Counting the cost of misdirected investment

In the fifteen years from 1994 to 2009 the size of the New Zealand economy expanded by 58%.   This represents an average annual growth rate of3.1%, which sounds quite impressive if one compares this with the 29% (1.7% pa) growth experienced in the prior fifteen-year period to 1994.   It does not appear so impressive when one considers that the Australian economy expanded by71% (3.6% pa) from 1994 to 2009 and this was after growing by 55% (3.0% pa) in the fifteen years to 1994.   Not only have we failed to catch up, the gap has actually continued to widen.

My analysis indicates that the whole of the gap in our growth performance compared with Australia can be attributed to the decisions about what is produced rather than anything to do with how good we are at doing the things that we actually do.   Indeed, it would seem that we have been marginally better than the Australians at improving the way we do things, but we have been less adept at producing what the world wants to buy.  

In both countries there has been a 34% growth in the number of hours worked between 1994 and 2009.   This implies that labour productivity growth has been far stronger in Australia, growing by 27% (1.6% pa) in Australia compared with 18% (1.1% pa) in New Zealand.   It is my contention that a better choice of economic activities in Australia is the source of their better economic performance.  

I have developed a method for using the relation between growth in individual industries with overall economic growth to identify the degree that over or under-investment in different industries has constrained economic growth.   The results are summarised in the accompanying table.   This is a pure statistical analysis, so it will not account for real world factors such as physical constraints or the interaction between production in different industries (eg the purchase of electricity by manufacturers).   For these reasons the analysis is likely to overstate the production potential for each country.   For example, the analysis suggests that higher forestry output would generate a greater than proportional increase in New Zealand output, but this result presupposes that there is a ready supply of trees waiting to be harvested.

There are considerable similarities in the results for Australia and New Zealand.   In both countries more harm to economic growth appears to come from over-investing in unproductive industries rather than from missed opportunities.   Home ownership, education, and health are areas of over-investment in both countries.   Social and political decisions are part of the reason for this over-investment in these areas, but my analysis suggests that the economic cost of these choices has been large, hampering economic activity by up to 7% in Australia and by up to 10% in New Zealand.

There are also interesting differences between the two countries.   Business services appears to be an area of underinvestment in Australia, but of over-investment in New Zealand.   Government administration appears to be more of a drain on economic performance in Australia than in New Zealand.

But in net, the intriguing conclusion from a comparison of the results for New Zealand and Australia is that the general misallocation of productive resources appears to have been less severe in Australia.   The total potential loss of economic growth in Australia in the period from1994 to 2009 was 46%, compared with 64% for New Zealand.   This difference in lost potential economic growth, 18%, more than explains the difference in economic performance between the two countries during the period.   Indeed, if New Zealand’s misdirection of investment had been no worse than in Australia, the New Zealand economy is likely to have outperformed Australia’s not by working any harder or being any cleverer than we are, but by simply focussing our efforts more on what the world is willing to buy from us.     

So why the difference?   Part of the reason could be the larger scale of the Australian economy means that there is a higher level of competition in Australia, which naturally weeds out poorer performing activities.   A follow up to this line of thinking is that the consequences of poor policy have a bigger impact on overall economic performance in a small economy like New Zealand.   Higher levels of competition will provide an offsetting force to institutionalised privilege.   An implication is that to perform as well as Australia requires New Zealand to have a superior suite of economic policies.  

It may be attractive for politicians to be seen initiating new activities and opening new facilities.   But they are likely to make a greater contribution to our collective wellbeing by focussing on more humdrum things.  Things like improving public sector performance, and simplifying the tax system and the regulatory environment so that there is a minimum of distortions influencing investment decisions.

Enjoyed this article?

You might like to subscribe to our newsletter and receive the latest news from Infometrics in your inbox. It’s free and we won’t ever spam you.