So how does this small size influence outcomes for New Zealanders?

The growth of big cities has been one of the main features of the world economy since 1950. Back then, there were only 15 cities with more than 3 million people. Now there are over 110. People flock to big cities for a variety of reasons. Incomes tend to be higher, and the selection of occupations wider. Oftentimes education and health care are better. For young people, the social life tends to be more interesting, and less subject to traditional restrictions. Cities tend to have a lower environmental footprint, although it does always appear this way because any excesses are more concentrated.

In the last three decades, the growth of big cities in OECD countries has been associated with another dynamic – they have increasingly become centres for service sectors that rely on highly educated workers.

Up until 1980, this phenomena was not so noticeable. Big cities and small cities both had large amounts of manufacturing work, and big cities were a great places for people with middle levels of education (a full high school level education) as they offered a wage premium relative to small cities. As manufacturing and clerical jobs vanished, however, the earnings premium for people with medium levels of education disappeared (Autor 2019). Given big cities typically have higher real estate prices than small cities, big cities are now much less attractive destinations for people with moderate education levels.

The decline of manufacturing

The decline in manufacturing has been massive. New Zealand’s experience is typical – in 1976 25% of jobs were in the manufacturing sector, but now it is only 10%. Many of the jobs that have replaced them are in the health and education sectors, or in professional and business services.

Firms in the latter sectors seem to have a strong preference to locate in big cities. For example, when employment in New Zealand’s finance sector expanded from 4.9 to 6.7 percent of total employment between 1976 and 2013, or from 50,000 to 100,000 job, two-thirds of the increase occurred in Auckland. This might be fine if you live in Auckland or want to live in Auckland. However, it creates difficulties for smaller towns that lost their manufacturing jobs but could not easily take advantage of the expansion in employment in other sectors (Coleman, Maré and Zheng 2019).

Globally, the McKinsey Institute has identified 50 “super cities” which have very high incomes, a large fraction of the largest and most dynamic service sector firms, and highly educated workforces. Singapore but not Auckland features; Sydney and Melbourne are in the next tier above Auckland.

These super cities are attractive destinations for the most productive firms and the most skilled workers, creating a virtuous circle of high income, highly productive locations. Labour economists attribute a large fraction of the rise in income inequality to this assortative matching process, as the most skilled people earn increasingly large amounts in the most productive firms.

If other firms were able to copy the productivity performance of these frontier firms, the increased productivity would filter down to everyone, raising wages generally. This is not happening, however.

In the last two decades it has proven increasingly hard for other firms to copy the best firms. These means productivity gaps and wage gaps have widened. Big-time bankers in London earn more than “big”-time bankers in Auckland, who earn more than those in Christchurch. This seems to be an important component of the rise in inequality in OECD countries.

Questions of scale

At one level, the problem for small town New Zealand relative to Auckland is the same as the problem of small-town Auckland relative to major world cities.

If it is difficult to copy the production techniques of the best firms, a city needs to attract the best firms to obtain the benefits of the high productivity and high wages they offer. If a city can’t attract these firms or copy their productivity levels, wage levels will lag behind.

In this case people wanting the better life-styles normally associated with higher incomes will find it easier to move to where the good firms are located rather than wait for the good firms to locate where they live. Lots of New Zealanders have worked this out – both those that have moved from New Zealand to higher productivity locations abroad (or within New Zealand), and New Zealanders who have migrated here from lower productivity locations abroad when they had the chance.

To take just one example, the statistics are very clear that the easiest way Maori have found to make high incomes is to migrate to Australia – Maori earn nearly the same as other Australians and nearly the same of Pakeha migrants, as they take advantage of the high incomes and high productivity levels that are offered by Australian firms but which New Zealand firms do not seem able to match. (Kukutai and Pawar 2013 provide data on Maori incomes in Australia).

Nineteenth century America was characterised by boosterism – competition by cities to promote themselves to attract the best firms and the best people (Chicago was the bigtime winner, as William Cronon documented in his magnificent book “Nature’s Metropolis.” ) 

Does this provide a clue to understanding New Zealand’s low productivity woes?

I am not sure, but understanding why productive firms choose to locate in one place and avoid other locations is a key part of understanding productivity performance when it is difficult to copy what the best firms do.  For years I have joked that New Zealand’s approach to attracting the best international companies is to give them the chance to pay some of the highest business taxes in the world. Unfortunately, the productivity statistics suggest this strategy is not enough. If New Zealand’s cities are not a desirable location for the world’s most productive companies, additional effort might be needed to work out how to attract them in the future.

In this post I will discuss how the solution to these three issues can be linked. In a follow up I’ll use the example of New Zealand to show how policy settings may be making the third issue worse than it needs to be.

Before getting started, it is useful to discuss the three issues in a bit more detail.

The first issue concerns the way the world economy will function if global emissions of greenhouse gases significantly decline – although a low emission economy may be preferable to allowing the concentration of emissions to increase. The necessary decline in global emissions may require a decline in the goods and services produced – maybe not by as much as some fear due to technological change – and lower growth will mean the global economy will be allocating fewer resources than it currently anticipates.

The second issue is the way the incomes of one or two billion people who live in poverty (or who will live in poverty, as many of these people are not yet born) can be significantly increased. By 2050 a majority of these people will live in South Asia, the Middle East and Africa, the last countries with rapidly rising populations. Lifting these people out of poverty will require more material resources and greater energy use.

The third issue is the way the economies of western countries and East Asian countries such as China, Korea, and Japan deal with a process of population ageing that is likely to see a reduction in the population of several countries. For a discussion of these issues that I’ve found particularly informative see Macroeconomic implications of population ageing and selected policy responses or Some macroeconomic aspects of global population aging.

This ageing process influences not only what goods and services are demanded by these populations, but also their willingness and capacity to work as well as the type of assets they are willing to invest in as part of their general saving for retirement.

Put this way, these three issues are clearly linked. 

The first two issues are linked because the people in the poor countries located around the Indian Ocean want to develop, but this has always taken vast quantities of capital and energy, and in the past this has always meant coal, gas, or oil – and CO₂ (see Ayres and Warr, 2009). Is it possible for half of the world’s population develop without massively increasing the amount of CO₂ in the atmosphere?  The answer is ‘Maybe’ .

Technological breakthroughs in renewable energy and storage technologies mean the lifetime costs of renewable electricity are now competitive with gas-fired electricity and cheaper than coal (Geoffrey Heal (2018) Financial & Technological Prerequisites of the Energy Transition). This means poor countries could develop and increase their energy usage without a massive increase in carbon usage. Simultaneously, these technologies will help currently rich countries reduce their reliance on carbon emitting energy sources.

One of the difficulties with this solution is that renewable electricity has much higher up-front costs than carbon-based electricity, even though it has much lower ongoing costs. It is expensive to build renewable energy plants, an expense most developing countries will struggle to meet because they are capital poor. 

But this provides an opportunity for the older people in western and east Asian countries, whose ageing populations wish to accumulate capital for their retirements. Recycling this capital from ageing countries to young countries to enable green development is possibly the greatest development and climate-change opportunity of our time. 

However, there are two major constraints. 

The first is ensuring the recipient countries have the appropriate political and institutional structures that encourage investment without expropriation. This is no small task. No one wants to invest in an undeveloped country if they believe the country is too corrupt to operate properly, or is likely to take the proceeds of their investment. But change can occur, even if it is one country at a time. 

For example, Morocco, where I am currently visiting for a year, is actively encouraging investment in green energy plants financed by Germany and other countries, and has ambitious plans to build solar and wind energy plants to reduce reliance on gas. 

The second constraint is to ensure the savings of current and future generations of middle-aged people living in rich countries are productively invested. In a follow up post I will use the example of New Zealand to explain this issue in greater detail. As we shall see, a key issue is to design savings institutions for young cohorts that will enable their savings to be used in a manner that is consistent with the environmental situation they want to live in.

In a ray of light, this morning’s FT (£) reported a study of over 15,000 German employees that examined the relationship between ageing and productivity. One of the authors is quoted saying:

As workforces age, employers are concerned that productivity will decrease. That is not so. What matters is not chronological age but subjective age.

The research suggests that older people are systematically excluded from training activities, and are relegated to less creative and meaningful work, which renders them less productive. As the workforce ages, that may begin to change. As it changes, the relationship between growth and age structures is likely to weaken.

The review doesn’t break any new ground but it is eloquent and engaging. Her central themes are:

1. The Industrial Revolution and Great Enrichment have increased incomes by 2,900% over the past two centuries. They have elevated the poor to a state of wealth, relative to their lot even fifty years ago. It is that increase in the absolute lot of the poor that we should be ethically concerned about, not the relative inequality that Piketty focuses on. Considering their capabilities and dignity, not simply incomes, is even more encouraging because of advances in, for example, access to education.
2. Piketty focuses on the accumulation of physical capital but the engine of growth for the past 200 years has been human capital. The exclusion of human capital from his calculations is particularly problematic because it is owned by the workers, not the capitalists. That growth has enriched the poor by magnitudes more than redistribution could achieve.
3. Wages and capital returns are important price signals that generate a response from supply. Stifling those signals damages the efficiency of the economy and retards the very growth that will help the poor.

The focus on real GDP growth and its possible–or likely–slowing is a setup to panic us into making policy decisions we really do not want to make. The “great stagnation” literature as it is currently constituted seems to me at least to guide our attention in the wrong direction–and to quite possibly stampede us into making policy decisions we really would not want to make if we thought more deeply and calmly. The chain of logic is that measures to reduce inequality have a cost in terms of reducing the growth rate of the economy–that the bucket of redistribution is, in the terms of Arthur Okun’s Equality and Efficiency: The Big Tradeoff, a leaky bucket–and that when growth is slower we can no longer afford to engage in redistribution. This seems to me to be the wrong way to conceptualize it: the evidence that the bucket is leaky is weak–or, rather, there are many buckets, some very leaky, some not leaky at all, some anti-leaky–and in any event whether we should tradeoff potential growth for other objectives is not something the depends on how fast growth is. Policies that make sense if underlying GDP per worker growth is 3% probably still make sense if underlying GDP per worker growth is 1%. Policies that don’t make sense if underlying GDP per worker growth is 1% probably still don’t make sense if underlying GDP per worker growth is 3%.

But my aim here is simply to lay down a marker as far as point is concerned: to enjoin you not to get stampeded into going someplace you really do not want to go.

 

But, as a description of what would happen if people in LDC’s (least developed countries) had the choice, was he actually correct?

Over the past 20 years, significant numbers of people have been moved out of absolute poverty by a strong push to industrialise in countries such as China.  By taking on these manufactured industries, there has been a change in the relative price of different types of goods and services – such that developed countries have focused on services (and New Zealand, as greener machinery like this CNC plasma systems, on clothing- but with a climbing terms of trade).  In the same way the ‘centre of manufacturing’ has shifted towards developing Asia, so has pollution.

By ramping up manufacturing activity and pollution, these countries have effectively said “we think we were relatively under polluted (given the benefit of the output that occurs during the pollution process), as a result we’ve decided to switch to a situation with higher material standards of living and higher pollution.

By creating “import competition” (ht awesome post on the Economist) and having manufacturing output and ‘jobs’ go from the US to China, we are essentially going through the very process Summers was discussing – the process that he suggested would be in the LDC’s interest.  The “morally reprehensible” arguments of Summers actually represent the situation and what is favoured by groups within those countries.

Does this suggest that everyone has given Summers a bit of a hard time?

• The initial post.
• Tyler Cowen’s thoughts.
• The R-R reply. (Here)
• A post suggesting that it mattered for policy settings.

All very nice.  Depending on the message people were trying to sell they either said the result was meaningless, or central, so I don’t think this makes any actual difference.  Honestly, without clear causal drivers there just were not good evidence based claims for actual policy adjustments – a lot of people were actually just saying we need to do X based on their preconceptions.  And they found this correlation either something that supports that (somehow) or something they need to rule out.

Over the last few years I have seen authors, at different times, use R-R as central to their argument on one thing, and then dismiss it for arguments regarding other issues (I’m not going to name names).  For example, you can’t use this result to say we need more savings policy because the stock of debt is to high, then complain that the study is flawed when you want more government borrowing … just focus on the actual core elements of your frikken argument instead!

My problem with the result isn’t the excel errors, or anything R-R appear to have said – it is the way it has been used as an inconsistent marketing tool by people for selling their own unrelated ideological policies.  I’m just hoping that this shuts that up.

As a side note, here are my feelings on twitter:

People who think the R&R result caused austerity overestimate the impact evidence has on government policy.

What I take from that is we need to think laterally, not literally. When we think about investing in particular sectors, we must realise we will need capabilities that aren’t necessarily obvious to us. We just won’t know what types of knowledge we are going to need to build particular parts of our economy.

The interesting thing is that many economists agree with some of what the author mentions in their piece, in terms of discussing scale and the inter-relationships of firms – but from this loose description there is no clear role for policy, or understanding.

In truth, we need to understand the idea behind inter-relationships in a way consistent with methodological individualism.  Then given that theory, we need to go back to data truly quantify what is going on – given the framework that this theory provides.  From there, we can try to decipher if policy can help of not.

And any such theory relies strong on relative prices – contrary to the inference the article appears to be making, we do not have a command and control economy, and the government is not trying to work out the allocation of resources.  Relative prices, both implicit and explicit, are the driving force of any description of what is going on in New Zealand – and our starting point, and final discussion in terms of policy needs to rely on these.

Think about it, we are told how these firms rely on each other, how they add value to each other, and in each others markets.  This doesn’t make an “externality” in the traditional sense, it just tells us that we have firms whose markets are interconnected – and as a result, there will be some implicit contracts between these firms (and implicit prices) that help to share the surplus of their trade.  In an extreme case, when the benefit is enough, and the outside contracting is weak enough, these firms would horizontally (or vertically depending on the relationship) integrate.

The fact that firms are inter-related doesn’t suddenly provide a role for government.  The fact that scale matters for output does not mean that FORCING an increase in the population distribution will increase welfare.

Update:  Bill discussed this here.  And Eric.  How did I miss it when I read both of those blogs daily … I blame my new Kindle for making me focus on Mill instead of my blog reading.

Sidenote:  I have to mention this statement:

Because New Zealand doesn’t have a truly large city by international standards, we must work harder at innovation to compensate for our economic geography and collaborate as if we were a city of four million people.

I have tried to be kind in the rest of the piece, but I have to admit that this statement is blatantly ridiculous.

Two things:

1. The benefits of population density in large cities come very much from population density – saying we are a city doesn’t do anything to change this.
2. More importantly, saying we need to “innovate more” because of our disadvantages doesn’t necessarily make sense – it depends on the marginal benefit of innovation relative to the cost.  If our distance from market reduces the marginal benefit from innovation, then this statement isn’t just wrong – its harmful if its followed through with.

I love to hear scientists describe the potentials for technology, and discuss the production possibilities they face.  But they really should get an economist to join the party when it comes to discussing issues of allocation – given that this is the economists area of expertise.

A bias to small firms is costly. The productivity of European firms with fewer than 20 workers is on average little more than half that of firms with 250 or more workers (see right-hand chart). …If the best small firms were able to grow bigger, Greece and the rest might solve their competitiveness problems…

This is pertinent to New Zealand since we also have a small number of very large firms, although we may not have the prevalence of very small firms that Greece does. Beyond the arguments over data issues, it’s interesting to ask whether we might agree with The Economist that this poses a problem for growth. Certainly, New Zealand’s growth might be higher if firms grew, but then why haven’t they already? Not because the owners don’t want to reap the rewards of growth, surely.

Of course, what we need to ask is why the proportion of small firms/large firms is the way it is. The Economist points to tax and labour laws in Greece that punish large firms. In New Zealand it is hard to point to similar legal barriers to growth in firm size, as far as I know. It may be that New Zealand firm owners prefer smaller firms, or that it is difficult for firms to find local, skilled labour (random speculation, not to be taken too seriously). What this highlights is the importance of understanding the differences in countries, as well as their similarities, before rushing to emulate them. Are we the next Ireland/Singapore/Finland? Well, no, we’re a bit different from all those countries and we can’t replicate their successes without understanding those differences.

Although I doubt this is the sole factor behind the growing concentration of wealth, it is a factor I’ve been thinking about – and that I’m keen to see someone else quantify.

One thing we have to keep in mind is that standard economic theory does predict a growing concentration of wealth as

• the idea of  “rational expectations” when some agents are not rational implies that rational agents will tend to suck up wealth from irrational agents – it is a common misconception that “rational expectations” requires any agents to be “rational” in the strictest sense …  however, it does imply that agents that are “more rational” do receive transfers through time from their “irrational” buddies.
• the fact that individuals have different discount factors suggests that more patient individuals who are more patient will tend to accumulate more wealth.

Now this isn’t necessarily even an issue, after all if people built up wealth due to their own choices they deserve it.  However, trying to understand how much of the recent change is due to the full functioning of financial markets in recent decades, how much is due to demographics, and how much is due to other policy change is important to understand before we really know anything.