Monday, August 11, 2014

The Rock Star Economy

More than ten years ago, I was flying from Wellington to Auckland and the man sitting next to me began a friendly chat. He was a farmer in his seventies. He asked me what I do and I said that I am an economist, which encouraged him to ask questions about the New Zealand’s economy. He said so what is the main problem with our economy? I said, well, the numbers suggest that we, as a nation, are not very productive compared to others. He wanted details.

I told him that one day I was flying from Honolulu to Auckland and an old fellow sitting next to me was a rich native Hawaiian American who was coming to New Zealand to play golf. The Hawaiian asked me, very bluntly, if we are lazy. I was taken by a surprise by his question. He noticed, and replied that Hawaiians are lazy because Hawaii is a beautiful place. People like to enjoy the sun, the warmth so they forget about work. He said, New Zealand must be just as beautiful as Hawaii and that he assumes that we are just as lazy. I said if you mean we are not as productive as our neighbors the answer is yes. The Kiwi farmer acknowledged. So what do we do, he said. I said it is hard to explain all that in a layman term. But let’s think about your dairy farm. Suppose that you produce milk and sell it to the rest of the world at a dollar a bottle. If you produce two bottles, your income would be two dollars. Suppose that the Chinese, the Europeans etc like you milk very much and they ask for more. Without you producing more, the price of your milk goes up, say to two dollars a bottle. Your income is four dollars now. He nodded in agreement. Income doubled while you still produce two bottle of milk. You production has not doubled. That increase in income is a result of higher prices and has nothing to do with productivity. Economists call it the term of trade effect. He fully agreed. Then where is the problem? The problem is that when the rest of the world reduces its demand for our milk for whatever reason, your income will plummet. He asked so what do we do? I said in my wild imaginations I reckon that you have to do something to increase the real value of your milk. How? He added. I said maybe you want to produce milk that when you and I drink it we get younger!

Useable Knowledge can do that as Simone Kuznets discovered. Research that can transform milk into a magical product increases its value. Products change everyday. Newer products are more valuable. The smart phones we use are made of some cheep plastics and metals that are not worth much, but we pay a lot to buy them. We do so because we pay for the knowledge, which is used to make them. The Kiwi farmer agreed. He said he would like to drink that milk that makes him twenty years younger.

A highly educated CEO of a major government department told me that many OECD countries, which are more productive than New Zealand, are richer than New Zealand so for us to increase productivity we ought to be rich. Stunning, isn’t it? While the Kiwi farmer understood the difference between a term of trade effect and productivity effect, the CEO did not, unfortunately.

That brings me to a phrase we hear a lot today, “we are a rock star economy.” Our income has increased perhaps, but it will also decrease tomorrow when the price of milk falls. The metric for a rock start economy is a secular economic growth, not an increase in income due to a temporary higher demand for milk. The road to riches requires more production of new goods and services. And, that requires usable knowledge.

I do not know what is meant by a rock star economy, but I take as it means a spectacular economic performance. The fact that the unemployment rate is 5.6 percent is good news. However, this is still a cyclical fluctuation around a “natural Rate of Unemployment”. It is far away from our estimate of the Natural Rate of Unemployment, which is between 4 and 4.5 percent.

The Natural Rate of Unemployment is unobservable. It is a hypothetical rate that is consistent with production being at its long-run level.[1] The recent fall in the unemployment rate is also consistent with the fact that productivity is higher than real wage, at the margin, and over the current business cycle. Firms hire workers as long as the marginal productivity of labor is higher than the real wage, so unemployment falls. Firms stop hiring workers when the real wage is equal to productivity and layoff workers when marginal productivity is less than real wage.

Calls to increase wages arbitrarily – without any considerations to productivity – is not a good economic policy; it sounds like it is politically and election-driven calls. Wages will increase naturally because they are below productivity now, and when the real wage is equal to productivity, hiring will cease, and the fall in unemployment comes to a stop. Presumably, that will have to happen when the unemployment rate drops to 4 or 4.5 percent.

How far are we from 4.5 percent unemployment? The time to get there depends on how fast the labor market adjusts. When the unemployment rate was 6.9 percent in December 2012 my estimated speed of adjustment implied that it would take up to 10 quarters for the unemployment rate to reach the Natural Rate. So it took a year and a half for unemployment to fall by 1.3 percentage points (from 6.9 to 5.6). Everything else remains the same, the unemployment rate is expected to drop to 4.5 (another 1.1 percent) in a year time. During this period, the average real wage will continue to rise until it is equal to labor productivity.

A further drop in milk prices will make the labor market adjustment slower. As income falls, business activity slows, and the hiring rate slows. The demand for labor will fall; but that is only one problem. If everything in the economy hinges on milk prices, we will see more problems in other markets.

Here are some statistics, which are related to my main concerns. The 2013-2014 global competitiveness index published by the World Economic Forum is based on 12 pillars: (1) the soundness of institutions, (2) infrastructure, (3) macroeconomic environment, (4) health and primary education, (5) higher education and training, (6) goods market efficiency, (7) labor market efficiency, (8) financial market development, (9) technological readiness, (10) market size, (11) business sophistication, and (12) innovations. Under each pillar, there are a number of indicators, more than 80. New Zealand ranks 18 after Switzerland, Singapore, Finland, Germany, USA, Sweden, Hong Kong, Netherlands, Japan, UK, Norway, Taiwan, Qatar, Canada, Denmark, Austria, and Belgium. Australia ranks 21. Our ranking has jumped up five places, which is great. The report says, “New Zealand emerges as an economy with a strongly articulated political commitment to environmental stewardship better than neighboring Australia.” We have done very well in many pillars and according to many indicators.

However, we still have problems. We rank 27th in infrastructures; 43rd in macroeconomic environment; 24th in technological readiness; 62nd in market size; 26th in business sophistication; and 26th in innovation.[2]        

It seems to me that the New Zealand’s market size is the main reason for New Zealand’s overall ranking. Market size along with pillars (5) to (10) above are keys for efficiency-driven economies. New Zealand domestic market size ranks 60th and its foreign market size ranks 74th. Competition fuels innovation. We rank 30th in terms of the intensity of local competition. We ought to focus on issues related to efficiency and increasing market size.

[1] W. A. Razzak, “New Zealand Labour Market Dynamics: Pre- and post-global financial crisis,” Treasury Working Paper 14/03. Many others, e.g., Brain Silverstone, have also estimated the Natural Rate to be lower than current unemployment rate.  See references in my paper.