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:
- 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.
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