Roger Kerr Speech - The Size Of Nations

9.00 AM WEDNESDAY 2 FEBRUARY 2005
PAPAKURA DISTRICT COUNCIL BUSINESS BREAKFAST
THE SIZE OF NATIONS
ROGER KERR
EXECUTIVE DIRECTOR

NEW ZEALAND BUSINESS ROUNDTABLE 2 FEBRUARY 2005

THE SIZE OF NATIONS

From time to time people question whether New Zealand’s small size and geographical remoteness hold back its economic performance. For example, David Skilling, now chief executive of the New Zealand Institute, has claimed that these factors constrain business growth and make it difficult for businesses to specialise, so limiting investment in human capital and the value added to the primary products that make up a sizeable share of the economy. He speculates that some sort of interventionist industry policy might succeed in overcoming these handicaps and improving the country’s long-term performance.

Against this, Winton Bates, writing for the New Zealand Business Roundtable, has claimed that the appropriate antidote to smallness and remoteness is economic openness, including the continuing integration of New Zealand’s economy with Australia’s. Indeed, smallness and remoteness can even work to our advantage: for example, New Zealand may not need to spend as much per capita on defence than either Australia or the United States. It is also less vulnerable to things like foot and mouth and mad cow disease.

I read the evidence as being on the side of Bates. New Zealand is itself an illustration of the point that small nations can do just fine. In the latter part of the nineteenth century, New Zealand was among the top three countries in the world in per capita income terms. The average New Zealander was richer than the average citizen of the United States. In those days, transport and communication costs were a much greater handicap for New Zealand than they are today. And New Zealand’s prosperity was not just due to its links with Britain and its natural resources. Mostly it was due to its free and open economy: total government spending and taxation at the time was only about 10 percent of national income (compared with about 40 percent today).

The main reason for New Zealand’s subsequent slide in relative incomes, arrested only in the 1990s, was not any disadvantages of size and location. Rather, it was the bad economic policies that were followed for many decades, in particular moves away from economic freedom and towards intrusive government control of the economy. The worst mistakes were protectionism, heavy labour market regulation and much higher levels of government spending and taxation. Tariffs, high taxes and inefficient ports were among the things that added to the costs of distance.

A brief glance around the world today confirms that many small countries are faring very well. The richest member of the Organisation for Economic Cooperation and Development (OECD) is Luxembourg with a per capita income estimated by the OECD (on a purchasing power parity basis) of around US$50,000, more than twice that of New Zealand. It could be argued that Luxembourg is hardly a country, merely a small region within the giant European Union economy. But Norway, Ireland, Switzerland, Denmark, Austria, Belgium, Sweden and Finland, all OECD countries with a population of around 10 million or less, have an average per capita income above the OECD average, while tiny Iceland, with a population of a mere 300,000, is in 10th place in the 30-member OECD.

Outside the OECD, Hong Kong and Singapore are of course well known cases of small, successful countries. In Africa, Botswana is a country with a growth record that has far exceeded much larger countries like South Africa and Nigeria in recent decades. Tiny Mauritius, with its remote location in the Indian Ocean, is another strong performer.

An even more extreme case is Bermuda. Its population is only 60,000, it is a barren island in the mid-Atlantic, and it has no valuable natural resources. Yet its per capita income is above that of the United States and nearly twice that of New Zealand.

Bermuda has prospered through low levels of government spending and taxation (it has no income or corporate taxes), respect for the rule of law (ultimately adjudicated by the Privy Council), limited government intervention in business, strict welfare policies and no welfare dependency. Bermuda is thought to have a higher level of economic freedom than Hong Kong.

Of the ten countries with populations over 100 million, only the United States and Japan are prosperous. Gary Becker, a Nobel laureate in economics, has noted that since 1950 real per capita GDP has risen somewhat faster in smaller nations than it has in bigger ones.

Becker argues that "dire warnings about the economic price suffered by small nations are not at all warranted". He goes so far as to say that smallness can be an asset in the division of labour in the modern world, provided economies are open to international transactions.

If the debate on the economic effects of smallness and remoteness continues, as it no doubt will, it needs to engage with the findings of a recently published book by respected economists Alberto Alesina and Enrico Spolaore, titled The Size of Nations. They begin by reminding us of a fact that many have overlooked in all the talk about globalisation: that globalisation has been accompanied by a substantial increase in the number of countries. Since 1945 the number of independent countries has more than doubled, from 74 to 193. More than half have fewer people than the US state of Massachusetts, which has 6 million inhabitants. Relatively speaking, New Zealand is not as small as it once was.

Why do we need reminding that the number of countries has been rapidly growing under our noses? Because we are used to thinking that globalisation eliminates national borders. In 1990, a book was published titled The Borderless World: Power and Strategy in the Interlinked Economy. Its author, Kenichi Ohmae, viewed the expanding multinational networks as having ever less attachment to any home base, so making national borders increasingly irrelevant. That is the direction in which many people have imagined a globalising world to be moving. And yet, since Ohmae’s book appeared, many thousands of kilometres have been added to the total length of international borders in our so-called borderless world.

The great increase over the last 50 years in the number of countries, and their falling average size, has mostly followed the break-up of empires. Decolonisation of the old European empires added several new countries to the world list, especially in Africa. The collapse of the Soviet Union added 15 more. The continuing demise of communism in Europe led the federation of Yugoslavia to fall bloodily apart, whereas Czechs and Slovaks arranged an amicable divorce. Against the trend, Yemen reunified, and so did Germany. But I would surmise that many former East Germans regret that they did: showered as they have been with largesse by their rich Western relations, they have done far worse than their Polish and Czech neighbours, who had no choice but to sort themselves out as independent countries. This is also the lesson of foreign aid: at best it is a minor factor in helping countries to develop, and works only if institutions and policies in recipient countries are in good shape. At worst it helps prop up corrupt and ineffective governments and holds development back.

The growing number and falling size of nations has often been accompanied by devolution, even within old and well-established countries. In response to growing regional sentiment, Spain has adopted a system of regional government. In the United Kingdom, Scotland and Wales, as well as Northern Ireland, now have their own assemblies.

All these trends share an underlying logic that Alesina and Spolaore articulate in their book. Part of that logic is globalisation: free trade in goods, services and capital makes small countries viable. The book suggests that economists have generally regarded the size of countries as ‘exogenous’, that is, not to be explained but treated as a brute geographical fact. Yet a country’s borders are man-made, and as such they could have turned out differently and are always subject to potential change. At one time New Zealand was a dependency of New South Wales, and later had the option of joining the Australian federation. Occasionally speculation surfaces that it might yet choose that option. From an economic point of view, however, the choice is largely irrelevant. Since around 1993, when New Zealand finally established a generally sound overall framework, our trend growth rate has improved substantially and has more or less matched that of the median Australian state.

Alesina and Spolaore acknowledge the benefits of size can be considerable. Big countries can spread the fixed costs of government over more taxpayers, and so can more easily restrain the size of their public sectors if they so wish. Defence spending in particular is easier for big countries to afford. Bigger economies allow for more specialisation, which contributes to higher productivity. Of course, the size of a country’s market crucially depends on its trade policy. Nowadays, in principle, all countries can trade with the whole world but, to the extent that national barriers to trade survive, bigger countries have an advantage over smaller ones. Big countries can provide regional insurance; since they are more diverse, downturns in some regions can be mitigated by upswings elsewhere.

Some people might argue that another benefit of size is that big countries can more easily redistribute income between regions and individuals. But this is a doubtful benefit. It is certainly not a benefit for richer regions, which are burdened by high taxation and may press for devolution or secession as a result. And, as already noted in relation to East Germany, the largesse showered on poorer regions may of dubious benefit to them. Consider Tasmania. It is not beyond the bounds of possibility that tiny Tasmania would now be more prosperous if it had become an independent country trading freely with the rest of the world, rather than being shielded from economic reality as a mendicant state of the Commonwealth of Australia

The costs of bigness are considerable too. The bigger a country is, the more diverse the preferences of its citizens are likely to be, and therefore the more difficult it is for any government to satisfy them. The authors cite studies that claim to have found that people prefer, for better or worse, to live in countries that are homogeneous in terms of income, race, or ethnicity. The more diverse a country is in these respects, therefore, the greater the costs of size are likely to be.

This logic can be illustrated by the changing fortunes of the nation in the twentieth century. The first half of the century included the rise of totalitarian ideologies and dictatorships in countries that were large, aggressive, and militaristic. Such countries tried to maximise their military and other government economies of scale by social engineering of their subjects’ preferences, which they did by ceaseless mobilisation and propaganda, not to mention outright terror. The collapse of totalitarianism and the reassertion of diverse citizen preferences has been a major force making for more but smaller nations. Thus, over the second half of the century, democratisation and globalisation went hand in hand in leading to a world with more but lower borders. Democracy better registers spontaneous preferences with regard to public goods, while free trade allows those preferences to be realised by providing access to the markets needed to sustain them.

The big apparent exception to this explanation is the United States, which is not just the world’s most successful large economy and society but also very diverse while also being highly democratic. No trade-off between size and diversity seems to operate there. The obvious answer to the riddle is federalism: a form of devolution that has enabled the United States to enjoy the benefits of size while allowing considerable leeway for the expression and realisation of diverse preferences. The country would not otherwise stay together.

Besides Spain and the United Kingdom, several other European counties adopted devolution in the 1970s and 1980s in response to taxpayer dissatisfaction with the standard of government services. They include the relatively small countries of Denmark and Sweden. Half of Denmark’s 14 counties have fewer than 10,000 people, yet they collectively control two-thirds of Danish public spending and run transport, secondary schools, hospitals and other health services. A system of what we might call ‘competitive localism’ operates whereby patients can choose a hospital in another county. Subordinate municipalities run primary education. Sweden too has a devolved system, with nearly half of all taxes going to local government. Service standards diverge widely, as do policy models. Under devolution such divergence can be controversial and open to the charge of inequity. However, in Sweden the central government redistributes from richer to poorer municipalities by block grants, and in any case people are free to move among localities to obtain their preferred mix of local taxes and benefits.

The best example of the potential for devolution is Switzerland, another small and rich country and a miracle of diversity with its four language groups. The central government collects less than a third of tax revenues; most services are provided by the cantons. Any system of substantial devolution generates a good deal of local politics; in Switzerland this includes the widespread use of the citizen initiative and referenda, which are also used in some central government policy areas.

The popularity of devolution in continental Europe can be contrasted with widespread dissatisfaction with government services in the United Kingdom, which over the last two decades has gone against the European trend and increasingly centralised the funding and control of public services. Britain has the best-performing economy of the big European ones, but its public services are notoriously poor: its public transport is a shambles, its health system mediocre, its school system slowly disintegrating, and its clear-up rates for crime low and falling. No wonder: service providers are tormented by a permanent drizzle of performance targets issued from the centre. As under the old Soviet system of central planning, such targets can be met only in devious ways that actually reduce service standards and that cause bureaucracies to grow out of control. In New Zealand we have recently seen similar trends towards re-centralisation of services such as health and education, and similar levels of community dissatisfaction.

Economic theory adds some further insights to the points that I have been making about the size of nations. It is true that having a small population means that the gains from specialisation within a country are limited, but the same is true of any other economic area. New Zealand might find it difficult to develop a space industry, but so might Kentucky. In general, however, with an open economy, demand from world markets for the products that a small economy can potentially produce is virtually unlimited, regardless of trade barriers. Similarly, a small economy is not dependent on the savings of its own citizens for investment capital: it can tap into deep world capital markets. Even labour is no longer a major constraining factor: international mobility of labour is increasing, firms can often recruit internationally for specialist talent, and many tasks can readily be outsourced to workers in other countries. In addition, firms can benefit from access to the technology and management skills of parent companies or business partners anywhere in the world.

In many ways it is better to think of the New Zealand economy today not as a self-contained entity (as it was in fortress New Zealand days) but as part of an Australasian economy and indeed the broader world economy. The new era of globalisation is in some ways coming to resemble the earlier pre-World War I era when international movement of goods, capital and labour was even freer than it is today. According to one historian, the early New Zealand settlers saw the country as being part of Britain and firms thought nothing of having their London and Auckland addresses together on their letterheads. Today the national identity of many firms and the goods and services they produce is becoming blurred. And rather than produce for the domestic market and then get into exporting, many New Zealand firms gear their operations to world markets from the outset.

It follows that just as New Zealand’s average per capita income in 1900 was second in the world only to the United Kingdom, we can aspire to match the living standards of the most prosperous countries today. In theory, if there are no barriers to trade between countries with similar endowments, and if all products are tradable, wages and returns to other factors of production would equalise across countries, even if some factors of production (like land) are immobile. Obviously these conditions are not fully met, but more and more activities are becoming globalised. Education and health services, for example, which were formerly thought of as non-traded, have now entered into international commerce with long-distance teaching, consultations and even surgical operations. Only higher transport and communication costs would limit returns to a producer in a small, distant economy and to be competitive, other costs in that economy – such as the costs of land, natural resources and non-traded inputs – would have to be lower to compensate. It is easy to see the same pattern within a country: a farmer on remote land may do as well as an equally competent farmer on better located land, but the price of the remote land may be lower to offset the costs associated with distance. If we could put an outboard motor on New Zealand and push it up to the coast of California, we might all be a bit better off. However, with domestic and international transport and communication costs continuing to fall, the gap between actual and potential incomes and asset values is shrinking all the time.

Let me summarise the implications of what I have said and draw some general conclusions.

First, Alesina and Spolaore’s analysis of the optimal size of nations crucially turns on the optimal size of jurisdictions, and that depends on the kind of service being provided. Many such services can best be supplied in small, local jurisdictions. To that extent, New Zealand benefits from being relatively small, since even its central jurisdictions are correspondingly small. At the local government level, our experience suggests bigger is typically not better: smaller councils tend to be more efficient and more responsive to local preferences. Where economies of scale matter, such as in defence and infrastructure, for example, better solutions than larger jurisdictions are supranational organisations and international alliances on the one hand and commercial structures, joint ventures and private sector participation on the other.

Secondly, the evidence is clear that small economies tend to perform at least as well as large economies, if not better. Moreover, the economic penalty for remoteness allied to smallness seems to be small and reducing. To see why geography is usually relatively unimportant, just think of the relative levels of prosperity of tiny Bermuda and giant Brazil, or of Canada and Mexico, just north and south of the US border.

Thus my third and final point is that what matters most for economic success is the institutions and policies a country adopts. The key to good performance is economic freedom, in particular openness to international transactions. As New Zealand’s ranking rose in the indexes of economic freedom, its economic growth rate picked up. Research suggests that the quality of institutions and policies accounts for 80 percent or more of the differences in standards of living across countries. As one economist has put it:

Economic growth is not a mysterious force that strikes unpredictably or whose absence is inexplicable.

On the contrary, growth is the fruit of two forces: the ability of people to recognize opportunities, on the one hand, and the creation by government of a legal, fiscal and regulatory framework in which it is worthwhile for people to exploit those opportunities.

That framework requires respect for property rights, sound money, effective government limited to its core functions of public goods and a welfare safety net, and public spending, taxation and regulation that does not stifle entrepreneurial activity.

In any case, the bottom line is that New Zealand can do nothing about its location and little about its size. An activist industrial policy certainly wouldn’t help: as New Zealand-born University of Berkeley economist David Teece told the first Knowledge Wave conference, “Governments cannot pick winners, and they shouldn’t even try.” To the extent that geographical factors are handicaps – and they seem minor at most – New Zealand can aspire to better institutions and policies than other countries to offset them. We should spend time worrying about the things we can control, like our policy environment, rather than about things we can’t, like our size. Given superior policies, there is no reason why New Zealand cannot regain its ranking among the highest income countries, which the government tells us is its top priority goal.

ENDS

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