Brian Fallow: We're busy bees but unproductive ones

Productivity isn't everything, but in the long run it is almost everything, said American economist Paul Krugman.

A country's ability to improve its standard of living over time depended almost entirely on its ability to raise its output per worker, he said.

In that context the latest report card on the economy, Economic Development Indicators 2005, compiled by the Ministry of Economic Development and Treasury, makes sobering reading.

We rank only 20th among 30 OECD countries in per capita gross domestic product and 21st when allowance is made for the 5 per cent of GDP which does not belong to us but to the foreign suppliers of capital.

What that reflects is a low level of labour productivity or output per hour worked.

It is the legacy of a long period of slow growth in productivity compared with other developed countries. While the growth rate has improved in recent years (to around 1.3 per cent on a five-year rolling average) it remains in the bottom half of the OECD and significantly below United States, Australian and British rates.

Part of our relatively low labour productivity might be the result of strong growth in jobs in recent years, as the absorption of less productive workers into the labour force lowers average productivity. By contrast France, which has very high rates of hourly productivity, has high unemployment and a 35-hour week.

But that can only be part of the explanation, the report says, pointing to Australia's ability recently to combine strong growth in both labour utilisation and productivity.

New Zealand firms are "capital shallow"; that is, the amount of physical capital such as computers, plant and machinery their staff have to work with is relatively low for a developed country.

For a period between 1992 and 1996 growth in capital per hour worked declined markedly, suggesting that the combination of high unemployment in the early 1990s and the Employment Contracts Act made hiring a cheaper option than investment.

"With the labour market now tight, skill shortages and wage increases should provide an incentive to invest more heavily in capital - at least in those industries where capital and labour are substitutes," the report says.

Since 1996 the capital-to-labour ratio has been improving again but not nearly as fast as in Australia, for example.

Between 1987 and 2003 rates of business investment as a share of GDP were in the lower half of the the OECD for all but three of those 17 years.

One reason, the report's authors suggest, could be the cost of capital as real interest rates in New Zealand are generally higher than in comparable countries - though the differential has been reducing.

"However, New Zealand's real interest rates are only marginally above Australia's and the cost of capital does not appear to have held back investment there."

New Zealand firms' reliance on bank debt, rather than equity or corporate bonds, is high by OECD standards.

The problem with that, the report's authors suggest, is that capital markets are important for growth as they are better suited than banks to dealing with uncertainty, innovation and new ideas because they allow for a diversity of opinion.

Another factor inhibiting business investment could be our relatively low level of "multi-factor productivity" - roughly, how effectively labour and capital are used - since that depresses returns on capital investment.

This reinforces the need to focus on policies to lift multi-factor productivity, through increasing innovation and improving human capital and skills.

Innovation is a slippery thing to measure.

The report cites evidence that New Zealand firms are introducing new products and processes at a rate similar to European firms, but there is little comparative information on the quality of these innovations or their productivity impact.

On other measures, the amount of research and development spending by businesses and the issuance of patents, we still rank at the relegation end of the OECD league tables, although we are improving.

Business accounts for only 27 per cent of R&D activity, with the public sector doing the rest (though part of that is with business funding).

While linkages between businesses and Crown Research Institutes appear reasonable, links with universities are less strong.

Given that the overwhelming majority of the world's innovations are generated overseas, adopting and adapting them is arguably more important than the generation of new knowledge.

One indicator of how we are doing in that respect is rates of investment in information and communications technology (ICT).

Unhappily, recent work by the OECD and Statistics New Zealand suggests ICT investment as a proportion of business investment overall is relatively low, though, like everyone's, increasing. We rank 14th out of the 19 countries they looked at.

But on another indicator relevant to innovation and productivity we don't look so bad.

This is the churn of enterprises, the rate at which new firms are set up and others disappear.

New entry is a rough indicator of entrepreneurial activity and can spur existing firms to innovate and invest in productivity-boosting ways.

Likewise exits are a rough indicator of the vigour of competition.

New Zealand firms' entry and exit rates are at the high end of the OECD range although not much different from the US or Britain.

Survival rates of new firms are towards the higher end of the range.

But the rate at which they generate new jobs is closer to Europe than the United States, which is troubling.

On the skill and education front the indicators are mixed.

By some measures, like the average number of years spent in the education system and the proportion of the adult population with tertiary qualifications, New Zealand compares well with other developed countries.

But still 15 per cent of children leave school with no qualifications and for two of the three forms of adult literacy the OECD measures we are below par.

All in all, then, this benchmarking exercise gives little ground for complacency.

Clearly part of the productivity challenge facing firms is to boost capital investment. Forthcoming tax changes to allow faster depreciation of short-lived assets such as computers should help. A lower company tax rate wouldn't hurt, either.

And while it should not be necessary to repair such shortcomings of the nation's schools, money spent on adult literacy and numeracy looks as though it should pay dividends.