Wednesday, September 17, 2014

Comments on Economic Policies for 2014 New Zealand's Election

My former colleagues at the Reserve Bank of New Zealand, Sean Collins, Francisco Nadal De Simone and David Hargreaves wrote a very informative Bulletin article in 1998 about the current account imbalances in New Zealand.[1] Economists at the RBNZ were also concerned about our relatively high real interest rate. In 2005, my colleagues at the New Zealand Treasury, Julia Hall and Grant Scobie wrote about the problem of shallow capital in New Zealand.[2] These issues are just as important today as they were then, and they are highly related to the current election's debates. 

The law of diminishing returns implies that the marginal product of capital, which is equal to the rate of return on capital investment in the long run, is relatively higher in the less productive country. Given that capital is freely mobile across borders, the neoclassical model of growth and trade predicts that capital investment flows from the relatively more productive country to the relatively less productive country until the capital-labour ratios, wages and returns (real interest rates) are equalized.

New Zealand is relatively less productive than Australia and G7 countries. One reason that GDP per worker is relatively low is that we have relatively less capital to work with. Thus, the marginal product of capital is higher in New Zealand than in Australia and in the G7 countries. Thus, the rate of return on capital investment in New Zealand is relatively higher. Relatively capital rich countries must find investments in New Zealand attractive. This is consistent with the data. We have relatively lower output per worker (thus relatively lower labour productivity), a lower saving rate, a smaller capital stock, a higher real interest rate, and a persistent current account deficit.

Suppose that both Australia’s and New Zealand’s output per worker can be represented by a simple Cobb-Douglas production function, where output per worker is a function of capital per worker raised to a power, which is the share of capital in output, y = Ak^b, where y is output per worker, A represents exogenous technological progress, k is the stock of capital per worker, the hat symbol means that the variable is raised to the power, and b is the share of capital. The marginal product of capital is then equal to the return on capital r= b A k^ (b-1). Re-writing this in terms of output per worker, we would have r= b A^(1/b) y ^ (b-1/b). Australia’s real GDP per capita in 2010 was 1.45 times larger than ours, and thus the marginal product of capital in New Zealand relative to Australia’s is approximately (1.45)^(b-1/b). If we assume that the share of capital is 0.4, our marginal product of capital is 1.8 times more than Australia’s. It follows that the Australians invest more than New Zealanders.

The same is true for the G7 countries. I computed the same ratio for all the G7 countries relative to New Zealand. The Penn Table publishes the chain GDP per capita PPP-adjusted figures for 2010. I used these figures to compute the relative rates of return on capital. The estimates for New the Zealand’s rates of returns on capital relative to France, Germany, Italy, Japan, the U.K., and the U.S. respectively are 1.52, 1.51, 1.46, 1.51, 1.26, 1.47, and 2.0. These relative rates of return on capital imply that investment flowing into New Zealand from these countries must exceed New Zealand’s investment in them, with the U.S. and Australia being the largest investors in New Zealand.

Further, the level (and the growth rate) of human capital in New Zealand are similar to that of Australia’s and the G7 countries. Human capital level as estimated by Barro and Lee is the average years of schooling, which is approximately the same in New Zealand, Australia, and every G7 country. Average years of schooling in 2010 were 12.1, 11.37, 10.53, 11.82, 9.50, 11.52, 9.59, 12.2, and 12.69 for Australia, Canada, France, Germany, Italy, Japan, U.K., the U.S., and New Zealand, respectively. These numbers indicate that differences in technological progress or human capital are not large enough to affect the model’s prediction that investment will continue to flow from Australia and the G7 countries to New Zealand, until at some point the capital/labour ratio, wages and the rates of returns equalize. This can take decades.  

Foreign investment in New Zealand will diminish as the relative rate of return on investment approaches one. This means that foreign investors are indifferent between investing in New Zealand or in his or her own country. This simple model predicts that for this to happen, output per worker in New Zealand must increase relative to the other countries. Productivity is the key to resolving all these issues.

The 2014 elections in New Zealand produced many ideas, which aim at resolving New Zealand’s productivity problem. Proposed policies, which I believe could alleviate the imbalances mentioned above in the long run include:

  1. Compulsory savings may increase capital and productivity. They also reduce the marginal productivity of capital and the rate of return on capital in the long run. They may also resolve the current account imbalance and change the international investment position of the country over time.
  2. Direct large investments in infrastructure would also work as a direct increase in capital;
  3. Investment in knowledge such as via increasing the quality of human capital and R&D may increase growth because they boost technical progress as well as increase and speed-up the diffusion of new knowledge;
  4. Encouraging manufacturing, especially environmentally-friendly manufacturing may also help as it has been the driver of all successful growth experiences around the world. Example may include encouraging the manufacturing of high value added exportable goods rather than exporting row materials.
Policies, which aim at reducing immigration are seriously misguided and they would adversely affect productivity growth. Expanding the labour force via immigration, especially if immigrants are well educated, increases productivity by raising the probability of finding new ideas, which are essential for growth. Similarly, policies that aim at restricting international trade would be unhelpful. Monetary policy has nothing to do with long run growth so changing the Reserve Bank Act would be a useless policy and may endanger the preconditions of higher growth, which unavoidably include price stability. 

Thursday, September 11, 2014

The Minimum Wage and the 2014 New Zealand’s Election

Yesterday we listened to the debate between the Prime Minister and David Cunliffe on TV 3. The leaders spoke at length about the minimum wage. The Prime Minister’s story that the increase of the minimum wage would increase unemployment and that would actually make us worse off.  He said that the correlation between the minimum wage and the unemployment rate is positive. Put simply, a rise in the minimum wage of $2 would increase the cost of production for small businesses. In turn, they either reduce employment or pass the cost’s increase to consumers by raising prices. This is the typical textbook argument. 

My colleagues Dean Hyslop and Steven Stillman, both professors of labour economics at leading New Zealand universities, studied the youth minimum wage in New Zealand. It might be worth restating their findings . They say, "we find no robust evidence of adverse effects on youth employment or hours worked. In fact, we find strong evidence of positive employment responses to the changes for both groups of teenagers, and that 16-17 year-olds increased their hours worked by 10-15 percent following the minimum wage changes. Given the absence of any adverse employment effects, we find significant increases in labour earnings and total income of teenagers relative to young adults. However, we find some evidence of a decline in educational enrolment, and in unemployment inactivity, although these results depend on the specification adopted."

In another paper on the issue, which they examined the 2008 youth minimum wage reform, they say," The study found that the introduction of the New Entrant (NE) minimum wage was largely ignored by businesses and that most 16 an 17 years old workers were moved on the adult minimum wage, which resulted in an increase in the minimum wage of 28 percent of this group. This research found that the minimum wag increase accounted for approximately 20-40 percent of the fall in the proportion of 16 and 17 years olds in employment (4,500 - 9,000 jobs) by 2010. The introduction of the NE minimum wage did not have a significant impact on unemployment, because most of the 16 and 17 years old impacted were students who were combining study with part-time employment." 

I have no doubt that both the Prime Minister and Mr. Cunliffe care about jobs, want to put people to work, and provide them with decent wages. They have the same objective (same preferences), but different policies (different budget constraints) to achieve it. However, the fact is that there is an empirically significant relationship between wages, productivity and unemployment; i.e., the Wage Curve, which has been ignored in the debate. I have shown in a previous blog that there is a significant correlation between the real wage rate-labour productivity wedge and unemployment.

However, I want to provide an alternative, appealing, interventionist or activist, policy proposition, which might encompass both of the PM and Mr. Cunliffe’s views. It is appealing because it accounts for productivity, wages and unemployment. The Economics Nobel Laureate Edmund Phelps argues that the government can subsidize low-wage employment, by paying employers for every full-time low-wage worker they hire, and calibrate the subsidy to the employee’s wage cost to the firm. The higher the wage cost, the lower the subsidy, until it has tapered off to zero. With such wage subsidies, competitive forces would cause employers to hire more workers, and the resulting fall in unemployment would cause most of the subsidy to be paid-out as direct or indirect labor compensation. People could benefit from the subsidy only by engaging in productive work – that is, a job that employers deem worth paying something for.