By Winton Bates, on November 18th, 2010
The ratchet theory suggests that government spending tends to ratchet up in times of crisis (wars, social upheavals, recessions) and then to remain at the new higher level. It has been put forward as an alternative to Wagner’s law (discussed in an earlier post).
In terms of the ratchet mechanism, the explanation for upward movement in government spending may appear straight forward, reflecting public demands for the government to ‘do something’ to help solve a problem. The process is not entirely mechanistic, however, because public demands for government action can vary depending on ideological factors e.g. changing perceptions about the role of government in helping people who are adversely affected by a recession and about the effectiveness of deficit spending. It is also possible for the upward movement to occur for opportunistic reasons e.g. politicians with an ideological leaning toward big government ‘never want a serious crisis to go to waste’.
A variety of reasons have been put forward to explain why public spending might remain at the new higher level after the end of the crisis. The most mechanistic explanation is status quo bias – the tendency of people to choose to maintain the status quo rather than to change a policy. For example, once tax rates have been increased to fund war time spending, status quo bias may favour retention of higher tax rates.
In addition, new programs created during a crisis may tend to develop a life of their own by creating interest groups with a vested interest in their continuation – including newly created bureaucracies that will fight to prevent themselves from being eliminated.
However, the ratchet theory does not provide a complete explanation of the growth of government. In his review of Robert Higgs’ book, ‘Crisis and Leviathan’, Gary Anderson notes that while most historians argue that the Civil War was the pre-eminent crisis in American history, ‘following this particular crisis, government sank like a stone relative to the growth of the private economy’.
Dick Durevall and Magnus Henrekson did not find strong support for the ratchet theory in their recent study of trends in size of government in the UK and Sweden from the beginning of industrialization until the present:
‘There is no consistent evidence of a ratchet effect in either country. There is some evidence of an asymmetric effect in both countries in the post-war period, but this is reversed in subsequent periods. Hence there is no clear evidence that government exploits recessions and crises to permanently shift the government spending ratio upwards’ (p. 22).
In New Zealand, government spending as a percentage of GDP seems to have fallen during WW2 as well as in the latter half of the 1950s and the 1990s. At the same time, as noted by Bryce Wilkinson, ‘the timing of the increases in the state’s share looks opportunistic’. Wilkinson suggests that growth in government spending reflects ‘changing ideas about the role of the state and the increasing power of vested spending interests’ (‘Restraining Leviathan’, 2004: Figure 5, p.41).
It is also difficult to see a consistent ratchet effect in the following chart for Australia showing estimates of government spending as a percentage of GDP over the period from 1939 to the present. The increase that occurred in the 1970s has not been reversed, but during the 1950s the Menzies government seems to have managed to defy the ratchet effect by reducing government spending to levels close to those in 1939.
I have never previously thought that I might one day have reason to praise the economic achievements of the Menzies government. It seemed to me that the Menzies government’s greatest claim to support free enterprise was to have removed war-time price control, rationing and import controls (more or less and belatedly). However, the efforts of this government in reducing the size of government during the 1950s deserve high praise.
Summing up, it seems to me, to be important not to downplay the role of ideology in influencing trends in government spending. During some periods there may be a tendency for government spending to ratchet up in response to crises. Changes in government spending may also be influenced by changes in the power of interest groups (for example as changes occur in the age structure of populations). In the end, however, ideas about the role of government matter a great deal.
By Winton Bates, on November 8th, 2010
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.
McCann sums up: ‘ … although New Zealand underwent fundamental institutional reforms in the 1980s and 1990s, at exactly the same time as this was taking place the landscape of global economic geography was shifting in favour of other places. It may well be that the deregulatory reforms limited some of the most adverse aspects of these shifts, thereby minimising the productivity gap. Yet the point still remains that the world changed, and the world of the late 20th and early 21st centuries is very different from the world that provided New Zealand with almost a century and a half of productivity advantages’ (p. 300).
 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.
The Taskforce concludes: ‘… modern growth theory provides stronger support for the importance of institutions and policy than it does for geography, especially in the deterministic interpretations of economic geography’ (p. 41).
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.
By Winton Bates, on May 29th, 2009
Some New Zealanders might say that this is a question that only an Australian could ask, but it seems to me to be a good way to raise the issue that I want to discuss. (I hope that when I look back on this in a few days time it will still seem like a good idea!)
The ratings that I am writing about are the ladder of life ratings from the Gallup World Poll – the top step of the ladder represents the best possible life and the bottom step represents the worst possible life. But I could be referring to any of a range of surveys that ask people to place a numerical rating on how happy they are or on how satisfied they are with their lives.
I do not intend to argue that New Zealanders have a peculiar propensity to over-rate their satisfaction with their lives. The issue I want to discuss is what it means when surveys show that New Zealanders are just as satisfied with their lives as people in the U.S. even though average incomes in NZ are only about two-thirds of the U.S. level. I propose to compare the impact of income differences and other factors on the survey measures of subjective well-being in order to enable readers to consider whether the impacts attributable to income differences provide an accurate measure of its impact on the quality of lives.
It is now possible to make fairly accurate comparisons of the impact of income and other factors on average ratings of subjective well-being at a national level. Recent research by John Helliwell, Christopher Barrington-Leigh, Anthony Harris and Haifang Huang has shown that a high proportion of differences in average life evaluations between countries can be explained statistically by differences in a relatively small number of variables reflecting social, institutional and economic circumstances of life (See Table 3, ‘International Evidence on the Social Context of Well-being’, Working paper 14720, NBER, 2009). The most important variables are income (log of per capita GDP), friends (the proportion of survey participants who have relatives or friends they can count on for help when they are in trouble), freedom (the proportion who satisfied with their freedom to choose what they do with their lives) and corruption ( responses to questions relating to whether corruption is widespread throughout government and business).
In the Figure below I have used these research results to show reasons why average survey measures of subjective well-being in several countries differ from the U.S. ratings.
The net differences from U.S. ratings are shown next to the label for each country. If you focus on New Zealand you can see that the perception of NZers that their country is relatively free of corruption outweighs the negative impact on survey responses of the fact that average incomes in NZ are substantially lower than the U.S. average.
If you consider that corruption is as big a problem in the U.S as, for example, in Greece, you might think that this provides an accurate depiction of the relative impacts of income differences and corruption on the quality of life in New Zealand and the U.S. However, when I look at the expert ratings of corruption levels in Transparency International’s corruption index, the U.S. doesn’t look too bad. The rating of the U.S. in this index (7.3) is lower than Denmark and NZ (both on 9.3) and Australia (8.7) but well above Italy (4.8) and Greece (4.7). (It is also interesting that Greeks do not perceive that their corruption problem to be any worse than that in he U.S. and that NZers do not perceive themselves to be as free of corruption as the Danes).
The point is that the influence of various factors on the survey ratings of quality of life depends on the way they are perceived. Americans are sensitive to corruption in their society and they don’t like it. The ratings are more like emotional responses than dispassionate evaluations. It seems to me that self-reports of how people feel about their lives tell us about their emotional state, which is an important influence on well-being but is not identical to it.
One way to test survey ratings is to ask ourselves to what extent we would be prepared to rely on them in making decisions affecting our own well-being. It seems to me that income may be more important to people when they make decisions affecting their our well-being than when they answer questionnaires about the quality of their lives. If you were in Europe contemplating a choice between moving your family to either the U.S. or NZ, would you consider the importance of differences in average income levels to be adequately reflected in survey ratings of the quality of life?
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By Cheryl Grey, on August 1st, 2008
How Small Is It?
New Zealand’s entire gross domestic product, the value of all goods and services produced within a year, was approximately $128.1 billion in 2007, around the same amount as the state of Iowa. The importation of one major piece of industrial machinery earlier this year required a comment in investment banks’ economic reports so as not to set the import-export seesaw tottering. Economic analysts regularly track “external migration” as workers flock to Australia, Canada and the United Kingdom for jobs, then flow back home when economic times pick up. When 29,000 jobs were lost in the first quarter of 2008, that was 1.3% of all the jobs in the nation, and it was enough to send the unemployment rate from 3.4% to 3.6%.
Services comprise the largest single sector of the economy and in 2006 made up 76% of employment. Agriculture, although only 7% of the total economic pie, heavily influences the rest, with industrial sectors including food processing such as milk and meat, wood and paper production from forestry and textiles from wool. It’s estimated that the recent drought’s effect on agriculture, and its attendant industrial sectors and hydroelectric production, was enough to knock a full percentage point from GDP growth in the first half of 2008.
Industrial production is kept discreet so that it doesn’t injure the other major industry—tourism—nor the burgeoning film sector. Crude oil, extracted offshore from the Tui oilfield, is loaded aboard tankers from the wellhead and immediately exported to overseas refineries rather than touching those pristine shores, while the government has funded an agency called Film New Zealand as a “one-stop shop” (their term) for producers of movies both major and minor to simplify the process from casting to special effects.
Achilles’ Heel
But much of this economy is based on trade, and exports influence fully 22% of New Zealand’s GDP, leaving the economy at the mercy of global whipsaws. Although soaring commodities prices, including milk, meat and crude oil, have bolstered trade-based cash flows for the past few years, imported refined gasoline costs have surged even higher, rising 12.8% in the first quarter alone and driving consumer inflation to income-crunching levels.
The Reserve Bank of New Zealand’s attempts to contain inflation have included raising the interbank (wholesale) interest rate to an eye-popping 8.25% and leaving it there for a solid year. However, this has made the New Zealand dollar a favorite for international investors dabbling in what’s called the carry trade, where funds are borrowed in a nation with a very low interest rate (such as Japan’s 0.5% or the 2.0% current in the United States) and invested in a nation with a high one. Although the investor risks currency fluctuations wiping out those gains, the practice has become so popular that New Zealand’s currency has been pushed to frantically high levels—making their goods more expensive overseas and reducing the volume and value of those all-important exports proportionally.
It doesn’t help that there’s a housing market “correction” underway there, too, matching those in the U.S. and UK although not as severe. With banks passing on those high interest charges to their clients, mortgage rates are variable and in double digits, sending home sales plunging by 42% since June 2007.
The official definition of a recession is two consecutive quarters of negative GDP growth. With first quarter 2008 GDP printing at −0.3% and the second quarter looking even worse, it’s likely that New Zealand will be the first industrialized nation in 2008 to meet this definition.
Economic analysts expect that the slowing growth will cool inflation and give the Reserve Bank a chance to lower those interest rates, leading to higher domestic growth over time and sending international investors elsewhere in their search of carry trade profits. As the New Zealand dollar weakens against other major currencies, their exports will become more affordable overseas and those discreet industries will become more competitive on the global marketplace.
Who knows, Peter Jackson’s next New Zealand movie, The Hobbit, scheduled to go into pre-production in 2009 and into shooting in 2010, may be enough to pull the entire nation out of the recession. And an end to the drought won’t hurt, either.
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