David Skilling: Full steam ahead into tricky overseas waters

David Skilling

The New Zealand economy has generated strong economic growth over the past 15 years, with growth rates higher than in previous decades and that compare well against countries such as Australia and the United States.

The challenge now is to build on this and to look ahead to the sources of economic prosperity: to move from good performance to great performance.

This is a significant challenge because, despite strong recent economic growth, New Zealand's per capita income ranks 21st out of 30 OECD countries and remains over a quarter lower than in Australia. New Zealand's per capita income is well below the OECD average because labour productivity (the amount of value produced for each hour worked) is just 79 per cent of the OECD average, which more than offsets the relatively high level of hours worked per capita.

And it is not clear that the present course and speed will deliver economic growth over the next 15 years at the level generated over the past 15 years. This is because key drivers of recent growth are not sustainable at their current levels.

Two-thirds of the economic growth generated since 1990 has been due to growth in hours worked, as unemployment has reduced and labour force participation has risen.

Only one-third has been due to labour productivity growth. Our productivity growth rate of 1 per cent over the past 15 years is in the bottom quartile of OECD countries.

Indeed, the country has only maintained its relative income position since 1990 by working more hours to almost exactly offset its declining relative labour productivity level. This is not a sustainable way to proceed.

This means that the way in which growth has been generated since 1990 will not be sufficient to deliver the type of economic future that many people aspire to, characterised by high and growing incomes and world-class opportunities. Having the lowest rate of unemployment in the OECD is cause for celebration, but New Zealand now needs to build on this achievement by raising labour productivity.

Substantially higher labour productivity growth will be required just to maintain economic growth rates at their average rate since 1990. And to move into the top half of the OECD by 2020 will require additional labour productivity growth.

These are demanding goals in the context of historical productivity performance. But the good news is that countries such as Ireland, Finland and Australia have turned in performances at these levels over the past 15 years.

New Zealand needs to chart a course between complacency and fatalism.

We cannot afford to become complacent on the back of our recent strong economic performance, because it cannot be sustained. Neither should we adopt the fatalist view that achieving demanding productivity goals is beyond us. Other small countries have demonstrated that it is possible to do this.

The key question, then, is what are the priorities for action to generate this improvement in labour productivity growth? Why is New Zealand's income level still so much lower than in most other OECD countries? One obviously distinctive feature of New Zealand is its combination of a small domestic market and remoteness from other major markets.

There is a well-documented link between the effective size of a market and productivity. And so there is good reason to believe that the relatively small scale of the local market has acted to persistently constrain labour productivity growth.

That small scale reduces the incentive of firms to invest and means that some types of economic activity are not feasible here.

A lack of scale also reduces the intensity of competition, lessens specialisation and means that there is less scope for productive firms to grow. This is an important reason why the policy reforms have not led to even greater economic gains than they have.

In this context, expanding the effective size of the market through increased international economic activity, in terms of firms exporting and investing abroad, becomes vitally important in achieving substantially higher productivity growth. The domestic market is too small to generate and sustain significantly higher growth rates without a much greater proportion of national income coming from international activity.

Of course, increasing growth is about getting many things right, including addressing issues around infrastructure, savings, tax, education and so on. But policies that increase the efficiency of the domestic economy need to be coupled with a clear focus on international engagement so that the productivity gains from domestic policy changes can be leveraged across a much larger market.

As we have seen over the past 15 years, policy change without an increase in international activity does not deliver the sustained productivity growth needed.

The key to substantially raising labour productivity, then, is to take the economy to the world. We have spent the past 20 years increasing the efficiency of the domestic economy. But in order to move the economy forward over the coming decades, we will need to take it to the world and work towards having many more firms competing successfully in international markets.

The priority now is to substantially increase the extent of New Zealand's international economic activity. Efforts are under way in this area, but they are not sufficient.

The vital importance of this issue to our economic future, combined with the low level of international economic activity, means that additional action and real seriousness of purpose are required from business and the Government.

* Dr David Skilling is the chief executive of the New Zealand Institute, a think-tank comprising business, community and education leaders.