 2009). The Reserve Bank’s prime tool for inflation targeting is the Official Cash Rate (OCR). The bank reviews the OCR 8 times per year to achieve a 2 percent inflation target midpoint (RBNZ, 2016).

New Zealand Inflation 1
(Source: World Bank, 2016; own calculations)

Figure 1 shows inflation measured by the GDP deflator and the CPI for New Zealand from 2000 to 2015. Furthermore, it includes the difference between the two indicators by subtracting GDP deflator inflation from CPI inflation. It can be seen that the two inflation measures have diverged considerably in the case of New Zealand over the last couple of years. Inflation measured by the CPI was lowest in 2015 at 0.23 percent. It was highest in 2011 at around 4.43 percent. Overall, New Zealand’s Reserve Bank missed its CPI inflation target 7 out of 13 years since 2003 after the last band amendment.

Inflation measured by the GDP deflator was highest in 2007 at 5.19 percent inflation per annum. The lowest inflation occurred in 2012 with almost perfect price stability (0.03 percent), closely followed by the year 2002 (0.26 percent). Overall, GDP deflator inflation has been more volatile than CPI inflation. This, however, is at odds with the existing economic theory that the CPI tends to be much more volatile than the GDP deflator (Sexton, 2016). The positive divergence of the two measures was greatest in 2002 and 2011 with a difference of 2.4 percentage points. The greatest negative divergence occurred in 2007 and 2013 with 2.8 percentage points and 2.7 percentage points, respectively.

New Zealand is a small open economy and domestic consumption depends largely on imports. Hence any price increases abroad are transferred into the economy and are hard to tackle with monetary policy (inflation targeting) of the Reserve Bank.  This imported inflation can partly explain the spikes in the CPI of 2008 and 2011. In 2008, CPI inflation was mainly driven by rising petrol prices. New Zealand relies mostly on imported fuel from refineries in Asia, the Middle East and the Pacific (Ministry of Business, Innovation and Employment, 2015). The oil supply shock of 2008 pushed CPI inflation briefly above 5 percent (Statistics NZ, 2016). In 2011, CPI inflation was driven by higher prices in the categories transport, food and housing, as well as due to a GST (indirect tax) increase (Tarrant, 2011).

The rise in the GDP deflator from 2002 to 2003 might be explained by higher prices for key exports such as milk, butter, cheese and meat as well as higher grain prices (Statistics New Zealand, 2010; 2011). It could be argued that these production and export price increases are only indirectly reflected in the CPI through final consumption expenditures while they have a larger impact on New Zealand’s nominal GDP and therefore the deflator. Secondly, the land and housing bubble might have caused stronger GDP deflator inflation. Land, for example, is not included in the CPI anymore, but it saw a significant price rise over the period from 2001 to 2007, especially in Auckland (Zheng, 2013). Also the commercial property investment boom with the total value of sales increasing from $2.87 billion (2001) to $7.13 billion in 2007 and the subsequent drop to $4.04 billion in 2008 might explain the large difference between inflation rates in 2007 (Colliers International, 2015).

New Zealand Inflation 2
(Source: World Bank, 2016; own calculations)

Figure 2 shows the inflation trend over the period together with the lower and upper bound of the Reserve Bank’s inflation targeting strategy. The log difference of the CPI and the GDP deflator are equal to the respective inflation rates. The logarithmic scale also ensures that the percentage changes have the same vertical distance on the scale so that one can (1) include the linear inflation trend bounds and (2) estimate linear trend lines for both the CPI and the GDP deflator. Overall, the CPI index has grown by 2.59 percent on average while the GDP deflator has risen by 2.52 percent on average per year.  The Reserve Bank has therefore been successful in keeping inflation within the band on average and in the long-run while often failing in the short-run as noted above. This short run failure in controlling CPI inflation likely stems from imported inflation as New Zealand’s domestic consumption falls largely on foreign goods which the Reserve Bank cannot control. Furthermore, it can be seen that the bank kept inflation more closely to the upper bound than the 2 percent inflation target midpoint in the long run.

The diagram also reveals that after 2008 the indices have fluctuated more from another. The GDP deflator overtook the CPI in 2009 and 2010 as well as in 2013 and 2014. While CPI inflation has come down closer to the 2 percent midpoint target since 2011, the GDP deflator has been taking off.

So that’s me for today. I hope this blog post shed light on key differences between the CPI and the GDP deflator and why inflation measured by the indicators can differ at least in the short run. This is important especially for small open economies such as New Zealand. The second part of the post showed that CPI and GDP deflator inflation rates in New Zealand differed significantly over the period from 2000 to 2014 which is not normally the case. For example, if you were to plot the series for Germany they would differ less, because (1) the country consumes more of what it also produces and relies less on imports and (2) is also a significantly larger economy. Finally, the post also looked at how well the Reserve Bank performed at targeting a CPI inflation rate of between 1 to 3 percent.

Thanks for reading!

Jasse


Colliers International (2015). New Zealand Capital Markets Report: New Zealand Unleashed Q2 2015. Auckland: Colliers International. Retrieved from: http://truecommercial.nzherald.co.nz/download/12940

Mankiw, N.G. (2008). Principles of Macroeconomics (5th ed.). Mason, O.H.: South-Western Cengage Learning.

Ministry of Business, Innovation and Employment (2015). Fuel industry in New Zealand. Retrieved from: http://www.consumerprotection.govt.nz/for-consumers/goods/fuel-quality-1/fuel-quality-monitoring-scheme-1

RBNZ (2009). Explaining New Zealand’s Monetary Policy [pdf]. Retrieved from: http://www.rbnz.govt.nz/-/media/ReserveBank/Files/Publications/Factsheets%20and%20Guides/factsheet-explaining-new-zealands-monetary-policy.pdf

RBNZ (2016). Official Cash Rate (OCR) decisions and current rate. Retrieved from: http://www.rbnz.govt.nz/monetary-policy/official-cash-rate-decisions

Sexton, R.L. (2016). Exploring Economics (7th ed.). Boston, M.A.: Cengage Learning.

Statistics New Zealand (2010). Slicing and dicing meat and poultry prices. Retrieved from: http://www.stats.govt.nz/browse_for_stats/economic_indicators/CPI_inflation/slicing-and-dicing-meat-and-poultry-prices.aspx

Statistics New Zealand (2011). Tracking milk prices in the CPI. Retrieved from: http://www.stats.govt.nz/browse_for_stats/economic_indicators/prices_indexes/tracking-milk-prices-in-the-cpi.aspx

Statistics NZ (2016). 100 years of CPI – Price changes 1994-2014. Retrieved from: http://www.stats.govt.nz/cpichanges/cpipricechanges/index.html

Tarrant, A. (2011). NZ CPI hits 21 yr high of 5.3% on rising petrol, food, housing prices, Stats NZ says; Even without GST hike, inflation above RBNZ band. Retrieved from: http://www.interest.co.nz/news/54451/nz-cpi-hits-21-yr-high-53-rising-petrol-food-housing-prices-stats-nz-says-even-without

Thoma, M. (2008, 3 September). The GDP Deflator and the Inflation Rate. Retrieved from: http://economistsview.typepad.com/economistsview/2008/09/the-gdp-deflato.html

World Bank (2016). World Development Indicators: New Zealand [Data file]. Retrieved from: http://data.worldbank.org/country/new-zealand

Zheng, G. (2013). The effect of Auckland’s Metropolitan Urban Limit on land prices. Wellington: The New Zealand Productivity Commission. Retrieved from: http://www.productivity.govt.nz/sites/default/files/research-note-mar-13-auckland-mul.pdf

New Zealand’s Output Gap and the OCR

Today my post is ECON101 stuff. It is going to be about output, unemployment, and Okun’s Law – one of the basic concepts in Economics – but in the context of New Zealand for the period from 2000 to 2014. In the second part of the post I will also dicuss the effects of the decrease in New Zealand’s OCR in March 2016. This is part of one of my assignments for Macroeconomics and therefore I take it as an opportunity to use it as content for today’s post!

So let’s look at the theory first. Okun’s Law states that there is a negative relationship between a country’s output gap and deviations from the natural rate of unemployment (NAIRU), i.e. unemployment higher than normal corresponds to a recessionary (negative) output gap and unemployment lower than normal corresponds to an inflationary (positive) output gap (Krugman & Wells, 2009).

In order to visualize this relationship for New Zealand for the time period from 2000 to 2014, the following inputs are needed:

  • The actual rate of unemployment and actual output from 2000 to 2014
  • The estimated natural rate of unemployment

New Zealand’s unemployment rate (ILO estimates) and its real GDP (constant 2005 US$) can be obtained from the World Bank database. In addition, its natural rate of unemployment comes from the Macroeconomics textbook and is estimated at 5.34 percent, which is the average unemployment rate from 1996 to 2006 (Krugman & Wells, 2009).

After having obtained these two data series and the natural unemployment estimate, potential GDP can be calculated as follows, where the unemployment rates are stated in decimals:
okuns law 1

okuns law 2.png
(Source: World Bank, 2016)

We are then ready to plot the results. The diagram above shows New Zealand’s actual GDP (constant 2005 US$) and potential output over time. One can see that from 2002 to 2008 potential GDP was below actual GDP. Since 2009 potential GDP has been above actual GDP. Overall, potential GDP has risen steadily over the period except from 2007 to 2008. Actual GDP has risen steadily over the period except from 2007 to 2009, i.e. one year less than potential GDP. The difference between actual and potential output was highest in 2007 ($2.07 billion) and lowest in 2012 (- $2.12 billion). Furthermore, the output gap can also be calculated as output gap as percentage of potential GDP and unemployment can be shown as the difference between actual and natural unemployment:

okuns law 3

Taken together, the diagram below highlights the negative relationship between New Zealand’s output gap and cyclical unemployment as stated in the beginning. If unemployment is below its long-term trend, New Zealand’s economy is overheating, meaning that it is running above capacity and experiences a positive output gap. Conversely, if unemployment is above its long-term trend, New Zealand’s economy is running below capacity and experiences a negative output gap.

okuns law 4.png
(Source: World Bank, 2016)

The diagram shows that New Zealand is now almost back at full capacity. In 2014, the recessionary output gap decreased to 0.27 percent of potential GDP. This trend is likely to continue in 2015 and 2016 and therefore the output gap is expected to become positive at some point in the near future. However, on 10 March 2016 the Reserve Bank of New Zealand decided to lower the Official Cash Rate (OCR) by 25 basis points to 2.25 percent (RBNZ, 2016). We are now ready to analyse what is likely to happen as a result of this intervention. Let me give you my answer first and I will explain it in depth: The lowering of the OCR will accelerate an overheating of the economy rather than accelerating a recovery from the 2008/09 recession.

In theory there are two possible scenarios; either New Zealand’s economy currently suffers from excess capacity or the economy is at its long run equilibrium close to its natural rate of output and unemployment. The ultimate effect of a decrease in the OCR will differ depending on these circumstances as shown in the panels (i) and (ii) below. In both scenarios a decrease in the OCR will initially increase aggregate autonomous spending (AE0) at any level of GDP. This assumption holds true, because intuitively a lower interest rate induces people to increase spending. The formal explanation is the following: either the opportunity cost of saving the money that people kept in their vault falls due to the fall of the OCR, because they do not earn as much interest as before and therefore go spend the money instead, or people can now borrow at a lower interest rate, which will render some unprofitable investments profitable, and will do so. Overall, the lowering of the OCR will both induce consumers and businesses to increase their autonomous spending. This will shift the planned aggregate spending line to AE’planned and the aggregate demand line to D’ in both scenarios. However, thereafter the outcomes differ.

Another important point I want to make on the go is that this is probably a re-run of the story of the early 2000s, where low interest rates set by the Federal Reserve (FED) triggered a housing boom in the US. A similar thing is happening in New Zealand; Auckland is at the forefront of this with skyrocketing house prices. But let’s get back to the theory for now.

Copy of Decrease OCR Income Expenditure Model (8)

In the first scenario New Zealand’s economy starts below its long-run equilibrium with excess capacity. The short-run aggregate supply curve (SRAS) is perfectly elastic, because firms can readily meet increased demand by scaling up production. This does not put inflationary pressure on the country’s price level P in this scenario, because there is an excess supply of labour (positive unemployment gap) and an excess amount of inventories, for example due to the earlier shortfall of aggregate demand in the global financial crisis (GFC). In this case, the lowering of the OCR pushes the economy back to its long-run equilibrium at point B where actual GDP is equal to potential GDP (Yn). The intervention of the Reserve Bank of New Zealand to lower the OCR by 25 basis points therefore has a positive long-run effect.

Copy of Decrease OCR Income Expenditure Model (7)

In the second scenario New Zealand’s economy is already at its long-run equilibrium (point A). This is the case when there is no output gap and unemployment is at its natural rate. An increase in the OCR in this scenario triggers a positive output gap coupled with an increase in the price level to P1 in the short-run because the short-run supply curve is not perfectly elastic in this case. As actual output increases to levels above potential output, unemployment falls below its natural rate and becomes relatively scarce in the economy (at least skilled labour). This will allow workers to bargain for higher wages. In the long-run firms will need to adjust by cutting back on their supply. They will be affected by the higher price level through the rise of input prices (labour, capital). This moves the economy back to its natural rate of output (Yn) at an even higher price level P3 (point C). Hence the decrease in the OCR causes an overheating of New Zealand’s economy in the short-run; thereafter further inflation and a contraction of GDP in the long-run. In this case, the intervention has no long-run effect on GDP; the short-run boost in actual output is not sustainable. What is more, the intervention likely to harm the economy due to the costs of inflation (distortions, e.g. for home-owners in the housing market; menu costs).

In summary, it can be argued that New Zealand is in the second scenario, because it is (1) close to its natural output level and (2) the unemployment rate has come down to 5.6 percent over the last two years. The lowering of the OCR will therefore do more harm than good. If this intervention had happened for example in 2011 or 2012, then the economy would have benefited from a faster recovery from excess capacity and an excess labour supply after the GFC. Now, however, this intervention is expected to trigger an inflationary output gap through channels like a housing boom. In the long-run this boom will be unsustainable. It is forecast to trigger inflation, a contraction of output, which is bringing GDP back to its natural level, and an increase in unemployment rates, which is bringing unemployment back to its normal level.

So that’s me for today. I hope you enjoyed the analysis,

Jasse


Krugman, P., & Wells, R. (2009). Macroeconomics (2nd ed.). New York, N.Y.: Worth Publishers.

RBNZ (2016, 10 March). Official Cash Rate reduced to 2.25 percent [online]. Wellington: Reserve Bank of New Zealand. Retrieved from: http://www.rbnz.govt.nz/news/2016/03/official-cash-rate-reduced-to-2-25-percent

World Bank (2016). World Development Indicators: New Zealand [Data file]. Retrieved from: http://data.worldbank.org/country/new-zealand

New Zealand’s Productivity Paradox

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.

New Zealand Productivity Paradox 1

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:

  1. Low population density
  2. Large share of primary/ agricultural goods in exports for an advanced economy
  3. Low export diversity compared to other advanced economies: New Zealand’s Export Diversification Index were at 2.28 in 2010 (IMF, 2014)
  4. 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:

New Zealand Productivity Paradox 2

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].

New Zealand’s Balance of Payments

Friday’s macroeconomics class was all about Trade and Capital Flows. After discussing international trade and Ricardo’s comparative advantage, we looked at a country’s balance of payments and its current & financial accounts. To finish off we analysed New Zealand’s BoP. As the data was a bit dated I decided to reproduce the analysis based on Statistics New Zealand’s most recent statistics. We also have a class test coming up, so it’s a good exercise, I guess!

Let’s take a closer look at New Zealand’s overall balance of payments as percentage of nominal GDP. (I decided to use nominal instead of real as I don’t think the BoP statistics are in real terms.) New Zealand’s current account balance has been consistently negative over the period from 2000 to 2015. The capital account balance is negligible except from 2011. This spike was triggered by the Canterbury earthquakes in September 2010 and February 2011. So these capital transfers are “reinsurance claims on non-residents associated with the exceptional Canterbury earthquake events” (Statistics NZ, 2011, p.4). Financial accounts have been positive over the last 15 years with the exceptions being 2011 and 2014.

New Zealand Balance of Payments

The second diagram is a close-up of the current account balance. It reveals where the current account deficit comes from. While New Zealand has been running a steady services surplus and also a merchandise trade surplus in some years, this is largely offset by high outflows of primary income. So the key to the country’s large current account deficit is its net international investment position.

Primary income is defined as:

  • Earnings from providing capital (company profits, dividends from shares, interest from lending money)
  • Wages/ salaries from providing labour (Statistics NZ, p.7, 2015)

The driver is the former though. There are many foreign-owned firms in New Zealand and hence there has been an excessive amount of primary income earned from foreign investments in New Zealand compared to New Zealand’s primary income from abroad over the last couple of years.

New Zealand Balance of Payments Current Account

The financial account is the counterpart. New Zealand has been running a financial account surplus in most years. This is intuitive as the BoP should ultimately balance. (Not to mention the considerable net errors and omissions here.) To finance the country’s current account deficit New Zealand borrows from overseas more than it lends (McDermott and Sethi, 2015). In particular, the main drivers are portfolio investment liabilities and direct investment liabilities for 2015. In comparison, New Zealanders are investing abroad, most importantly in portfolio investment assets, but there is still a net inflow of investment into the country.

New Zealand Balance of Payments Financial Account

So what can be done about New Zealand’s BoP? Well, my prof said go to your online banking account and buy a share in the foreign-owned banks (for sure a great not so serious advice). But that’s me for the day! The data for my analysis was taken from Statistics New Zealand and my spreadsheet can be found here: New Zealand Balance of Payments. This was a personal exercise and I do not recommend anyone reproducing my results without checking the analysis.

Thanks for reading!

Jasse


 

C. John McDermott and Rishab Sethi. ‘Balance of payments – What is the balance of payments?’, Te Ara – the Encyclopedia of New Zealand, updated 28-Oct-15
URL: http://www.TeAra.govt.nz/en/diagram/23954/elements-of-the-balance-of-payments

Statistics NZ (2011). Impacts of the Canterbury earthquakes on New Zealand’s international accounts. Wellington: New Zealand Government.

Statistics NZ (2015). Balance of Payments and International Investment Position: December 2014 quarter. Wellington: New Zealand Government.