Release Date May 4 2002

THE FIFTH PARLIAMENTARY CONFERENCE

REVISITING MULDOON - MULDOON AND THE ECONOMY

By Len Bayliss

When Rob Muldoon became Prime Minister and Minister of Finance in late 1975, he faced a range of serious economic problems - they included

- A record Balance of Payments deficit which totalled 14% of GDP in YE March 1976

- High rates of inflation with the CPI increasing by 15.7 % in YE Dec 1975

- A strong downturn following the very powerful 1973/74 economic boom.

- A large budget deficit totalling $1002 mill or 8 % of GDP with a much larger

deficit ($1400 mill) forecase for 1976/77

IN ADDITION - there were a number of major strategic concerns arising from

- The first oil crisis with a very major rise in real oil prices dating from June 1973

- The sharp (17%) fall in the terms of trade over 1966/68 and record low terms of trade

in 1975

- The UK becoming a member of the European Common Market in 1973.

- The breakdown in wage negotiating procedures following the nil award in 1968.

- Growing international agricultural protectionism

In regard to strategic policy, many persons belonging to New Zealand’s economic, business, financial and farming "establishment" were major participants in, and were strongly influenced by, the National Development organisation set up by the National Government in 1969. In part, this was a response to the Labour Party`s espousal of economic planning - the French "indicative" model or "Planning through the price mechanism", not the highly dirigistic Soviet version. But more importantly, there was a recognition that major changes in economic strategy were required with the UK embracing the Common Market, the growing strength of overseas agricultural protectionism, the major fall in the terms of trade and a sharp acceleration in inflation following the breakdown of wage negotiating procedures in 1968 accentuated by rising import prices.

In essence, the NDC recommended a sharp acceleration in export growth, particularly of non pastoral products, together with some modest financial and transport deregulation and a very modest decline in import protection. This latter recommendation was strongly resisted by a highly protectionist manufacturing lobby who saw it, with some justification, as the thin end of the anti protectionist wedge. Deregulation generally had little public or political support - in fact it is not too much of an exaggeration to say that for many older persons it was still associated with the traumas of the 1930 depression.

In 1975, New Zealand was still characterised by very high levels of import protection - as well as by comprehensive controls over prices, bank lending, interest rates, shopping hours, road and rail transport etc. There was little effective competition over many sectors through licensing and other protective measures. There were extensive food subsidies. Resource allocation was severely handicapped by distorted price signals. The chairmen of the Farm Producer Boards, Federated Farmers and the Manufacturers Federation and the leading Trade Union Officials were all well known public figures. A very costly "producer welfare state" flourished, and was vigorously defended by ardently free enterprise businessmen who, in the same breath, strongly criticised the much less costly "social welfare state".

New Zealand`s highly protectionist economic policies, widely regarded as very successful in both social and economic terms by the general public, were criticised by some economists as having increasingly harmful consequences on resource allocation. Certainly the extent of protection/controls in New Zealand was excessive by comparison with those of many developed overseas countries. Nevertheless, virtually all these countries indulged in what would now be regarded as protectionist anti competitive policies.

Escalating inflation, combined with slowing growth, to which there appeared to be no answer, unless the heavy social costs of high unemployment were accepted, was having increasingly adverse consequences. It was only in 1981 when US inflation reached 13.5% that the Federal Reserve decided that only very tough monetary policies could defeat inflation. Additionally, there was a growing consensus that firm monetary policies should be supplemented by deregulatory/pro competition policies generally - and by extensive privatisation. It was only in 1983 that Keating floated the Australian forex rate. The important point being that these major policy changes only began to dominate OECD policy making from 1981 onwards - and had in 1975 very little awareness, let alone support, in New Zealand and indeed not much more in many other countries.

On the other hand, whilst the events of the previous decade had undoubtedly caused considerable public concern, there was still widespread confidence in the future of New Zealand. There was also a belief that firm economic management would soon get the country back on an even keel Muldoon was widely regarded, on the basis of his previous successful term as Minister of Finance, as being the right man for the job - a view he undoubtedly shared. Not even the severest critic, or the most pessimistic forecaster, even remotely imagined the huge deterioration in New Zealand’s economic position which was to occur over the next 27 years. This matter is covered in Appendix A.

It is because of this extraordinary deterioration that this paper will primarily judge Rob Muldoon`s economic policies by their contribution towards overcoming New Zealand’s structural economic problems. The primary aim of economic policy since 1968 should have been to restructure the New Zealand economy so that its dependence on relatively low skill commodity based pastoral exports was restructured to a much higher skill based export economy embodying modern technologies and research.

This objective required three interconnected policies to be implemented - skilfully, vigorously and consistently.

- Much greater priority accorded to mass (for all persons) quality education covering primary, secondary and tertiary levels.

- Much greater focus on accelerating export growth incorporating modern technologies and research and reducing dependence on commodity exports - and encouraging investment in efficient import replacement industries and in the tradeable sectors support industries. The critical ingredient for this policy was a consistently highly competitive forex rate to encourage long term confidence and investment in the tradeable sectors .

- Much greater emphasis on deregulation and liberalisation to improve competition, savings and resource location.

Reference to other (macro economic) policies will be made but they are clearly of less importance as compared with the structural policies referred to above. However, it is macro economic policies which are generally the major influences determining voter support. Naturally enough, they are what most politicians and the media focus on, and as a result they dominate economic debate and public perceptions. But they are clearly of much lesser importance than restructuring policies in a long term New Zealand context - and it is these policies which will be the primary focus of this paper in judging Muldoon’s economic policies.

The Economic Background

The first six years of the Muldoon government were particularly difficult - with a massive balance of payments deficit (14% GDP), exceptionally poor terms of trade - the worst in the post war period - a massive budget deficit and high inflation. There was no practical alternative to firm, in fact by most standards, harsh economic policies. In the first six years, 1976/82, real GDP rose by only 3.0%. Registered unemployment. which had averaged 4,166 in 1975, rose to 76,475 in 1983 (or from 0.3% to 5.3% of the labour force. This would rise to nearly 8% if the 38,110 on special work/job creation were added - making a total of 114,585. In addition, there was large scale net outward long term migration - which totalled 150,000 over 1975/85 - without which unemployment would have been very much higher since two thirds of the migrants were classified as "actively engaged". Even if only half (some 50,000 persons) of the "actively engaged " long term migrants were included, the unemployed rate would have risen to nearly 12% of the labour force from virtually nothing in 1975.

Prior to the price freeze in 1982, consumer inflation averaged around 15% and there was a second major oil price rise to contend with in 1978. These difficult, bleak years were in striking contrast to the prosperity and negligible unemployment of the previous thirty years - particularly the 1945/66 period. Muldoon and his economic policies naturally incurred intense criticism - but it is difficult to see how economic conditions could have been significantly ameliorated. The policy challenge was to lay the foundations for future growth whilst resisting the intense pressure for short term palliatives to sustain activity.

Education was not a major consideration in Muldoon`s economic strategy. This was hardly surprising as New Zealanders considered themselves well educated and the importance of education in fostering productivity had little, if any, recognition in 1975. Moreover, a steep decline in the birth rate was seen as an argument to contain expenditure. Hence Muldoon clearly failed over education - but so has every other Government since then. It is probably true to say that in recent years, with its importance being increasingly recognised, the failure to make substantial progress in education is all the more reprehensible. That is not to infer that there have not been significant improvements - but there have also been significant improvements in other comparable countries. In other words, the gap has not been narrowed and New Zealand overall lacks the educated skilled labour force that is essential for productivity growth.

In making judgements on long term education policy, it should be recognised that Ireland, the OECD`s basket case economy in 1975 and currently its star performer, recognised the crucial importance of education and so gave its highest priority to educational reforms from the 1970`s onwards. There are plenty of other examples of OECD countries giving much higher priority to mass education than New Zealand - in the realisation that mass tertiary education was as important as mass primary and secondary education.

Muldoon’s restructuring policies can be summarised under four major headings

- Export Development

- The NZ Planning Council

- Deregulation and Liberalisation

- The Major Projects

Export Development -

Muldoon was strongly influenced by the National Development Council reports over 1970/72 when he was Minister of Finance. The main conclusions of the NDC reports, as noted earlier, were that New Zealand must accelerate export growth, particularly for non pastoral exports, add value to pastoral exports and diminish (somewhat) very high levels of import protection. The latter recommendation provoked intense opposition from the powerful manufacturer’s lobby. Many National party members believed that this opposition cost the National Party the 1972 election.

Hence, when Muldoon became Prime Minister, he moved very strongly to substantially accelerate export growth. This export development strategy embracing manufactured exports, horticulture, fishing, tourism and forestry - as well as adding value to traditional pastoral exports - was remarkably successful. Export growth of goods and services would all have developed much more slowly without Muldoon’s forceful initiatives.

Remarkably, the growth of manufacturing exports virtually achieved the status of a crusade and was extremely important - together with Industry Development plans - in weakening the opposition to lowering import protection, and for a growing view that further reductions in import protection were inevitable. The grudging acceptance of the very important CER agreement and import license tendering would not have occurred without the growing support from manufacturing exporters. The manufacturing sector was not internationally competitive in 1984 but it made substantial progress towards this goal over1975-84. These major gains covered import replacement as well as manufacturing exporting. It is also worth noting that the export development strategy also embraced raising the efficiency of the tradeable sector service industries.

Whilst the objectives of these export development/tradeable sector policies was generally strongly supported, the means - export subsidies and tax incentives - were increasingly strongly criticised by some economists. They maintained that the all encompassing price and profit effects of a forex devaluation on the tradeable sectors was much superior to specific subsidies and that certain subsidies - such as SMP`s - were unnecessary. .... a view supported by the farming industries. However, whilst Muldoon moved quite strongly in a number of liberalisation policies and in some forex depreciation, he continued to mainly rely on tax incentives and subsidies for his export development policies.

First, because of convincing political reasons, the Labour party and the Trade Unions were strongly opposed to market mechanisms - as were many others.

Second, Muldoon believed economic liberalisation would not succeed if pressed too rapidly. An excessively rapid adjustment would not permit adequate time for business to adjust - thus damaging confidence and investment...... a belief not wholly lacking in validity as later experience demonstrated.

Third, and most importantly, the main justification for export subsidies was that a major devaluation within a highly protected cost plus economy - with inflation running at around 15-17% - was not a viable policy. In this situation, and until there was effective import competition, subsidies were the best surrogate policy.

In retrospect, the NZ Planning Council, particularly under the Chairmanship of Sir Frank Holmes, together with the National Development Council /Organisation - both creatures of the National Government - deserve much more credit than has been accorded to them. They were an intelligent, political and economic policy response to deep rooted, structural economic problems, the obvious lack of strategic vision in the Treasury, superficial economic comment in the media and the desirability of creating an informed public opinion. The abolition of the NZ Planning Council by the National Government in 1991 was a highly regressive move and must bear a major share for the depressing deterioration in the standards of public economic debate and in economic policy formulation since then.

Neither of the above organisations would have existed without Muldoon’s support - even if at times such support could not be classified as wildly enthusiastic. Even this may have been a calculated political ploy. The problem for Muldoon was to gain political support for major economic policy changes against strong political and business opposition and this is often not best achieved by leading the charge. Appearing to initially oppose change and then be gradually convinced of its necessity is an excellent political ploy. It is commonplace for Muldoon to be blamed for all his bad policies and others take credit for the good ones. But it is difficult to accept that Muldoon implemented major policy changes that he did not support.

Prior to the reimposition of widespread price and interest controls in mid 1982, the Muldoon government had been characterised by far reaching liberalisation and deregulation policies.

Much the most important, were the CER agreement with Australia - a major break with import protection - and the1976 monetary policy deregulation.

In addition there was -

- The introduction of import license tenders -a further major break in import protection

- Industry Development Plans

- Longer and more flexible shopping hours in1977

- Saturday shopping 1980

- Removal of most food subsidies

- A crawling peg Forex rate and improved forex markets

- Government Bond and Treasury bill tenders

- Meat industry delicensed

- Termination of Dairy Board funding from the Reserve Bank.

- Road transport licensing significantly eased

- Diminished protection for NZ Rail

- Corporatising NZ Rail and the Government Life Corporation

These important liberalisation/deregulation measures have been largely forgotten in the aftermath of the reintroduction of price and wage controls in mid 1982. However, they were very major and positive moves and meant that there was a very different climate of opinion by 1984 - which greatly facilitated the introduction of further liberalisation policies.

Major Projects

The Major Projects, covering steel, aluminium refinery, oil refinery expansion, urea and methanol/synthetic petrol plants, etc. were very important measures involving a very large rise in investment, in the balance of payments deficit and in consequent overseas borrowing. They also placed major cost strains on the construction and related engineering industries - thus aggravating inflation. The objective of the major projects was to strengthen the economy through import substitution - specifically by using surplus domestic supplies of natural gas and electricity. The existence of these large surpluses largely reflected poor energy investment planning in previous years.

The major projects had the support of many highly qualified and experienced persons who believed in their overall economic viability. The latter was predicated on expectations of high oil prices - whereas in fact oil prices in real terms have been far below those widely forecast. Nevertheless it must be acknowledged that if the forecasts had proved more accurate the major projects would probably be regarded as a very successful contribution to the restructuring of the New Zealand economy. Predicting future oil prices is a hazardous pastime and even a strictly uneconomic investment might be justified as a legitimate insurance.

Major efforts were also devoted to energy policies - apart from the major projects - covering oil and gas exploration, energy conservation, etc. It is difficult to recreate the importance and urgency of these energy measures at a time when real oil prices are far below those of 25 years ago - but in many respects they dominated economic policy formulation. A balanced judgement, with the advantages of hindsight, on the major projects requires a high quality cost benefit analysis which has yet to appear.

Macro Economic Policies

Apart from supporting export development, the major projects and other energy policies, the overriding objective of macro economic policy was to restrain what in the public’s perception.... in fact by any standard, was a huge rise in unemployment. This was a problem which most New Zealanders at that time were quite unprepared for and viewed with the greatest concern - with all its attendant political consequences.

There were other much more familiar concerns ..... winning elections was, needless to say, a major objective resulting in the customary election year stimulation followed by post election restraint. Another major concern was to rapidly reduce the record balance of payments deficit (14% GDP) and thus avoid incurring the opprobrium of overseas markets - particularly credit rating organisations and the IMF.

All governments face conflicting objectives, but the basic conflicts faced by Muldoon, for instance reducing the external deficit and tackling unemployment, were far beyond those experienced by other post war governments. Long term governments also have to change priorities - in Muldoon’s case, the immediate objective was to reduce the balance of payments and budget deficits and push hard on energy conservation and exports...... rising unemployment and the major projects attracted increasing attention - with the failure to reduce inflation latterly became the dominant priority.

Fiscal Policy

After initially reducing the budget deficit from 9% to 3.4% GDP in 1976/77, further reductions were made extremely difficult because of very low growth - which reduced the growth of company tax receipts and increased expenditure on unemployment. In addition, expenditure was increased by higher National Superannuation payments and by higher debt interest payments reflecting the 1976 monetary policy changes and further budget deficits. On the other hand, high marginal tax rates combined with rapid inflation (fiscal drag) led to a very substantial increase in personal tax receipts.

Table 2 Budget changes % GDP

1976 1982 1984 1985

Personal Tax 16.9 21.1 19.2 18.1

Company tax 3.7 2.4 2.0 2.8

Total tax 28.7 32.0 29.8 30.0

Interest Payments NZ 1.8 2.9 4.0 4.1

O`Seas 0.6 1.5 1.8 2.3

Social Welfare/Super 7.9 10.8 11.4 11.0

Stabilisation 1.9 0.5 0.0 0.0

Total Expenditure 39.5 40.8 40.7 38.6

Overall deficit 9.0 6.6 8.9 7.0

Total public debt 8.9 21.5 31.5 40.5

Source Treasury

The rising deficit from 1977 onwards might well be criticised, but with rapidly rising unemployment it is difficult to justify a much tighter fiscal policy. A more valid criticism would be the sharp deterioration in the deficit from 1982 - largely resulting from over generous personal tax reductions and in spite of much faster growth. A further valid criticism is that price stability would have revealed a large structural deficit.

Monetary and public debt policy was greatly improved - as was the efficiency of the financial sector. Government security bonds and Treasury bill tenders were introduced - leading to much improved security markets. Similarly, the forex market was improved by less rigid (crawling peg) forex policies and by the introduction of futures trading. Very substantial increases in interest rates were achieved .The average interest rate on new mortgages nearly doubling from around 8.5% in 1976. A much more competitive and efficient financial market was developed - although monetary policy did not play the major anti inflationary role which occurred post-1984 under the Labour government.

Inflation and the Freeze

The major failure over the 1976/82 period was in combating inflation. This failure was particularly highlighted by the margin between New Zealand and the major OECD countries consumer inflation rate which rose to 9.2% in 1982 as a result of very firm anti inflationary policies in the latter from 1981 onwards. This victory over inflation was at the cost of a substantial rise in unemployment from 4.7% in 1979 to 7.6%. in 1982 - a rise of nearly 3%. In the UK, the rise was from 4.7% to 11.1% - an increase of 6.5%. With the massive increase in New Zealand unemployment, together with work creation and worker emigration since 1976 the question facing Muldoon in 1982, was whether he should implement OECD policy and deliberately accept responsibility for a further very major increase in unemployment. It is worth noting that between 1987 and 1991, when inflation was vanquished, New Zealand’s unemployment rate increased from 4.1% to 10.3% - a rise of 6.2%.

Consumer Price Increase (%)

1970-78 1979 1980 1981 1982 1983 1984 1985

New Zealand 12.0 13,8 17.1 15.4 16.1 7.4 6.1 15.4

Major OECD 8.6 9.6 12.5 10.0 6.9 4.4. 4.5 3.8

Difference 3.4 4.2 5.6 5.4 9.2 3.0 2.6 11.6

source OECD Economic Outlook.

In considering this dilemma, it should be noted that although there had been very substantial liberalisation since 1976, New Zealand was still a highly protected/cost plus economy with very rigid wage setting structures - backed by still powerful Trade Unions.... unemployment had not greatly weakened their bargaining position.

There are a number of explanations as to why Muldoon chose a wage price freeze.......

A popular, indeed probably majority, explanation is that he was intrinsically a "control freak". In addition, it is argued, he was worn out, drinking heavily and under increasing attack within his own party (and from many others), that the 1981 election was a lucky shot and therefore that the freeze was a last throw of the dice from an embattled politician slowly sinking.

Whilst there may be some elements of fact in these views, a more substantial explanation is that he had no option but to face up to the inflation problem - which was clearly becoming the paramount OECD concern and the test of his reputation as an economic manager. One option was to apply the recent OECD orthodoxy of a very tough monetary policy and deregulate - particularly import protection. This would have caused, as noted above, a very substantial rise in unemployment - which would have had disastrous political consequences for both himself and the National Party. Heroic politicians, putting country above self and party are pretty rare in New Zealand - indeed in most democratic countries!

In addition, Muldoon probably considered that after the previous six years the New Zealand public was ill prepared for a further strong dose of harsh economic medicine - a pretty accurate judgement. He also probably believed, with considerable justification, that if such measures were applied too quickly, they might well seriously weaken New Zealand’s economic structure. Whatever the reasons, if he was not prepared to adopt tough OECD liberalisation and monetary policies he had to try a different tack to break inflation and inflationary expectations.

The other alternative to the freeze, with the failure of his tax /wage tradeoff policy, was to carry on his policies of steady liberalisation, export development, energy investment, major projects, etc etc. and face the music as New Zealand’s inflation rate diverged from that of major OECD countries by over 10%. . In this situation his claim to be an excellent economic manager would have been ridiculed . The almost certain consequences were electoral defeat at the next election and his removal as National Party leader - in fact, with hindsight, whatever policy he chose was likely to have the same result!

Muldoon’s misfortune was to be confronted with a near impossible situation after winning the 1981 election- many would argue a just reward for the manner of his winning. Labour had a lucky escape since they would have faced the same economic choices as Muldoon. Labour would also have decisively rejected the orthodox OECD medicine and would have floundered on with a "caring" policy but with a price freeze conspicuously absent. The economic situation was vastly different from 1984 - no successful liberalising Australian Labour government, no price freeze, much less domestic and international support for liberalisation. - in short, no ‘Rogernomics’ - .Labour would have been very lucky to have won the 1984 election.

Still the freeze was much more successful politically than critics had envisioned - the large fall in inflation was widely welcomed by the general public. But for the intervention of Bob Jones NZ Party, which largely impacted on the National Party vote, the 1984 election might have been a much closer contest. Moreover, the freeze had two important consequences. The Trade Union movement, which strongly opposed the wage controls under the freeze, was shown to be a "paper tiger" - a lesson readily absorbed by the next Labour government which treated the Trade Union movement and the Public Service Association with contempt - and greatly undermined their power.

The second major effect of the freeze was because of a passionate hatred and opposition to Muldoon it converted many Labour MP`s, who had strongly opposed his liberalisation/deregulation policies, into strong advocates of economic liberalisation - or what they thought was economic liberalisation. Even in retrospect, this was a remarkable transformation.

One of the most significant acts of the Muldoon Government was to abolish the Labour Party`s funded superannuation scheme and replace it with a more generous version of the previous, and still current, PAYG scheme. It was claimed, incorrectly, that the compulsory Labour scheme would increase savings, but its major defect was to create a huge investment fund , liable to be strongly influenced by government with enormous power over the direction of investible funds. The decision to abolish it was correct - even if the "doing "was unconstitutional.

Its replacement has often been characterised as a manifestly over generous election bribe. In fact, whilst it clearly had a strong political element, the Muldoon proposals were strongly influenced by the Royal Commission on Social Security’s 1973 report which, quite correctly, was very critical that the elderly had not shared in the prosperity experienced by others over the 1950`s and 1960`s. This was also the time when many OECD countries were implementing far more generous superannuation schemes than Muldoon`s, when the birthrate had only recently contracted and when there was not much concern about any problems sixty years hence. Nor did anyone forecast the economic disasters of 1975 and the need for subsequent severe fiscal restraint - or even the huge deterioration in the performance of the New Zealand economy over the next 25 years. With all the advantages of hindsight, NZS should have been set at around 70% of average wages for a married couple rather than 80% - with provision for gradually increasing the age of entitlement from 60 to 65. But it is easy to be wise when viewing 1975 from a 2002 viewpoint.

Much of the criticism of Muldoon`s economic management has been weakened by the dire trends since 1984 in productivity, savings, overseas and household debt etc. and the major deterioration in New Zealand’s relative international economic standing. It is for this reason that this paper has concentrated on Muldoon`s restructuring policies since that was, and still remains, the overriding economic issue.

How does Muldoon compare with subsequent government economic managers?

This is not so difficult as it may first appear, since there have only been two Ministers of Finance who have made really determined efforts to overcome New Zealand’s structural economic problems - Muldoon and Douglas . The others, Caygill, Richardson, Birch Peters, English and Cullen, have all kept their eyes firmly on the political ball and on "political" economics.

For instance, since 1990, economic policy has been aimed at weakening Trade Union power, or what remained of it, reducing government expenditure - particularly for superannuation and welfare - reducing tax rates, implementing further privatisation, maximising market freedoms and minimising the role of regulatory bodies such as the Commerce and Securities Commissions. These policies, which have been marginally changed by the present Labour government have, on the available statistics, accentuated New Zealand’s very poor productivity, savings and (domestic and overseas) debt performance. As a matter of fact, "productivity" has rarely ever been mentioned .

The vigorously implemented micro policies of Roger Douglas, combining wide ranging deregulation, liberalisation, corporatisation, privatisation, tax and tax subsidy reforms, were the mark of a major reformer. In formulating these policies in1984, he had a clean slate, much public and overseas market support and evidence from other OECD countries - particularly Australia - that they stood a good chance of success. In following Muldoon, he clearly had many advantages including much improved terms of trade from 1987 onwards. His major deficiency was in macro policy where he strongly opposed taking really firm measures after the 1984 devaluation ("that’s what Muldoon would do") and this led to the hugely economically destructive, but politically very successful, boom over 1984/87. In addition, his denigration of exporting, combined with an overvalued forex rate, (the real forex rate rose by an incredible 48% between Sept 1984 and March 1988), together with the extremely rapid removal of import protection, did enormous damage to the tradeable sectors - as well as causing much unnecessary unemployment Continued major fluctuations in the real forex have seriously depressed tradeable industries’ confidence, investment, vigour and creativity and performance.

Muldoon tackled New Zealand’s structural problems, in a more difficult environment, by expanding and encouraging the tradeable sectors; Douglas, by contrast, undermined them - though this was clearly not his objective - a case of good intentions undermined by flawed judgement. The OECD May 1987 New Zealand report stated "the short run effects of the inevitable restructuring of the economy will depend on whether the contraction of (newly) uncompetitive activities is offset by the expansion of competitive ones". How true. Clearly this did not and has not occurred. Only large scale overseas borrowing has enabled a modicum of growth to be sustained in the 1990`s.

APPENDIX

CAUSES AND CONSEQUENCES OF NEW ZEALAND’S ECONOMIC FAILURE

- 1975/2002 -

CAUSES OF FAILURE -

The New Zealand economy has failed badly because of extremely poor economic management and poor corporate governance. Successive Governments, their Treasury and Reserve Bank advisers and the business and farm leadership have failed to grasp the core policies essential to a successful major economic restructuring. More specifically, business boards and managers, besides being responsible in many cases for major reductions in shareholder wealth, have performed very poorly compared with their counterparts in Australia, the UK and the USA. Poor corporate governance must be considered a major cause of New Zealand`s miserable productivity performance.

The OECD`s paper on "The Principles of Corporate Governance" stated "a key element in improving economic efficiency is corporate governance" (Shareholder value - Is there a Corporate Governance Crisis in New Zealand - Joseph Healey ANZ Bank ).

The quality of public economic debate, together with policy formulation, has suffered greatly since the Planning Council `s demise. A Planning Council would have influenced public and political perceptions by drawing attention to the key issues - whilst tactfully demolishing superficial and usually spurious ideologies masquerading as economic policy. What were, and still are, some of the key issues?

- Why has labour productivity declined to its present low level?

- Why is NZ corporate governance so poor and what can be done to improve it?

- What are the key educational and training deficiencies and how can they be overcome ?

- How can the disadvantages of high domestic and international transport costs and a

small domestic market be minimised?

- What are the key research priorities and how can they be implemented without

excessive bureaucracy?

- How can inflation be controlled without raising the real forex rate and so undermining

tradeable sector confidence, investment and innovation?

- How can technology uptake in the business and farm sectors be accelerated - and

improved qualitatively?

- How can the Reserve Bank effectively influence the growth of household debt?

Rather than face up to these hard gritty question and their inevitably difficult and controversial answers, the New Zealand leadership has taken the political soft option of either ignoring these problems or pretending they do not exist..

Much the most important restructuring policy is to substantially raise educational and training standards. An economically developed/technologically advanced country requires a high quality educational system with mass primary, secondary and tertiary education - the latter covering universities, technical colleges/institutes and apprenticeships.

This core educational objective has never been formalised - although lip service to the need for higher educational standards is universally declaimed with monotonous regularity..... "words not deeds" might well have been the motto of successive ministers of education irrespective of party. If New Zealand wishes to have a much better educational system it will require substantially increased funding with emphasis on quality - and on motivated teachers and instructors. Much more money is not the only requirement - but without it there is no chance of successfully achieving core educational objectives.

The second major strategy is to accelerate export growth - particularly non commodity exports - with increasing emphasis on achieving progressively higher standards of technology, research, marketing, etc. In essence, this primarily means adding value to our pastoral, horticultural, forestry, fishing and tourist industries and not having visions of emulating Silicon Valley. We have to play to our strengths. This strategy has to be widely understood and supported as New Zealand’s "over-riding economic strategy" which at all times has priority.

This strategy requires consistent implementation, with a competitive real forex rate being the key ingredient for encouraging long term confidence and much higher rates of investment in the tradeable sectors. Confidence and investment has suffered severely since 1985 from long periods of an overvalued real forex rate, by denigration of export priority policies and by irrelevant criticisms that government should not "pick winners" - about as stupid a comment in New Zealand`s economic circumstances as the TINA slogan (There Is No Alternative).

A competitive real forex rate, that is one which makes possible a high rate of profitability and investment over the long term in the tradeable sectors, requires major changes in anti- inflation policy. Currently the Reserve Bank fights inflation by raising interest rates which also results in a higher forex rate - thus undermining tradeable sector confidence, profits and investment. Rather, monetary policy should have a lower profile in fighting inflation and fiscal policy should have a higher one. For instance, anti- inflationary policy should place more emphasis by operating through short term changes in GST with increases being used to repay government debt rather than government expenditure - and vice versa. Similarly, the Reserve Bank should be prepared to act directly to restrain excessive increases in household debt. The Reserve Bank Act should stress that the Bank’s responsibilities cover not only consumer price stability but also asset price stability - as well as trends in domestic and overseas debt

The third overriding strategy required was to liberalise New Zealand`s excessively protected and over regulated economy - so increasing international competitiveness and improving productivity, savings and resource allocation. This objective has been implemented with great vigour and determination, particularly since 1984, but as the statistics unfortunately reveal, with very little success - due to very poor macro economic management .

To liberalise using only one (badly managed) leg of a three pronged strategy has proved a major failure - as the facts amply demonstrate. It has also brought market oriented policies into much disrepute, a perfectly understandable reaction, and one that will make it very difficult to win public support for major policy changes essential for a successful economic restructuring

Long to medium term trends in labour productivity are generally considered to be much the best indicator of a country’s economic performance. Even better would be a measure of total factor productivity, which include estimates of the productivity of capital. However, these statistics are not widely utilised because of major difficulties in their computation. Moreover, productivity statistics do not measure changes in the quality of life - which should be a major consideration in assessing economic performance However, statistics are lacking which would enable accurate and balanced judgements to be made on quality matters

The December 2000 OECD Economic report on New Zealand reveals that labour productivity has massively deteriorated since 1978/84 in spite of improved terms of trade

Table 1 Labour Productivity

1978/84 1985/92 1993/98

Labour Productivity (1) 2.6 1.8 0.5

(1) Annual % change

Source OECD NZ Report (page 67) Dec 2000 and Statistics New Zealand

Table 2 below reveals not only the deterioration in New Zealand’s labour productivity but also its much poorer performance compared with other english speaking countries. Over the last five years, the US labour productivity has averaged 2.5% compared with its long term average of 1.8% - a remarkable increase. Over the four years 1998/01, New Zealand’s labour productivity averaged 0.9% - but this is too short a period to judge if this is a long term trend.

Table 2 Labour Productivity - Growth of GDP per person employed

1980/90 1990/99

USA 1.4 1.8

United Kingdom 2.0 1.8

Canada 1.1 1.3

Australia 1.1 2.3

New Zealand 2.2 0.5

Source: Table 11, Page 65, OECD Report - December 2000

There is abundant evidence of the consequences of relatively low productivity.

- Currently New Zealand ranks 20th out of 26 OECD countries in real GDP per capita

whereas as it rated 9th in 1970. (Social Report 2001, Ministry of Social Policy)

- New Zealand`s real GDP per capita rose by 9.5% between 1986 and 1999 whereas the

OECD average was 29%. (Social Report 2001, Ministry of Social Policy ).

- In spite of a very substantial increase in overseas debt New Zealands real gross national

disposable income rose by just under !% annually between 1986 and 2000.

(Source: Statistics New Zealand).

The OECD NZ December 2000 report (page 126), shows that of the seventeen OECD countries listed New Zealand had much the lowest savings ratios... i.e gross national saving as a % of GDP and household savings as a % of disposable income.

Table 3 OECD Gross and Household Savings Ratios 1998

Gross Household

United States 18.4 4 .2

Canada 18.5 26.1

Australia 20.1 2.1

UK 18.0 5.8

Ireland 24.8 10.4

New Zealand 12.4 - 1.5

OECD 21.7 NA

Source OECD Economic Outlook 2001

The table below shows how New Zealand’s gross savings ratios have deteriorated since 1985 .

Table 4 New Zealand : Gross Savings Ratios % GDP

1978-85 19.3

1986-93 16.7

1994-98 15.8

Source: OECD Economic Outlook 2001

The two main causes of the fall in the household savings ratio have been financial liberalisation and the increase in central government saving - which increased by $6 Billion (approx 7% GDP) over 1992-95.... (OECD Economic Outlook Tables 26 and 30 and Crown Accounts Analysis Statistics, New Zealand.)

Financial liberalisation has encouraged a very rapid increase in household debt - mainly in the form of mortgage and credit card debt. This has enabled consumer spending to grow faster than incomes and so stimulating economic activity, profits and employment. An additional gain is that this short term economic boost significantly enhances the electoral prospects of the Government - a role previously played by election year budget largesse. This political advantage is the main reason no efforts are being made to restrain the rise in household debt and yet be able to point to the budget surplus under the Fiscal Responsibility Act to demonstrate their election year integrity!

The rapid increase in household debt as a percentage of household income is shown in the table below.

Table 5 Household debt as a % of Nominal Disposable Income

March 1990 47.0

1996 67.6

1999 104.6

2001 111.0

Source Reserve Bank

Reserve Bank Governor Don Brash has recently commented that by comparison with the major (G6) OECD countries, New Zealand household "net financial wealth to income" ratios are at a very low level. New Zealand’s ratios have also sharply declined since 1995 - whereas all the G6 countries’ ratios have substantially increased - except for a small increase in Germany. Similarly, New Zealand households have a much higher "household debt to household financial asset" ratio than these G6 countries.

Table 6 reveals that New Zealand`s external accounts have been in deficit in every year since 1975. These deficits have to be financed by a combination of drawing on overseas reserves, by overseas borrowing, or by selling New Zealand domiciled assets. When there is a balance of payments surplus the reverse occurs. The sum total of all overseas assets and liabilities is called "New Zealands Net International Investment position" with the latest total being minus (-) $NZ88.8 billion in December 2001 - which compares with minus (-)$44 billion March 1989.

This large total is the consequence of funding many years of overseas deficits - as shown in table 6. The OECD has often drawn attention to these deficits and the increase in the net investment international position. In its December 2000 NZ Report it stated "at around 84% of GDP New Zealand’s external liability ratio is easily the highest amongst industrial countries".

Table 6 Balance of Payments Current Account deficits % GDP YE March

1975 14.00 1981 3.62 1987 5.16 1993 3.66 1999 4.35

1976 8.94 1982 5.93 1988 3.64 1994 3.79 2000 6.99

1977 5.85 1983 6.07 1989 0.74 1995 4.72 2001 4.77

1978 4.55 1984 5.49 1990 4.15 1996 5.41 2002est 3.20

1979 2.80 1985 8.45 1991 3.25. 1997 6.21

1980 4.20 1986 8.87 1992 3.26 1998 5.58

Source: Reserve Bank/Statistics New Zealand

Current account deficits are the result of domestic savings being less than domestic investment - with the difference or deficit being financed by overseas capital (i.e. overseas savings). The major decline in the savings ratio has meant that there is currently much greater reliance on overseas capital. It should be noted that incurring external deficits is justifiable if they enable an increase in tradeable sector investments - but not, as at present, if used to finance excessive growth in household expenditure. It is generally accepted that consistent deficits averaging 5% or more of GDP are bound to cause international concern and must over time lead to a substantial depreciation of the forex rate.

Table 7 International Investment Income Debits - ($ mill)

YE March Inv Inc Debits Exports G/S %

1975 219 2073 10.6

1985 2627 13035 20.2

1995 6579 26932 24.4

1999 6626 30378 21.8

2000 8069 33153 24.3

2001 8827 41067 21.5

2001 (Dec) 8869 43148 20.6

Source Statistics New Zealand

New Zealand’s large scale overseas borrowing (and asset sales) has greatly increased the servicing costs paid to overseas investors - as shown in Table 7. Another major loss is the very substantial increase in overseas ownership of a large number of New Zealand companies. Currently a high proportion of New Zealand’s major businesses are now overseas owned. The servicing costs, shown above, must continue to rise as long as New Zealand continues to incur overseas deficits equal to around $5,000 mill (4-5% of GDP.) However, the real burden of these payments, that is the proportion of export income required to meet these payments, has not greatly increased for some years. This is because as a major international debtor New Zealand has greatly benefited from the very large fall in international interest rates since 1990.

The other major benefit has resulted from the incredibly destructive outbreak of foot and mouth disease in the UK - which has been a huge bonus for New Zealand since it led to very large increases in dairy and meat export prices - .i.e much improved terms of trade. A further gain to the whole tradeable sector was a sharp depreciation in the New Zealand dollar. These changes had very significant short term effects in substantially raising exports, in reducing the external deficit, and in increasing the tradeable sector profits (savings) and investment - particularly in pastoral farming. Hence giving the economy a strong boost. The large rise in exports also reduced international investment income debits as a % of total exports.

These interest rate and terms of trade benefits on past evidence are certain to be reversed over the next decade and the real burden of international investment income debits must significantly increase with continuing large external deficits.

.

Higher Technology Exports

It is unlikely that an updated version of the table below would show any significant differences. The table reveals that New Zealand still lags badly in the technology intensiveness of her exports - and that at best only very limited progress has been achieved.

Table 8 Technology Intensiveness Exports (%) by Country Size (1996)

High Medium high Medium Low Low

Small countries 12.5 39.2 13.1 35.2

Medium sized countries 14.0 49.8 13.0 23.2

Large countries 25.4 51.8 9.8 13.0

New Zealand 3.3 13.4 9.0 74.3

Source: "Lessons from Nordic Countries" University of Auckland Business Review

Vol 2 No2 2000

The social and political consequences of very low productivity increases are not generally understood. There is increasing concern at the higher incomes available to many categories of the skilled worker - particularly in other English speaking countries. If, however, New Zealand’s productivity continues to remain well below that of these countries, the present adverse income margin will rapidly increase. In this situation the incomes of internationally mobile New Zealanders will have to rise - relative to those of other New Zealanders - to retain them in this country. It is difficult to see how a further significant rise in income inequality, which has characterised New Zealand since 1990, can be avoided.

There are also increasing public concerns at the quality of educational and health standards and their failure to match equivalent standards in overseas countries. Because of lower productivity, New Zealand must spend a higher proportion of its GDP to achieve the same real per capita expenditures on health and education services as richer countries - and this margin must rise with continued lower productivity. This situation must progressively worsen - unless there is a remarkable and, on existing trends, highly unlikely improvement in labour productivity.

Again, sooner or later, an event or series of events will cause overseas financial markets to pay increasing attention to New Zealand’s poor, abysmal economic performance and its rising overseas debt and debt servicing ratios. This will result in New Zealand having to pay an even higher interest rate differential than at present on its new and maturing overseas debts. Currently short and long term interest rates are well above those of other English speaking countries because of much higher risk - and also because of cyclical influences on short term rates.

Short and Long Term Interest Rates

3 month money market 10 year govt

United States 1.8 5.2

Canada 2.4 5.7

Australia 4.5 6.3

UK 4.1 5.2

New Zealand 5.8 (1) 6.9

Source London "Economist" 13/04/02

(1) 90 Day Bills

Increasing international pressure on New Zealand to get its economic house in order must occur some time in the future - only very determined and far reaching efforts to retain the confidence of overseas markets and governments - particularly the USA - together with fortuitous recent events, has prevented this from occurring. .