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Market Reform: Lessons from New Zealand

Tuesday, April 1, 2003

A decade ago, New Zealand was at the forefront of cutting-edge liberalizing economic reforms, an agenda that was pursued by both the country’s main political parties. First, the left-of-center Labour party, elected in 1984, deregulated, privatized, cut industry and agriculture welfare, and pushed through a major switch from an income to a consumption tax. It ended up proposing — but not enacting — a 21 percent flat rate tax. Then, in 1990, the right-of-center National government took up the reform baton with steep cuts in welfare programs and the most radical shake-up of labor law outside Margaret Thatcher’s Britain. The economics worked: 4 percent growth in the mid-1990s and the fastest growth of employment in any OECD country.

But now the reformers are to be found at the margins of New Zealand politics. The current Labour government led by Prime Minister Helen Clark — containing some of the politicians most opposed to the Kiwi reforms — was reelected in a 2-1 landslide in July 2002 after three years in power. What happened? In fact, the New Zealand case is part of a pattern. Bill Clinton and Tony Blair reaped what Ronald Reagan and Margaret Thatcher sowed. In central Europe, reformers have been replaced by their opponents — Vaclav Klaus as prime minister in the Czech republic by Milos Zeman, and the author of Poland’s Balcerowicz plan by former communist Aleksander Kwasniewski.

New Zealand’s experience is instructive for free-market reformers around the world. On these South Pacific islands of a little under 4 million people has been distilled the political dynamics of market-based reform and the countervailing forces opposed to it. Does reform create or consume political capital? To what extent is reform reversible, or does it create new constituencies and permanently change the terms of political debate? Has reform reached a natural frontier at the fortress gates of big-government social welfare programs?

 

The economics of reform

New zealand has a palpable sense of economic underperformance — of a country that has come nowhere near testing the envelope of what is possible. Its stock market has yet to recover its pre-October 1987 highs. In Auckland and capital city Wellington, it has urban areas that, given their natural setting, should be two of the most magnificent waterfront cities in the world. But neither compares to Sydney across the Tasman Sea, to San Francisco, Hong Kong, or even Seattle. Their architecture seems trapped in the 1970s, more like Santiago de Chile or Warsaw.

There aren’t enough people in New Zealand. Indeed, it is one of the most underpopulated countries in the world. Take away Australia, with its vast interior deserts, and countries such as Canada, which extends into the Arctic, and New Zealand has the lowest population density of any country in the OECD. In terms of land area, New Zealand is 50 percent larger than Washington State but has just over half the population. New Zealand should be one of the fastest-growing countries in the world, a magnet for ambitious people looking for a better life. The change in migration flows with Britain illustrates the problem. From 1974 to 1980, both New Zealand and Australia were net importers of people from the uk. While Australia has continued to be a net importer, New Zealand started to lose people to Britain. Since the election of the current Labour government in 1999, the country’s talent drain has worsened.

New Zealand entered the twentieth century as one of the wealthiest countries in the world in terms of income per head. On the eve of World War i, per capita income was higher than in the uk and within 3 percent of the United States. It maintained its ranking through the Depression years, and in 1950 per capita income was still 88 percent of that of the U.S. But the tightening grip of protectionism and corporatist policies remorselessly pushed New Zealand down the international rankings. By the 1970s, it had been overtaken by all the major European economies other than Britain, which had been suffering from a similar disease.

Not only was the New Zealand economy experiencing decelerating growth, but what little growth there was risked also becoming unsustainable. In the 10 years from 1974, overseas debt rose from 11 percent of GDP to 95 percent. For virtually all that period, inflation was in double digits. Just as Richard Nixon in the U.S. and Britain’s Ted Heath produced their countries’ worst economic policies of the second half of the twentieth century, so it was the purportedly pro-private enterprise National Party government led by Robert Muldoon that pushed New Zealand over the edge in 1984.

Muldoon was a populist. Despite considerable political talent, he avoided taking the tough decisions required by the dire state of the economy. It meant that the National Party, nominally in favor of free markets and private enterprise, became essentially socialist, presiding over a corporatist regime of price and wage controls, welfare to buy support from business and trade unions, and extensive government control over the banking and financial system.

The collapse of the Muldoon government in 1984 set the stage for two remarkable bursts of reform led by two remarkable politicians. Although many of the individual elements of New Zealand’s reforms can be found in other countries, two aspects make the reforms there unique in the West. The first is that they took place in the context of a coherent overall framework focused on economic efficiency, stressing predictability, transparency, and accountability. As a result, individual reforms became mutually reinforcing. Supply-side gains were driven by a flatter tax structure and the elimination of distorting tax breaks. Farmers accepted the phasing out of agricultural subsidies because their costs fell with the reduction of tariffs on imported manufactured goods, while the costs of transporting agricultural exports also fell as a result of the commercial management of New Zealand’s ports and railways. That way, losers were also winners. As the economy was freed up and growth kicked in, the gains outweighed the losses. The reformers were influenced by economic thinkers such as Mancur Olson, Ronald Coase, and James Buchanan, and the reforms were shaped by insights from public choice theory, agency theory, and transaction cost economics. The whole process was characterized by robustness and coherence. The “scientific” nature of the reforms enabled them to be successfully directed to the core functions of government, leading to practical results.

The second distinctive feature of the Kiwi experience is political. Economic liberalization was initiated by a party of the left. When the reforming Labour government lost cohesion and fell in the 1990 election, the reform momentum was regained by the opposition National Party, which was then able to tackle areas that a Labour government was constrained by its natural supporters from reforming, notably the labor market and welfare. In both governments, reform was driven by the finance minister rather than the prime minister. In both cases, the momentum of reform was lost and the cohesion of the government fatally undermined when the prime minister of the day withdrew support for the finance minister’s reform program. While those prime ministers — Labour’s David Lange and National’s Jim Bolger — have been largely forgotten outside New Zealand, if indeed they have made any impact at all, their finance ministers, Roger Douglas and Ruth Richardson, put New Zealand on the map.1

As well as intellectual grasp and strong convictions, Roger Douglas and Ruth Richardson share an ideal of citizen-politicians who solve the problems of their country as best they can and then quit the stage once they have given it their best. “Ask yourself why you’re in politics,” advises Douglas. “It seems to me that too many politicians never ask themselves that question. My view is that it is better to be in politics for three years and do something, than to be there for twenty and do nothing.” As Ruth Richardson puts it: “Prepare to be a pioneer. Political bravery reaps dividends. Do it once. Do it properly and use up your political capital doing something useful.”

The economic impact of the Douglas/Richardson reforms was far-reaching. Government subsidies to industry and agriculture fell from 16 percent of government spending to just 4 percent. This was achieved especially through the drastic reduction of farm subsidies, which fell from NZ$1.2 billion (about $670 million U.S. at current exchange rates) in 1983 to NZ$206 million (about $115 million U.S. ) in 1990. New Zealand remains the only developed country to have scrapped farm support, a political achievement all the greater given that agriculture is New Zealand’s largest sector. The move also revealed the malign economics of farm welfare and the benefits of injecting market economics into agriculture. Since abolition, agriculture has increased its share of New Zealand GDP, and total factor productivity growth (labor and capital) averaged 6.3 percent a year for the first nine years of the reforms.2

Tax reform gave New Zealand one of the flattest tax structures in the developed world. The top rate of income tax was halved from 66 percent to 33 percent. Tight control of government spending under Ruth Richardson reduced government spending (excluding debt service), which had peaked at just under 40 percent of GDP, to 35 percent — and trending down to 30 percent if the reform momentum had been maintained. Together with higher growth, the liberalization of the labor market and welfare reform to encourage active job-seeking by the unemployed resulted in rapid job creation. Minority groups particularly benefited from the improved performance of the labor market. Unemployment among the indigenous Maori and Pacific Island people dropped by 10 percentage points. In 1995, Maori had an employment growth rate double that of non-Maori.

 

The politics of reform

So much for the economics. What about the politics? Given the economic success of the reforms, why was the reformers’ legacy inherited by their opponents? To what extent were the reformers able to constrain their successors from turning the clock back?

The reform momentum came to an abrupt halt immediately after the 1993 election. New Zealand has a three-year election cycle — not long enough for voters to appreciate the fruits of good policy or to live with the consequences of bad policy. Jim Bolger, National’s prime minister, won the election by one seat. He put his narrow victory down to reform fatigue and decided to shift Ruth Richardson from the Treasury. Instead, she decided to quit politics altogether once her landmark Fiscal Responsibility Act had passed. Bolger had also promised a referendum that switched the voting system to proportional representation, thus lumbering New Zealand with an electoral system institutionally destructive of good government, as would be seen after the first election held under the new procedures.

What followed the 1993 election was a long, drawn-out farewell to principle. The National Party’s professional politicians thought that making such compromises would be politically smart. It was a judgment that was to have a heavy economic and political cost. The first thing to go was tighten control over public spending. A government’s ability to control spending is the touchstone of its worth: It requires political will to control it, but the economic consequences of transferring a higher proportion of national output from the private sector to the public sector are invariably damaging. Under Ruth Richardson, spending estimates were undershot. Under her successors, the upward creep of public spending began to exceed estimates. It started to affect economic performance. Instead of reversing New Zealand’s relative economic decline, the net effect of the reforms and the post-1993 policy weakening was to stabilize its international position — a case of keeping up, not catching up.

The political trade-off turned out to be illusory as well. Both Roger Douglas and Ruth Richardson sold their bold reforms as a package. Voters could join up the dots and see it made sense. They were left cold by the subsequent nuances of political compromise.

The 1996 election, the first fought under proportional representation, brought a defeat for the National Party. But the party clung to office by striking a deal with the populist New Zealand First Party, notwithstanding that the latter had campaigned on a pledge to evict National from government. The National government couldn’t survive the compromises it had made. It duly collapsed at the 1999 election.

What had this unnatural extension to its life achieved? Essentially, it paved the way for a decisive Labour victory, just as John Major in Britain and the first President Bush prepared the ground for their parties’ defeats. Such compromises can be especially lethal to parties that generally espouse free-market policies, as their opponents carry more conviction in calling for government intervention and tend to be better at appealing to softer values such as fairness.

Meanwhile, Labour had reverted to its pre-Roger Douglas belief in an activist, bossy government. Helen Clark rebuilt the party on the rump that had opposed the Douglas reforms and governed in coalition with the Alliance grouping, which was formed by left-wing refuseniks who had quit Labour during the 1980s. Her government’s attitude toward the reforms is therefore decidedly ambivalent. On one hand, the reformers are systematically attacked as being neo-liberal Neanderthals. On the other, there is acceptance of some of their work, particularly on the management of public finances. Thus the current finance minister, Michael Cullen, can declare with one breath that “the New Zealand model of extreme market liberalization is no longer sustainable for one simple reason: It does not work.” Then, in the next, he can say that “at the macroeconomic level the government is continuing with a program of fiscal conservatism and monetary orthodoxy.”

So there is no debate now in New Zealand about the benefits of low inflation, prudent levels of public debt, and sustainable public finances. In this regard, New Zealand has gone from having one of the worst records in the OECD to one of the best, an outcome which the reformers set out to entrench by creating a new institutional framework. The central bank was given operational autonomy and an explicit mandate to deliver price stability. The Fiscal Responsibility Act requires the government to publish long-term objectives for key fiscal indicators, such as the level of public spending, taxes, and debt. Such disclosure, with the provision of regular, transparent financial statements, changed the nature of the political debate. According to Ruth Richardson, the act’s author, “The act has radically altered politicians’ budgetary behavior. Since the act has been in force, New Zealand has run eight successive budget surpluses, a significant break from decades of deficits. Fiscal responsibility is regarded as the political norm and the requirement to publish fiscal strategy over the longer term has helped to curtail the chronic short-termism that generally characterizes political decision making.”

The economic debate in New Zealand therefore has been narrowed to what the state’s claims on the country’s resources should be and how the resources it appropriates should be managed. It is a step forward that politicians who argue for a higher share are now forced to finance it honestly, without recourse to inflation or unsustainable levels of borrowing. In this respect, the New Zealand Labour Party is not much different from its Labour cousin in Britain, which implemented a variant of central bank independence for the Bank of England, or indeed from the Clinton administration. Whether the Clark government needed these legislative constraints is a matter of conjecture. The New Left has generally eschewed budget deficits and inflationary finance. Whether out of principled conversion or pragmatic adherence to the new rules of the game, its conformity with these fiscal norms makes it a much harder target for opponents. The existence of fiscal and monetary rules imposes a discipline on the governing party and its coalition partners, which strengthens the hand of the leadership and curbs any fissiparous tendencies toward faction within the party.

The consensus between the government and the reformers on macroeconomic management is not found on microeconomics. Prime Minister Clark has no truck with economic liberalization: “Whilst some still hanker after lower taxes and further deregulation as the key economic prescription, I believe many more are seeing the strategic focus the government is adopting and the policy interventions which accompany it as more likely to contribute to sustained growth.” Whereas the reformers were animated by trying to reduce the incidence of government failure, the current government tries to locate blame on market failure. Thus the finance minister, Michael Cullen, has derided the economic impact of the reforms. “Productivity growth during the 1990s has been pathetic,” he told a group of Australian CEOs. Without government intervention, businesses will just focus on cutting costs and not adding value. New Zealand, Cullen claimed, will be turned into a deindustrialized husk engaged in “commodity extraction and simple transformation.” Of course, when lots of jobs are created, measured labor productivity growth, being an average over the whole economy, will tend to fall. But productivity growth in old sectors that are restructuring is likely to rise. That’s precisely what happened in New Zealand. Don Brash, governor of the central bank, points out that after the reforms, average labor productivity improved by little more than 1 percent a year, but “productivity in agriculture improved by almost 4 percent per annum — a rate of productivity growth which, if achieved across the economy as a whole and sustained for a decade, would easily see [New Zealand’s] per capita incomes reach the OECD median within a decade.”

The Clark government has yet to present a coherent alternative to the market. There is the standard New Left boilerplate about overconsumption (what, after all, is the purpose of economic activity?), inadequate capital formation, and panaceas such as “smart partnerships” and integrating “the skills development system, the science and technology system and the financial system.” All the talk about systems integration masks the futility of attempting an interventionist industrial policy in a modern Western democracy. True, Japan and Southeast Asia have been examples of high-growth economies subject to government intervention. But many of them are now trying to move away from this model. Indeed, Japan’s decade-long difficulties have been exacerbated by its inability to do so. It is a different matter trying similar policies in a mature Western democracy. Insofar as industrial policy has had successes, it has only been in countries where it has been grafted onto pre-democratic structures.

So what does the new policy amount to? Its main impact has been on public spending. Helen Clark came to office promising to increase public spending by NZ$5 billion ($3.35 billion U.S.). Having troughed at 32.5 percent of GDP, public spending is now 37 percent of gdp. The Clark government said it was not in the business of picking winners. However, its largest intervention to date has been to pick a loser, when last year it renationalized Air New Zealand. Similarly, for all the talk about skills and investing in people, one of the government’s first decisions was to increase the top rate of income tax from 33 percent to 39 percent. Reducing the after-tax return on human capital is hardly conducive to rewarding investment in human capital. The new top rate cuts in at $30,000 U.S. — equivalent to 60 percent of average New Zealand incomes but less than one-third higher than the average Australian salary. A small English-speaking country with a culture that encourages young people to travel widely cannot afford uncompetitive tax rates. In the modern world, tax increases in New Zealand have the effect of increasing the supply of ambitious New Zealanders in Australia and London.

Decelerating growth since the mid-1990s has put slowing growth on the political agenda. Helen Clark has set herself the “simple goal” of getting New Zealand back into the top half of the OECD. Her government’s acceptance of the reformers’ institutional framework promoting macroeconomic stability is a necessary condition to raise New Zealand’s growth. It is not sufficient. The New Left’s brand of collectivism without ideology has turned politics into an exercise in using government programs to build political support among business and social constituencies and encouraging negative-sum rent-seeking by special-interest groups. It is therefore in direct conflict with a genuine pro-growth agenda, which involves the removal of government-sanctioned economic privileges.

In the field of industrial intervention, this strategy has not worked. The political payback the government might have expected has not been forthcoming. In the main, business leaders have not been impressed with the prospect of being bribed with their own money or weighing down the economy with a raft of privileges. The experience of the gains to business as a result of economic liberalization appears to have altered business lobbying behavior. The most effective business organization in this respect is the New Zealand Business Roundtable, which is a direct product of the reform years. It has campaigned against tax breaks for research and development and the restoration of export guarantees and is strongly pro-free trade. Although demonized by Helen Clark, the organization has frustrated the government’s aim of winning approval from business for its interventionist instincts. As a result of the limited political upside, the government’s reversal of market liberalization has been more limited than it might otherwise have been. On trade, for example, while planned tariff reductions on textiles and footwear have been frozen, the government has not moved in the opposite direction. Instead, the Clark government has had more political success in feeding a grievance culture with the indigenous Maori minority.

But for the Maori, as indeed for all New Zealanders, the best solution is more rapid economic growth and the freeing of public services, especially education, from the grip of provider interests. Indeed, the reformers’ frustrated efforts in the field of public services such as health and education demonstrate the strength of producer interests (such as teachers’ unions). These have to be overcome. New Zealand’s experience provides a powerful lesson in the use of political capital. Politicians can successfully use their capital to transform structures and institutionalize consumer choice. But politicians can’t stretch their political capital to provide constant management oversight and direction of unreformed structures. Bureaucracies get captured by producer groups and temporary gains get eroded over time, the net result being a costly overlay of extra administration. The New Zealand experience does not bode well for the sustainability of any gains from the national education standards provided by the No Child Left Behind Act in the U.S.

 

Getting “super” wrong

Labour’s most powerful electoral weapon is social security — superannuation, as it is known in New Zealand. Unless approached with principle and courage, the politics and the policy pull in entirely opposite directions. The National Party currently has neither, leaving it highly vulnerable to Labour. Twelve years ago, National experienced the lethal nature of social security if handled badly. Before the 1990 election, the party had agreed to support a Labour policy of tightly targeting social security on the needy. But in the middle of the election campaign, Jim Bolger, National’s leader, overturned this position and pledged a generous and universal social security provision. His new policy was unaffordable and had to be dropped soon after National took office. Bolger’s credibility never recovered, and the flip-flop was a major factor in National’s wafer-thin majority in 1993.

Going into last year’s election, National repeated the mistake. Labour pitched its “65/65” policy, under which married retirees receive 65 percent of average net of tax earnings from the age of 65. It then set up a massive government-directed fund, which at its peak is projected to represent nearly 50 percent of GDP. The scheme has all the inherent defects of defined-benefit schemes with the moral hazard that politicians will have ultimate responsibility for managing enormous amounts of capital. The government ends up borrowing from the debt markets to try to get a higher return on the equity market. The fund’s investment decisions will have a large weight in the total investment flows in the New Zealand economy. It gives the public the illusion of an implicit contract that underpins the benefit payments, although there is no relationship between what’s in the fund and what’s paid out. By making permanent the role of government, it undermines personal responsibility for individuals to save for their retirement. But it was politically smart.

In a Bolger moment, National’s new leader, Bill English, pledged to match Labour: “We won’t touch superannuation — we have agreed with Labour on the 65/65 formula.” It was, he said, a matter of trust and his party’s need to persuade older voters to back him. “Once they do believe that I won’t touch national super,” he claimed, “they will agree with us about a whole lot of other issues.” The problem is, that belief is hard to come by. According to one poll, 70 percent of New Zealanders under 45 believe there will not be a pension for them when they retire. When conservative politicians stake their credibility on a pledge that people are skeptical can be delivered, they undermine their credibility across all issues. On the other hand, they gain voter confidence when they acknowledge there’s a problem and have a policy to fix it.

Copying Labour on social security compromised the economics of National’s warmed-over supply-side policies. There is an inherent contradiction between 65/65 and National’s promise to put a lid on public spending. To cast its objectives in terms of a 10-year tax target of a top rate of 25 percent is tantamount to having none. No New Zealand government has lasted that long in 30 years. If cutting marginal tax rates is good for growth, it makes sense to cut taxes more quickly. The delay precluded National from selling a tax-cutting agenda as stimulating growth and making all citizens better off.

In 2002, National implicitly accepted the terms of the debate set by Labour rather than offering an alternative vision. After National matched Labour on social security, Labour could argue that National’s tax cuts were unaffordable and irresponsible. National was buried in a 2-1 landslide, a victory that caught the attention of politicians such as Britain’s Tony Blair, who saw how left-of-center governments could raise taxes and still win elections.

 

Squandering a legacy of reform

After this crushing defeat, what is the legacy of the liberal reformers? New Zealand politics has been permanently altered by the reforms of the 1980s and early 90s. The cycle of macroeconomic crises caused by weak public finances is a thing of the past. As one observer put it, the retreat from reform would not produce “a blow-out that would land us in the ditch. Rather, the air will slowly go out of the tires.” Yet the effect on the political parties has been made more problematic by raising the electoral hurdle for a pragmatic right-of-center party to win power. Economic crisis is not going to get them elected.

But the right in New Zealand assisted the left’s recovery and current ascendancy by rendering their own market principles inoperable, as these bore a diminishing resemblance to what they actually did when they were in government and to their policies when in opposition. They squandered the legacy of low public spending, which corroded their political standing and has become an increasing drag on growth. Above all, they ceded the political high ground by failing to articulate positions based on principle. It therefore made sense for the electorate to choose Labour. As a party which had greater consistency between what it said and what it does, Labour could deliver a more decisive style of governance.

The linkages between rhetoric, principles, and political advantage can sometimes be subtle and complex, but when sheared apart, the results are disastrous. The turbulence of democratic politics exposes such parties — and voters make their choices accordingly.


Notes

1 The decisive role of the finance minister — or equivalent post — is common to countries with a Westminster form of parliamentary government. The finance ministry drives not just macroeconomic policy, but also microeconomic supply-side reform. Leszek Balcerowicz, for example, was finance minister in the reforming Solidarity government. Thus a government’s performance is driven by the quality of its finance minister. For this reason, if Tony Blair’s government is judged to be better at words than actions on the economy, the blame should not be laid at the doorstep of No. 10, but at that of his next-door neighbor in Downing Street, Chancellor of the Exchequer Gordon Brown. Tony Blair’s ideology is sufficiently elastic to provide pr cover for a reform-minded chancellor in the mold of a Roger Douglas. But that would require a chancellor who is willing to expend political capital on his day job and not hoard it to try for the top spot.

2 As with the former communist countries of Eastern Europe, GDP numbers don’t capture the value of the wider choice consumers have in spending their money. By their nature, improvements in the quality of life are difficult to quantify and tend to be ignored. These are real enough to young New Zealanders. Since the reforms, New Zealand has become one of the few countries in the world that allows the commercial importation of second-hand autos. The country therefore became an extension of the Japanese used car market, making auto ownership much more affordable to young New Zealanders, who have switched from motorcyles to second-hand Japanese cars. Since 1984, the number of motorbikes has halved and usage has fallen even more sharply. Motorbike injuries and fatalities have fallen by over 75 percent, a powerful example of how economic reform has improved the quality — and length — of life.