Mongolia Economic Forum Ulan Bator, Mongolia, March 2011

1. The Natural Resource Curse I:Can Mineral Wealth Cause Problems?Jeffrey FrankelHarpel Professor of Capital Formation & GrowthHarvard University Mongolia Economic Forum Ulan Bator, Mongolia, March 2011

2. The Natural Resource Curse • The NRC pertains especially to oil and minerals, but sometimes to timber & agricultural products too. • Seminal references: • Auty (1990, 2001, 07, 09) • Sachs & Warner (1995, 2001) • Other studies find a negative effect of oil, in particular, on economic performance: • including Kaldor, Karl & Said (2007); Ross (2001); Sala-i-Martin & Subramanian (2003); and Smith (2004). • Frankel, “The Natural Resource Curse: Survey,” • NBER Working Paper 15836, 2010. • forthcoming in Export Perils, • edited by B.Shaffer (University of Pennsylvania Press) • translated into Mongolian.

3. Examples • Conspicuously high in oil resources and low in growth: Venezuela & Gabon. • Conspicuously high in growth and low in natural resources: China & other Asian countries. • The overall relationshipon average is slightly negative:

4. Growth falls with fuel&mineral exports

5. Are natural resources necessarily bad? No, of course not. • Mineral wealth need not necessarily lead to inferior economic or political development. • Rather, it is a double-edged sword, with both benefits and dangers. • It can be used for ill as easily as for good. • The priority for any country should be on identifying ways to sidestep the pitfalls that have afflicted other mineral producers in the past, to find the path of success.

6. The goal is to enjoy the success of • a Chile, not a Bolivia • a Botswana, not a Congo • a Norway, not a Nigeria. • The last section of my paper explores some of the policies & institutional innovations that might help avoid the natural resource curse and achieve natural resource blessings instead.

7. How could abundance of mineral wealth be a curse? • What is the mechanism for this counter-intuitive relationship? • At least 7 channels have been suggested:

8. 7 Possible Natural Resource Curse Channels • Downward price trend • Price volatility • Crowding-out manufacturing • Inhibited development of institutions • Unsustainably rapid depletion as a result of unenforceable property rights • Proclivity for armed conflict • The Dutch Disease

9. The 7 NRC Channels Elaborated • World commodity price trendcould be downward (Prebisch-Singer); • High volatility of oil prices could be problematic ; • Natural resources could be dead-end sectors (Matsuyama):they may crowd out manufacturing, • which may be the home of dynamic benefits & spillovers. • “Industrialization” could be the essence of development.

10. The 7 NRC Channelscontinued 4. Countries where physical command of mineral deposits by the government or a hereditary elite automatically confers wealth on the holders may be less likely to develop the institutions that are conducive to economic development (Engerman-Sokoloff …), • e.g., rule of law & decentralization of decision-making, • as compared to countries where moderate taxation of a thriving market economy is the only way to finance government.

11. The 7 NRC Channelscontinued 5. Non-renewableresources are depleted too fast, where it is difficult to enforce property rights,as under frontier conditions. 6. Countries that are endowed with minerals may have a proclivity for armed conflict, which is inimical to economic growth. 7. Swings in commodity prices can engender macroeconomic instability(Dutch Disease), via the real exchange rate and government spending.

12. We now go through the 7 possible NRC channels (1)The claim of a negative trend in commodity prices on world markets was already dealt with: the data do not suggest a robust long-term trend, certainly not a negative one if updated to 2010.

13. (1) Long-term world price trend • (i) Determination of the price on world markets • (ii) The old “structuralist school” (Prebisch-Singer): • The hypothesis of a declining commodity price trend • (iii) Hypotheses of a rising price trend • Hotelling • Malthus • (iv) Empirical evidence • Statistical time series studies

14. (i) The determination of the export price on world markets • Developing countries tend to be smaller economically than major industrialized countries, and more likely to specialize in the exports of basic commodities. • As a result, they are more likely to fit the “small open economy” model: • they can be regarded as price-takers, • That is, the prices of their export goods are generally taken as given on world markets.

15. (ii) The old “structuralist school”Raul Prebisch (1950) & Hans Singer (1950) • The hypothesis: a declining long run trend inprices of mineral & agricultural products • relative to the prices of manufactured goods. • The theoretical reasoning: world demand for primary products is inelastic with respect to world income. • That is, for every 1 % increase in income, raw materials demand rises by less than 1%. • Engel’s Law, an (older) proposition: households spend a lower fraction of their income on basic necessities as they get richer. • Demand => P oil

16. (iii) Hypotheses of rising trendsHotelling on depletable resources;Malthus on geometric population growth. • Persuasive theoretical arguments that we should expect oil prices to showan upward trend in the long run.

17. Assumptions for Hotelling model • (1) Non-perishable non-renewable resources: • Deposits in the earth’s crust are fixed in total supply and are gradually being depleted. • (2) Secure property rights: Whoever currently has claim to the resource can be confident that it will retain possession, • unless it sells to someone else, • who then has equally safe property rights. • This assumption excludes cases where warlords compete over physical possession of the resource. • It also excludes cases where private mining companies fear that their contracts might be abrogated or their holdings nationalized.

18. One more assumption, to keep the Hotelling model simple: • (3) The fixed deposits are easily accessible: • the costs of exploration & extraction are small compared to the value of the mineral. • Hotelling (1931) deduced from these assumptions the theoretical principle: • the price of oil in the long run should rise at a rate equal to the interest rate.

19. The Hotelling logic: • The owner chooses how much mineral to extract • and how much to leave in the ground. • Whatever is mined can be sold at today’s price (price-taker assumption) • and the proceeds invested in bank deposits • or US Treasury bills, which earn the current interest rate. • If the value of the commodity in the ground is not expected to rise in the future, then the owner has an incentive to extract more of it today, so that he earns interest on the proceeds.

20. The Hotelling logic,continued: • As minng companies worldwide react in this way, they drive down the price today, • below its perceived long-run level. • When the current price is below its long-run level, companies will expect the price to rise in the future. • Only when the expectation of future appreciation is sufficient to offset the interest rate will the commodity market be in equilibrium. • Only then will mining companies be close to indifferent between extracting at a faster rate and a slower rate.

21. The complication: supply is not fixed. • True, at any point in time there is a certain stock of reserves that have been discovered. • But the historical pattern has long been that, as that stock is depleted, new reserves are found. • When the price goes up, it makes exploration & development profitable for deposits farther under the surface. • …especially as new technologies are developed for exploration & extraction.

22. What is the overall statistical trend in commodity prices in the long run? • Some authors find a slight upward trend, • some a slight downward trend.[1] • The answer seems to depend, more than anything else, on the date of the end of the sample: • Studies written after the 1970s boom found an upward trend, • but those written after the 1980s found a downward trend, • even when both went back to the early 20th century. [1] Cuddington (1992), Cuddington, Ludema & Jayasuriya (2007), Cuddington & Urzua (1989), Grilli & Yang (1988), Pindyck (1999), Hadass & Williamson (2003), Reinhart & Wickham (1994), Kellard & Wohar (2005), Balagtas & Holt (2009) and Harvey, Kellard, Madsen & Wohar (2010).

23. (2) Effects of Volatility • Is volatility per se bad for economic growth? • Cyclical shifts of resources back & forth across sectors may incur needless transaction costs. • A diversified country may indeed be betterthan one 100% specialized in minerals. • On the other hand, the private sector dislikes risk as much as the government does, and will take steps to mitigate it; • thus one must think where the market failure lies before assuming that a policy of deliberate diversification is necessarily justified.

24. Effects of volatility, continued • Policy-makers may not be better than individual private agents at discerning whether a commodity boom is temporary or not. • But the government cannot ignore the issue of volatility: • When it comes to exchange rate or fiscal policy, governments must necessarily make judgments about the likely permanence of shocks. • More on medium-term cycles when we get to the Dutch Disease

25. (3) Do natural resources crowd out manufacturing? • Matsuyama (1992) provided an influential model: • the manufacturing sector is assumed to be characterized by learning by doing, while the primary sector (agriculture, in his paper) is not. • Also van Wijnbergen(1984)and Gylfason, Herbertsson & Zoega(1999). • The implication: • deliberate policy-induced diversification out of primary products into manufacturing is justified, and • a permanent commodity boom that crowds out manufacturing can indeed be harmful.

26. Counterarguments • There is no reason why learning by doing should occur only in manufacturing tradables. • Nontradable sectors can enjoy learning by doing. [1] • E.g., construction… • The mineral sector can as well. • The USA is one example of a country that has enjoyed big productivity growth in commodity sectors. • Productivity gains have been aided by American public investment, • since the late 19th century, in such knowledge infrastructure institutions as the U.S. Geological Survey, School of Mines, and Land-Grant Colleges. [2] • [1] Torvik(2001) and Matsen & Torvik (2005). • [2] Wright & Czelusta(2003, p.6, 25; 18-21).

27. Counterarguments, continued • Public investment in knowledge infrastructure ≠government subsidy or ownership of the resources themselves. • In Latin America, e.g., public monopoly ownership and prohibition on importing foreign expertise or capital has often stunted development of the mineral sector, whereas privatization has set it free. • Attempts by governments to force linkages between the mineral sector and processing industries have often failed.

28. (4) Institutions Recent thinking in economic development: • The quality of institutions is the deep fundamental factor that determines which countries experience good performance.[1] • It is futile (e.g., for the IMF & World Bank)to recommend good macroeconomic or microeconomic policies if the institutional structure is not there to support them. [1] Barro (1991) and North (1994).

29. What are weak institutions? • A typical list: • inequality, • corruption, • insecure property rights, • intermittent dictatorship, • ineffective judiciary branch, and • lack of any constraints to prevent elites & politicians from plundering the country. • “Quality of institutions” has been quantified by World Bank, Freedom House, Transparency International, and others. • Rodrik, Subramanian & Trebbi (2003) use a rule of law indicator and protection of property rights (taken from Kaufmann, Kraay & Zoido-Lobaton, 2002). • Acemoglu, Johnson, & Robinson (2001) use a measure of expropriation risk to investors. • Acemoglu, Johnson, Robinson, & Thaicharoen (2003) use the extent of constraints on the executive.

30. Institutions can be endogenous: • the result of economic growth rather than the cause. • The same problem is encountered with other proposed fundamental determinants of growth, e.g., openness to trade and freedom from tropical diseases. • Many institutions tend to evolve endogenously, in response to the level of income, • such as the structure of financial markets, • mechanisms of income redistribution & social safety nets, tax systems, and intellectual property rules…

31. Addressing endogeneity of institutions statistically • Econometricians address the problem of endogeneity by means of the technique of instrumental variables. • What is a good instrumental variable for institutions, an exogenous determinant? • Acemoglu, Johnson & Robinson (2001) introduced the mortality rates of colonial settlers. • The theory is that, out of all the lands that Europeans colonized, only those where Europeans actually settled were given good European institutions. • Acemoglu et al figured that initial settler mortality determined whether Europeans settled in large numbers.[1] • [1] Glaeser, et al, (2004) argue against the settler variable. Hall & Jones (1999) consider latitude and the speaking of English or other European languages as proxies for European institutions.

32. Institutions: Econometric findings • The finding is the same, regardless of IV: • “Institutions trump everything else” – Rodrik et al (2002) • Acemoglu et al (2002) • Easterly & Levine (2002) • Hall & Jones (1999) • Geography and history matter mainly as determinants of institutions; • which is not to say that institutions don’t also have other important determinants. • In any case, institutions are important.

33. The “rent cycling theory” as enunciated by Auty(1990, 2001, 07, 09) : • Economic growth requires recycling rents via markets rather than via patronage. • In oil countries the rents elicit a political contest to capture ownership, • whereas in low-rent countries the government must motivate people to create wealth, • e.g., by pursuing comparative advantage, promoting equality, & fostering civil society.

34. A related view by economic historians Engerman & Sokoloff(1997, 2000, 2002) • Why did industrialization take place in North America, • not Latin America? • Lands endowed with extractive industries & plantation crops developed slavery, inequality, dictatorship, and state control, • whereas those climates suited to fishing & small farms developed institutions of individualism, democracy, egalitarianism, and capitalism. • When the Industrial Revolution came, the latter areas were well-suited to make the most of it. • Those that had specialized in extractive industries were not, • because society had come to depend on class structure & authoritarianism, rather than on individual incentive and decentralized decision-making.

35. The theory is thought to fit Middle Eastern oil exporters well. • E.g., Iran. Mahdavi (1970), Skocpol (1982, p. 269), and Smith (2007). Econometric findings that “point-source resources” such as oil and mineralslead to poor institutions • Isham,Woolcock, Pritchett, & Busby (2005) • Sala-I-Martin & Subramanian (2003) • Bulte, Damania & Deacon (2005) • Mehlum, Moene & Torvik (2006) • Arezki & Brückner (2009).

36. Which comes first,minerals or institutions? • Some question the assumption that mineral discoveries are exogenous and institutions endogenous. • Mineral wealth is not necessarily the cause and institutions the effect, rather than the other way around. • Norman (2009): the discovery & development of oil is not purely exogenous, but rather is endogenous with respect to the efficiency of the economy.

37. The important determinant is whether the country already has good institutions at the time that minerals are discovered, in which case it is put to use for the national welfare, instead of the welfare of an elite, on average. • Mehlum, Moene & Torvik (2006), • Robinson, Torvik & Verdier (2006), • McSherry (2006), • Smith (2007) and • Collier & Goderis (2007). • Luong & Weinthal (2010), in a study of the 5 oil-producing former Soviet republics:the choice of ownership structure makes the difference as to whether oil turns out a blessing rather than a curse.

38. (5)Unsustainably rapid depletion • What happens when a depletable natural resource is indeed depleted? • This question is important for 3 reasons: • Protection of environmental quality. • A motivation forthe strategy of economic diversification. • A motivation for the “Hartwick rule”: • All rents from exhaustible natural resources should be invested in other assets, so that future generations do not suffer a diminution in total wealth (natural resource plus reproducible capital) and therefore in the flow of consumption. • Hartwick (1977) and Solow (1986).

39. Rapid depletion,continued • Each of these problems would be much less severe if full assignment of property rights were possible, • thereby giving the owners adequate incentive to conserve the resource in question. • But often this is not possible, • either physically • or politically. • Especially in a frontier situation. • The difficulty in enforcing property rights over some non-renewable resources constitutes a category of natural resource curse of its own.

40. Unenforceable property rights over depletable resources • Some natural resources do not lend themselves to property rights, whether the government wants to apply them or not. • Very different from the theory that the physical possession of point-source mineral wealth undermines the motivation for the government to establish a regime of property rights for the rest of the economy. • Overfishing, overgrazing, & over-use of water are classic examples of the “tragedy of the commons” that applies to “open access” resources. • Individual fisherman or farmers have no incentive to restrain themselves, while the fisheries or pastureland or water aquifers are collectively depleted.

41. Unenforceable property rights,continued • The difficulty in imposing property rights is particularly severe when the resource is dispersed over a wide area, as timberland. • But even the classic point-source resource, oil, can suffer the problem, especially when wells drilled from different plots of land hit the same underground deposit.

42. Unenforceable property rights,continued • This market failure can invalidate some standard neoclassical economic theorems in the case of open access resources. • The resource will be depleted more rapidly than the optimization of the Hotelling calculation calls for. [1] • The benefits of free trade may be another casualty: • If exports exacerbate the excess rate of exploitation, • the country might be better worse off. [2][1]E.g., Dasgupta & Heal (1985).[2]Brander & Taylor(1997).

43. (6) War • Where a valuable resource such as oil or diamonds is there for the taking, factions will likely fight over it. • Oil & minerals are correlated with civil war. • Collier & Hoeffler (2004), Collier (2007), Fearon & Laitin (2003) and Humphreys (2005). • Chronic conflict in such oil-rich countries as Angola & Sudan comes to mind. • Civil war is, in turn, very bad for economic development.

44. (7)The Dutch Disease and Procyclicality • Developing countries have historically been prone to procyclicality: • Procyclical capital inflows • Procyclical government spending. • This is particularly true of commodity producers. • The Dutch Disease describes unwanted side-effects from a strong, but perhaps temporary, upward swing in the world price of the export commodity.

45. Procyclicality Volatility in developing countries • arises both from foreign shocks, • including export commodity price fluctuations, • and from domestic shocks • including macroeconomic & political instability.

46. Procyclicality Volatility in developing countries • Most developing countries in the 1990s brought under control the chronic runaway budget deficits, money creation, & inflation, that they experienced in the preceding two decades, • but many still showed monetary & fiscal policy that was procyclical rather than countercyclical: • They tend to be expansionary in booms • and contractionary in recessions, • thereby exacerbating the magnitudes of the swings. • The aim should be to moderate swings • -- the countercyclical pattern that economists, after the Great Depression, originally hoped discretionary policy would take.

47. Procyclicality in developing countries Procyclical capital flows • According to theory (“intertemporal optimization”),countries should borrow during temporary downturns, to sustain consumption & investment, and should repay or accumulate net foreign assets during temporary upturns. • In practice, it does not always work this way. Capital flows are more procyclical than countercyclical. [1] • Theories to explain this involve capital market imperfections, • e.g., asymmetric information or the need for collateral. [1] Kaminsky, Reinhart, & Vegh (2005); Reinhart & Reinhart (2009); Gavin, Hausmann, Perotti & Talvi (1996); and Mendoza & Terrones (2008).

48. Procyclicality in developing countries Procyclical capital flows,continued • As countries evolve more market-oriented financial systems, the capital inflows during the boom phase show up in prices for land & buildings, and also in prices of financial assets. • Prices of equities & bondsare summary measures of the extent of speculative enthusiasm, • often useful for predicting which countries are vulnerable to crises in the future.

49. Procyclicality in developing countries Procyclical capital flows,continued • In the commodity & emerging market booms of 2003-11, net capital flows have typically gone to countries with current account surpluses, especially Asians and commodity producers in the Middle East & Latin America, • where they showed up in record accumulation of foreign exchange reserves. • This is in contrast to the two previous cycles, 1975-1981 and 1990-97, when the capital flows to developing countries largely went to finance current account deficits.

50. Procyclicality in developing countries • One interpretation of procyclical capital flows is that they result from procyclical fiscal policy: • when governments increase spending in booms, the deficit is financed by borrowing from abroad. • When they are forced to cut spending in downturns, it is to repay the excessive debt incurred during the upturn. • Another interpretation of procyclical capital flows to developing countries is that they pertain especially to mineral exporters. • We consider procyclical fiscal policy in the next sub-section, return to the commodity cycle (Dutch disease) in the one after.