How do we generate improved economic growth for New Zealand? Sir Paul Callaghan argues that we must shift from low productivity industries, like wine and tourism, to new high productivity industries, such as advanced manufacturing. If we were to do this, we would no doubt lift our economic performance. So why don’t we just get on with it? What’s holding us back?
It’s the economy, stupid
There is no lack of opinion on the matter: check out the comments that follow this NZ Herald editorial. Much of the debate relates to the size and role of government. Twenty years ago, a group of economists might have held a similar discussion. The Washington Consensus (now defunct) more or less held that
’Once a developing country government establishes the rules to a fair game and ensures their enforcement, it would be well advised to stand back and enjoy the self-generating growth’
J. Talbott and R. W. Roll, Why Many Developing Countries Just Aren’t. (The Anderson School at UCLA, Finance Working Paper No. 19-01. 2001).
In other words, once New Zealand’s economy was liberalised in the 1980s, the economic theory of the day said that we should have ‘just gotten on with it’. Instead, this happened.
New Zealand’s liberalised economy is not alone in its failure to perform as advertised. Latin America signed up wholesale to the Washington Consensus in the 1990s, with disappointing results. In contrast, the Asian tigers (South Korea, Taiwan and Singapore) didn’t follow the script: their governments were active in encouraging industry and R&D in advanced sectors, and their economies have flourished.
In fact, over the last decade, economists have spent a lot of time thinking about why some governments have been more effective in growing their national economies than others. Do governments have a role to play beyond simply ensuring macroeconomic stability and building strong institutions?
Economic complexity
As I discussed in a recent post, economies are complex things. A recent collaboration between economists and physicists at Harvard has attempted to illustrate this by mapping the relationships between products that countries export [1]. These maps of ‘product space’ provide a way of representing the complexity of a country’s economy. A more complex economy will tend to contain firms that are more specialised, and according to Adam Smith, a more specialised firm is a more productive firm. Indeed, the Harvard analysis shows that countries with more complex economies are richer.
In addition, the Harvard team found that countries face barriers when exploring the manufacture of new products. Some parts of product space are more densely populated with opportunities than others. Countries that export existing products in these regions find it easier to develop comparative advantage in the manufacture of new products.
Countries that occupy sparsely populated regions, on the other hand, find it difficult to develop new areas of comparative advantage. It appears to be difficult to jump to new regions in product space.
Countries like Taiwan and Singapore, where governments have not been afraid to intervene, have made the transition from sparse to rich regions of product space, enabling them to grow rapidly in the last few decades. Governments don’t always get it right: Taiwan’s push into the aerospace industry has not been as successful as its move into electronics. However, it seems that governments do have an important role to play in moving economies into new regions of product space.
The trouble with markets
What might be behind some of the barriers to moving to new areas of product space in a free market?
A few posts ago, when I made a case for R&D tax credits, I looked at an externality that reduces innovation. In a competitive marketplace, a firm will not put as much effort into innovation as is optimal for society as a whole, because its innovations can spill over to other firms, preventing the innovator from capturing the full benefit.
This spillover of knowledge is an example of a positive externality: society shares some of the reward from private R&D without contributing to its costs. Because of this, many countries, including New Zealand, subsidise R&D to encourage innovation in the private sector, via tax credits or otherwise.
A second type of externality is relevant to this discussion [2]. This arises at the point where an entrepreneur or firm starts producing a new product. When a firm does this, it is experimenting. If the new product is not a success, the firm will withdraw it from the market, or maybe even go bankrupt.
On the other hand, if the product sells profitably, the innovative firm may do quite well for a while, but eventually other firms or entrepreneurs will notice and play copy-cat. The first mover bears all the risk of launching the new product, but does not necessarily reap the all the benefits. Hence it is possible that firms may not be as entrepreneurial as would be socially optimal.
If these externalities are in play, then a laissez-faire approach to economic development might not be sufficient to diversify an economy.
Shockley Semiconductor
The story of the transistor illustrates some of these points. The transistor was invented at Bell Labs in 1947, but it was not commercialised until one of its inventors, William Shockley, left to found Shockley Semiconductor Laboratory in Mountain View, California (near where his mother lived). In the end, Shockley Semiconductor floundered as Shockley’s employees left to found their own firms and it is these later entrants that dominate the market today.
Why should we care whether or not Shockley Semiconductors turned a buck? Today, we all own billions of transistors — this hardly seems to be an example of market failure. But look at it from Shockley’s point of view. He and his investors bore much of the risk for establishing the semiconductor industry in California, but later arrivals like Fairchild and Intel went on to reap much of the benefit.
If first movers are not adequately compensated for the risks they take, then there will be less entrepreneurship than is optimal. While patents reduce some of the risks associated with being a first mover, Shockley’s discovery that the San Francisco Bay area was a great place to found a semiconductor industry is not something that is subject to intellectual property law.
In the end, even the success of Silicon Valley was contingent on the support of the US government, which bought almost every integrated circuit built during the first decade after they were invented. The large volumes required by the Apollo space programme and the US military drove down the cost of production until the circuits were cheap enough to be incorporated into consumer products for the general public.
Economic self-discovery
The key to improved economic growth for New Zealand lies in the discovery of new areas of comparative advantage and the diversification of our economy. Unfortunately, by retaining the focus of its innovation system on areas of historic comparative advantage, I would argue that New Zealand has largely failed in this task. Indeed, the Harvard team found that New Zealand’s productivity is quite consistent with the existing complexity of its economy.
So can New Zealand escape its productivity trap? Laissez-faire does not seem to provide a way out, and the data suggest that a focus on historic comparative advantage will also lead to a productivity dead end. We have little choice but to explore fresh economic territory.
The success of companies like Fisher & Paykel Healthcare and Rakon show us that we can learn new tricks. Forty years ago, an Auckland doctor identified an unmet need for respiratory humidification in his intensive care patients, and took his problem to the DSIR. A DSIR engineer put together a prototype and took it to Fisher & Paykel. Fisher & Paykel tried it out and discovered that Auckland was a great place to build respiratory humidifiers.
Could this light handed, serendipitous approach to picking winners be what is needed today? As Sir Paul Callaghan says, we will be good at what we are good at. It’s just that at the present moment in our economic development, we need to discover a lot more of what we are a good at.
[1] Hidalgo, C. A. & Hausmann, R. (2009). The Building Blocks of Economic Complexity Proc. Natl. Acad. Sci. 106(26):10570-10575 arXiv: 0909.3890v1
[2] Hausmann, R. (2003). Economic development as self-discovery Journal of Development Economics, 72 (2), 603-633 DOI: 10.1016/S0304-3878(03)00124-X
Shaun
Some quick comments.
The key question is how should the Government intervene to beat the market? Spill overs do mean medium to long-term investment in R&D will be lower than optimum, but it isn’t trivial deciding what the Government should invest in to compensate (although it is always easy to do this in hindsight as the Shockley Semiconductor example illustrates).
We can see this today in NZ where in the main the investment process used by FRST over its lifetime did not lead to capability being built in areas apposite to economic growth. Investments were small, spread over a number of projects, in cheaper science and not relevant to much of NZ industry.
The current fashion for responding to this by increasing the public resources going into close-to-market product and process development misses the point that in those areas the spill overs are much lower and so the rationale and returns from public intervention will be similarly much lower. We risk throwing the baby out with the bathwater.
[As an aside I should add that increasing the research intensity of industry is probably welfare enhancing for NZ, but this is a matter for systemic intervention and is linked to a general issue related to under-investment in intangible assets rather than being R&D specific.]
The other fashionable cry is for better commercialisation, more start-ups etc. Ten years ago this was an area that required attention, but I suspect now our policy settings are OK and we are into diminishing returns. The very notion of commercialisation carries with it the notion that an idea has been developed independent of commercial partners, and we are now looking around for someone to take it of our hands. In NZ the universities need this kind of capability because so often the IP is a by-product of their core role, and they naturally wish to realise value out of this. But this isn’t the main game for economic development based on applied R&D.
What we need is for subsectors of industry to engage in a strategic discussion with applied research providers about where their markets are going and the technologies they are likely to need in the medium term, and for these partnerships to co-invest in getting there (markets, products, technologies). The CRI task force got it right by suggesting this is more likely to happen if the CRIs managed this than having it all run from the centre – although this has somewhat been honoured in the breach.
Note that this involves investing where we already have commercial capability (although it doesn’t mean that new areas shouldn’t be included within a portfolio if we have international competitive advantage in the R&D). This is unashamedly an argument for leveraging off our larger firms and historic comparative advantage – because the latter does include highly transformed products as well as primary products.
The types of investments we should favour are those that are platform in nature i.e. we should be investing in capability that touches a number of companies (not just for risk management reasons or to build scale, but also because we are farming spill-overs). We also should be thinking more about investing up and down the value chain, rather than horizontally (which is a mind-set that comes from our commodity industries). In addition to the obvious economic sense this helps make economic activity stickier in NZ.
So that’s the challenge IMHO.