Investigating New Zealands potential
How quickly New Zealand can grow before setting off inflationary pressures is a question that is open to debate at present. In June, the Reserve Bank explicitly lowered its perceived “speed limit” for the economy. In this article we ask why this change might have come about and have a look over the evidence.
With the New Zealand economy only recovering slowly from the sharp recession of 2008/09, the Reserve Bank feels that slower economic growth is the “new normal” – at least for now. The Bank’s forecast of moderate economic growth, combined with average inflationary pressures in New Zealand during the next three years, is due to a cut in its assumption of New Zealand’s potential growth rate. The potential growth rate is an indicator of New Zealand’s speed limit – how quickly the economy can expand before firms start to push up prices, and employees demand wage increases, at a pace that exceeds the rate of inflation.
We have compiled a list of reasons why the Bank and/or other analysts believe that New Zealand’s potential growth rate has slowed, and have then considered whether these factors are likely to actually have any effect on potential growth.
These reasons are:
- the lack of investment by firms in recent years
- credit constraints, and issues of trust, in the financial system
- the impact of the Canterbury earthquakes
- the mismatch between the employees available and the employees that firms need
- population growth and aging.
Apart from the Canterbury earthquake, which has no effect, each of these issues could potentially limit New Zealand’s economic speed limit going forward. The two reasons that are expected to have the largest influence are issues in credit markets and the disjoint in the labour market.
In order to ascertain exactly what is going on, we look at the NZIER’s capacity utilisation index – where firms directly report how much they can increase production before the cost of making each additional unit of output rises. According to this measure spare capacity exists now, but not to the same degree that it did in the 1988-1992 and 1997-2000 periods. This data suggests that the New Zealand economy has lost some capacity during the financial crisis, but it does not give us a clear guide of what has happened to potential output growth.
We also discuss the claim that productivity has fallen. For this claim to make sense we must explain what has happened based on one or more of the five previously mentioned causes of lower potential growth. In other words, economists using lower productivity as an explanation are not really offering any explanation at all.
Pulling all the evidence together, we believe that the breakdown in financial markets, combined with sharp changes in the New Zealand labour market, will restrict New Zealand’s ability to grow during the next five years, and these restrictions have been included in our forecasts. However, we do not believe that potential growth has been pushed down as sharply as the Reserve Bank and many other analysts have suggested.
Simply put, technology has continued to improve and the population has risen over the last four years, even as overall economic output has barely budged – implying that the capacity for the economy to grow remains in place.
Having identified that New Zealand’s speed limit is being influence by issues in the financial and labour markets, we have a better understanding of the risks. If the European debt crisis finally comes to an end, and the banking system can begin to function normally, then there is scope for significant economic growth. Furthermore, if we have overplayed the level of skill mismatch in the economy, the labour market could improve more quickly – helping to support economic growth going forward.
In its June Monetary Policy Statement, the Reserve Bank explicitly stated that it believes New Zealand’s “potential” to grow will be very limited in the coming years.
To a non-economist, this assertion sounds like quite a strange and meaningless comment. However, in the economics discipline, this statement has a very precise meaning – New Zealand’s potential to grow indicates how much GDP can rise before it starts to put excessive upward pressure on prices (ie too much inflation).
One popular analogy for the idea of potential growth is that of a speed limit for the New Zealand economy. As businesses and households begin to spend more, it pushes up how much firms produce, stretching the economy’s capacity – at this stage the private sector is putting its foot down on the economy’s pedal. Once we’ve hit the speed limit of the economy, additional spending by firms and businesses (further pushing down on the economy’s accelerator) translates into rising prices, rather than rising output by firms. As a result, a lower level of potential output growth tells us that less additional spending by households and firms can be sustained without pushing up prices.
By saying that it believes New Zealand’s potential growth has fallen, the Reserve Bank is saying that the rate of increase in economic activity that can occur without firms pushing up prices strongly, and employees pushing up wage claims sizably, is lower than it has been. The economy can grow less without creating inflationary pressures.
The concept of potential growth in an economy comes about for a number of reasons. We may see the number of inputs in an economy rise (eg population growth climbs, the discovery of oil) or as a country we may see an improvement in technology and/or our nation’s institutions, which allows us to use the inputs we have to make goods and services more efficiently. Over the very long term, potential growth in New Zealand is expected to average around 2.5%pa.
All economics organisations within New Zealand agree that New Zealand’s ability to produce goods and services has been lowered by the crisis. If we believed that the output New Zealand should be producing was growing at 2.5%pa, that would suggest that activity is 8.3% below where it should be! In order to catch up to potential activity by March 2016 the New Zealand economy would need to grow at the roaring pace of 4.6%pa – well above the expectations of any forecasters.
Furthermore, all forecasters have assumed that New Zealand’s true ability to grow without sparking off inflationary pressures over the next five years has fallen. However, there is significant debate regarding how much lower New Zealand’s ability to grow is during the next five years.
This difference can be shown by comparing the outlook for non-tradable inflation and GDP forecasts between the Reserve Bank and Infometrics in Graph 1.1.
For the same level of inflationary pressure (the lift in non-tradable consumer prices) Infometrics is forecasting a significantly larger increase in underlying economic activity (2.0%, or 0.7%pa during the next three years). This gap directly indicates that we are assuming potential output, or the capacity New Zealand has to produce goods and services, will be higher than the Reserve Bank has assumed over the next three years.
In this article, we provide five reasons why potential growth may have changed, and we will discuss two indicators that have been mentioned when discussing this concept. We then pull the evidence together to talk about risks to the outlook for potential growth going forward.
A dearth of investment
The original concerns about New Zealand’s potential appeared during late 2009, when the IMF and OECD noted the sharp drop in investment that had occurred in New Zealand in the aftermath of the Global Financial Crisis. Although investment levels have risen since then, they remain low relative to their pre-financial crisis trend. The Reserve Bank explicitly noted that it felt these low levels of investment would limit the capacity for New Zealand to grow in the coming years.
National investment levels are shown by the volume of gross fixed capital formation in Graph 1.2.
Investment is a driver of growth by increasing the stock of capital we have to work with. When New Zealand as a whole has more capital to work with, we can create more goods and services with the same land, technology, and workers.
As a country, just with a firm, we invest for two reasons: to make up for the depreciation of the current stock of capital, and to add to the current stock of capital. Gross fixed capital formation tells us how much the country is investing – but it doesn’t tell us how much the capital stock is growing. In order to analyse growth in the capital stock, we need to look at net capital stock figures from Statistics NZ (see Graph 1.3).
Removing residential building from the capital stock indicates that there was actually a decline in the amount of capital in New Zealand in 1991/92. Between 1988 and 1992 (a period of very weak growth in New Zealand), the net capital stock rose at an average rate of only 2.2%pa – in line with growth during the four years to March 2011 (the latest data we have).
Even so, the slow growth in the net capital stock did not prevent growth in economic activity of 5.2% in 1993, 5.7% in 1994, and 4.6% in 1995! Furthermore, Graph 1.4 shows that this growth came off the back of a similarly weak economic performance to the one New Zealand is facing now.
Fundamentally, the protracted period of weak economic and investment growth was related. However, it did not stop technological progress taking place, and as a result it did not fundamentally impair New Zealand’s ability to grow once the recession was over.
What do investment levels mean for potential growth going forward?
Although capital investment has been weak, it is more a symptom of current soft economic conditions, rather than a direct indicator that the potential for the New Zealand economy to produce goods and services is lower.
As a result, the lack of investment spending does not support the idea that potential growth, or New Zealand’s economic speed limit, will be lower going forward.
Banking crises: the cost of lost relationships
The New Zealand economy has experienced a protracted set of financial crises in recent years. The years of financial panic in New Zealand can be separated into three parts.
- The finance company failures from 2005 till mid-2008
- The Global Financial Crisis from mid-2008 until mid-2009
- The European Debt Crisis from mid-2009 until today
It is well known that a financial crisis can tighten monetary conditions and increase interest rates in an economy. However, a central bank can lean against this directly by cutting interest rates sharply – just as the Reserve Bank did from mid-2008.
However, financial crises can also have a negative effect on potential output directly. This effect can be shown most clearly by looking at credit default swaps (CDSs) for Australasian banks.
A sharp increase in CDSs directly implies that it is now more costly to insure a deposit with the bank against the risk of default. As a result, a bank’s role of “financial intermediation” between potential lenders and potential borrowers becomes much less efficient.
In many ways, New Zealand suffered more from this change than many other economies, due to the collapse of the non-bank financial sector. The previous relationships between the finance companies and a number of corporate borrowers in New Zealand were destroyed by the collapse of these lenders, leading to not just higher capital costs, but a significant increase in the difficultly of sourcing credit for new projects.
This outcome is an incredibly costly thing to happen for an economy. The breakdown of financial intermediation was a major contributor to the depth and persistence of the Great Depression, and is believed to have played the same role during the recent Great Recession.
The breakdown in financial intermediation hasn’t affected all sectors equally. Industries that relied most heavily on funding from the non-bank financial sector (construction and property development) are now relatively starved of funds. With capital not being provided to areas where it is most valuable, growth in the New Zealand economy will be restrained.
However, there are other areas of the economy where the banking system appears to be fully functioning again. Growth in lending to households has been picking up, while retail banks have increased competition for mortgage lending – pushing down mortgage rates. The general sentiment in the banking industry at present is that banks want to lend to households, but households just do not want to borrow.
What do financial conditions mean for potential growth going forward?
Infometrics’ forecasts have explicitly allowed for a weak recovery in building activity due to the breakdown in financial intermediation in this sector. The Reserve Bank has also taken this factor into account, and even with the Christchurch rebuild taking place, the Bank does not expect spending on residential construction as a percentage of income to reach its mid-2000s level.
It is important to note that, in the same way that difficulties in financial intermediation lower an economy’s potential to grow, an improvement in financial intermediation helps economies to increase this “speed limit”. As a result, if the financial issues in Europe are solved, New Zealand’s potential to grow without sparking sudden inflationary pressures will be higher.
This outcome occurred at the close of the Great Depression, and will happen at some point in the future following the Great Recession. However, no economic forecasters are currently putting their money on financial markets returning to “normal” within the next five years.
The Canterbury earthquakes
Another factor that has been blamed for lower potential growth is the Canterbury earthquakes.
From a purely economic standpoint, it is clear that a natural disaster of this magnitude implies that the level of economic activity in the country must be lower than it would otherwise have been. However, we are concerned about the growth rate in activity rather than the level. It is unclear whether this type of disaster would lower or increase potential growth.
We have all been told that rebuilding in the region will boost economic activity, and this assertion is true. However, we also know that this boost will come with higher prices for building activity and other things. When we are talking about potential growth, we are asking whether the earthquake means that we can have a bigger increase in GDP without the pricing pressures!
Given that the expenditure during a rebuild from a natural disaster is usually on “more productive” things than it would have been otherwise, it is often assumed that potential growth is in fact higher following a natural disaster!
The flipside to this outcome is the question of how it is funded. Given the government is covering the cost for much of the rebuild, there is the risk that tax rates may have to be higher in the future, thereby lowering potential growth.
What do the earthquakes mean for potential growth going forward?
Although the Canterbury earthquakes have been raised as a reason why potential growth will be lower, this claim does not hold up to scrutiny.
Neither the Reserve Bank, nor Infometrics, sees the earthquakes as a contributor to lower potential growth in New Zealand in coming years.
Unemployed, but with the wrong skills
The debt crises around the world have been the major driver of slower economic growth in New Zealand, and higher unemployment. However, the drop in demand and lift in uncertainty stemming from these crises are not the only reasons why unemployment has risen.
A mixture of high petrol prices, an uncompetitive non-food manufacturing sector, and elevated domestic debt levels have created a situation where some industries – and as a result some skill sets – are no longer in demand in this country.
In our view, the key area that will require a smaller proportion of the labour force going forward is the general retail sector. With online retailing becoming increasingly important, and consumer spending more restrained, the industry needs to adjust.
With unemployment among retail workers elevated, this adjustment may take some time.
What does unemployment mean for potential growth going forward?
Although the mismatch between skills and jobs available is not as intense as it was in the early 1990s, the gap between the type of skills people have and the skills that employers want will hold the unemployment rate up during the next three years.
The Reserve Bank has held back from explicitly including such a structural unemployment element in its forecasts, given the uncertainty associated with making any such claim. As a result, structural unemployment is not a factor behind the Bank’s forecasts.
New Zealand is getting older
An aging population was part of the reason that we were able to sustain strong growth over most of the first decade of the 21st century, as a greater number of people entered the most productive time of their lives. However, with an increasing number of these people starting to retire, the aging population will be a driver of weaker sustainable growth going forward.
So how does an aging population affect the level of potential growth in a country? There are three channels.
· As the population ages, people move into and then out of the labour force.
· A middle-aged population will have more children, increasing population growth. An old population will not.
· Experience and productivity generally rise with age.
According to Statistics NZ’s population projections (see Graph 1.7), 6.9% of the population is expected to be over the age of 65 by 2016 – up from only 3.0% in 2006. This lift in retirees will see New Zealand’s effective labour force shrink, and see a lot of our most experienced workers leave the labour force. These two factors will limit New Zealand’s ability to grow.
However, we only expect this change to lead to slightly lower potential growth. An increasing number of retirees will be tempted into staying in the labour force, at least part-time. Furthermore, for at least the next five years the proportion of the population in the most productive 45-64 age range will continue to grow.
What does the aging population mean for potential growth going forward?
The combination of slowing working age population growth, and the retirement of many of New Zealand’s most skilled workers, will negatively affect potential growth going forward. However, the size of this effect is open to debate.
Capacity utilisation: firms suggesting their own capacity
While each of these five reasons for a change in the economy’s potential growth rate are useful, when it comes to looking at what a firm can produce without increasing prices, there is nothing better than asking the firm itself.
Thus it is useful to look at measures of capacity utilisation. The NZIER’s QSBO provides one such measure, where firms are asked “Excluding seasonal factors, by how much is it currently practicable for you to increase your production from your existing plant and equipment without raising unit costs?”
What do the responses show us?
Relative to the low level of capacity utilisation in the 1988-1992 period, and even compared to the drop during the Asian crisis in 1997-2000, capacity utilisation by manufacturers and builders has held up at average levels.
This index illustrates how inflationary pressures in New Zealand have evolved. The non-tradable side of the economy has helped to hold up overall inflationary pressures in New Zealand – with no effective competition overseas and a small domestic market, non-tradable goods face greater capacity constraints and larger pricing pressures. With this part of the index close to its 2001 level, domestic pricing pressures are relatively soft, consistent with spare capacity in the economy.
The rebuild in Canterbury will push up non-export capacity utilisation and lead to increased pricing pressures in the economy. However, this change will occur due to the rebuild directly lifting economic activity.
With the overall index around its average historic level, it is fair to assume that there is less spare capacity now than there was during the Asian crisis or the large New Zealand recession of the early 1990s. As a result, unless there are some issues with the data (which is unlikely), these figures rule out the 5%+ increases in GDP growth without inflation that New Zealand experienced during the mid-1990s.
What does capacity utilisation mean for potential growth going forward?
The NZIER’s capacity utilisation index tells us that there is spare capacity in New Zealand now, but not to the same degree that there was in 1988-1992 or 1997-2000.
Sadly, the index does not tell us anything about the outlook for potential growth – it only indicates how far the economy is below potential now.
The index suggests that New Zealand’s ability to produce goods and services has been negatively hit by the financial crises and Canterbury earthquake. Even though output is 8.3% below its trend level, capacity utilisation has not fallen as far as it did during the much smaller recession during the Asian crisis. But it doesn’t tell us anything about whether New Zealand’s speed limit has been cut.
Just because: total factor productivity growth
There have been suggestions that potential growth has been weaker than expected according to recent estimates, and so may continue to be so going forward.
According to this train of thought, we do not need to explain why this outcome is the case. We do not have a full understanding of the recent weakness in potential growth, and should just accept a weaker outlook as being the case.
This is the scapegoat of a poor economist. Total factor productivity (TFP) growth is a catch-all term for things economists have trouble explaining, such as technology and institutions. Beyond that, TFP estimates tend to be very poorly measured, they are heavily revised as new figures are released, and they are not independent of what has happened within the economy. For example, if the Reserve Bank fails to do enough to stabilise the economy at a point in time, some of this policy failure will show up in TFP growth.
In truth, any of the five previously mentioned causes of lower potential growth could show up in lower TFP growth. Beyond these factors, there are four other potential reasons.
- Technological growth has slowed.
- The quality of governance (corporate and public) has deteriorated.
- The introduction of microprudential regulations by the Reserve Bank has limited New Zealand’s ability to grow.
- The terms of trade may be a reason for lower TFP growth (although, given that the terms of trade is still elevated, it actually points to higher potential growth at the moment).
An economist who says that potential growth is lower because total factor productivity growth is lower is essentially trying to talk circles around you. Saying that total factor productivity growth is lower is in many ways saying potential growth is lower, and as a result it needs an independent explanation.
Conclusion: what of NZ’s potential?
Taking all these ideas and indicators together, it is clear that recent years have knocked back how much New Zealand can produce without firms starting to push up prices. Although New Zealand has some spare capacity, it is far less than would be expected given the drop in GDP that the country experienced in 2008/09 and the subsequent non-recovery.
However, there are two assumptions that have been made widely that we are uncomfortable with.
- Although the level of potential activity has dropped, it is far less clear that the future speed-limit of the New Zealand economy has fallen. Potential growth is unlikely to be far below its historic average.
- Without explaining why potential has fallen, we don’t have a clear idea about why it could suddenly recover.
By identifying the problems in financial intermediation at present, and the mismatch of skills in the labour market, we have noted two of the factors that have pushed down potential output. However, just like during the Great Depression, it is clear that once the issues in financial markets have been moved through there is plenty of scope for the economy to recover. Unfortunately, as the Great Depression showed, those issues can take many years to resolve, and thereby constrain the economy’s ability to recover for a prolonged period of time.
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