SHOULD New Zealand employ selective government interventions to boost its growth rate? Evidence strongly suggests that government-induced distortions, rather than enhancing growth, actually detract from it. Hence, New Zealand’s “neoclassical” approach to restructuring its economy may indeed be the one most conducive to raising its long-term growth rate.
Economists have long debated the proper role of government intervention in the growth process. Since the mid-1980s, New Zealand has been at the forefront in implementing a “neoclassical” approach to economic restructuring. Successive governments have been engaged in a broad-ranging economic reform program that involves liberalizing key sectors of the economy, reducing trade protection, and trimming the public sector. Yet growth performance in recent years has been rather lackluster. By contrast, some (but by no means all) of the dynamic Asian economies have at times adopted a more interventionist stance to promoting growth (see preceding articles based on the “East Asian Miracle” project).
Which approach works best, in the sense of raising a country’s long-term growth prospects? Put in terms of the policy options facing New Zealand, is the lesson from East Asia that the neoclassical approach alone does not work and, therefore, that New Zealand ought to rethink its strategy of economic liberalization, adding to it the type of selective policies that have apparently worked in the dynamic Asian economies?
A number of recent empirical studies by the IMF, the World Bank, and outside academics show little evidence that government intervention is linked to superior growth performance. If anything, the studies suggest that less intervention in the economic arena (i.e., more liberal trade and industrial policies) is strongly correlated with growth. This would imply that a rethinking of the policy approach adopted in New Zealand is not warranted and that the slow response of New Zealand to the pro-growth economic reforms is likely to reflect other factors.
The East Asian model
In the dynamic Asian economies, it is often alleged that governments have been more successful in using intervention to promote growth. Indeed, government policies (including trade and industrial policies) are often credited as a major factor behind their phenomenal growth performance. According to this view, a number of these economies (including Japan, the Republic of Korea, and Singapore) have at times adopted policies that have favored some sectors at the expense of others. Allegedly, these governments’ success at “picking winners” has been reflected in these countries’ high growth rates.
How valid is the view that selective government interventions helped to boost growth in the dynamic Asian economies? When economists look at the factors accounting for growth, they do not usually think of selective industrial and trade policies as being of first-order importance. In the standard neoclassical growth theory, for example, an economy’s long-run growth rate depends only on the exogenous rate of technical progress. Along the transition to the long run, the growth rate depends on the initial level of national income relative to the steady-state level, and policies can influence the growth rate temporarily by affecting the steady-state income level. In more recent studies of endogenous growth, policies (including trade and industrial policies, and public investment in infrastructure and education) can theoretically affect the productivity of factors in the steady state, and thereby directly alter the long-run growth rate of an economy.
A number of common factors help to account for the exceptional performance of the dynamic Asian economies. These include high domestic savings and investment rates, an emphasis on educating and upgrading the skills of the labor force, the relative flexibility of domestic labor markets, and historical accidents, such as the unusual opportunity to import foreign technology and production methods.
The case that selective government interventions played a major role in the development of these countries is, however, much more difficult to make, precisely because there were very major differences in the nature and scope of such interventions across countries. Hong Kong, for example, is an obvious example of a laissez-faire economy, whose growth performance ranks on a par with that of the other East Asian economies over the last 30 years. Others, such as Japan and Korea, are often seen to have been much more interventionist, but the extent of intervention does not appear to be correlated with superior performance.
Several studies, moreover, suggest that the perception that government intervention is correlated with East Asia’s superior economic performance is not borne out by facts. A recent study by the Australian Industries Commission concluded that “it is naive to argue that the success of Japan and the dynamic Asian economies can be explained principally by governments providing industry-specific assistance.” If anything, the report concludes, where success was observed, interventions broadly conformed to the market and were short-lived.
What is the empirical verdict?
A number of econometric studies shed light on the link between government intervention and growth. A recent IMF study by Malcolm Knight et al shows that more openness (defined as lower tariffs on imports of intermediate and capital goods) stimulates productivity growth. The authors argue that because the tradables sector in many countries serves as a vehicle for technology transfer through the importation of capital goods, this result is not surprising. Their analysis also shows that the productivity of physical investments increases with the degree of openness.
A study by Jong-Wha Lee finds that trade distortions tend to lower growth directly and also indirectly by reducing investments in physical capital. This study thus concludes that countries with less distortive trade and industrial policies have tended to grow faster. Finally, a study by Vinod Thomas and Yan Wan finds a negative association between relative price distortions and economic growth in a sample of ten Asian countries. Moreover, the effect of a lower level of distortions was significant, accounting for two fifths of the variation in per capita income growth and one fifth of the variation in total factor productivity growth.
The above evidence suggests that, controlling for other factors, government-induced price distortions in these countries are lower than the average for both developed and developing countries. In addition, the authors observe that although growth was impressive in the 1960s and 1970s—when relatively more interventionist policies were adopted—it was even more remarkable in the 1980s after market reforms swept the region. The gap between average income growth in the Asian countries and other developing regions roughly tripled in size after 1982 compared with the period before. Thus, the evidence clearly points to a more liberal environment—rather than greater government intervention—as being responsible for improved growth performance.
An examination of Korea’s experience by Jong-Wha Lee also reinforces the above conclusions. Lee examines the relationship between selective government interventions and sectoral factor productivity growth in a large cross section of Korean industries. He finds that government interventions, such as tariffs, import restrictions, and subsidized credits, decreased both labor productivity and total factor productivity in the favored sectors. The results show that growth and technical progress would have been higher had the government reduced the amount of selective interventions.
Lee’s evidence, in particular, illustrates the intrinsic difficulty of picking winners. Although it is theoretically possible to raise productivity growth by protecting a few well-chosen industries, Lee’s findings clearly illustrate the mistakes governments are prone to make in granting selective incentives. In addition, such incentives are likely to make firms operating in the protected sectors less efficient, by decreasing competition—both domestic and international. Finally, Lee’s study reinforces the results of surveys that show that Korean import-competing manufacturing firms strengthened their efforts to improve quality and productivity only after the government liberalized imports of the same products.
New Zealand’s experience
During the three decades leading up to the economic reforms of the mid-1980s, New Zealand had one of the most heavily protected and regulated economies in the Organization for Economic Co-operation and Development (OECD). Tariffs were high and import licensing and quotas pervasive, resulting in some sectors receiving effective rates of protection that were extremely high by any standard, in some cases ranging more than 200 percent. In addition, the government was actively involved in propping up a number of loss-making commercial activities through regulatory interventions and subsidies. It is also during this period that many of the so-called “think big” projects were initiated, which have left New Zealand with a heavy burden of external debt. Finally, institutional arrangements in the labor market, as well as being conducive to government interference, tended to produce wage settlements that had more to do with maintaining living standards and avoiding industrial conflicts than with the underlying economic conditions in affected enterprises.
This period of extensive government intervention was also one of relatively poor growth performance in New Zealand. For example, annual per capita income growth over 1950-85 was 1.4 percent, roughly half the OECD average. Moreover, the sources of growth in New Zealand were quite different from those in the leading OECD economies (the United Kingdom, United States, Germany, France, and Japan), with growth in factor inputs—as opposed to growth in efficiency or total factor productivity—accounting for over two thirds of New Zealand’s expansion compared to less than one half in leading OECD countries.
Thus, prior to the initiation of reforms, growth performance in New Zealand was poor in comparison to other rich countries. Indeed, this might be expected since, in a highly protected economy, the forces of domestic and international competition—so essential to improvements in economic efficiency—are relatively weak. Combined with rigidities in labor and goods markets, the result is likely to be a very poor allocation of resources, with investments not necessarily flowing to sectors where their productivity would be greatest. This was indeed the case in New Zealand prior to 1985, when enterprises had relatively little incentive to control costs and improve the efficiency of production.
The economic restructuring program initiated by the newly elected Labor Government in late 1984 was broad-ranging. Initially, the finance, communications, and transport sectors were deregulated; agricultural subsidies and export assistance were cut sharply; border protection was reduced; and a free trade agreement was concluded with Australia. Other reforms included privatization of state-owned enterprises, corporatization of government departments providing commercial services, tax reform, and a number of measures to improve the accountability and efficiency of government operations. The result was a complete turnaround from the pre-reform period, including very sharp reductions in government assistance to pastoral agriculture, the creation of one of the least-distorting tax systems in the OECD area, and great strides in the area of trade reform, with effective rates of assistance to industry declining from 37 percent in 1985-86 to around 19 percent in 1989-90.
The reforms, however, were not associated with a turnaround in employment and growth. In some sense, though, this was to be expected. As the experience with market liberalization has since shown in a number of other countries, the process of structural change—that is, of reallocating resources from declining sectors to newly profitable sectors—can be quite lengthy, particularly if distortions are initially large and the credibility of the government is initially low.
But other factors were clearly also at work, including the restrictive macroeconomic policies that were adopted to reduce inflation. The tightness of monetary policy, in particular, led to increases in interest rates and the exchange rate, which put pressure on the tradables sector. In addition, a number of factors were beyond New Zealand’s control, such as reduced access of agricultural exports to industrial country markets and escalating support for farmers in most OECD countries and many developing ones.
Another important factor that is likely to have contributed to New Zealand’s lackluster growth performance in the post-reform period is the considerable delay in implementing effective labor market deregulation. It was not until May 1991 that the Employment Contracts Act, which significantly lowered work-practice rigidities and thereby helped to create one of the most deregulated labor markets in the OECD, was introduced. Because labor market deregulation is clearly crucial for increasing the economy’s responsiveness to the incentives created by the removal of relative price distortions, its passage only six years after the initiation of reform in the mid-1980s should be viewed as a key factor in accounting for the subdued response of aggregate output.
Lessons for New Zealand
Contrary to common perception, the message from a number of these empirical studies, as well as from New Zealand’s own experience with interventionist policies, is that more liberal trade, industrial, and credit policies—rather than greater government intervention—are linked to stronger growth performance. Indeed, since the nature and scope of interventions have varied so widely among the dynamic Asian economies, it would be difficult to attribute to this factor alone a central role in these countries’ growth performance.
These conclusions suggest that the reorientation of macroeconomic policies and structural reforms pursued by the government of New Zealand are precisely those that, in due course, are most likely to improve the economy’s growth prospects. Of course, long lags are to be expected in response to the far-reaching reforms that have already been undertaken, particularly when one considers that credibility of policy changes is not achieved immediately and that there are large costs associated with the resource shifts to be elicited from the reforms. In particular, the last crucial piece in reforming the labor market is really quite recent, and the experience of other countries suggests that the improvement in economic performance that should result from these reforms does not occur overnight.
Future growth performance will also be influenced to an important degree by increasing investments in human and physical capital in order to achieve higher total factor productivity growth. Indeed, if one looks to history, New Zealand’s relatively poor growth performance has not been due to a failure to increase the quantity of its productive factors (labor and capital), but rather to a failure to increase the efficiency of their use. In the past, most of the blame could be attributed to high levels of protection, factor and product market rigidities, highly distortionary tax systems, and high and variable inflation rates. In this sort of environment, investment was often undertaken in the “wrong” sectors, that is, in those sectors that were artificially favored by the distortions in the economy.
The previous system of labor relations and the wage-setting mechanism compressed relative wages across skill levels, discouraging human capital development and leaving a relatively high proportion of workers with no formal qualifications. New labor arrangements emerging in the wake of reforms have increased the rewards for skills and will encourage investment in human capital. Again, however, time will be needed to redress the skill deficiencies of New Zealand’s labor force. To facilitate this adjustment process, the government has moved to make the education system and worker training programs more responsive, effective, and relevant.
For further detail and references to the empirical studies, see “Selective Government Interventions and Economic Growth: A Survey of the Asian Experience and Its Applicability to New Zealand,” by the author, IMF Paper on Policy Analysis and Assessment, PPAA/93/17.