Reflections on a report I wrote for the New Zealand Productivity Commission

The Government has asked the New Zealand Productivity Commission (NZPC) to enquire into the resilience of the New Zealand economy to supply-chain disruptions. It wants to identify policies and interventions that can enhance the robustness of New Zealand’s economy and living standards to medium-term disruptions.

The NZPC is not the only public agency pursuing this goal. The Government also has the Ministry of Transport and Infrastructure Commission looking at the transport infrastructure underpinning supply chains, while the Ministry of Foreign Affairs and Trade is leading the identification of essential goods (and services) that New Zealand needs to be able to access, and policy options for dealing with six-month to one-year disruptions.

Obviously concerns arise from the shortages during the Covid crisis, but they reflect changes that have been happening: 

            - Production processes are increasingly relying on more components sourced from different locations and suppliers, while what they produce is more varied and complicated.

            - There has been more offshoring so New Zealand is even less self-sufficient. (That is also true locally. Once every reputable town had a mass-production brewery. Today they are concentrated in a few centres; the local craft breweries could not cope if the big breweries were cut off.)

            - Just-in-time supply has lowered stock holdings and costs, but made businesses more vulnerable to supply disruptions. (As the occasional empty shelf at your supermarket demonstrates.)

            - Perhaps the world economy is getting more volatile. It may seem that way, but perhaps it is just that the increasing international interdependence is transmitting national shocks through to the international economy quicker and stronger.

So it seems a good time to look at the resilience of our economic system to shocks. It won’t make an iota of political difference, but it may reduce the stress of adjusting to future shocks even if they cannot be avoided.

The NZPC commissioned me to look at the history of shocks on the New Zealand economy and what lessons we can learn from our response to them. (The report is here.) These shocks were not only economic ones. There have also been major geological ones such as earthquakes, and biological ones such as the nineteenth-century pandemics, which devastated the immunologically virgin Māori, the 1918 influenza epidemic and, of course, the Covid pandemic.

Shocks are very common. New Zealand experiences about 14-15,000 earthquakes each year. Most are so familiar that we have automatically built into our buildings and behaviour a resilience to them. However, we also put a lot of effort into dealing with those above magnitude of, say, 6 (as those familiar with the rebuilding program in Wellington of recent years are acutely aware).

It is the same with economic shocks. They are not counted but in any year there must be myriads. We cope. Businesses build in buffers to deal with fluctuating demand and supply; so do households. It is only the biggies that we have to consciously deal with.

The minor ones are dealt with by ordinary market behaviour. One of my objections to the degree of interventions in the market economy before 1984 was that they reduced the degree of resilience. (For instance, in 1974 there was a huge housing boom. The local supply of lavatory pans was so limited so that almost completed houses were left unoccupied because, literally, there was nowhere to shit. Pans could not be imported because the import licences and consequential supply chains did not exist. Admittedly we had a shortage of some building supplies recently complicated by international availability – that is the sort of thing the NZPC is looking at. I cannot help noticing that one factor was monopolies in the supply chain. Perhaps they are inevitable in small New Zealand, which a reason why we need to think differently from elsewhere.)

So the first line of response to deal with economic shocks is the market. By increasing market flexibility we can increase resilience to slightly bigger shocks. But that is not enough as the recent difficulties following the Covid crisis show. Unintervened markets do not deal with big shocks. That is the point of the NZPC enquiry (and of macroeconomic policy).

That is the main lesson we learn from my history of big shocks. Each time we adapted afterwards. Following the nerve-wracking 2008 Global Financial Crisis, New Zealand – especially the Reserve Bank – has introduced a number of changes to the financial system to avoid some of the defects found in 2008. You could say they were ‘fighting the last war’ or that ‘experience comes just after you need it’. However, what has been learned leads to changes which added to the economy’s resilience to future shocks.

 The difficulty is that the financial sector keeps innovating, an integral feature of a market economy. As my report shows, it is a kind of poacher and gamekeeper relationship. We keep learning from the last policy failure, but the next shock is different.

This led me to categorising shocks into three categories:

            - Category 1 (unimportant unknowns): small shocks which require little policy response, if any;

            - Category 2 (known unknowns): medium shocks which may require some policy response, but can be largely prepared for, including designing potential policy responses;

             - Category 3 (unknown unknowns): large novel shocks which require innovative policy responses.

History shows that we are not too bad at dealing with the known unknowns (Category 2). The challenge is how to cope with the unknown unknowns (Category 3); what John Kay and Mervyn King call ‘radical uncertainty’.

The first thought is that humility can be a help, something hardly evident when it is announced ‘this time it is different’ as we head into the next financial crisis. The important differences are the unknown unknowns.

Nevertheless, I am impressed how well the public health sector dealt with the Covid crisis. The Ministry of Health had cut back on its commitment to public health in the 2010s. But the universities had retained a cadre of able public health specialists who worked together energetically and cooperatively. They were following what had happened overseas for years (Covid was only the latest SARS virus, albeit a particularly nasty one), had studied previous pandemics such as the 1918 influenza epidemic, had discussed policy responses and prepared their students.

I am not sure that is true that economists are generally as well prepared (although the Reserve Bank and Treasury economists performed very well in 2008). My report traces the lamentable response to the 1966 wool price crash which some advising the government decades later did not think was important – even if it was obvious in the data. Today we are not paying enough attention to the creeping structural change.

New Zealand economics is so much part of the conventional wisdom that it tends to be intolerant of economists who think ahead of it about the radical uncertainty of the unknown unknowns. It is not helped by a media and other parts of the establishment comfortable with the conventional wisdom. So are you – until you are shocked.