The Political Economy of the Natural Resource Curse: An Interpretive Survey Robert T. Deacon

1. The Political Economy of the Natural Resource Curse:An Interpretive Survey Robert T. Deacon University of California, Santa Barbara Resources for the Future June 2, 2010 17th Ulvön Conference on Environmental Economics Ulvön, Sweden, June 22-24, 2010

2. Former U.S. President William J. Clinton: • “With … [its] vast human and natural resources, a revitalized Nigeria can be the economic and political anchor of West Africa ….” • From remarks on signing of a joint declaration with Nigerian President Obasanjo, August 26, 2000.

3. Sheik Ahmed Yamani, former Oil Minister of Saudi Arabia: • “All in all, I wish we had discovered water.” • Cited in Ross, Michael. “The political economy of the resource curse.” World Politics 1/1 (1999) 297-322.

4. Motivation: anecdotes • Nigeria’s per capita GDP in 2000 was 30% lower than in 1965, despite oil revenue receipts of $350 billion. • Venezuela’s terms of trade grew 13.7% per year during 1970-1990, but its output per capita fell by 1.4% per year; ran a current account deficit. • Saudi Arabia’s GDP per capita was lower in 1999 than it was before the oil price increases of the 1970s. • OPEC: per capita GNP decreased 1.3% per year during 1965-1998 • Average growth in all lower- and middle-income countries 2.2% per year.

6. Motivation: case study evidence Gold: 16th century Spain Tin & natural gas: Bolivia Timber: Indonesia & Philippines Oil: Venezuela and Nigeria Bird Guano: Peru

7. Motivation: case study evidence Gold: 16th century Spain Tin & natural gas: Bolivia Timber: Malaysia & Philippines Oil: Venezuela and Nigeria Bird Guano: Peru

8. Counter examples: resource rich countries that are, well, rich • Norway, following North Sea oil boom. • Botswana, diamond capital of the world. • U.S., Canada, Australia, Iceland, New Zealand prospered from natural resource wealth. • Malaysia, Chile, …

9. Motivation: Why care about the resource curse? • May provide insight on the key question in economics: • Why do some countries grow and become prosperous, while others remain poor? • May prove a valuable ‘testing ground’ for models of political economy.

10. Market-based explanations for the RC • Resource wealth and the Dutch disease • Resource wealth diverts attention from education, entrepreneurship, … • Volatility in resource prices hinders investment, growth. • Resource rich countries experience long run declining terms of trade.

11. Market-based explanations for the RC • Dutch disease • Resource rents divert attention from education, entrepreneurship, … • Volatility in terms of trade hinders investment, growth. • Long run declining terms of trade for resource intensive countries. • Unexplained patterns in the data • RC most problematic when governance institutions are weak; • Doesn’t operate when institutions are strong. • RC more problematic for concentrated than diffuse resources.

12. Market-based explanations for the RC Dutch disease Resource rents divert attention from education, entrepreneurship, … Volatility in terms of trade hinders investment, growth. Long run declining terms of trade for resource intensive countries. Unexplained patterns in the data RC most problematic when institutions are weak. RC more problematic for concentrated than diffuse resources. Consider political economy explanations for RC

13. Rent-seeking models of the RC The ‘Voracity’ Effect, Diverted Entrepreneurship and the Resource Curse Rent-seeking among Competing Groups and Institutional Decline Rent-seeking, Violent Conflict and Resource Exploitation Policy Political Economy (Institutional) Theories of the RC Rent-induced Regime Transitions, Public Employment at a Commitment Mechanism, Protection (Resources) for Sale and Political Competition Concentrated Power, Resource Rents and Public Goods Supply Political Competition and Entry Barriers

14. Rent-seeking (Institution-free) Models of RC • The ‘Voracity’ Effect • Tornell and Lane, Amer. Econ. Rev., 1999; Tornell and Velasco, Jour. Pplit. Econ. (1992); Lane and Tornell, J Econ. Growth, 1996; Tornell and Lane, J Int. Econ. 1998. • Diverted Entrepreneurship and the Resource Curse • Torvik, J Dev. Econ., 2002; Mehlum, Moene and Torvik, Econ. Jour., 2006. • Rent-seeking among Competing Groups and Institutional Decline • Hodler, Eur. Econ. Rev., 2006. • Rent-seeking, Violent Conflict and Resource Exploitation Policy • Van der Ploeg and Rohner, Working paper, University of Oxford, 2010.

15. Political Economy (Institutional) Models of RC • Rent-induced Regime Transitions • Aslaksen and Torvik, Scand. J. Econ., 2006 • Public Employment at a Commitment Mechanism • Robinson, Torvik and Verdier, J Dev. Econ., 2006. • Protection (Resources) for Sale and Political Competition • Bulte and Damania, B.E. Jour. Econ. Anal. & Policy, 2008. • Resource Rents, Concentrated Power, and Public Good Supply • Smith, Jour. of Politics, 2008. • Political Competition and Entry Barriers • Tsui, Working paper, Clemson University, 2009.

16. The Political Response to Windfalls: Voracity, Growth and the Resource Curse • Politically powerful groups can costlessly transfer highly productive capital from the formal sector: ‘formal’ capital stock is a common pool. • These groups can transfer capital to a less productive, but invulnerable, ‘informal’ sector. • Capital flows from formal to informal sector; growth rate and PV welfare are suboptimal. • Availability of secure ‘wealth haven’ may or may not improve welfare.

17. Voracity, … Response to windfall on formal k stock rate of return. • Contrary to (my) intuition, an increase in the rate of return to formal capital causes transfers by elite groups to increase by more than the productivity gain. • Consequently, formal sector capital is reduced • Contrary to intuition, the size of the transfer is relatively large when the number of powerful groups is small (but > 1) • ….economic outcomes are worse when political power is concentrated. • Reminder: no institutional barriers to prevent transfers. • Personal comment: I haven’t worked so hard to understand a paper since graduate school.

18. Voracity, … • A representative group’s perceived after-transfer rate of return on capital left in formal sector: • where p is output price, a is physical productivity of formal capital stock, n is number of groups, x is one group’s transfer as a share of formal capital stock

19. Voracity, … • Introduce a second, informal sector. Its productivity is b < a, but it is immune to transfers. If rates of return equalize, we have • Each group counts only the transfers other (n -1) groups take from the stock, when calculating the rate of return it perceives on formal capital.

20. Now the magic happens … • Suppose the rate of return on formal capital increases due to price increase, Dp. Capital naturally flows from formal to informal sector. If rates of return are again equalized in equilibrium, the change in transfers per group, Dx, must satisfy • since the informal sector’s productivity is unchanged. This implies that each group’s transfer changes as follows:

21. Now the magic happens … The aggregate transfer, nx, changes by That is, the increase in aggregate transfer exceeds the productivity gain. Notice that the aggregate transfer is larger when n is small (so long as n > 1).

22. What’s going on here? • The equilibrium concept here is Markov perfect equilibrium: • Each group’s strategy is a function of payoff relevant state variable, k. • Each group internalizes the fact that its transfer will reduce k, and therefore affect other groups’ demands. • “Don’t kill the goose that lays the golden egg” • If the net-of-transfer rate of return on formal capital falls below the rate of return on informal capital, each group’s best response is to transfer the entire stock of k to the informal sector. • Risk of “killing the goose that lays the golden egg” disciplines transfer demands. • May also be extreme equilibria, where all k is transferred.

23. How to Interpret? • ‘Small n’ economies (concentrated political power) always perform worse than ‘large n’ economies (diffuse political power): • Economy with larger n always always achieves higher growth rate and PV utility. • However, perverse response to windfalls is more dramatic in large n economies—pushes their performance down toward what small n economies achieve. • Tornell and Lane’s (1999) interpretation: • “… if the shift to democracy brings with it the destruction of entrenched interest groups, and power becomes more diffused, then growth performance and adjustment to windfalls will improve.” • Similar to political economy principle, but different reasoning.

24. Evidence on Voracity and Resource Curse • Tornell and Lane (1999) informally examine response of 3 oil-rich economies, Mexico, Nigeria and Venezuela, to oil price shocks of 1970s and early 1980s. • Government transfers as share of GDP more than doubled: Payments to special interests? • Growth rates in all three well below rates predicted from empirical growth model. Growth negative in Nigeria and Venezuela!

25. Evidence on Voracity, cont. • Lane and Tornell (1996) examine cross-country cross section data: • Controls: Absence of institutional barriers to transfers, ICRG scores. • Controls: Concentrated political interests, concentrated manufacturing sector. • Voracity term: Price shock, average terms of trade growth. • Results: Positive price shock increases growth in countries with strong institutions, but no growth occurs when institutions are weak. • Results: Similar effects on investment rates (formal k growth), but less robust.

26. Voracity: Untested Implications • Tornell and Lane (1999, 1996): Price spike causes increased ‘theft’ of formal capital by political interests. Formal capital is largely linked to oil extraction, so theft may be visible in: • Greater risk of expropriation, nationalization of oil capital by government; • Greater frequency of bribes, kickbacks to resource contractors. • Voracity predicts that formal capital will actually shrink following price jump; possibly visible in data on oil production investments, etc. • Lane and Tornell (1996): Institutional barriers control is arguably a measure of ‘theft’ activity; thus endogenous and not a valid control.

27. Rent-seeking, Diverted Entrepreneurship and RC • Historical example: Spain’s appropriation of gold from the New World (Karl, 1997). • Most spectacular windfall in history, linked to natural resource discovery. • Resource curse of epic proportions: eight declarations of bankruptcy between 1557 and 1680. • What happened (Karl, 1997):

28. Rent-seeking, Diverted Entrepreneurship and RC Historical example: Spain’s appropriation of gold from the New World: What happened (Karl, 1997): “[The monarchy] consolidated the loyalty of the lesser aristocracy through political favoritism, especially by selling patents of nobility and ecclesiastical appointments. This practice dramatically expanded the size of a parasitic noble class . . . while simultaneously siphoning off the most productive talent from business and commerce. ….. “The state bought the talents of those who might have become small entrepreneurs through awarding of offices …”

29. Rent-seeking, Diverted Entrepreneurship and RC • Torvik (2002), Mehlum, et al, (2006) develop a model that formalizes this story. • A fixed number of talented individuals can apply their skills in either of two ways: • Operating a ‘modern,’ increasing returns firm that can generate profits. • Rent-seeking at the public trough. • Allocation of talent depends on returns in both activities, returns equalized in equilibrium. • Resource rent accrues to government, encourages rent-seeking. • Rent reduces talent allocated to modern firms, so less profit is generated.

30. Rent-seeking, Diverted Entrepreneurship and RC • Profit from modern firms spurs growth throughout the economy, ‘big push’ logic. • Shifting resources away from modern sector to primitive sector reduces income. • Return to rent-seeking depends on country’s institutional quality and size of the resource rent.

31. Rent-seeking, Diverted Entrepreneurship and RC • Predicted effect of larger resource rent: • With low quality institutions, larger resource rent shifts talent away from modern sector to primitive sector and reduces income, an economic resource curse. • An economy otherwise immune to rent-seeking may succumb, if rents are large enough, a political resource curse.

32. Empirics: Diverted Entrepreneurship, … • Hypothesis: Resource rent is a curse only when institutions cannot resist rent-seeking. • Format: Sachs-Warner cross country growth (1970-1990) regression equation. • Control for Institutional quality with country ratings on corruption, contract repudiation, expropriation risk, … • Resource rent proxy is share of GDP in primary products sectors. • Control for initial income, openness to trade, education, other factors. • Result: Resource rent reduces growth when institutions are weak, but not otherwise.

33. Empirics: Diverted Entrepreneurship, … • Untested predictions: • Resource rent windfall can increase rent-seeking activity, rendering institutional quality endogenous. • Resource rent windfall should shift economic activity away from modern sectors toward primitive sectors.

34. Political Economy (Institutional) Models of RC • Rent-induced Regime Transitions • Aslaksen and Torvik, Scand. J. Econ., 2006 • Public Employment at a Commitment Mechanism • Robinson, Torvik and Verdier, J Dev. Econ., 2006. • Protection (Resources) for Sale and Political Competition • Bulte and Damania, B.E. Jour. Econ. Anal. & Policy, 2008. • Resource Rents, Concentrated Power, and Public Good Supply • Smith, Jour. of Politics, 2008. • Political Competition and Entry Barriers • Tsui, Working paper, Clemson University, 2009.

35. Political Economy Models …. • Government, or gov’t. leader, is a distinct decision making agent • Institutions whereby leader is selected are spelled out. • Selection rules generally discipline actions the leader can take. • Contrast: rent-seeking models characterize outcomes as equilibria of effort expended by private agents. • Lindbeck-Weibull ‘probabilistic’ voting framework • Specifies very dispersed distribution of political power • Can be generalized to represent systems in which power is held by powerful, organized interests.

36. Rent-induced Regime Transitions • Historical accounts: competition to control resource wealth can erupt in violence • Examples: civil wars in Angola, Nigeria, Sierra Leone, Zaire, fought to control diamonds, oil and metallic minerals. • Criterion for controlling government shifts away from an electoral process, toward violent struggle.

37. Rent-induced Regime Transitions …. • Aslaksen and Torvik, Scand. J. Econ., 2006 combine political economy and rent-seeking models to examine transitions. • Candidates seek office to control a resource rent. • Adapt Lindbeck-Weibull voting model to characterize outcomes under democracy. • Characterize welfare of election’s loser as function of resource rent , preference parameters, … • Adapt rent-seeking model to characterize each candidate’s expected welfare under violent competition. • If election loser’s expected welfare under democracy is less than loser’s expected welfare under violent competition, violence erupts.

38. Rent-induced Regime Transitions …. • General setup • Rival candidates (politicians, factions, parties) play repeated game. • Reward is resource rent controlled by government, net of any transfers to supporters in democratic regimes and ‘fighting’ costs in non-democratic regimes • Strategies depend on history of play;. Once violence erupts, it continues indefinitely. • Focus on (‘best’) Nash equilibria when agents play Nash reversion (trigger) strategies. • Acquiescing to democracy = cooperating;Resorting to violence = defecting.

39. Rent-induced Regime Transitions …. • Objectives • Characterize conditions under which democracy can persist • Determine how resource rent affects the viability of sustained democracy.

40. Utility from income (policy) Relative popularity of B versus A Ideological preference for B relative to A • Rent-induced Regime Transitions … • Probabilistic voting: • Citizens get utility from income, which depends on government policies, and from candidates’ attributes • Citizen i’s utility if candidate B wins is: • Let be citizen i’s utility from income if A wins. Then i votes for candidate B iff

41. Rent-induced Regime Transitions … • Role of non-income based preferences: • s, ideological preference for B vs. A, is uniformly distributed with densityf. • d, relative popularity of B vs. A, is uniformly dist. with density y. • Candidates know density of d, but value is not realized until after election. • The smaller is ythe more willing voters are to trade off ideology for money. • Candidates will exploit this and capture greater shares of rent in equilibrium when yis small.

42. Rent-induced Regime Transitions … Candidate A’s objective function: B’s objective function is symmetric. Given symmetry, both candidates choose the same policy (Hotelling) and outcome is determined by realization of popularity term, d. Vote share for A, depends on A’s transfers. Transfers promised to supporters Resource rent, captured by winner

43. Rent-induced Regime Transitions … Equilibrium rent retained by winning candidate is: The more important is the non-monetary component of preference, i.e., the smaller is y, the greater is the rent retained by winner. Winner’s rent also depends positively on R. Citizen’s wage income

44. Discount factor Rent-induced Regime Transitions … Candidates’ payoffs under perpetual democracy: Loser’s expected PV payoff under continued democracy:

45. Rent-induced Regime Transitions … In conflict regime, candidates compete by spending effort fighting. Prize is the resource rent, R. Opportunity cost of effort is foregone consumption. Initiating conflict has a fixed cost, F units of effort. Once initiated, conflict lasts forever. Expected PV payoff from perpetual conflict is:

46. Rent-induced Regime Transitions … An outcome under which each candidate continues to submit to elections, rather than initiating violence, is feasible only if This cannot be satisfied (democracy cannot be sustained) unless Future cannot be discounted too heavily Non-monetary preferences must be sufficiently large (small y). (If non-monetary preferences are important, candidates capture large share of rent under democracy.)

47. Rent-induced Regime Transitions … • Empirical implications? • Transition from democracy to conflict is more likely when R is large, or after a resource rent windfall arrives. • Democracy more likely to be sustained when ideology is important, future not discounted too heavily. • Possibility of transition from conflict to democracy?

48. Public Employment at a Commitment Mechanism • Robinson, Torvik and Verdier, J Dev. Econ., 2006. • In political systems where politicians need popular support to gain office, candidates and citizen-supporters face commitment problems. • Candidates’ promises not fulfilled until after election. What guarantee promises will be kept? • Citizens’ support, at individual level, cannot be verified by candidate.

49. Public Employment at a Commitment Mechanism • Public employment as a political commitment mechanism: • Incumbent offers jobs to like-minded supporters; public jobs pay more than private sector jobs. • Incumbent finds it costly to fire public employees after election, so she cannot renege; if challenger wins, he can fire employees hired by incumbent. • Workers know they will benefit if incumbent wins, so they carry through with promised support.

50. Public Employment, …. so, what about the RC? • Candidates seek to gain office, in order to control a resource rent: • Rent can be taken as private income, or spent on public employment to enhance probability of winning election. • Greater rent, i.e., a windfall, increases desire to retain office, and expands public employment. • Public employment is less productive than private sector employment: • Hiring more public employees to retain office lowers income. • Connecting the dots, higher resource rent leads to lower income—a resource curse. • RC mechanism is political competition to stay in office.