This is the last post in my series on Philip McCann’s paper [1], which considers New Zealand’s productivity paradox: why, despite being ranked very highly for the factors that are normally thought by economists to drive economic growth, is New Zealand’s economy is just an average performer? In the previous post, I discussed why McCann doesn’t see a paradox. In fact:

“In the current era of globalisation, New Zealand’s combined lack of any major home market effect, the lack of major agglomeration effects, and the extreme geographical isolation, breaks the usual link between entrepreneurship, innovation and growth which is evident in other countries.”

McCann’s argument is based on ideas from economic geography, in particular that high spatial transaction costs in knowledge-based activities have lead to the regional agglomeration of high technology industries. New Zealand’s small population base means that we don’t enjoy the benefits of agglomeration in knowledge generation experienced by larger countries and cities.

Do agglomeration benefits exist? My patent data seems to suggest they do, and the continued existence of regional clusters of knowledge-based industries (such as the Nokia cluster of inventors in Helsinki) seems to be further evidence of this.

This may not seem intuitive; we are told every day that the world is flat.  However McCann argues that it is only in low knowledge-intensity activities where the terrain has levelled off.  The landscape for knowledge-intensive activities, McCann’s work suggests, has become more mountainous.  Despite the availability of electronic communications, my personal experience is that face-to-face contact in scientific collaborations remains vital.

Picking winners?

So what can New Zealand do about its economic geography? Are there some silver bullets for Mr English?

One approach discussed by McCann is to reduce spatial transaction costs between New Zealand and Australia (and the rest of the world).  He suggests that we move towards economic union with Australia, invest heavily in broadband, and look to reduce the monopoly that Auckland’s international airport currently enjoys.  I’ll leave it to the reader to rank these in order of political feasibility.

McCann also suggests that government will need to “pick winners” i.e. find mechanisms to grow New Zealand companies to scales at which they can invest and grow offshore rather than simply export.

… finding systems that also encourage New Zealand firms to move from simply exporting to overseas ownership, thereby promoting outward FDI and increasing New Zealand’s global engagement, would appear to be critical. Such an approach can also be allied  with  an  approach  that  targets  particular  types  of  inward  investors. While ‘picking winners’ is widely regarded as having a poor history in much of New  Zealand’s  industrial  policy,  using  inward  FDI-promotion  strategies (Boston Consulting Group, 2001) to help to attract technologies regarded as  critical for New Zealand (and agri-biotechnology technologies would appear to be high on the list) is a pragmatic approach that is freely adopted by almost all of New Zealand’s competitor countries.

I would add that government will need work out how to deliver the highly-skilled human capital that these ‘winners’ will require.

A city of four million people

Another obvious approach is to increase our own domestic levels of agglomeration.  As a colleague of mine put it, “New Zealand needs to act like a city of four million people”.

McCann makes several suggestions as to how we might do this:

1. Take full advantage of our existing spatial agglomerations e.g. Auckland-Hamilton-Tauranga by ensuring their continued growth and by investment in their infrastructure.
2. Increase knowledge flows between Auckland and the rest of the country.  McCann argues against concentration of resources in the University of Auckland, suggesting that knowledge transfer primarily occurs through the mobility of people between regions rather than through direct spillovers.
3. Increase competition on domestic airline routes to lower internal airfares.
4. Reduce the breadth and fragmentation of our RS&T sector. In particular, he cites Rod Oram [2], suggesting that we focus on our agricultural sector.

With regards to point 4, as I have revealed before in this blog, my opinion is that a sole focus on agri-biotechnology for New Zealand is risky and perhaps even misguided.  New Zealand has exceptionally low export diversity, with a heavy reliance on commodity dairy products.  Do we play to our strengths by trying to leverage the existing scale in our dairy sector, or do we try to develop fresh export sectors, building scale from scratch?

This is a question that occupies the minds of many commentators.  A conservative approach would be to play to our perceived strengths.  In New Zealand’s case, these are generally perceived to lie in agriculture, so it is not hard to make a case for putting our brain power to work in this sector.  Yet as McCann points out, our labour productivity in agriculture is only 16th in the OECD, despite the strong agricultural focus of our RS&T system.

The alternative is to develop new sectors of our economy, as small countries as Denmark and Finland have done over recent decades.  As I have noted in my study of Finland’s inventor network, this will require substantial targeted investment in human capital over a sustained period.

The reality is that to maintain our place in the world we will need both to back our existing strengths and to develop new ones, quite simply because other countries are also doing both.

Depth not breadth

The science reforms in the early 1990s were intended to make New Zealand’s RS&T sector more efficient and paid little heed to the idea of building scale.  Institutional financial needs pre-empted wider collaboration and FRST effectively capped the size of the grants it awarded, explicitly acknowledging that it could not manage programmes larger than ~$NZ2m. (Note to overseas readers: this is not as large as it sounds, partly as it is in NZ$ ;-), but mostly as it is full-cost funding rather than marginal funding – in a University or a CRI for instance, it might fully fund 7-8 scientists.)

An early policy response to this problem was the establishment of the Centres of Research Excellence (CoREs), including the MacDiarmid Institute which I work for, and seven other organisations.  In fact, I have come to think of the MacDiarmid Institute as a mechanism that has both reduced spatial transaction costs for collaboration and increased the scale and coherence of the physical sciences in New Zealand.

If we are going to take the economic challenges ahead of us seriously, then I think it is worth carefully studying the way that the CoREs have built scale and collaboration within New Zealand science.  The MacDiarmid Institute experience is that a multi-institutional network of researchers distributed across the country can be an effective way to build scale and increase research productivity and impact.  This is something I am now looking at quantitatively with the Ministry of Education and will no doubt be blogging about soon.

Where to from here?

Most of us would agree that New Zealand must diversify its economy through knowledge intensive-industries to reduce its dependence on low-value commodity exports.  Policies that seek to do this, but that do not take into account our economic geography (scale in particular) will probably not succeed.  Nonetheless, small countries, such as Denmark, Finland and Israel, have overcome the disadvantages of size to build successful high-technology industries with scale in areas unrelated to previous strengths.

I will conclude with an observation that Philip McCann made to me over coffee last year.  We were discussing my study of the Finnish experience, and I was arguing that a similar economic transformation was possible here.  He did not agree, yet his argument was not based on economics, but rather on culture.  His view was essentially that science and technology are so much more deeply embedded in the Scandinavian worldview that their businesses and governments have the ability and confidence to do things that ours cannot.

Unfortunately, it is difficult to disagree with this last statement.  Conventional wisdom in New Zealand politics holds that Kiwis don’t care about science and technology, so good policy and increased spending in this area doesn’t win votes.  We will need to change this, if we are to ensure that New Zealand’s economic geography is not its destiny.

[1] McCann, P. (2009). Economic geography, globalisation and New Zealand’s productivity paradox New Zealand Economic Papers, 43 (3), 279-314 DOI: 10.1080/00779950903308794

[2] Oram, R. (2007). Reinventing  paradise:  How  New  Zealand  is  starting  to  earn  a  bigger, sustainable living in the world economy. North Shore: Penguin Books.

In this post, I will continue my discussion of Philip McCann’s paper, “Economic geography, globalisation and New Zealand’s productivity paradox” [1]. McCann argues that it is New Zealand’s economic geography that is the reason for its poor productivity performance. In this post I’ll try to sketch some of the underlying ideas from economic geography that McCann utilises.

There is a general perception that globalisation is levelling the world economy (see Thomas Friedman’s book “The World is Flat”).  The outsourcing of manufacturing from Europe and the US to parts of Asia certainly receives a lot of attention in the media – even I have blogged about it.  However, McCann argues that the world is not becoming as flat as we might think.  In fact, over the last two decades, he notes that the share of global output, global trade, global foreign direct investment and global R&D, of the three super-regions (the EU, NAFTA and South and East Asia) has grown.

How does McCann reconcile this increasing regionalisation with the idea of globalisation?  The key to McCann’s argument is the relationship between the agglomeration economies (or economies of scale) and the spatial transaction costs involved in trade and manufacturing.

The idea that economies of scale might be important for productivity goes back at least as far as Adam Smith.  In his Inquiry into the Nature and Causes of the Wealth of Nations, Smith observed that division of labour offers advantages in a manufacturing process.  Using the example of a pin factory, he noted that the larger the factory, the more a factory could specialise tasks in pin manufacture among its workers.  Smith argued that if one doubles the size of the factory, the increased opportunities for specialisation meant that the factory was bound to more than double its output.  In other words, the larger the pin factory, the higher the productivity of its workers.

McCann suggests that it is high-value added or knowledge intensive manufacturing that benefit most from this type of specialisation and the division of labour.  Therefore, it is this type of manufacturing that will exhibit economies of scale.

If this is the case, economists have shown that if there are high transportation costs or trade barriers that lead to high spatial transaction costs for trade, then all countries and regions will have similar production patterns and similar levels of productivity. For example, every country will manufacture its own cars as it is too costly to ship them across national borders.

If, however, transaction costs fall, then knowledge intensive manufacturing that exhibits economies of scale will become localised in particular regions.  These regions will exhibit high levels of productivity.  For example, the large number of high technology workers in Silicon Valley gives it an advantage in productivity that other regions can’t match.  Only when spatial transaction costs for generating new knowledge fall to close to zero will this regionalisation disappear and productivity return to being spatially homogenous.  This leads to an inverted U-shaped relationship between agglomeration and spatial transaction costs.

McCann argues that while it’s true spatial transaction costs for low value, low knowledge intensive manufactured goods have fallen dramatically over recent decades, the spatial transaction costs for high value, knowledge intensive activities have increased:

This is because of the increasing importance of timeliness, speed, variety, customisation, and service-quality, in all high knowledge intensive forms of production and service delivery (Disdier & Head, 2008; Duranton & Storper, 2007; McCann, 2007).  The principal reason for this is that the premium associated with face-to-face contact in high knowledge intensive activities appears to have increased (Gaspar & Glaeser, 1998; McCann, 2008; Storper & Venables, 2004), because the spatial transactions costs on the inputs side of the production process, rather than the outputs side, have increased for high value goods (McCann, 2008).

It is this increase in transaction costs for knowledge intensive activities that has led to agglomeration of research and development in places like Silicon Valley and the productivity advantage that large cities enjoy today.  Spatial transaction costs for knowledge intensive activities are sitting near the top of the inverted-U, while the costs for commodity manufacturing have climbed it and are heading down the other side.  So the production of commodities may have become globalised, but the generated and application of new knowledge has not. What does this mean for New Zealand?

Part V
Part VI

[1] McCann, P. (2009). Economic geography, globalisation and New Zealand’s productivity paradox New Zealand Economic Papers, 43 (3), 279-314 DOI: 10.1080/00779950903308794