Rock Star Economy 2014

HSBC economist Paul Bloxham has been doing the rounds saying New Zealand is on track to be a Rock Star Economy in 2014. What does this mean?

Well, unemployment is falling, businesses are investing more, wages are growing and the minimum wage is still going up automatically at a rate higher than underlying productivity growth for low skill workers.

Our terms of trade are increasing significantly which means cool stuff which isn’t made in New Zealand is easier to buy. It also means that imported inputs for high value add production processes are cheaper.

What happens if the NZD reaches parity with the AUD? Manufacturers will hurt. But if they’re actually hurt by currency fluctuations to the point where they earn no profits and are depleting capital to stay in business, it’s time to call in the liquidators.

Manufacturing firms have faced a floating exchange rate since 1984. They have had every opportunity to invest in better business processes, staff training, automation or simply building a world class product that is priced to maximise value extraction and not on a 19th century “cost plus” dumb bugger pricing strategy.

So a key part of the rock star economy will be creative destruction of firms that have failed to get with the 21st century. This obviously includes a lot of SMEs that still don’t have websites or respond to emails requesting quotes promptly.

When it comes to telling macroeconomic stories, prediction is impossible, anything could happen, but we should bear in mind that the negative stories are more believable because they are rooted in fear.

So instead of moaning about things and why the system is evil, identify opportunities and take advantage of them. They exist, they are there for the taking and they won’t stop arising because of a change of government.

Why Are We Happy With 3-4% Economic Growth?

Canterbury is on track for growth of about 6% in 2013, down from over7% in 2012, but New Zealand as a whole is on track for almost 4% growth in 2013.

The two-speed economy is in full swing, but the recovery hasn’t started for a lot of people. Larry Summers was onto something when he suggested that very high economic growth – possibly bubble territory – is necessary to enable high levels of employment and economic achievement in an age where average is over.

Why are we happy with 3-4% economic growth? There are so many projects in this country that should be going ahead – but are not because of red tape and risk aversion on the part of potential backers – that could easily see economic growth look like Canterbury for the whole of the economy including the regions in 2014.

It is an unsurprising indictment of central planning we are witnessing in Christchurch. It should be considered a national embarrassment that it has taken a few years to get to the point of recovery where things are finally looking like Christchurch can be rebuilt before I’m retired.

But the real tragedy of all of this is that no one is talking about the opportunity cost. Everyone from John Key down has fallen for the broken window fallacy – all of the resources expended in rebuilding Christchurch are simply getting Christchurch back to where it was before the earthquakes. If only “net new” investment and activity was as bold as it should be, and silly buggers had thought about supply and demand before calling loans in on needed housing developments, a lot of our problems as a society over the next few years would be a walk in the park to solve with the amount of money flowing around now.

Import-led growth and the productivity divide

Aaron Schiff writes about how the ratio of productivity between a 90th percentile firm and 10th percentile firm can be as much as 9.

This means that there are a lot of relatively unproductive firms that are surviving in New Zealand. Aaron argues that these firms are unlikely to bother going head-to-head with a firm selling a similar product from Denmark and thus New Zealand could be in a “low-competition, low-productivity, low-trade equilibrium”.

This is linked to the fact that most New Zealand firms do not have websites, use email or make online ordering easy for customers. These firms will die out because they are probably owned and operated by older people who have been able to tick along in an industry where they’re not facing ruthless global competition.

There are high returns to getting on a plane, renting a firm apartment in a target city and getting boots on the ground. Face-to-face is still how the world works, but I think we need to link both strategies together.

A firm at the 90th percentile of productivity in an exporting industry should not only have fully embraced the potential of doing business on the internet, but have a footprint in key export markets.

This means if you’re selling more than $1 million a year to a particular country, on say a 20% margin, you need to be building on that aggressively for the first few years you’re in that market.

It also means that language skills are becoming more valuable. English might be the language of business, but in 2013, knowing other languages simply makes doing business across borders even easier.

There are a lot of pieces to the puzzle but e-commerce and competition in whatever industry you’re working in is a good place to start.


Why Wellington Won’t Become A Backwater

Wellington has a unique position within New Zealand. It’s the transit point between the North and South Islands, but most importantly it’s the nation’s capital.

Because of this, Wellington won’t become a backwater. It’s simply impossible for that to happen because of the money being made by people connected to the public sector.

The technology industry and creative industries also have a strong foothold. Whether it’s a craft brewery or technology start-up, Wellington is the place to be if you don’t want to live in Auckland.

And there’s the rub – as Wellington’s economy adds more high skill jobs and formerly secure middle income roles are automated or outsourced, the income inequality already evident will increase even further.

I think Wellington will do just fine over the coming decades. But only if you are a high skill worker, or connected to the public sector in some way, shape or form.

For the masses of people not fortunate enough to benefit from this, Wellington will become a very tough place to live and raise a family. The baby boomer elite have pulled the ladder up after themselves.

One day, enough people will become angry enough to make some changes. Until then, don’t expect anything to change. The permanent government will always think of itself before it thinks of others. And that’s their greatest flaw.

How Picking Winners Misses The Point

The government thinks that targeted subsidies, tax credits and policy will take our economy to the next level. But picking winners – this includes industries – misses the point behind why we have fewer start-ups than we should have for a country supposedly with a No-8 wire mentality.

The biggest obstacle to starting a business is not having any money. Working backwards from that, an economy that delivers consistent increases in the cost of living alongside negligible increases in real incomes is the root cause of a lack of entrepreneurial drive leading us out of the biggest setback to our economy since the Great Depression.

It would be awesome if all business ideas could be bootstrapped from an untapped credit card balance, but the sort of technology ideas that is possible with won’t lead to massive net job creation.

Technology start-ups will deliver a lot of high skill jobs and some lower skill support roles. But nowhere near enough to create dozens of new cottage industries that will employ the 175,000 unemployed marginal workers.

When the government focuses on spending money directly on financing R&D they’re admitting failure. If the economy functioned properly – rising incomes, falling costs and an ability for the average household to experiment with entrepreneurship without signing over their entire asset base – there’d be no need for technology grants and the like.


Increase The Retirement Age Now

 I don’t think baby boomers realise what current trends in emigration, average tax paid, average transfer payment received and attitudes towards older people will converge to.

The inability of people to perform basic math means that we’ll never have entitlement reform.

The government will borrow from overseas to pay people who are no longer working.

Many of these people never worked a day in their lives. Many more will live to a very old age and receive far more in taxes that they or their children will ever pay.

And wealthier couples who sell their $800,000 villas in Auckland and retire to the Bay of Islands will keep getting superannuation even when they could live comfortably off the interest or dividends their capital would provide.

This isn’t about political ideology – it’s a mathematical imperative that there are some restraints put on the exploding cost of superannuation before we turn into Greece.

But because we have cast our lot at the foot of universal suffrage, the political reality is that nothing will ever change.

It’s New Zealand, we’ve been on a trajectory of decline since the 1950’s and we’re never going back up the OECD rankings in anything.

The current level of Kiwisaver contributions are so pathetic that the relief they will provide to future governments in reducing superannuation payments based on the level of assets you have will barely dent the cost.

How can the 2020 government possibly reduce their debt or keep rolling it over through issuing more debt when faced with the likelihood of riots in the streets?

Get ready for lower living standards everyone! We’ll shoot through the Reinhart-Rogoff debt/GDP lower growth threshold faster than any other developed country!

Premature Tax Cuts Lead To Debt Blowouts

Premature tax cuts started back in 2005 with Working for Families. That was a tax cut because it is social policy administered by Inland Revenue. This turned a substantial number of net taxpayers into net beneficiaries – they received more in Working For Families payments than they paid in taxes.

When the National government was elected, they did not remove Working For Families tax credits, which had already significantly reduced net government revenue. They then implemented a program of income tax cuts lowering the top rate of tax on income over $70,000 to 33%.

This program of tax cuts was carried out on the basis that it would stimulate the economy and create new jobs. It was even argued that these tax cuts were “revenue neutral”. This has not happened as evidenced by the 13 year high in unemployment and billions of dollars in additional deficit borrowing. Before the massive shock of the Christchurch earthquakes, the government was already on a pathway to higher long term debt.

There are several problems with higher government debt. Reinhart and Rogoff (2011) found that over debt-to-GDP levels of 90% are related to poor economic growth. One key problem for New Zealand is that once a threshold of 60% debt-to-GDP is reached, growth declines by ~2%. New Zealand is currently growing at less than that. Reaching that threshold of debt-to-GDP ratio could conceivably lead to a recession.

Other costs associated with higher government debt include the crowding out effect. There is a limited amount of capital available for New Zealand borrowers. When the government borrows more, the sovereign guarantee means that it is preferable to buy government debt over corporate debt. With the Local Government Authority issuing its own debt, it is even harder for firms to raise capital in the debt markets.

When firms find it harder to raise debt or equity capital, investment is delayed or put off indefinitely. Because investment is a key driver of economy activity and leads to substantial job creation, lower investment is terrible for New Zealand in the long run. There are also major concerns over arguments that a “multiplier effect” exists when the government spends money. The money has to come from somewhere, and we know that each dollar collected in tax costs the economy at least $1.30 according to Treasury analysis.

Is it possible to estimate how much premature tax cuts might have cost the New Zealand economy? The IRD attempts to do so in their Briefing to the Incoming Revenue Minister in 2011.


What if we look at GDP figures for each of these years and figure out how many millions of dollars in additional borrowing has been incurred by the government solely because of Working for Families and the tax cuts program?


At the end of June 2012, sovereign guaranteed debt was equal to $75.7 billion dollars. If we take this $32 billion dollar estimate of net revenue lost because of premature changes in fiscal policy as given, that means almost half of government debt wouldn’t be there if the changes hadn’t been implemented.

Many people who complain about “tax cuts for the rich” have missed is that it’s not just the tax cuts that have reduced net revenue had accelerated budget deficit blowout – it’s a system that produces the absurd marginal tax rates shown here:

While New Zealand has tried to pursue a mixture of deficit spending and cost cutting, the revenue side of the equation has been rundown significantly. Another problem is that the recession is leading a lot of poorly managed businesses to run up massive tax debt that they have no hope in paying.

How much of that will have to be written off? Putting all ideological debate about whether lower taxes are good for growth or not aside, the National government is refusing to take steps to shore up the financial position of the government.

They are setting up the framework for a Greece-style situation to happen in New Zealand. A rising population, meagre national wealth, high overseas debt and tax revenue falling further as emigration rises will all combine to create a catastrophic debt crisis in 10-15 years time.

Any attempt to smooth over the debt figures with talk of “net debt” is PR spin. In order for “net debt” to hold, the debt must be rolled over continually or new debt issued continually.

The moment that does not happen, the “net revenue loss creep” from 2005 to whenever that happens will number in the tens of billions of dollars. And for what?

The sickness in the New Zealand economy hasn’t suddenly reversed itself with the lowering of the top tax rate and creating perverse incentives for people who qualify for Working For Families.


Australia Is In For A Hard Landing

Starting in 2005 a resource boom in Australia has propelled their economy onwards and upwards. All good things come to an end, and I believe that Australia is in for a hard landing. The combination of a shock to commodity prices, piercing of a housing bubble and extremely poor productivity growth since 2005 could lead to a serious drop in Australian GDP when the day of reckoning arrives.

McKinsey Global Institute have produced an essential study that breaks down what has caused Australia’s growth spurt since 2005, and how the causes of growth have differed from previous growth spurts in the early 1990’s and early 2000’s. It’s called “Beyond the boom: Australia’s productivity imperative“.

Their analysis looks at five different contributors to growth:

Terms of trade: The effect of changing prices for imports and exports

The increase in terms of trade has been fuelled by massive increases in commodity prices. The Reserve Bank of Australia governor is quoted in the report that while one container of iron ore was worth 2,200 flatscreen TVs in 2005 it’s now worth over 22,000 flatscreen TVs. The Australian dollar is at very high levels and is currently at 1.03 USD/AUD – above parity!
Additional capital: The increase in capital stock

The increase in capital stock in Australia since 2005 is astonishing – some A$120 billion in additional capital investment has been made in iron ore and coal mines, roads, ports, natural gas exploration and other resource industry projects. That alone is responsible for 53% of the growth since 2005, meaning any reduction in capital investment would significantly reduce Australian economic growth.

Additional labour: The increase in the total number of hours worked in the economy

Since 1993 Australia has averaged 143,000 immigrants per year and its own growing population has led to a massive increase in the size of the workforce. Massive Kiwi immigration has thus played a key role in accelerating Australian growth. MGI state that the increase in labour is the steadiest contributor to Australia’s growth.

What does this mean if lots and lots of Kiwis return to New Zealand? Well, the Australian economy recovery could potentially be lower than if they stayed there. The same obviously applies to other sources of Australian immigration – Southeast Asia, UK, Ireland, South Africa. Birth rates in Australia seem to be propped up by the baby bonus they have there. If fiscal necessity means that has to be cut the rise in natural born population will decrease sharply and affect this contributor to growth by the 2020s/2030s.
Capital productivity: The amount of output generated per unit of capital stock

Between 2005 and 2011 capital productivity has plummeted and led to tens of billions of dollars in losses of national income. MGI argue that this is because of the massive time lags between planning a resource project and getting the first shipment despatched, which can feasibly take years because of the size of the projects.

This finding is amazing – all of this capital investment, yet the losing capital investments are essentially cancelling out many of the one-off gains from a resource boom. This does not bode well if commodity prices decline, because that would reduce the value of resource projects already committed to and underway even further.

Despite hundreds of billions in domestic wealth, hundreds of billions more is being borrowed from overseas to finance these capital investments. If Australia’s exchange rate plummets in the wake of reduced commodity prices the repayments on bonds issued in USD, EUR, JPY, RMB or even SGD will skyrocket and reinforce a downward spiral of investment.
Labour productivity: The amount of output generated per hour worked

Despite having 25% more capital at their disposal from 2005 to 2011, output only increased 7%. Over the past 6 years labour productivity increases have only contributed a roughly a third as much as they did between 1993 and 1999. (A$17 billion vs A$57 billion). Other sectors in Australia have been achieving lacklustre labour productivity growth of ~1% a year.

All in all, MGI conclude that at least 50% of the growth from 2005 to today is one-off effects of the mining boom. The reality is that Australian multifactor productivity is actually declining at 0.7% a year. McKinsey talk about four different scenarios for Australia, linked directly to how much they increase productivity. They call these scenarios “hangover”, “lucky escape”, “earned rewards” and “paradise”.

This is how they arrived at their numbers:


Using the methodology that MGI used to calculate these 4 scenarios, what happens if we make the assumptions slightly more negative? If the “hangover” situation occurs, there is not much breathing room until the total change of total income becomes negative.

In the “hangover” situation, if the relationship between additional capital and capital productivity (-43/120) holds the negative contribution of capital productivity would surely be (-43/120)*107= -$38.34 billion. That would change the “hangover” calculation to : -109+107+28-38+8= -$4 billion.

Any further deterioration in Australia’s terms of trade would make the reduction in total income even higher. Any decrease in additional capital would make the reduction in total income even higher. This report reinforces my bearish opinion of Australia – they’re squandering their resource boom resources and not focusing aggressively enough on improving multi-factor productivity.

And let’s not forget where a lot of this capital investment is coming from:

When Australia’s terms of trade decline, any foreign-denominated borrowings will be more expensive to repay. This could prove fatal to any recovery because a substantial proportion of national income will be spent on debt service instead of capital investment, further reinforcing the hard landing provided by a decline in commodity prices.

Australia is in for a hard landing because they’ve squandered their natural resource dividend on a housing boom and holiday homes in Bali. Their failure to address productivity issues in the resource sector and other sectors will make the inevitable recession far more painful than it could have been if a more responsible approach to shoring up the long-term prospects of Australia had been taken.