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.

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

Bailout Denial

September 29, 2008

Every individual intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his original intention. By pursuing his own interest he frequently promotes that of society more effectively than when he really intends to promote it
~Adam Smith, (1776)

Most of us say, ‘I want this thing to pass, but I want you to vote for it — not me’
~Paul Ryan, Republican Congressman for Wisconsin

Today’s WSJ first page reads
Historic Bailout Vote Fails in the House by Narrow Margin; Industrials Drop 700 Points Amid Broad Stock-Market Swoon

By preventing the very visible hand of the goverment to act, the US Congress will allow the Invisible hand of the markets clear up the mess of the Barons of Wall Street, but the cleaning up is going to hurt.

A real pure capitalist should be glad: One of the most important attributes of Capitalism is letting failing companies disappear. No help is received by inefficient companies the same way that pop ‘n mom stores do not receive any help when a Walmart gets in town.

A Pure socialist should be sad: The WSJ is predicting one million houses foreclosures in the next six months. A lot of hard working people are going to pay the price of not being rich. They will pay for the greed of the CEOs of the US Financial Industry.

Interesting enough, the true is the exact opposite: The bailout sought by G. Bush is widely unpopular, no congressman wanted to vote for it so close to the elections; nobody wants to help the greedy big fish of Wall Street. The capitalist are panicking since the lost in the Dow Jones are going to be huge, as I am writing, the DJCI is down 700 points, about 8%.

The true is that in this case realpolitiks should prevail. Everybody is going to pay if the huge barons of Wall Street lose. All the manufacturing industry, badly beaten now, will get worse. A credit crunch is surely to follow, and a lot of unemployment will be salted with hose foreclosures. The US Government should help the companies that are struggling now, so its representatives, the US People, can dodge a huge economic crisis. That does not mean bailing out the culprits. The CEOs that took the risky bets should be charged and go to trial for misdemeanor. Conrad Black deserves a lot of company, but I think he will remain alone.

Global Corporate Citizenship

June 11, 2008

Corporate governance is how a company behaves when nobody is looking
~Klaus Schwab

I always find curious the attitude of some people that advocate for certain actions but cry foul when a corporation actually engage in such actions. We want the world to go organic, but we do not like when Walmart sells organic food. We want Fair Trade coffee, except if it comes from Starbucks.

Michel Porter and Mark Kramer stated that “Corporations are not responsible for all the world’s problems, nor do they have the resources to solve them all. When a well-run business applies its vast resources, expertise and management talent to problems that it understands and in which it has a stake, it can have a greater impact on social good than any other institution or philanthropic organization.”

We can think of organisations as evildoers looking to predate the world. Certainly, the Rational Theory advocates for companies only looking after their shareholders; but Rational Theory has been challenged nowadays and we can look at companies not only responsible for their shareholders but for all the stakeholders involved in the company’s environment and sphere of influence.

The new vision for companies as global citizens incorporates a host of concepts and practices, including the necessity for adequate corporate governance structures, the implementation of workplace safety standards, the adoption of environmentally sustainable procedures, and philanthropy. We tend to use the umbrella term”corporate social responsibility” to explain the new vision, but this concept is an oversimplification that has led to a great deal of confusion. Klaus Schwab distinguishes four different categories or behaviors:

  • corporate governance
  • corporate philanthropy
  • corporate social responsibility
  • corporate social entrepreneurship

A new attitude for business will be described as “global corporate citizenship”. Companies not only must be committed with stakeholders but need to become themselves stakeholders, side by side with governments and civil society, The logic being:Global issues impact business -> Global issues impact the bottom line.

Global citizenship is then part of a corporation’s self-interest, hence, it is sustainable. It is not an act of charity, is a business model.

Companies are getting involved in the health of workers, the education of employees and their children, and the pensions that sustain them in retirement. Corporations have an impact on everything from air quality, to social justice, to life-saving drugs availability. It is normal then, and justified, to look to corporations with request for help and criticism for wrongdoing the same way we looked upon governments.

The focus of much of the civic action of NGOs has naturally been corporations. After initial confrontations, some of the critics came to appreciate that many business leaders are engaged in society.In 1971, the World Economic Forum identified the stakeholder concept: the idea that a company has a clear responsibility to the community beyond its shareholders. In 1973 it became the cornerstone of the Davos Declaration, Five core concepts -corporate governance, corporate philanthropy, corporate social responsibility, corporate social entrepreneurship, and global corporate citizenship- define the different types of business engagement.

Over 3,000 companies in 120 countries have signed on to the UN Global Compact: Ten core principles to guide business behavior in areas such as human rights, the environment, labor practices, and corruption. Some others are subscribing to the Global Reporting Initiative, launched in 1997, to institute international guidelines for sustainability reporting, the publishing of an organization’s economic, environmental, and social performance and impact.

Corporate philanthropy is engagement that does not go beyond writing a check or handing out donated goods. Social investing is a special form of corporate philanthropy, in which a company invests in organizations or programs that have broad social appeal, such as inner-city housing projects or funds for student loans.

Corporate social responsibility is measured through so-called triple bottom-line accountability, according to which a company reports not only on its financial results but also on what it is doing and what it is not doing in meeting stakeholder expectations of its environmental and social responsibilities.

Corporate social entrepreneurship is strictly defined as the transformation of socially and environmentally responsible ideas into products or services. The role model of these social entrepreneurs, Muhammad Yunus, the inventor of microcredit, received the Nobel Peace Prize in 2006

Global corporate citizenship goes beyond the concepts of corporate philanthropy, including social investing; corporate social responsibility; and corporate social entrepreneurship in that it entails focusing on “the global space,” which is increasingly shaped by forces beyond the control of nation-state. It means engagement at the macro level on issues of importance to the world: it contributes to enhancing the sustainability of the global marketplace.

Nestlé voluntarily takes measures to reduce the water it uses in its operations. As Nestlé engages with governments and NGOs to reduce water use in a broader way, it also offers an example of global corporate citizenship. If the company gave free water to a community, it would be engaging in corporate philanthropy. And if it sold recycled water in biodegradable bottles, that would be an act of corporate social entrepreneurship.

How Biofuels Could Starve the Poor

July 18, 2007

The world’s poorest people already spend 50 to 80 percent of their total household income on food
~C. Ford Runge and Benjamin Senauer

I wrote some time ago about how the increasing use of ethanol was damaging the economy of the poor in Latin America, with little benefit for the environment. The rise of corn prices, driven by the excessive demand, increased the price of corn and other staple foods, and make them harder to afford for the more vulnerable citizens. C. Ford Runge and Benjamin Senauer just published an article in the May/June issue of foreign affairs that expand on this problem.

There were 110 ethanol refineries in operation in the United States at the end of 2006. Many were being expanded, and another 73 were under construction. When these projects are completed, by the end of 2008, the United States’ ethanol production capacity will reach an estimated 11.4 billion gallons per year. President George W. Bush called on the country to produce 35 billion gallons of renewable fuel a year by 2017, nearly five times the level currently mandated.

The push for ethanol and other biofuels has spawned an industry that depends on billions of dollars of taxpayer subsidies, and not only in the United States. In 2005, global ethanol production was 9.66 billion gallons, of which Brazil produced 45.2 percent (from sugar cane) and the United States 44.5 percent (from corn). Global production of biodiesel (most of it in Europe), made from oilseeds, was almost one billion gallons.

Of course this growth in the demand means that more and more of the corn production is used to produce ethanol, and this is affecting the food system. It is binding the prices of a staple food with oil, third world countries are double whammed with oil and food prices going up:

Filling the 25-gallon tank of an SUV with pure ethanol requires over 450 pounds of corn -which contains enough calories to feed one person for a year. By putting pressure on global supplies of edible crops, the surge in ethanol production will translate into higher prices for both processed and staple foods around the world. Biofuels have tied oil and food prices together in ways that could profoundly upset the relationships between food producers, consumers, and nations in the years ahead, with potentially devastating implications for both global poverty and food security.

Worse, this is not an economically driven phenomena, but a political one:

In the United States and other large economies, the ethanol industry is artificially buoyed by government subsidies, minimum production levels, and tax credits. High oil prices over the past few years have made ethanol naturally competitive, but the U.S. government continues to heavily subsidize corn farmers and ethanol producers. Direct corn subsidies equaled $8.9 billion in 2005.

Two additional effects are: the high price of yellow corn, the current source of ethanol and used to feed cows, will drive white corn -used for human consumption- and other staples foods’ prices higher, and more surface will be deforested to harvest corn:

With the price of raw materials at such highs, the biofuel craze would place significant stress on other parts of the agricultural sector. In fact, it already does. In the United States, the growth of the biofuel industry has triggered increases not only in the prices of corn, oilseeds, and other grains but also in the prices of seemingly unrelated crops and products. The use of land to grow corn to feed the ethanol maw is reducing the acreage devoted to other crops. Food processors who use crops such as peas and sweet corn have been forced to pay higher prices to keep their supplies secure — costs that will eventually be passed on to consumers. Rising feed prices are also hitting the livestock and poultry industries. According to Vernon Eidman, a professor emeritus of agribusiness management at the University of Minnesota, higher feed costs have caused returns to fall sharply, especially in the poultry and swine sectors. If returns continue to drop, production will decline, and the prices for chicken, turkey, pork, milk, and eggs will rise. A number of Iowa’s pork producers could go out of business in the next few years as they are forced to compete with ethanol plants for corn supplies.

And for what? Are we really helping the environment with corn based ethanol? Ford and Senauer do not agree:

Ethanol and biodiesel are often viewed as environmentally friendly because they are plant-based rather than petroleum-based. In fact, even if the entire corn crop in the United States were used to make ethanol, that fuel would replace only 12 percent of current U.S. gasoline use. Soybeans and especially corn are row crops that contribute to soil erosion and water pollution and require large amounts of fertilizer, pesticides, and fuel to grow, harvest, and dry. They are the major cause of nitrogen runoff. Nor is corn-based ethanol very fuel efficient. Debates over the “net energy balance” of biofuels and gasoline have raged for decades. Corn-based ethanol appears to be favored over gasoline, and biodiesel over petroleum diesel — but not by much. Scientists at the Argonne National Laboratory and the National Renewable Energy Laboratory have calculated that the net energy ratio of gasoline is 0.81, a result that implies an input larger than the output. Corn-based ethanol has a ratio that ranges between 1.25 and 1.35, which is better than breaking even. Petroleum diesel has an energy ratio of 0.83, compared with that of biodiesel made from soybean oil, which ranges from 1.93 to 3.21. (Biodiesel produced from other fats and oils, such as restaurant grease, may be more energy efficient.) Similar results emerge when biofuels are compared with gasoline using other indices of environmental impact, such as greenhouse gas emissions. The full cycle of the production and use of corn-based ethanol releases less greenhouse gases than does that of gasoline, but only by 12 to 26 percent. The production and use of biodiesel emits 41 to 78 percent less such gases than do the production and use of petroleum-based diesel fuels.

Using gasoline blends with 10 percent corn-based ethanol instead of pure gasoline lowers emissions by 2 percent. Likewise, diesel containing 2 percent biodiesel emits 1.6 percent less greenhouse gases than does petroleum diesel. On the other hand, biodiesel can increase emissions of nitrogen oxide, which contributes to air pollution. In short, the “green” virtues of ethanol and biodiesel are modest when these fuels are made from corn and soybeans, which are energy-intensive, highly polluting row crops.

One root of the problem is that the biofuel industry has long been dominated not by market forces but by politics and the interests of a few large companies. Corn has become the prime raw material even though biofuels could be made efficiently from a variety of other sources, such as grasses and wood chips.

The World Bank suggests that caloric consumption among the poor declines by about half of one percent whenever the average prices of all major food staples increase by one percent. When one staple becomes more expensive, people try to replace it with a cheaper one, but if the prices of nearly all staples go up, they are left with no alternative.

If the prices of staple foods increased because of demand for biofuels, the number of hungry people in the world would rise by over 16 million for every percentage increase in the real prices of staple foods. That means that 1.2 billion people could be chronically hungry by 2025. The world’s poorest people already spend 50 to 80 percent of their total household income on food.