New Zealand's two-cylinder economy is starting to splutter, writes Peter Lyons.
I enjoy teaching my pupils how the New Zealand economy works in its dealings with the rest of the world. It is like a simple two-cylinder engine.
We mainly load ships with low value-added commodities such as milk powder, meat, logs, butter, cheese and other odds and ends.
We send these ships overseas and in return we get back oil, computers, cars, cellphones, whiteware and various other manufactured goods.
This pattern fits with a core economic concept called the law of comparative advantage.
This law states that international trade allows countries to specialise in producing the things in which they have a natural advantage.
For New Zealand with its relative abundance of productive land this natural advantage is in producing primary commodities.
Other developed countries seem to have a natural advantage in producing high value added items such as pharmaceuticals, software, high tech manufactured goods, advanced services and high end foodstuffs such as quality cheeses and chocolates.
These countries generate higher and more stable incomes for their citizens.
Unfortunately for countries like New Zealand that rely heavily on commodity exports, the prices of these items are very volatile on world markets.
Their economies can quickly move from boom to slump.
There has always been vigorous debate among economists about how ''natural'' these advantages in producing high value added products actually are.
History suggests that the ''natural'' advantage that developed countries enjoy in producing high value added items is partially the result of smart active government policy.
New Zealand's trade policy ignores this aspect of economic history. We continue to sign endless free trade agreements and lament our heavy reliance on fickle commodity exports.
New Zealand's two-cylinder economy usually fails to generate enough income to pay for what we buy from overseas plus the interest and dividends we pay to overseas.
This is reflected in the current account deficit
Lucky for us, overseas people have been willing to keep lending to us so we can keep buying our widescreen TVs, SUVs , iPad and cellphones.
They have also helped fund our lifestyles by buying our businesses, farmland and more recently, our houses.
We have been able to live beyond our means because overseas people have wanted our dollars to lend back to us and to buy our assets.
They like lending to us because the interest rates on offer here have been very attractive.
This is because our Reserve Bank uses short-term interest rates to bludgeon any potential inflation.
The Government set up a productivity commission several years ago to investigate why we keep experiencing these inflationary pressures.
Like many commissions and task forces, its recommendations have been largely ignored.
Our politicians prefer to listen to voter focus groups when developing policy.
If overseas people weren't willing to lend to us and buy our assets, the New Zealand dollar would fall against other currencies.
This would quickly expose the fact that collectively we have been living beyond our means for a long time.
This may be starting to happen.
Much of the money that is lent to us from overseas comes via our banking system.
The banks hoover up New Zealand dollars by issuing bonds to overseas lenders.
They lend these funds out here mainly for mortgages to allow us to buy our houses.
This has been a very profitable activity for the banks operating here, particularly before the global financial crisis.
Total bank borrowing from overseas currently stands at $117 billion.
This is up from $55 billion in 2001.
So, in a nutshell, we spend more than we earn in our dealings with the rest of world.
Fortunately, foreigners have been willing to lend our money back to us as well as buy our assets, including houses.
Much of the lending is used for mortgages helping fuel the Auckland housing bubble.
This maintains the illusion of prosperity for homeowners in Auckland.
The rest of the country looks on with uneasy bemusement.
World dairy prices have fallen precipitously in the past year.
Our dollar is starting to slide as the Reserve Bank cuts interest rates to bolster the economy.
Unfortunately, our two-cylinder economy may be starting to splutter.
The Finance Minister recently responded by stating the dairy industry isn't really as important to our economy as it used to be.
Let's hope he's right.
• Peter Lyons teaches economics at Saint Peter's College in Epsom and has written several economics texts.
