Preparing for a Post-Covid19 Economy: capacity building or building capacity?

We seem to have the pandemic under control - what next?

Now that community transmission has been eliminated in New Zealand and some rigour brought to border control, it is timely to think about economic recovery. That’s not straightforward. As the pandemic rages globally restricted travel, limited trading opportunities, and disrupted supply chains mean that we have to make the most of an inevitably shrunken economy.

Making decisions about where to put economic resources – including spending on recovery – is made harder because we have no idea what the future holds. We can no longer predict economic conditions and the outcome of policies with any confidence if we rely on past experience.  We can, however, make decisions about how to deal with today’s crisis in a way that prepares us for tomorrow’s unknowns. 

This post suggests focusing early recovery on employment-intensive sectors that better equip the community to rise to the unknown challenges of the new normal, rather than building the infrastructures associated with the old.

The Infrastructure Capacity Consensus

To date, New Zealand’s rebuilding strategy has been defined mainly in terms of building physical infrastructure to cater for economic activity as we knew it.  Among other things, the Government has just committed $3bn to start on its list of shovel-ready projects. While it's early days, the National opposition already says we need more infrastructure. While there may be debate about how much, what projects, and in what order, there is no obvious disagreement with the notion of building our way out of the darkness.

This risks justifying spending on uneconomic infrastructure that undermines productivity and prejudices long-term growth. Promoting infrastructure to create jobs simply promotes investment that cannot otherwise be justified in sectors already facing supply chain and skill bottlenecks. When these are publicly funded they not only increase fiscal risk; they potentially starve activities that promise greater employment and a more assured long term return.

Building Capacity as an Alternative

What about another approach? What about building the capacity of people, rather than structures, to deal with a future that will not be a rerun of the past? This will emphasise more jobs more immediately, maintain better short-term domestic demand , and build the adaptability and resilience needed in the long-term.

It does not mean dismissing infrastructure, but calls for spending on it to be moderated, focusing on what we know is needed and not the nice-to-have or me-too projects, favouring instead activities that deepen the skill base, develop talent, promote creativity, and encourage entrepreneurship.

Investing in people

Today we are confronted by a deficit of demand, not a deficit of infrastructure. Investing in people will lift demand directly, hold together a fractured domestic economy, and lay the groundwork for long-term recovery and resilience. Our nation’s capacity to respond will be best served if the population is in good health, well housed, well educated, and well employed.

So, what are the best sectors for promoting employment?
Employment multipliers are used here to address this question.  The multipliers relate job numbers to output in each of the 106 sectors used to define the economy.  The jobs may be direct (within the sector in question), indirect (associated with supplying materials, components, goods, and services to that sector),and induced (from the spending of employees in the first two categories). [1]

Table 1 lists the sectors with the highest employment multipliers. Among other things, this indicates that one million dollars of additional output (or funding) in pre-school education would give the most jobs for $1,000,000 spent: around 29 in total, comprising  around 21 in the sector itself, 3 in activities supplying it, and 5 from the resulting household spending. Specialised food retailing also scores well, with a strong indirect effect reflecting how it draws on domestic suppliers.[2]   

Table 1: Sectors with Highest Output:Employment Multipliers (2017)

Table 2 compares multipliers from the most employment-intensive industry groups drawn from Table1 with those for the industry targeted by infrastructure spending, construction.

From this we see that:

·   The employment boost from spending in construction sits close to the median for all sectors, but well below education, health, and social care services.

·  Residential building is a slightly better job-booster than civil engineering (roads, bridges, and the like) and non-residential building.

·  Residential and non residential building both generate significant indirect employment, reflecting reliance on local suppliers and subcontractors.

·   Non-tertiary education sectors have a substantial direct employment impact, with a relatively high induced impact suggesting that the sector’s typically “middle incomes” sustain above-average household spending.

Table 2: Employment Contribution, Selected Industries (2017)

·   Spending on tertiary education may generate less immediate employment because of higher overheads and salaries.

·   Medical and residential care and social assistance also have significantly greater employment impacts than construction.  Some of this will come from low paid “care” jobs, an issue highlighted by the critical nature of this sector to the Covd19 response.

Promoting job-intensive sectors may seem two-edged: they tend to pay the lowest wages (Figure 10).[3] However, low income households are likely to direct most of their additional spending to food and consumables, ensuring a large share of increased earnings flow through the retail and service sectors.

Figure 1: Average Wages by Sector, Q4 2019

In addition, these are the sectors that promote well-being across the community and should increase people’s skills and their abilities to deal with change.

Creating value

The benefits of recovery driven by employment-intensive industries also depend on how much value they add to the economy. According to the 2013 National Inter-Industry Tables, the share of output that is value added in the construction sector is modest, although low margins are offset in part by the substantial purchase of intermediate goods and services by the sector. 

While gross output is substantially lower in health and education than in construction, more value is created, largely in salaries and wages.  And because health and education each generate more household income than construction, funds channeled into these industries will lead to greater downstream demand in retail, services, and hospitality.

Table 3: Value Added, Imports, and Compensation of Employees, Selected Sectors (2013)

Towards a Multi-Layered Recovery – Scaling back the Infrastructure Sell

Infrastructure still has a role to play, especially in accommodating extra capacity in the priority sectors indicated by these figures. And, to be fair, the first $2.4bn of spending outlined by the Government included a strong commitment to social and affordable housing, well distributed sanitation and community enhancement projects, and environmental initiatives (Figure 2). Just under 30% was directed towards transport. However, this omits the big promises made to Auckland transit projects and major highway developments.

Figure 2: Distribution of the First Round of Shovel-Ready Spending

Investing in Human Resources

It is time to back off spending on mega-transport projects for which demand is uncertain and, instead, to focus on building the capacity of our people to deal with a changing economy.

Already there has been a commitment to step-up health funding in the May 2020 budget. The Simpson report on reorganising health and disability delivery (by consolidating and centralising administration and “professionalising” governance) may also help with a reset, although on the face of it looks a little like an expensive rearrangement of deckchairs.

Beyond that, a step up in new and innovative educational and vocational projects and initiatives across society may be the best means of ensuring that the recovery from Covid19 can be sustained, and that the country will be even better placed to deal with such crises in the future. 

Directing funding towards a more diverse, inclusive, and flexible education sector may mean increasing funding to both the educators and the educated. A simple start could include: increasing the funding of pre-school education; lowering staff student ratios in schools; developing applied tertiary courses in technology, production and distribution, agriculture and horticulture, and resource management; and encouraging and funding applied research.

Infrastructure should serve recovery, not shape it
Without doubt, initiatives in these areas will drive demand for further infrastructure.  But this investment will be focused on the needs of the sectors that underpin social well-being and economic productivity, and that foster the capacity of people to adapt to whatever demands the new normal might make. 

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[1]    The multiplier estimates are based on the national input-output tables (Statistics NZ, 2014) calculated and updated to 2017 by Insight Economics in Auckland. I gratefully acknowledge access to them, and am solely responsible for their interpretation here.

[2]    Employment in retailing largely reflects the induced effect of growth in other sectors. Spending by overseas visitors in retailing (and hospitality), though, represents additional external demand.  

[3]   Although wages in sectors like medical care span a wide range.

No light at the end of this tunnel - reflecting on failed infrastructure

The big risk and high cost of thinking big.
I flagged a concern in the last post about the fiscal and productivity impacts of projects that don’t stack up economically. The risk is that the post-Covid recovery leads to indiscriminate infrastructure spending which would compound the already severe fiscal effect of essential deficit spending on public health, household incomes, and business support .

Given their dismal track record here and overseas, it is likely that large infrastructure and especially transport projects will dig the fiscal hole deeper without delivering the benefits that might help the country climb out of it. We know that the Think Big energy projects of the early 1980s precipitated a foreign exchange crisis.  Had they been economically sound the ten hard years of economic restructuring that followed may have been moderated. 

Looking back to go forward
There is no sense in trying to replicate the past.  But it does make sense to learn from it.

In this case, it seems the lesson was not learned. I posted several critiques of Auckland’s Central Rail project back in 2011 and 2012. Today we can see just how big a cost ignoring past infrastructure failures has imposed - so far - in the case of the CRL if only to temper a new found enthusiasm for thinking big.

Auckland’s Central Rail Link, 25c in the dollar?
How ever long it takes to finish and however much it gets used, Auckland's CRL is an economic disaster.

The first cost estimate for the tunnel was $2.3bn, released by Auckland Council in 2011. That did not account for the prior expenditure of $500m on electrification to make the tunnel environmentally acceptable, or the consequential costs of purchasing new rolling stock, extending and updating existing stations, and compensating business owners badly impacted by prolonged civil engineering works. 

Even with those omissions, though, the project was deemed unworthy of government support by Transport Minister Brownlee, with “a decidedly weak benefit:cost ratio of just 44 cents in the dollar”. 

In any case, the estimated tunnel benefit:cost ratio turns out to have been on the high side.  That the project was under-specified is evident in the 2018 announcement that platforms had to be lengthened, adding around $250m to the costs. 

And it was under-costed.  By April 2019 the cost estimate was up to $4.4bn.  This covered construction cost increases of $327m, “non-direct costs” of $130m, and a new provision for escalation and contingencies of $310m.

Converting the original budget and additional costs to December 2019 dollars (using the price index for construction inputs) reveals an over-run of around $1.7bn, 70% ahead of the original budget after accounting for inflation.  Given that there has been no suggestion that the projected benefits will increase, the potential economic return now sits at around 25c in the dollar.

We can expect further cost escalation given that completion date (prior to Covid19) was pushed out from 2021 to 2024. This is likely to be extended further by pandemic-related constraints including disruption to contractors, labour, and supply chains, and by increased competition from local and international “shovel-ready projects”. That's more bad news for those central city businesses that have seen revenues plummet in the face of ongoing disruption by the prolonged street works.

Strong growth rates are misleading
Let's consider potential benefits in light of the past ten years' public transport performance.  The introduction of electric units in 2014 and station and service improvements across the network saw strong relative growth in rail patronage. It seems the benefits of improved service levels on the network are already being reaped without the $4.4+bn CRL.

However, this needs to be kept put in perspective. While rail boardings almost tripled over the ten years to February 2020, the real gains were in bus use (70% of the total):

     Source: https://at.govt.nz/about-us/reports-publications/at-metro-patronage-report/

Significantly, 87% of gains in bus patronage were in “frequent, connector, local, targeted” services according to Auckland Transport.  This strengthens the argument for flexible bus services rather than high cost, fixed route rail. 

It is also likely that gains to rail included a transfer of some passengers from buses so that the impact on car use and the increase in public transport use will be less than indicated by increased trips by rail. 

How important is rail to central city commuting?
According to the 2018 Census, a relatively low 55% of work trips by the 159,000 people working in the Waitemata Local Board Area were by private or company vehicle. Of those, 6% of were made by passengers.  Company vehicles accounted for 11% of the total. As these vehicles are most likely required for work purposes their occupants are unlikely to transfer to PT. 

This means that the market for improved rail and bus services is just 46% of possible commuter trips .  Public transport already has a high penetration rate of 29% of commuters working in Waitemata.  However, less than a third of these were by rail, despite the relative growth in numbers. The prospects of getting many of the remaining private car users to shift to rail are low. Rail patronage may have to grow mainly through trips transferring from buses.

Narrowing the focus , there were 18,000 commuters to the inner city in 2018. Only 19% relied on a private or company vehicle (between 3,100 and 3,200 vehicles) in 2018. The likelihood of getting a significant reduction in this number is slim. 

A surprisingly high 50% said they walked to work, while 22% used public transport (only a fifth of those by rail).  The strategy of getting more inner city workers living there seems to be working. Ironically, it’s a success that raises questions over expectations that investment in the CRL will influence travel in the inner city. 

Will CRL even deliver a significant mode shift?
The Council wants people out of cars.  Whether or not that's achievable - or even reasonable  - was the CRL the way to achieve it?

Apart from the fact that the project is uneconomic and fiscally damaging, the fact is that over three quarters of Auckland’s labour force works outside Waitemata Local Board area, with 77% of them relying on private or company vehicles to get to work.  

Even if the billions invested into the CRL were to effect a significant lift in public transport patronage, it is a spend that could have been much more effectively directed towards offering  more flexible bus-based transit serving the wider urban area.

And that was before Covid19.
Today, the lack of flexibility of rail comes into even sharper focus in light of the potential changes in working practices, the diminished appeal of high density living, commuting, and working, possible land use changes, and the imposition of social distancing for the foreseeable future. These prospects, along with post-Covid19 delays in constriction, mean that the CRL is likely to fall even further short of helping to achieve “Government’s plans for higher economic productivity and the Auckland Plan vision of being the world’s most liveable city” (City Rail Link, Business Case 2015).

Spending $4.4bn (and climbing) on lifting the capacity of rail patronage by building the  CRL tunnel looks like an economic and and fiscal fail. It is also looking like a major policy fail.

Which brings us to the even bigger white elephant in the room, Auckland's proposed light rail. This is the subject of my next post.

Its not the shovels that count: its what they're shovelling

Is boosting infrastructure the best road to economic recovery for New Zealand?

If we do not get investment for recovery right we will undermine productivity and economic progress for generations to come. Indiscriminate infrastructure development at this time risks limiting options by absorbing and concentrating resources in an area in which performance has been demonstrably deficient.

New Zealand's recovery from Covid19 requires short-term job gains and long-term income growth if we are to throw off the shackles of public debt. Committing substantial resources to “shovel-ready” projects without rigorous assessment risks excessive spending to meet uncertain demand. The result of over-investment will be lower foreign reserves, a diminished credit rating, and a prolonged productivity deficit.

Get the economics right first

Economic justification is essential to establish whether the benefits generated by infrastructure justify the resources consumed in its development. Projects that do not stack up have a negative fiscal impact, requiring ongoing tax- or rate-payer subsidy. While otherwise uneconomic projects may provide non-market benefits (to the environment, social equity, or public health for example), if we do not first consider their economic efficiency, we cannot know whether they are the best means of achieving those benefits. 

We do know, however, that the wrong projects can set our economy back: the Think Big projects contributed substantially to a run on foreign exchange reserves in the early 1980s.

Current failures

The damage from uneconomic projects tends to increase if they are large scale. The literature on cost blowouts for major infrastructure projects – especially in transport – is extensive. Auckland's Central Rail Link , for which the case was flawed from the outset, and Transmission Gully are text book cases.  Consider the following:

• Under-specification at the outset, with inadequate technical assessment or design myopia leading to re-specification and add-on costs in the course of development;
• Under-costing from relying on precedent and current (or historical) costs for estimation, failure to consider the effect of competing demand for resources, and the optimism-bias of project protagonists leading to unwarranted approvals and subsequent cost blow-outs;
• Contract failures from accepting low tenders and engaging at-risk contractors to meet tight project budgets, leading to higher costs when contractors fail and re-tendering is necessary;
• Project delays from under-specification and under-costing compounded by resource shortages (including labour and skills), tying up capital and delaying benefits.

The failures threatening the CRL are such that economist Tim Hazeldine’s view is that it is time to stop pouring good money after bad. The contingencies facing such large scale projects should double down the call for rationality in today’s perilous economic environment. 

Unproven Demand

Because large-scale investments take time to finish, demand at completion may be quite different from what was projected at inception. Along with the impact of unexpected disruptions, extended pay-back periods add to uncertainty over what demand a project may eventually have to meet. 

As of today, the Infrastructure Commission’s pipeline of major public capital works , although incomplete, outlines around $16b or more of spending. Approximately 60% of this is for transport. (These figures are based on the cost ranges provided).  Yet major transport projects today face substantial shifts in demand, such as:

• Revised working conditions lowering building occupancy and increasing the appeal of large footplate, low-rise, suburban workspaces with natural light and airflow;
• Changed working arrangements (staggered hours, home-based working);
• Newly suppressed demand for and lower passenger densities on public transport;
• An increased preference for medium/low density suburban living environments;
• A shift from large scale venue-based recreation;
• Reduced international travel and tourism;
• Reduced demand for mall-based retailing in favour of local services and centres;
• More on-line retailing and in-home services.

We can add to this market uncertainty the impact of changing technologies, including prospects for:

• Enhanced face-to-face telecommunications;
• Gains in vehicle autonomy increasing capacity on existing highways;
• Falling electric vehicle costs boosting private transport and demand-responsive public transport;
• Aircraft operations favouring smaller aircraft on point-to-point rather than hub-and-spoke networks;
• Continuing logistics gains integrating production and distribution with direct delivery;
• Artificial Intelligence, product printing, design refinement, innovation, and changing consumption preferences jointly supporting local production of specialised goods;
• Distributed specialist services (law, health, medicine) supported by AI, gains in computing power, seamless tele-conferencing, and advanced instrumentation;
• Decentralised settlement with modern, localised infrastructure, decentralised employment, and efficient inter-regional and international information and transport connections.

A Shortage of Resources

Supply chains are over-stretched in the development sector.  This flows through to delays, costs, and failures all-too-often overlooked by local politicians and their consultants in the haste to justify economically suspect projects. 

Shovel-ready projects track straight into this quagmire of unrealistic supply chain and labour market expectations.  Yet, Infrastructure New Zealand has effectively lobbied the civil engineering/development complex to the top of the national economic agenda. It is supported by a network of professional players (engineering, consulting, planning, design, and legal) and the vested interests of operators. Because of its visibility, infrastructure building also plays to political monumentalism. 

What are the alternatives?

A shovel ready recovery locks us into projects based on the economy and labour market of the past. Uneconomic or marginally economic projects limit our ability to do other things. It would be better to focus on initiatives that lift adaptability (the ability to change what we are doing), and flexibility (the ability to vary how we are doing it). 

Here are some ideas that might contribute: 

• Vet and prioritise infrastructure projects, ditching those like Auckland light rail plans with costs bound to blow out and which face uncertain demand; 
• Pursue best practice in the assessment, design, specification, and management of any projects that may be justified (most likely in public health, water quality, and the like); 
• Prioritise social infrastructure (education, health, and housing) for  short- and long-term benefits. 
• Promote innovation and entrepreneurship with vocational education to increase career mobility and deepen domestic skills and experience. 
• Pursue an open business environment to facilitate enterprise, mobilise capital, ensure productive resources and feedstocks can be widely accessed, and streamline regulation; 
• Address business support to future-oriented capacities, rather than propping up existing structures and practices; 
• Review approaches to trade facilitation, support for innovation and technology, and business taxation. 
• Maintain household incomes: increasing local consumer spending, especially among low income households, will have the highest immediate impacts on employment while providing breathing space as the country and the world adjust to the economic shock of Covid 19.

Quite simply, an infrastructure-dominated programme that imposes new and potentially open-ended fiscal demands on currently constrained incomes is more likely to undermine than boost economic activity.