It is good to be small
Fri 20 Sep 2013 by Matt Nolan.

New Zealand is a small country.  As the Global Financial Crisis has shown, the whims, fancies, and mistakes of the large economies in our globalised world have a significant impact on New Zealand.  However, as New Zealand has outperformed most of the world over recent years, and looks set to keep outperforming, I have learnt that it can be good to be small!

The benefits of specialisation

Focusing on what we are relatively good at, instead of trying to do everything, is a simple principle that holds at every level of human interaction.  In economics, and when talking about international trade, this idea is called comparative advantage.  This implies that by focusing on what we are relatively good at, we can trade and expand the number and type of goods and services available to us – relative to autarky (a situation of self-sufficiency).

But this is not just a story of the benefits of New Zealand specialising – in fact we want other countries to specialise as well.  According to theory, data, and the practice of recent decades the massive productivity improvements in China have been a massive boon to the living standards and incomes of New Zealanders as well as for the Chinese themselves!

I know that this doesn’t get mentioned nearly as much as it should, but the massive improvement in productivity and lower costs associated with production in China has made incredibly cheap manufactured goods available to New Zealanders.  New Zealanders haven’t had to sell as much in terms of tourism services, milk, meat, wool, and IT services in order to buy televisions, computers, vacuum cleaners and cars.  Having China develop its own economy and concentrate on its areas of comparative advantage is not a bad thing for New Zealand – it is a great thing for us!

Diversifying risk by diversifying markets

Now these benefits from specialisation might seem sort of obvious, and the crisis did nothing to make them seem any more apparent.  If anything, they highlighted the risk to New Zealand from having a set of businesses and households that were too dependent on certain kinds of production – namely the concern that as a society we are in some way not diversified.  My colleague touched on the idea of diversification here.

This issue becomes even more important when we start to think of the growing integration of supply chains across countries, and the fact that specialisation involves products becoming more and more heterogeneous (different).  But this is actually where New Zealand is in an amazingly strong position rather than a weak one.

With fertile land, excellent knowledge and technology, and a sparse population, New Zealand is relatively good at making food.  54% of New Zealand’s merchandise exports are in food and animal exports.  And yet, New Zealand’s production of food and related products accounts for only the tiniest sliver of total world production.

Milk, meat, wool, no matter how much we talk about our great produce these products are relatively “homogenous” (similar).  In that context when one country decides they really don’t want to buy any more, exporters can more easily switch where they sell these products somewhere else – compared to firms that sell speciality computer chips, or other manufactured parts. 

One of the recent examples of this was the rapid shift in dairy product sales to Venezuela.  The fact dairy exports to Venezuela slumped 56% in the past year has been in the news recently.  However, what the news stories forgot to point out is that dairy exports to Venezuela are incredibly volatile – doubling and halving on a regular basis.  Dairy exporters are able to look around the world, including Venezuela, and trade on the basis of market conditions in these countries – selling to the places which are willing to offer the most attractive price for dairy produce.

The fact that New Zealand exporters, and our nation’s comparative advantage, tends to be in a product that can be quickly shifted and sold in different countries helps these exporters deal with the risk associated with a slowdown or shift in demand in an individual country!

This wasn’t always the case – while the products were similar, New Zealand used to rely strongly on sales to Britain until they entered the European Economic Community.  The fact that New Zealand has been able to quickly shift its sales of commodities and products between nations in the face of a massive global economic slump has shown how much our primary product producers have matured and learnt to take advantage of this homogeneity over recent decades.

New Zealand’s small size and exporters reliance on homogenous goods actually makes the country relatively resilient to global economic shocks – an important point to keep in mind when demanding that the government interfere to “restructure” or “rebalance” the economy.

Terms of trade and insurance

While what I have discussed a lot of benefits from being a small trading nation, some that are too often glossed over, I would be remiss to ignore potential costs.  The intuition that being small and exposed comes with risks is true.

These risks can be seen as akin to an issue that has been discussed widely by economists in the past with regards to New Zealand’s rising terms of trade, the issue of “Dutch Disease”.  This focuses on the impact on the economy from a rise, then fall, in commodity prices.

I’ll be honest that I do not like the name, in truth this is the “Dutch Issue” – disease suggests only costs, while issue indicates to us that we are facing a situation with winners and losers, risk and reward, and given that we should be trying to understand what these risks are to see if we can somehow insure against them at a reasonable cost.

It is evidently not true that a jump in the price New Zealander’s are receiving for exports is a bad thing – the data does not suggest that the “Dutch Issue” hits growth (further explanation here), the assumed costs in terms of misallocated investment presumes that government knows how and where to invest better than the firms investing (dubious at best), and even a temporary lift in prices will be an income boon to those inside New Zealand who are exposed to it.

There are two policy relevant ways to think about how a resource boom impacts upon the economy:

  1. Distributional (explained in terms of question here):  The increase in the price of certain commodities (say milk) also leads to a shift in wealth within the country, from those endowed with milk (and those who work with them) and away from those who compete with milk in some way (eg milk consumers). 
  2. Variability and risk:  Given the size and scale of dairy exports as a proportion of our economy, sudden shifts in dairy prices have a sizable impact on economic outcomes.  Given that these shifts are unforeseeable, monetary and fiscal policy in of themselves may not be able to react sufficiently – the fact we know there is risk combined with a view that this risk is not being taken into account provides scope for social insurance.

Norway is one country that has responded on the basis of this type of issue – leading to the introduction of the Norwegian oil fund.  In this way the choice of the Norwegian government can be seen as a form of social insurance, and if we think that people within society are unable to insure themselves then this can be seen as a self-evidently good thing.

Note that the Australian superannuation fund, and Cullen fund in New Zealand, have also been justified on this basis even if they were not the main reasons given – and they were not funded in a way that is fully consistent with this idea.

A key point to keep in mind if we do want to think about terms of trade movements in this way is that it requires that individuals in society are, for some reason, unable to insure themselves against the risk associated with price variability.  If we cannot make this argument, then the concern about variability and risk also melts away – as it becomes the choice of the individuals involved.

All in all this implies that, being small is grand – as a nation we just need to be honest about what being small means, and the risks that do exist.

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