Editor’s Note: This abridged version has been prepared to publicise the method and key findings of a study performed for CAENZ under the auspices of BRANZ. With apologies to the authors and their sources, most of the source references and many of the graphs have been left out to conform with the ConstructingNZ newsletter size and format. The full report is available from the CAENZ website.
This study introduces complexity economics and systems thinking as a methodology and approach to understanding why boom and bust cycles exist in the construction industry. System models have been developed to better understand, not predict, the dynamics of the multiple complex interactions, which range from hard economic data to people’s irrational behaviour. During the study there has been extensive consultation with a broad cross-section of industry professionals and practitioners.
There is a broad appreciation of how the overall economic climate impacts the construction industry in New Zealand, but there is little uptake of the economic theories about boom and bust cycles by construction practitioners. There is broad agreement that cycles do exist and that they influence decision makers, but the cause of the cycles is uncertain and varies depending on the industry sector and perspective of the observer. Government spending and policy decisions are seen as a major influence for most participants in this study. Also, it is the rate of change, whether in boom or bust conditions, that cause the problem, not the fact that the industry has good years and bad years.
Generally it is accepted that a rapid upward phase of the cycle causes inflated prices and reduced competition due to full-order books; whilst the downward phase leads to competitive cost cutting, reduced margins and pressure on quality. It is this sort of
negative self-fulfilling prophecy that should be challenged if the industry is to break free of the most negative aspects of boom and bust cycles.
The study concludes that whilst external shocks will always impact the industry, much of the volatility is caused by internal system factors. Better communication within the supply chain, visibility of future orders, long range planning around resources (particularly skilled workers), and reducing delays in the approval and procurement systems can produce considerable improvements in performance and productivity.
The construction industry is an important bellwether and stimulus for the New Zealand economy. As a result, the construction industry is prone to manipulation by policy makers attempting to influence the domestic economy, often to the detriment of the industry itself. This duality of purpose causes increased uncertainty and volatility in the industry.
The key finding of the study is that the complexity and uncertainty that characterises the New Zealand construction industry demands changes to industry structures and strategic thinking that encourage collaborative learning processes.
The aim of this study was to establish and communicate a shared understanding of the key drivers in the boom/bust cycles of the construction industry in New Zealand. This shared understanding would allow for interventions and policy making to be more effective and responsive. It would also inform the industry about what it needs to know in terms of quantitative or qualitative data that would help further explain the interplay and interactions between the industry players, the environment, other industries and government.
The study adopted a systems thinking philosophy, for two main reasons: first, systems approaches are seen by many leading thinkers and research organisations as a more effective way to view complex, interconnected real world problems. Secondly, the construction industry is complex and fragmented, with many different bodies and differing objectives – systems thinking strives to understand the key systemic behaviours and relationships rather than finding an optimal solution.
Interpreting existing knowledge
Brief historical perspective of the New Zealand economy
Since its settlement in the early 19th century, New Zealand’s economy has been based on its natural resources. Exports, dominated by pastoral products such as wool, meat, and dairy products, were sold predominantly to UK markets. Incomes rose rapidly, surpassed as late as 1960 by only the United States and Switzerland, prompting waves of migration.
The economy was also marked by a high degree of state intervention.
A cradle-to-grave welfare system was implemented, funded by taxation. Controls were imposed on labour and financial markets while state ownership of industrial and commercial activities was prolific. The result of this extreme protectionism was gross inefficiency. The economy’s profound structural weakness was exposed following a succession of shocks in the 1970s. The 1973-74 oil shock exerted huge pressure on macroeconomic balances, but more damaging were the accession of the United Kingdom to the European Community and its adoption of the Common Agricultural Policy, which restricted New Zealand’s access to its core export market.
Inflation became entrenched and the budget balance moved deep into the red. Increasing recourse was made to international debt markets to finance both the budget and current-account deficits. By 1984, the economy’s chronic macroeconomic imbalances had prompted a collapse of confidence in foreign-exchange markets as New Zealand veered close to a Third World-style debt collapse.
The Labour government that came to power in 1984 implemented one of the most radical reform programmes adopted by an Organisation for Economic Co-operation and Development (OECD) nation. The New Zealand dollar was floated in March 1985, leaving its exchange rate to be determined by supply and demand, and the Reserve Bank granted greater autonomy from the government.
The impact of these macroeconomic and structural reforms was profound. The budget balance moved into large and recurring surpluses. Net external debt was eliminated, reversing New Zealand’s former position as one of the largest borrowers in international debt markets.
From the late 1990s, the economy has demonstrated considerable resilience, weathering successive shocks buoyed by robust domestic demand. Through internal structural reforms, the economy appeared, until the latest oil price shocks, to have broken its boom-or-bust cycle to transit to a trajectory of stable, sustainable growth. This has important implications for this study.
A 2007 OECD report warned that despite New Zealand having one of the most flexible and resilient economies in the OECD, large external deficit and very low household savings, combined with strong inflation pressures, are causing uncertain growth patterns. Moreover, despite economic growth since the early 1990s labour productivity growth has been lacklustre. The OECD report suggests the large swings in the New Zealand dollar and high interest rates are two of the key factors affecting productivity.
According to Bollard & Hunt (2008) there have been a number of growth periods in New Zealand since the Second World War, some longer than others, suggesting a trend towards more stability.
They suggest that structural reforms and Reserve Bank policy changes are significant factors in the reduction of volatility in the economy. They do warn, however, that the interconnectedness of global economies can mean that external shocks, such as the recent credit squeeze and oil price rises, can easily and rapidly influence New Zealand economic stability.
The Construction industry and the economy
Whilst there have been several growth periods followed by slowdowns in the economy as a whole, Bollard (1992) identified two significant boom periods for the construction industry; the ‘Think Big period’ from 1977 until 1982 and the ‘Construction Boom’ from 1984 until 1987. It can be argued that, since 1992, there has been an additional boom cycle, until 2007, caused primarily by house demand and subsequent price rises, albeit with a slight downturn through the late 1990s.
The Think Big Era
The ‘Think Big programme’ was initiated by the government of the day, who invested around NZ$6 billion per year through several industry departments. Although the investment programmes created thousands of jobs and supported the local production and processing of energy, it did not bring the ‘further accelerator effect’ (Bollard, 1992) that one might expect from such investment, and left New Zealand with over NZ$28 billion of debt.
The boom cycle in the construction industry was short-lived. The external environment, in the form of the international oil situation, had a very strong effect on this cycle. The ‘Think Big Era’ influenced future policy makers away from too much government involvement in a market-dominated industry. As a result we have a systemic loop set up of history-influencing economic evolution and future decision making, which in turn induces cyclical behaviour that then impacts policy and influences policy makers. Indeed, it is striking how similar the current economic crisis is to the 1970s crisis. It is all too easy to blame external conditions in these situations instead of acknowledging the influence of the internal dynamics of the economic/political system.
The Construction Boom
In the mid-1980s the government liberalised the economy and deregulated the financial sector. The subsequent growth of the financial sector coupled with government departmental restructuring increased demand for new office buildings. There were far greater returns on investments in sectors such as construction when the real exchange rate rose. This was a signal to the market to invest in the construction sector, though the key factor that caused the boom was the deregulation policy of the government (Grimmond, 1989).
There then followed a significant downturn in 1987, as stock markets crashed around the world, resulting in rapid retrenchment and over supply of non-residential property in the early 1990s. The estimated amount of ‘unnecessary, premature or misdirected construction investment’ (Bollard, 1992) was in total over NZ$3 billion. The next two years saw a sharp decline in the number of people employed in the industry.
The Recent Decades
In 1992, the New Zealand Institute of Economic Research forecasted that the contraction of the sector following the two boom periods had taken place and the trough of recession had passed. Despite small fluctuations in 1999 and 2001, there has been a steady growth in the construction sector since 1992 supported by overall building output figures Evidence from the Reserve Bank suggests that construction output closely follows the national GDP cycles, but swings more extremely. In macroeconomics, construction related indices are often used as the economy indicators. Orders for housing, building permits, housing prices and housing starts are all used as key leading indicators of the economy. Also, some indices in the construction industry, such as investment in building, plant construction and orders for engineering output, are key lagging indicators of the economy. In New Zealand at the moment there is a strong correlation between residential construction prices and inflation.
Thus there is a situation where the New Zealand economy is more volatile than its major benchmarking countries and the construction industry is more volatile than other industrial sectors in New Zealand as a whole (Figure 2). The construction industry is more vulnerable to economic fluctuations than other industries so consequently should be acutely aware of the causes and the nature of the cycles in the economy and elsewhere.
Whilst the construction industry represents nearly 5% of the total Gross Domestic Product (GDP) in New Zealand, it influences the economy in other ways. The construction industry in New Zealand has a multiplier effect into other industries. Also, efficiency improvements gained in the construction industry enhance the overall performance of the New Zealand economy, in terms of the national competitiveness.
Construction is often seen as a government economic regulation tool through adjustment of interest rates, public sector expenditure and the system of taxation. Also, government arranges for the construction of infrastructure and other goods regarded as public services, such as roads, water supply or schools. However, government is seen as handicapped by not having adequate methods for assessing the subsequent impact of changes on the industry, on society, or on the environment. Governments are often caught in a difficult position where they are damned if they do make industry interventions and damned if they do not. A clear and consistent strategy regarding infrastructure and policies that influence building and construction would help reduce the impact of cycles, but political cycles tend to work against such aims.