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. 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. 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
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:
- 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.
- Direct large investments in infrastructure would also work as a direct increase in capital;
- 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;
- 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.