Trans-Tasman trends in real equivalised mean household income since 1982

Real household mean incomes rose during Rogernomics; fell during the deep recession at the beginning of the early 1990s; then rose strongly until 2009 and the onset of the Global Financial Crisis.

Why doesn’t capital flow from the rich countries to supposedly capital shallow New Zealand?

Hall and Scobie (2005) attributed 70 percent of the labour productivity gap with Australia to New Zealand workers using less capital per worker than their Australian counterparts, rather than their using w3capital less efficiently. Figure 1 shows that the capital labour ratio is lower in New Zealand than in Australia and has been lower than Australia for several decades and is getting worse.

Figure 1: Capital intensity in New Zealand relative to Australia: 1978-2002

Source: Hall and Scobie 2005.

In 1978, New Zealand and Australian workers had about the same amount of capital per hour worked. By 2002, capital intensity in Australia was over 50 percent greater than in New Zealand. This lower rate of capital intensity is capital shallowness.

Capital should flow to countries with the highest risk adjusted rates of return. If workers in a country work with less capital than in other countries, the rate of return on providing them with more capital is higher than the global average return to capital. As Stigler (1963) said:

There is no more important proposition in economic theory than that, under competition, the rate of return on investment tends toward equality in all industries.

Entrepreneurs will seek to leave relatively unprofitable industries and enter relatively profitable industries, and with competition there will be neither public nor private barriers to these movements.

This mobility of capital is crucial to the efficiency and growth of the economy: in a world of unending change in types of products that consumers and businesses and governments desire, in methods of producing given products, and in the relative availabilities of various resources—in such a world the immobility of resources would lead to catastrophic inefficiency

Hall and Scobie (2005) acknowledged that lower capital intensities could be entirely a by-product of lower MFP. New Zealand had the third worst MFP growth performance since 1985, one quarter the OECD average (OECD 2009).

Rather than money being left on the table by persistent, known but unexploited entrepreneurial opportunities for pure profit by investing more in under-capitalised New Zealand and providing additional capital and equipment and more advanced technologies for New Zealanders to work with, investors have done the best they could the relative poor investment opportunities here.

Figure 2: Differences in capital intensity: the case of different production functions

Source: Hall and Scobie 2005.

A divergence in labour productivity levels between Australia and New Zealand emerged in the 1970s and 1980s. Kehoe and Ruhl (2003) attributed 96 percent of the fall in labour productivity in New Zealand between 1974 and 1992 to a fall in MFP. Changes in capital intensities played a minor role.

Aghion and Howitt (2007) found that three-quarters of the growth in output per worker in Australia and New Zealand between 1960 and 2000 was due to growth in MFP. New Zealand’s annual MFP growth of 0.45 percent between 1960 and 2000 was simply much lower than Australia’s 1.26 percent per year. Capital deepening was equally lower in New Zealand with 0.16 percent comparing to 0.41 percent in Australia.

Less would be invested in a country if the returns are lower because the capital is poorly employed. There might be a lack of complementary skills and education and, more often, policy distortions that lower MFP (Alfaro et al 2007; Caselli and Feyrer 2007; Lucas 1990).Investment in ICT capital is greatest in the USA because it is the global industrial leader and has very flexible markets. Investment in ICT in the EU is proportionately less because less flexible markets make ICT investments in the EU members less fruitful to investors.

To explore the relative role of lower MFP and the cost of capital in capital shallowness, Hall and Scobie (2005) used national accounts data to estimate the cost of capital and found that New Zealand faced a higher cost of capital than Australia, the USA and the OECD average since the early 1990s. Research that is more recent disputes these concerns about a higher cost of capital in New Zealand.

In Caselli and Feyrer’s (2007) revised cost of capital estimates, the cost of capital is significantly lower in New Zealand than in Australia and elsewhere in the OECD area such as the USA, Japan and UK – see Figure 3. Caselli and Feyrer (2007) correct for an overestimation of the cost of capital that is prevalent for countries such as New Zealand where the value of land and natural resources are high.

Figure 3: Caselli and Feyrer’s Estimates of the Cost of Capital, 1996

Source: Caselli and Feyrer (2007); Hsieh and Klenow (2011).

Notes: The measure of capital income used by Hall and Scobie (2005) to calculate the cost of capital includes payments to reproducible physical capital (equipment, machinery, ICT, buildings and other structures) as well as payments to natural capital (land and natural resources). Dividing the income that flows to all types of capital including land and natural resources by just the value of reproducible physical capital overestimates the cost of capital. Caselli and Feyrer (2007) used World Bank (2006) estimates of natural capital stocks in 1996 to estimate of income flows to reproducible physical capital. Their estimates excluded income flows to land and natural resources to estimate the cost of reproducible capital.

Caselli and Feyrer (2007) revised estimate in Figure 3 is for the cost of capital for investing in equipment, machinery, ICT, buildings and structures. When land and resources are included, shown in light blue as the naive cost of capital, the estimated cost of capital is one-half of percentage point higher in New Zealand than in Australia and two percent higher in New Zealand than the USA and UK in Figure 3. When land and natural resources are excluded, shown in red as the adjusted for natural capital estimate, the cost of capital is much lower in New Zealand than in Australia, the USA, Japan and UK – see Figure 3.

What Caselli and Feyrer (2007) show is the estimation of the cost of capital to New Zealand is fraught with statistical difficulties. A broader data set yields radically different results. That is the broader lesson.

At a minimum, safest thing to say, is there are no reliable estimates of the cost of capital in New Zealand. Depending on how you measure it, the cost of capital in New Zealand is either much higher or much lower than in the leading industrial countries such as the USA and UK. Such a broad range of estimates is no basis for public policy interventions.

When having to choose between arguing for a persistent, known but unexploited entrepreneurial opportunities for risk-free profit left on the table in New Zealand by foreign investors for decades, and measurement error in the case of one of the nastiest measurement jobs – measuring capital and natural resources – measurement error is more likely.

Capital is the most internationally mobile of factors of production. Entrepreneurs have every incentive to move it to new destinations with higher risk-adjusted rates of returns. Returns will not be exactly equal, but there will be a tendency for equalisation subject to these reservations listed by George Stigler in 1963:

  1. Some dispersion in rates of return exist because of imperfect knowledge of returns on alternative investments.
  2. Dispersion of returns would arise because of unexpected developments and events which call for movements of resources requiring considerable time to be completed.
  3. Dispersion in rates of return would arise because of differences among industries in monetary and nonmonetary supplements to the average rate of return.
  4. In any empirical study, there is also a fourth source of dispersion: the difference between the income concepts used in compiling the data and the income concepts relevant to the allocation of resources.

The last of these reservations listed by George Stigler in 1963 about the statistical concepts used in compiling what data can be collected and the concepts relevant to the entrepreneurial decisions about the allocation of resources appear to be crucial to the debate about capital shallowness in New Zealand. They also echo Hayek’s great reservation in his 1974 lecture The Pretence to Knowledge about focusing on what can be measured rather than what is important in both economic analysis and public policy making:

We know: of course, with regard to the market and similar social structures, a great many facts which we cannot measure and on which indeed we have only some very imprecise and general information. And because the effects of these facts in any particular instance cannot be confirmed by quantitative evidence, they are simply disregarded by those sworn to admit only what they regard as scientific evidence: they thereupon happily proceed on the fiction that the factors which they can measure are the only ones that are relevant.

Hall and Scobie (2005) were careful scholars who noted that possibility that the apparent capital shallowness in New Zealand is merely the result of measurement error because of the problems of measuring land and natural. Caselli and Feyrer (2007) justify their caution and vindicated the view that the marginal product of capital is pretty much the same all round the world. As Caselli and Feyrer (2007) explain:

There is no prima facie support for the view that international credit frictions play a major role in preventing capital flows from rich to poor countries.

Lower capital ratios in these countries are instead attributable to lower endowments of complementary factors and lower efficiency, as well as to lower prices of output goods relative to capital. We also show that properly accounting for the share of income accruing to reproducible capital is critical to reach these conclusions.

There is various debates in policy circles in New Zealand about this lack of capital per worker and a higher cost of capital in New Zealand.

But that debate and any policy measures that were introduced as a result may be misplaced and all due to measurement error, or more correctly the grave difficulties of measuring both the capital stock and the cost of capital, both generally and in New Zealand course of its large bounty of natural resources. The data was always in doubt, so any policy interventions should be very cautious and incremental.

It would have been surprising to find that lower productivity in New Zealand was due to a lack of access to capital. There is growing evidence that capital intensities are not a major contributor to cross-national per capita income gaps.

There is a broad empirical consensus that capital intensity explains about 20 per cent of cross-country income differences; differences in human capital account for 10 to 30 per cent of cross-national differences with MFP accounting for the remaining 50 to 70 percent (Hsieh and Klenow 2011).

The New Zealand capital shallowness hypothesis is too marred in measurement shortcomings to rebut this broad empirical consensus about MFP differences between all other countries. For example, when reviewing the trans-Atlantic productivity and income gap, Edward Prescott said:

The capital factor is not an important factor in accounting for differences in incomes across the OECD countries… [It] contributes at most 8 percent to the differences in income between any of these countries.”

At the broader level, this blind alley about capital shallowness in New Zealand illustrates the pretence to knowledge. The politicians and bureaucrats pretended to know the cost of capital and the size of the capital stock in New Zealand and then work out what to do in response while doing more good than harm. This was despite serious reservations about the quality of data at hand.

This blind alley about the cost of capital and capital shallowness in New Zealand illustrates Josh Lerner’s point about distractions such as these and their many equivalents overseas reinforce the importance of the neglected art of setting the table– of fostering a favourable business environment. The neglected art of setting the table includes:

  • investing in a favourable tax regime (low taxes on capital gains relative to income tax are particularly important as studies show people respond to incentives); and
  • making the labour market more flexible (again the opposite of what has happened in continental Europe ),
  • reducing informal and formal sanctions on involvement in failed ventures;
  • easing barriers to technology transfer, and
  • providing entrepreneurship education for students and professionals alike.

I prefer to link MPs pay rises to reductions in the trans-Tasman per capita income gap

Real GDP per capita: Australia, New Zealand and OECD, 1950-2007


Why is anybody still living in East Germany (or New Zealand)?

When I pointed to Jennifer Hunt’s so titled paper freshly released in 2000 on why does anyone still live in East Germany, none of my New Zealand colleagues understood the parallel with their own country.

The wage gap between East and West Germany is about the same as the wage gap between Australia and New Zealand.

  • East Germans have the advantage of being able to getting their car to go to the west. Some do commute from the east to jobs in the West; and
  • New Zealanders have to get into a plane and commuting done a daily basis is really out of the question – the air flight time alone is three hours.

There are in fact bigger language, or more correctly dialect differences between Germany than there are across the Tasman Sea between New Zealanders and Australians. Educational standards are similar between New Zealanders and Australians.


In 1997 GDP per capita in East Germany was 57% of that of West Germany, wages were 75% of western levels, and the unemployment rate was at least double the western rate of 7.8%.

The wage gap across the Tasman between New Zealand and Australia is about one third. Wage gaps between East and West Germany and between Australia and New Zealand are about the same.

Australia and New Zealand have a single integrated labour market. Any New Zealander Australian is free to work in the other country.

New Zealanders are not eligible for social security benefits if they first arrived in Australia after mid-2001. Prior to 2001, New Zealanders have the same rights as Australians for social security benefits.

One would expect that if capital flows and trade in goods failed to bring convergence between East and West Germany, labour flows should respond, enhancing overall efficiency.

Same goes between Australia and New Zealand. About 35,000 New Zealanders used to move to Australia each year, but that’s recently dried up to about zero. Funnily enough, by the late 1990s net emigration from East Germany has fallen from high levels in 1989-1990 to close to zero.

Jennifer Hunt found through her analysis of the eastern sample of the German Socio-Economic Panel for 1990-1997 that commuting is unlikely to substitute substantially for emigration.

Wage convergence between the East and the West was a main factor that stemmed immigration. The individual-level data further indicate that emigrants are disproportionately young and skilled, and that individuals suffering a layoff or non-employment spell are also much more likely to emigrate. This is all as predicted by the Roy model of immigration self-selection.

Like all human capital investments, both international and within country migration is based on the comparison of the present value of lifetime earnings in all available employment opportunities. Individuals compare the potential incomes and the destination country with the income in the home countries, and make the migration decision based on these income differentials (net of mobility costs).

Can New Zealand blame distance for its economic woes?

Distance is common in many discussions of the relative growth performance of New Zealand. New Zealand is said to be small and remote and poorer for it. The figure below from a Productivity Commission report is an example.

The Productivity Commission put it this way:

New Zealand firms face reduced access to large markets and limited participation in global value chains, where the transfer of advanced technologies now often occurs.

Indeed, global value chains – which can require intensive interaction and just-in-time delivery across borders – may have worsened the impact of New Zealand’s geographic isolation on trade in goods.

The Commission continues on to say that:

These limits on trade and the diffusion of new ideas into New Zealand may explain as much as 15 percentage points of the 27% productivity gap between New Zealand and the average of 20 OECD countries.

This 15 per cent claim is a daring claim. Physical location does not change over time.

New Zealand, Australia and the other European offshoots such as Canada and the USA all prospered for most to all their histories despite their distances from their mother country. Canada cannot blame distance for its weak productivity performance because it is next door to the USA.

Figure 1 below using OECD data suggests that New Zealand and Australian real GDP per capita are both about 10 percentage points lower than they otherwise would be because of distance. A bounty of natural resources gives a less than a two per cent boost to Australia’s real GDP per capita, see Figure 1.

Figure 1: Estimated impact of proximity to markets and natural resources on real GDP per capita, OECD members, average for 2000-2004

Source: OECD.

The burden of geography is about distance from large agglomerations of production, consumption and supply. There is from the extra cost of exporting to distant markets and the cost penalty from ordering from major suppliers who are far way. Geography can also affect the international flow of ideas and the diffusion of new technologies.

Figure 2 shows that most of the labour productivity gap of New Zealand and many others with the USA is not explained by geography – by access to major markets and any natural resource bounty.

Figure 2: Apparent and geography adjusted hourly labour productivity relative to the USA, 2006

Source: OECD (2008).

New Zealand’s apparent and geography adjusted productivity gaps with the USA are not far apart. In contrast, the OECD (2009c), geography cuts in half the gap in hourly labour productivity between the USA and Australia – see Figure 3.

Figure 3: Percentage point change in hourly labour productivity relative to the USA due to geography, 2006

Source: OECD.

The labour productivity gap of New Zealand with the USA is over four times larger than what could be reasonably attributed to geographic burdens. Other factors must account for the bulk of New Zealand’s productivity gap.

More to the point, distance and remoteness explain none of the productivity and income gaps across the Tasman and why this gap suddenly appeared in the 1970s and 1980s to NZ’s disadvantage.

New Zealand lost almost two decades of growth between 1974 and 1992 as shown in Figure 4.

Figure 4: Real GDP per New Zealander and Australian aged 15-64, converted to 2013 price levels with updated 2005 EKS purchasing power parities, 1956-2012

Source: Computed from OECD StatExtract and The Conference Board, Total Database, January 2014.

The Trans-Tasman gap is the income and productivity gap that concerns Kiwis and is the relevant policy yardstick everyone uses or should use.

The emergence of the Trans-Tasman income gap from initial income parity in 1974 – see Figure 4 – cannot be because of distance because both NZ and Australia suffer equally from a 10% productivity burden because of distance.

This common 10% productivity burden due to distance does not explain real GDP per working age person in Australia and NZ dropping from parity in 1974 to a 35% gap inside 20 years and then suddenly stabilising.

Figure 4 showed that NZ started growing again in 1992 after the Ruth Richardson horror budget stabilised economic policy sentiments. There was to be no going back on the economic reforms.

Figure 5 below shows that NZ’s labour productivity growth dropped like a stone between 1974 and 1992 then stabilised at 1.85% growth per year from 1992 to 2005. GDP per working age person in Figure 5 is based to 100 in 1974 and then detrended by 1.85% per year – the trend growth rate of the USA in the 20th century. A flat line in Figure 5 is annual growth in real GDP per working age person of 1.85%. Australia’s growth rate is pretty flat since 1970 bar the odd recession and recovery from the same.

Figure 5: Real GDP per New Zealander and Australian aged 15-64, converted to 2013 price levels with updated 2005 EKS purchasing power parities, base 100 in 1974, 1.85 per cent detrending, 1956-2012

Source: Computed from OECD StatExtract and The Conference Board, Total Database, January 2014.

This 34% productivity drop in NZ from 1974 to the mid-1980s was too rapid to be explained by distance and global value chains suddenly becoming more important than was the case for most of NZ’s history. Australian GDP growth rates was not affected in the slightest by these trends in the geography of trade and input markets.

The Productivity Commission looked at the wrong data to ask the wrong questions. The data analysis undertaken on behalf of the Productivity Commission started in 1980. Figure 6 below shows at all the action and excitement regarding total factor productivity in New Zealand occurred before 1980.

Figure 6: New Zealand total factor productivity and real GDP per New Zealander aged 15-64, 2 per cent detrended, 1955-2000

Source: Kehoe and Ruhl (2003).

Kehoe and Ruhl (2003) attributed the decline in the growth of GDP per working age New Zealander after 1974 to 1992 to a sharp decline in total factor productivity from 1974 to 1980.

Figure 6 plots detrended data constructed by Kehoe and Ruhl (2003) to show that total factor productivity fell rapidly in New Zealand between 1974 and 1980, by 30 per cent in all, and then levelled out to grow again at the trend rate of two per cent.

There was no subsequent total factor productivity recovery to make up the lost ground. If this were so, Figure 4 would have had to include a strongly rising line for total factor productivity over many years after 1980 to recover the 30 per cent fall in the level of total factor productivity between 1974 and 1980.

Kehoe and Ruhl (2003) suggested that the identification of the factors that permanently reduced total factor productivity levels in New Zealand between 1974 and 1980 may have great contemporary policy relevance.

The total factor productivity drop identified by Kehoe and Ruhl (2003) occurred before the 1978 start of the Statistics New Zealand productivity data series.

The great value of the Kehoe and Ruhl (2003) data is the drawing out of the major decline in total factor productivity on the eve of the Statistics New Zealand data series.

Kehoe and Ruhl (2003) attributed the 1970s total factor productivity collapse to a massive change in trade patterns after the entry of the UK into the then European Economic Community in 1973.

All discussions of income gaps should be against Australia and any additional burden of distance that New Zealand faces in addition to Australia since 1974 when the Trans-Tasman income gap emerged.

When New Zealand catches-up with Australia in labour productivity that will be the time to start worrying about the burden of geography – a burden that holds back relative productivity equally in both countries. You cannot explain the difference between Australia’s and NZ’s relative productivity by geographic factors they have in common.

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