Is New Zealand disadvantaged by economic geography to such an extent that it cannot hope to catch up to Australia’s average income levels, even with further improvements in institutions and policies? That is probably the most important question considered in the second report of the 2025 Taskforce that was released a few days ago.

The 2025 Taskforce was set up by the New Zealand government after the 2008 election to recommend how the gap between average incomes in Australia and New Zealand could be closed. Incomes of New Zealanders have generally risen less rapidly than those of Australians over the last 40 years, resulting in a gap between average incomes of around 35 percent in recent years. After the 2008 election, the NZ government committed to closing this income gap by 2025.

Since the Taskforce presented its first report last year, Philip McCann – an economist with expertise in economic geography – has advanced the view that New Zealand’s geographical disadvantages prevent it from becoming a high productivity economy. McCann has implied that structural features that are advantageous in the current era of globalization differ so much from those exhibited by New Zealand that this economy could not reasonably be expected to have relatively high productivity. He suggests ‘this is true irrespective of the degree of flexibility in the domestic labour market, the degree of transparency in the local institutional environment, or the levels of cultural aspirations for success’ (‘Economic geography, globalisation, and New Zealand’s productivity paradox’, New Zealand Economic Papers, Dec. 2009: 299).

The particular aspect of geography that McCann considers to be most disadvantageous to New Zealand is its relative lack of agglomeration economies associated with large cities. These agglomeration economies arise from knowledge exchanges, better networking and coordination, a nursery role for new enterprises, improved labour market matching processes and greater competition.

McCann argues that agglomeration economies can explain the decline in New Zealand’s per capita incomes relative to Australia because of the way the world has changed. One strand of the argument has to do with the increasing importance of knowledge-intensive activities that can often be undertaken at lower cost where face to face contact is possible among the various participants. Another strand is that with closer economic integration between Australia and New Zealand the economy with relatively larger agglomeration economies, i.e. Australia, has become a relatively more attractive location for capital investment and employment of highly skilled workers.

How does the Taskforce respond? The Taskforce acknowledges that both New Zealand and Australia have been disadvantaged by geography. It notes that according to recent OECD research the impact of greater distance to markets is equal to around 10 percent of GDP per capita for both countries. However, it judges the evidence in support of the view that New Zealand’s small population limits the potential to obtain agglomeration effects to be weak. In particular, Auckland’s position within the regional hierarchy of Australasian cities is not declining – the population of Auckland has been growing faster than the populations of Sydney and Melbourne. The Taskforce also points out that there is no evidence that New Zealand suffered an adverse shock from globalization during the 1980s; that migration from New Zealand to Australia is disproportionately of highly skilled workers as agglomeration theory implies; or that the relative performance of small countries has declined in the past 20 years.

Sitting in Australia, current concerns in public policy discussions about the emergence of a two-speed economy in this country make the agglomeration theory of relative decline in New Zealand’s economic performance seem rather odd. Rather than a concern that agglomerations centred on Sydney and Melbourne are leaving the rest of Australia behind, the main concern is that New South Wales and Victoria (along with other states) are being left behind as economic growth steams ahead in Western Australia and Queensland, as a result of rapid expansion of the minerals sector and related industries. There is also reason for concern that, over an extended period, the particularly poor performance of the New South Wales government has detracted from the substantial location advantages that Sydney should enjoy.

If we reject the idea that Australia’s alleged agglomeration advantages make it impossible for New Zealand to close the income gap, where does that leave us in terms of explaining New Zealand’s relatively poor economic performance? The Taskforce pours cold water – correctly in my view – on another geographical explanation, namely Australia’s good luck in having plentiful supplies of mineral resources to export to rapidly growing markets in China and India. It is only in the last few years movements in Australia’s terms of trade have been much more favourable than in New Zealand. Moreover, New Zealand also has substantial mineral and hydrocarbon resources.

I think that leaves us with having to explain New Zealand’s relatively poor economic performance in terms of policies that are less favourable to economic growth. That also poses a problem because the impression given by various international comparisons of institutions and policies is that since the mid-1990s there has not been much to choose in overall terms between the economic policy environments in New Zealand and Australia. It seems likely, however, that New Zealand has not performed so well in the areas that have mattered most from a growth perspective. For example, one major problem discussed by the Taskforce is the effect of relatively high levels of government spending in discouraging investment in export industries – via impacts on the real exchange rate as well as tax rates.

The Taskforce has expressed the view that closing the gap in average income levels by 2025 will require policies that are superior to those in Australia in their focus on growth. It seems to me that those who believe that New Zealand has geographical disadvantages should logically be strong supporters of that view (unless they reject the objective of closing the income gap). The greater the geographical disadvantage, the greater the policy superiority New Zealand will need in order to meet the objective of closing the income gap by 2025.