Economic diversification – at what cost?
Fri 23 Aug 2013 by Gareth Kiernan in RegionalGovernment

Two events over the last few weeks have highlighted the risks of a region, or the country as a whole, becoming highly exposed to a single industry, product type, employer, or trading partner.  Firstly, Fonterra’s botulism scare focused attention on the fact that the company’s dairy exports make up almost a quarter of New Zealand’s export earnings.  China’s strong reaction to Fonterra’s food safety issues was also a sharp reminder that the country now takes about 25% of our dairy exports.

Secondly, the government announced a $30m subsidy to Rio Tinto to ensure the Tiwai Point aluminium smelter keeps operating through until 2017.  In other words, securing the smelter’s 800 jobs for the next three years amounts to a subsidy of $12,500 per worker per year – although that’s before the cost of subsidised electricity is taken into account.

Putting aside the cynical view that National is keeping Tiwai Point open to make sure its programme of electricity company sales stays on track, it is easy to see why the government would want to keep the smelter going.  The loss of 800 jobs from Invercargill would represent a direct hit of almost 3% to employment in the city, without taking into account any effects on upstream industries or downstream spending.  Over time, of course, one would expect the labour to move into other industries, but the transition cost of such a large number of job losses at once is not trivial.

Returning to Fonterra’s problems, some commentators have suggested that New Zealand’s heavy reliance on dairy exports should be considered by policymakers, with the view that some action could be taken to try and broaden New Zealand’s economic base.  Although economic diversity is useful in terms of limiting the volatility of GDP growth, it needs to be remembered that “picking winners” is generally a costly and futile exercise – politicians will usually be worse than entrepreneurs at where to invest resources, and are worse at letting poor performers go.  Government intervention to assist firms or industries in the name of economic diversity ultimately means that labour and capital resources are diverted away from their most productive current use, with no guarantee of any future pay-off.

The regional experience

The fact is that New Zealand is heavily reliant on the dairy sector because it offers the best returns in utilising our land and climate and is an area where New Zealand has a comparative advantage in terms of production.  The same “natural endowment” logic applies a lot of the time when examining specific districts and regions within New Zealand and seeing what they’re “overexposed” to.

Our table shows that employment in 31 of New Zealand’s 66 local authority areas is most heavily overrepresented in primary sectors.  These rural and provincial areas are simply making the most of the hand they have been dealt.  Otorohanga, for example, with 24% of its employment in dairy cattle farming, is obviously highly exposed to the fortunes of the dairy sector.  Despite this concentrated focus on one industry, it does not make sense to force greater diversification on the district’s economy.

It is not just the primary sector where this lack of diversification can occur.  Accommodation and food service businesses are common in Queenstown-Lakes and Kaikoura due to the tourism draw-cards held by these areas.  Like the agricultural areas, employment in these districts is spread across a collection of smaller firms all exposed to the same underlying demand drivers.

The second type of concentration is part natural endowment, part large business dominance.  The areas falling into this category include Kawerau, Buller, and Gore.  In each of these areas, the presence of a major employer relates to the resources locally available.  However, the performance of the region is also affected by the performance of a specific business – eg Norske Skog Tasman in Kawerau.  Business management decisions have the ability to affect a district’s economy much more than if an area’s high exposure to a single industry is spread across a multitude of small businesses.

The third type of concentration reflects the government sector’s presence in a district.  Defence shows up in a number of areas around the country, while central government’s dominance of the Wellington City economy is also obvious.  Education also appears in some areas.

Perhaps one of the most interesting outcomes relating to the public sector is the strong reliance on the health sector across a range of (largely) provincial centres.  Although the location of hospitals and provision of health services is likely to be relatively secure, the importance of government funding for a major economic component of these towns needs to be recognised.

Keeping government’s role to a minimum

Experience suggests that politicians and policymakers are no better at picking winners than the private sector, and worse at letting poor performers go.  Furthermore, the wheels of government tend to move so slowly that any efforts to minimise or offset volatility in economic activity often have the reverse effect, with fiscal stimulus failing to kick in until the broader economy is already recovering under its own steam.

If there’s one area where government possibly has a role to play, it is maintaining open dialogue with major employers to prevent nasty shocks around employment, business viability, etc.  The keys, though, for government, is that it does not impose unnecessary compliance costs on businesses, and that it does not become overly captured by a single business’ interests or apparent power.

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