The Dutch Disease

September 25, 2009

Riches get their value from the mind of the possessor; they are blessings to those who know how to use them, and curses to those who do not.
~Terence

I am going to analise two important phenomenas that affect a country development: The Dutch Disease and The Democracy Effect in Economy. I will start with the former and analyse the later in my next post.

Dutch disease is named after the effect that the discovery of natural gas had in Holland in the 1960s. It is also called the Resource Trap but it can originate not only in natural resources discovery, but in any development in that results in a large inflow of foreign currency, including a sharp surge in natural resource prices, foreign assistance, and foreign direct investment.

Imagine first a country like Japan in the 1950s, with not natural resources. Japanese people want to buy imports, but they can only do so with hard currency, so they need to produce exports to get it. Exports (tradable goods) would sell in hard currency and sell it to importers who will use it to buy imports and sell them in Japan. Exports in such cases are manufactured products and some services (and some natural resources in a limited fashion), so the country start producing in order to import goods that lacks, making the national industry important and competitive. The local non-tradable good and services (like restaurants) get some of the money since people increase their standard of living, elevating the price of these non-tradable goods and services, and attracting some labour

Imagine then a country that discovers oil or gas or diamonds. This natural resource is sold in the international markets, creating a surge in the inflow of hard currency to the country. Since the price of tradeable goods is set internationally, the laws of supply and demand make rise the exchange rate of the country in question, hence making the rest of the exports in the country less competitive. Additionally, the extra revenue make non-tradeable goods and service more expensive in the country since there is more money to be spent and demand for new items.

Example, in the 1970s, Nigeria exported peanuts and cacao, then the oil revenues started to build up, and the Nigerian currency gain value, making their peanuts and cacao too expensive. Both industries collapsed. When prices eventually went down, the growth and standard of living of Nigerians was halved.

So the ill effect comes when the resource runs out or when the price goes down. The manufacturing industry has been badly damaged and cannot compete in international markets. All the foreign investment went towards the natural resource, and nothing to the traditional manufacturing sector. The country then stops development and spiral down.

Foreign Aid has the same effect that a natural resource discovery: It brings unearned hard currency to a country, making his own currency more expensive and killing its exports.

Hence, a sudden surge in the foreign currency inflows to a country make this country uncompetitive in the global markets, killing his tradable sector, making his non-tradable sector more expensive, and slowing the growth in the long run.

Now with pictures: In a normal economy without lots of natural resources, the manufacture sector is big (blue), some people and employ in services (green), and very few are in the natural resources sector (red) and, with hope, very few are unemployed (grey)

Country without resources

Country without resources

Then oil is discovered and a boom starts. The booming sector attracts all the labour force and foreign investment, while the traditional sector lags behind and gets reduced. The non-tradeable sector grows a little since there is a new demand for its goods and products, and draws some of the capital and labour, making these goods and services more expensive and in further detriment of the traditional sector. The excesive exports of the natural resource make the currency so expensive that further damages the traditional tradeable industry.

The economy in a natural resource boom

The economy in a natural resource boom

After some years or decades, the natural resources either ran out or the international prices plumbed. The former boom sectors shrinks, laying out people, the demand for non-tradable good and services shrinks too, laying out people, and the traditional manufactures are now too small to accommmodate the excess of labour. No further investment is done, and unemployment rises.

Dutch Disease effects

Dutch Disease effects


Globalisation Blues

September 25, 2007

Free markets, free people
~Wall Street Journal’s editorial motto

In economy, it is widely believed that market forces will correct any economic mischiefing. Adam Smith called it the invisible hand: “a free competitive market ensures that those goods and services perceived as most beneficial, efficient, or of highest quality will naturally be those that are most profitable. Thus, self-interest striving for profit has the side-effect of benefiting everyone by increasing standards” (The Wealth of Nations, 1776).

This same assumption is taken by Globalisation’s promoters as the way the open economy benefits all countries today: In the long run, they argue, everybody will be better. In the other hand, globaliphobics insist that the rich countries are getting richer on the back of poor nations.

Indur M. Goklany points out, correctly, it is a myth that the advent of globalisation has been accompanied by a rise in poverty and inequality. Revision of UN, World Bank, and IMF data about GDP per capita, paired with distribution curves, shows that the percentage of the world’s population that is poor has actually fallen over the past two decades and inequality has declined at some extent. “The surprisingly persistent picture of globalisation as a process whereby the developed world exploits and immiserates the developing one is just wrong”(James Surowiecki).

However, the number of countries that had improved their standards of living is surprisingly small, and they are mainly in Asia. Economic growth is the base for improving the state of the world, but globalisation has not done a very good job of figuring out how to spread the benefits of that growth around the globe. The economies of sub-Saharan Africa and the former Soviet Union have not just stopped growing but shrunk over the past 15 years. Most of Latin America has seen only marginal economic growth since 1980, and even Asia’s little tigers (Indonesia, Malaysia, and Thailand) have spent much of the present century recovering from the damage wrought by the 1990s Asian financial crisis.

Most of these countries have seen their human development indicators improve, thanks to the diffusion of technology and health care. But outside of Asia (and a few places such as Botswana and Chile), the economic benefits of globalization have been hard to find, which is why there has been such a backlash against what has come to be known as the Washington consensus. It makes makes sense to attack globalization if there is evidence that rich countries are getting richer on the backs of the poor, but it should not surprising that people are made unhappy by the sight of others getting richer while they stay the same or actually get poorer.

Goklany suggests one response: “the problem is that there has been too little globalisation, not too much, and that what governments need to do is step out of the way and let the market be free. There is no doubting the virtue of the free market as a wealth-creation machine, and it is certainly the case that in many countries bad policies (often designed to protect established interests) have discouraged entrepreneurship and scared away capital. Nonetheless, here, too, the evidence is far more ambiguous than The Improving State of the World implies”.

China and India, which together are responsible for almost all of the reduction in poverty in the world in the past two decades are great success stories, but when it comes to understanding what they say about how to attain economic growth, they are complicated rather than simple stories. China is a long way from a true free-market economy, and it has followed almost none of the rules that the Washington consensus set down:

  • A huge number of its enterprises remain state-owned
  • the allocation of capital in the country remains largely determined by politics
  • the country’s capital markets are not truly open
  • there are limitations on foreign ownership
  • the currency is not convertible

In the case of India:

  • has got massive tariffs
  • strict legal restrictions on foreign ownership and on new businesses
  • it is an aggressive regulatory state

The point is not to return to the old days of protectionism and import-substitution industrialization but rather that we know a lot less than we thought we did, for example Chile and Botswana are two of the only non-Asian developing countries to enjoy meaningful, sustained economic growth since 1990. Chile, under the dictator Augusto Pinochet, implemented many free-market reforms, and the privatization of its social security system has made it the daring boy of free marketeers. But a good part of Chile’s richness comes from its copper holdings, which even Pinochet did not privatize. And Chile also limited the flow of volatile capital into its markets.

Is it the following of free markets rules or the deviations from them that it is the cause for Chile’s success? or is it the combination of the two? No one is sure. Botswana, similarly, has followed orthodox economic policies and has a limited state and low levels of corruption, all of which surely have something to do with its success. But Botswana also happens to have huge diamond supplies, which account for around 40 percent of its annual output. Botswana’s efficient economic policies have helped it to receive greater benefits from this, but this is hardly a model that other nations, unless they can back up their growth plans with massive diamond supplies, too.

So, until we can define better the factors that are helping countries to reap the benefits of globalisation or planetary economic growth, and then apply them to the countries that are being left behind, we will keep hearing about anti-globalisation, protectionism movements, and no truly be able to respond to them.


Porter’s Diamond

June 29, 2007

In business, the competition will bite you if you keep running; if you stand still, they will swallow you.
~William Knudsen

It is impossible to keep talking about sustainability and fair trade without talking about Porter’s diamond model. In this blog I am committed to find new ways to apply economic law to sustainability models, so good social and environmental behavior can makes economic sense, and competition, trade barriers, and supply and demand are part of any economic environment.

Economic growth is linked with economic competitiveness, and there are three different approaches to measure it: the factor model, assessment of trade performance, and assessment of productivity. The first approach identifies critical success areas and compares the performance of different entities/economies in each area; the World Competitiveness Report is a perfect example. The second approach measure efforts to improve the inputs and indicators of outputs. The third approach use cost-based indicators to measure performance.

Professor Michael Porter uses the three approaches in formulating his competitiveness model. For Porter, the key question is why some firms in some nations achieve international success while others fail. He analyses why some industries tend to form clusters (Hollywood, Silicon Valley in USA; Bay Street, Ottawa Valley in Canada) and he conclude that nations do not compete between them, rather, it is the firms within a country than must be competitive.

Porter presents a four-factor model that he calls ‘the diamond’ and asses each component quantitatively and qualitatively:

Porter’s Diamond

Porter includes also two more factors: chance and the impact of government.

Factor conditions are divided between basic (human and physical capital, available general knowledge, infrastructure) and advanced (specialized knowledge). They are also divided between generalized and specialized.

Demand conditions are the market characteristics of a given industry, e.g. large versus small markets, scale economics, and quality of demand of domestic market.

Related and supporting industries are the complex industrial economies, with its network of suppliers integrating the production chains. For Porter, the relation between supplier and company is of capital importance.

Strategy – Structure – Rivalry address the company inner and outer environment. There is no ‘best’ managerial style, but there is a ‘better adapted’ to the company’s circumstances managerial style. Porter stress the importance of strategic goals and the company approach to risk. The domestic rivalry ensures the development of sophisticated and specialized sector; it is only natural that Porter opposes the creation of monopolies, as they inhibit the development of international competitive firms.

Porter believes the Government is not part of the diamond, but has the role of facilitator. He acknowledges that chance is a factor in the development of companies, since war, technological breakthroughs, and other factors can influence the competitiveness of any organization.

We will use this and Porter’s Five Forces Model later analysing Fair Trade and sustainability.


Protection Barriers; The Canadian Experience

May 15, 2007

You cannot protect something by building a fence around it and thinking that this will help it survive.
~Wim Wenders

People advocate for trade barriers when they feel that:

1) Local industry needs protection from abroad

2) Industry from abroad is playing dirty tricks (i.e. dumping, protecting their own industry, sending lower quality products)

3) The industry is of strategic importance (i.e. banking, communications, farming)

What are the cost of proteccionism? Let’s analise the Canadian Experience. In 1878, Sir John A. MacDonald’s conservative government introduced the National Policy. The idea was to encourage investment and economic growth within Canada, as well as build an east-west flow of goods to tie the country economically. The policy had two simple components: high tariff on manufactured goods and open market for foreign investment.

The tariff were imposed to encourage the growth of central Canada’s manufacturing industries, hoping that they would reach a scale to compete internationally. Some machinery was exempt, like those needed by the natural-resource industries. The Canadian companies will sell more to other Canadians, increasing the east-west commerce and hence helping to build the very needed TransCanada Railway.

The open-investment policy was intended to attract foreign capital, since locals had not got enough resources. The first invertors were British lending money first to other British, then to Canadians. During the 1900s however, Americans replaced British as the main capital source, and this was not in the form of debt, but equity. The reason is clear in retrospect, the Americans couldn’t sell in Canada due to the tariff, but they were able to open Canadian subsidiaries, which, being Canadian, could benefit from the protection.

The consequences are still affecting us, 130 years after. The Canadian manufacturing sector became a branch plants with no incentive to compete internationally, since they will compete against their parent companies.

A second legacy of the National Policy was the concentration of the wealth on very few hands. the National Policy make Canada a very comfortable place to compete; once established, they were protected by the tariff, and the incentive to be productive was limited. For the Canadian Companies, the profits were huge and resulted in very concentrated industries for each sector: Beer is dominated by Molson and Labatt, retail was dominated first by Eaton’s and Simpsons, then by The Bay and Sears. We only have five banks. You can count one or two large companies concentrating the national production for each sector.

Foreign ownership is not a matter of national pride, but economic sense: The typical organization have a profit of 10% of the revenue, but the lion’s share of the expenses is that 90% used on research, salaries, production, marketing campaigns… and, being branch plants, all those process take place on the main headquarters, outside Canada, so Canada is not only losing the 10% of the revenue, but an important component both of economic and strategic value. While there are exceptions, like companies doing an entire process in their Canadian branch (Pratt and Whitney, ICI explosives), this rule applies to the oil producers, the automotive manufacturers and so on.

The three final consequences of the National Policy enacted in 1878 are, that in 2007:

1) Canada has a very concentrated industry, so the free market rules, where supply and demand set the price, are not valid here, because when one or two companies dominate the market, they are price setters, no price takers. That is why is cheaper driving to Buffalo and buying your stuff there, that going to Eaton Centre or Yorkville and being fleeced up.

2) Canada’s wealth is concentrated within a handful, where 100 individuals or families have got a collective net worth of $141.6 billion

3) Canadian companies are not producing the world’s leading technology. We haven’t got any Microsoft, Hewlett Packard, or Intel. I don’t really now how much Research in Motion is licensing technology or really creating new one, so I cannot comment in this one, but the general rule is new technology being developed somewhere else and then being copy or license here.

So, protectionism has resulted harmful in the long way for Canada. We will measure some other trade barriers soon.


The Multiplier Effect and Fair Trade

February 12, 2007

Fools are not generous: the world of the gods is not for the stingy. Wise men are generous: they find happiness in the next life.
Dhammapada, pp. 98

A phenomenon exists in Economic Theory that has significant effects in everybody’s life, while only a few are aware of: The Multiplier Effect.

Let’s say that, in general, people in a country save 20% of their income and spend the rest. This 20% is called Marginal Propensity to Save (MPS). The opposite factor, the 80% that people spend is called Marginal Propensity to Consume (MPC). Since they are percentages, they always sum one: MPS+MPC=1.

Now, let’s say that a corn producer community with a MPS of 20% sells corn at $100 the metric ton. The corn is sold in the international markets, and when the producer receives $100, he’ll spend $80 in, let’s say new machinery. The guy who sold the machinery now has $80, so he saves 20% and spends $64 in furniture. The furniture seller now has $64, saves 20% and spend $51.20 in groceries. Successive rounds of spending will be $40.96, $32.76, $26.21 and so on. The initial spending of $100 triggers more spending in a ratio of 5:1. This is called the multiplier, and it’s calculated simply as 1/MPS. In this case, 1/.2=5, so the initial $100 injects the local economy a total of $500:

Corn Multiplier

Because the money came from international markets, the full $500 is reflected as an actual growth in the local economy.

Now let’s say that the Fair Trade price of corn is $120 instead of $100. Apparently the difference for the corn producer is only $20, but for the community is way more:

Corn Multiplier for Fair Trade

The local effect is $100, no $20, due to the multiplier

The 20% saving rate in a rural community is rather high. Rural communities in third world have very low savings rates, because they live in a day by day basis; thus, the multiplier effect is even higher, for a community with only 5% saving rate, the multiplier is 1/.05 = 20 times, so the extra $20 per metric ton translates in a $400 injection to the community.

THE PARADOX OF THRIFT

A key point that derives from the marginal propensity to consume is the paradox of thrift. If people start to save more money, the bank system will have more money to lend to the industry, thus investment will go up and there will be more good and services, and because people is saving more, their future is more secure. What really happen is that now people are spending less, so the demand curve for all goods and services shift to the right. As consumption decrease, so the economy; people start getting fired, companies have to decrease production, and the general income shrink. As income falls, so the savings. People were trying to save more, but they really ended up saving less.

This is why economies like USA’s promote overconsumption, so the economy never shrink. The people live over their limit because the way the economic sectors are integrated, spending more makes the economy grow.


Equilibrium, Disequilibrium and Sticky Prices

February 5, 2007

If economists were good at business, they would be rich men instead of advisers to rich men.
Kirk Kerkonian

In order to better understand the market’s forces, we need to handle three concepts which are very simple but also very powerful. You may want to go back to our little supply and demand post before moving on. If you know it already, let’s then move on.

When supply equals demand, we say that the market is in equilibrium. This means that all the goods and services produced are accommodated at a given price and no demand is left unattended. This is also called a clear market.
Supply and Demand

Equilibrium is a characteristic of free markets. When market imperfections exist, the market may take some time to clear. An example: when guarantee prices for commodities exist. Let’s say wheat’s producers are guaranteed a minimun price for metric ton. If the wheat demand goes down, the price of wheat won’t, because the price that they receive is guaranteed, the farmers are encouraged to keep their previous levels of production. The result is excess demand:

Excess Market

Pg is the guaranteed price, which produces Q1. When the demand curve moves downwards, Q2 becomes the new quantity which the market demands, thus the new price should be Pr, but because producers are still receiving Pg, they continue to produce Q1. The market only accommodates Q2, so the difference is now an excess.

In the agricultural sector, the excess is often bough by the government and then either sold with a loss, or pour into the ocean. Haven’t seen those Braziliean cargo ships pouring coffee into the Atlantic?

In the labour market, this would be manifested throught unemployment. Salaries can’t go down, and the market can only accommodate Q1 at the current wages, so, the excess is people either fired or not being able to find a job.

Price flexibility is crucial for continuous equilibrium in markets. If prices are flexible they adjust quickly to changes in supply or demand, so market equilibrium is restored. When a price takes to long to adjust downwards, is called a sticky price. Sticky prices have a considerable practical significance. At the onset of a economic recession, a slowdown in growth triggers cuts in production and drop in demand for goods and services. Unemployment rises; both labour income and business profits fall. The negative effect is worse if prices cannot adjust fast enough.

The most perfect market, the one that clears fastest, is the Capital Market. The price of money is the interest rate; the slightest adjust and capitals fly all over the world. The sticker price is labour, which due to regulations usually never moves downwards directly.

These apparent boring subjects will be very useful when we’ll examine Fair Trade price scheme. As reward for bearing with me during all this economic jargon, which I know may be pretty hard, here is THE funniest video:
http://www.youtube.com/watch?v=rfP90uJ12eQ


Why to Appeal to Economics and not to Good Heart

January 16, 2007

We have always known that heedless self-interest was bad morals;
we now know that it is bad economics.
Franklin D. Roosevelt

I saw Serenity the other day, a Sci-Fi movie where there is a Galactic Empire (where do I heard that before?) called The Alliance, and a bunch of outcasted rebels discovered a video which proves that, in its efforts to keep people calmed, the government’s scientifics have developed a gas that either make you calm, so calm that you leave yourself to die, or so violent that you deform yourself and go thought the galaxy eating mortals. Our heroes try to reach a broadcasting post where they hope to deliver a message, only to find that one of the government’s minions is waiting for them. After a fierce, guts-all-over-the-place battle, the minion watches the video and is quickly converted to the rebel’s side, letting them broadcast the message and joining the revolution. At the end we understand that the government has been seriously weaken by the diffusion of the message and public’s opinion now has shifted in favor of our heroes.

The sad part is that in reality, such a scenario will never happen. The majority of people just don’t care enough to actually fight for something they may believe. All America went to war against Iraq because they had weapons of mass destruction and because former President Saddam Hussein was linked on people’s minds to the attacks of the World Trade Centre and Pentagon. When it was obvious that everything was a lie and Bush Jr. just wanted to finished what Bush daddy was incapable to do, Where were the protest, the demonstration against the war? Are people now convinced that the war was unnecessary? Are we going to see George W. Bush judged for crimes against humanity, which already cost 3,000 American and 20,000 Iraqies lives? Not in our life.

When it was obvious that the CIA assassinated Salvador Allende in Chile, was Pinochet removed from the power and judged for its crimes? No.

In the same manner, if you ask people if fair trade is good they will answer yes, but when you try to make them pay more, they likely will run to the next Wal-Mart to profit on the low prices.

Dr. Ken Peattie, from Cardiff School of Business, made an excellent study about the green consumer. In previous posts I have shown how fair traders rely upon the green consumer a lot, and in the goodness of the heart of people. While is nice to think that consumers are going to buy green products by the sake of environment and social issues, the wide majority will not. It doesn’t matter how much you broadcast the message. It is not a question of people not caring. It’s a question of people not caring enough.

I am not cynical about the situation; while I hope that more people get involved in social matters, the only way to make fair trade and other similar initiatives successful will be using common sense and basic economic law. When it will make economic sense to do what is right, the rest will be done by addition. Ethel Barrymore stated that we must learn day by day, year by year to broaden your horizon. The more things you love, the more you are interested in, the more you enjoy, the more you are indignant about, the more you have left when anything happens. While we wait to people to be more enlighted, let’s work for justice following common sense and economic tradition.

UPDATE: Jorge has posted a comment that will cast more light on this subject