Commodity Traps and Super-Cycles

For nations that heavily produce and export commodities such as food, oil and other minerals, those rents it receives are important source of national income. More importantly, if invested wisely, commodity rents can be a basis for future growth and prosperity.

Economic rent “is an excess payment made to or for a factor of production over the amount required by the property owner to proceed with the deal (Investopedia; N.D.)”.

However, over dependence on the commodity sector and miss-use of commodity rents can lead to worse economic outcomes – this is known as the paradox of plenty.  This is because production capacity (capital, labour)  is diverted into the industry leading the growth cycle, while its associated rents are not reinvested in a way that strengthens the economy more broadly (Natural Resource Charter, ND).

Paradox of plenty “refers to the idea that resource-rich counties often have less economic growth compare with countries which have fewer natural resources (Natural Resource Charter, ND).

Collier (2007) even finds that commodity rents are also “particularly unsuited” to democratic situations with autocracies out performing their democratic counter parts. This is for several reasons including, that:

  1. democratic governments are pressured by election cycles leading to short sighted investments;
  2. democratic governments use rents as ‘slush funds’ to influence election outcomes; and
  3. tax payers appear to be less concerned with the way revenues are spent because they have not been ‘earned.’

That is, governments and tax payers treat the revenues more like the winnings from a night at the casino!

More specifically, Giugale (2014) notes that there are five main problems associated with commodity growth cycles and include:

  1. Dutch Disease – where non-commodity exports become less competitive as the economy focus on the resource sector. This occurs as Economic focus begins to target this high-income industry sucking in workers and production capacity from other sectors driving up prices;
  2. price volatility – complicating investments decisions often leading to short-term outcomes;
  3. over borrowing – lenders are more likely to provide greater debt access to governments that are expect to raise large amounts of revenue;
  4. sustainability – the amount of natural wealth to preserve for future generations; and
  5. corruption – the larger the rent, the ‘greedier’ a government and business can become leading to immoral and poor decisions.

While Collier (2007) adds that in developing nations two other problems include:

  1. a reduction in the implementation of democratic institutions – as government want to hold on to their power and wealth; and
  2. an increase in the likelihood of conflict – as a combination of the other problems destabilises growth, the government and society more generally.

The paradox of plenty is relevant to both developed and developing nations.  Academics (Collier, 2007; Giugale, 2014) agree that resource rich societies must have good policies, institutions and governance to ensure strong economic outcomes. These include those that protect budgetary checks and balances, transparency of spending, and accountability mechanisms to ensure impacts that enhance citizen welfare (World Bank, 2016).  An example is Norway’s Sovereign Wealth Fund, the world’s largest equity fund, set up to provide an autonomous investment mechanism to reinvest the surplus wealth produced by petroleum sector to provide alternative revenue streams that can be reinvested diversify the economy (McCarthy, 2017).

While there must be the right mechanisms, it is also imperative that there is greater awareness of the traps and mindfulness regarding the need to reinvest rents in long term initiatives that build capability and future growth potential. Otherwise, the alternative is that commodity rents can actually lead to a reduction in growth and development.

Super-cycles

Until recently, the concept of commodity super-cycles had been widely discussed but never proven.  In 2012 the UN (2012) claimed to have found evidence of commodity super-cycles which has now lead to wider agreement on their existence (Guigale, 2014).

Commodity super-cycles are defined as “periods of about forty years when commodity prices steadily climb for a decade or two, only to fall slowly back to where they were” (Guigale, 2014).

Super-cycles differ from business-cycles which are typically short-run and typically have micro-economic impacts. Super-cycles differ due to two main features, being:

  1. the presence of a “long wave” of growth of at least 10-35 years and the whole cycle taking 20-70 years; and
  2. the impact can be observed in a number of commodities across the economy (UN; 2012).

The key driver of a super-cycle is the “sudden rise in demand, often caused by technological innovation” and can lead to periods of increases in urbanisation and population. Increased demand associated with these factors drives long periods of growth in both prices and output before tapering and returning to pre-growth levels. Super-cycles also suffer from “acute capacity constraints” despite increased in production output and technology development (Guigale, 2014; (DeRooij, 2014). Whilst, tapering off within a cycle is driven from a number of factors including diminishing returns from technology, or, urbanisation and population growth steadying and the economy readjusting as a result.

Evidence suggests that in the last 150 years  the world economy has experience at least three super-cycles, each over a period of four decades, each driving up commodity prices “20 and 40 percent” before returning to previous levels. Examples include Britain’s industrial revolution where prices for coal, cotton, sugar and tea increase as well as production (DeRooij, 2014).

From a government’s perspective, recognition of super-cycles is of “critical importance” to ensure the right decisions are made in regards to inflation, currency, balance of payments, and re-investment of rents. Businesses also need to identify super-cycles to ensure capital investments are used to fund long term production expansion and not be distracted by short-term price fluctuations (DeRooij, 2014).

We can now see that we are in a super-cycle or perhaps, we have just hit tipping point. This cycle was largely driven by China and India’s appetite for commodities.  However, there may still be opportunities, as many people in South East Asia and other developing nations are still to transition to a more urbanised economy (DeRooij, 2014).

Thus, the question therefore is, are we to sit back and ride the wave out? Or do we ensure we maximise our future growth potential and extend the ride before through high impact re-investment?

Collier, P. (2007) The Bottom Billion: Why the Poorest Countries are Failing and What Can Be Done About. Oxford University Press: New York.

Giugale, M. (2014) Economic Development: What Everyone Needs to Know. Oxford University Press: New York.

 

Institutions and Incentives: A Guide for Policy Practitioners

Have you ever thought what stops some places from developing? Why is it hard for some places to implement progressive policy? What stops people from being more entrepreneurial? Well it can often be the institutions, the “legal and administrative organizations” that underpin society and they predict the ability of a place to prosper (World Economic Forum, 2015).

Institutions are a “consistent and organized pattern of behaviour or activities (established by law or custom) that is self-regulating in accordance with generally accepted norms” (Business Dictionary, ND).

Institutions “are the rules of the game in a society, […] the humanly devised constraints that shape human interaction. […] They structure incentives in human exchange, whether political, social or economic” (North, 1990, p. 4).

Why are institutions important?

Institutions are important because they form what is called the ‘enabling environment’ (World Economic Forum, 2015). Institutions move beyond the concept of an organisation to encompass social structures that guide “human interaction and activity” and include formal and informal rules. Institutions are important social structure as they “create stable expectations for the behaviour of others,” and create the incentives for economic and political development (Hodgson, 2006). Institutions therefore provide a framework for social cohesion and long term prosperity Bakir, 2009).

The four key sectors where institutions play the most effective role in promoting growth are “finance, education, justice, and public administration” and as a result, Institutions need to be a consideration for in policy and program design in both the developed and developing world (Paul, 2017).

In particular, strong institutions support economic development by:

  • reducing the costs of economic activity by lowering transaction costs such as search and information costs, bargaining and decision costs, policing and enforcement costs;
  • promoting a return on investment through common legal frameworks (e.g. contract terms and contract enforcement, commercial norms and rules);
  • reducing oppression, corruption and encouraging trust by providing policing and justice systems; and
  • Encouraging collaboration between public-private sectors to increase social capital (Bakir, 2009; Ferrini, 2012; World Economic Forum, 2015).

More specifically, institutions affect the level of production, adoption of new technologies, entrepreneurship and venture creation, environmental protection, ability to attract investment, property ownership, law enforcement, and levels of bureaucracy and red tape. Thus, institutions need to be a key consideration when designing policy and programs.

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Institutions and Policy

Often when transformational policy is required, consideration of the institutional framework is paramount. There are four different types of influences on institutions that practitioners should be aware, these include:

  1. Rational choice: where intuitions are influenced through ‘feedback’ that reinforces the decisions and actions to become norms. For example increasing returns on investments is a positive feedback that reinforces the norm;
  2. Organisational the adoption of common practices (i.e. imitation) and norm from other successful organisations and leaders;
  3. Discursive institutionalism is when self-interests and cognitive ideas are pushed until adopted as norms; and
  4. Historical institutionalism is a mix of the above three where logic and idea have amalgamated over time to become norms (Bakir, 2009).

Practitioners should examine the changes they wish to achieve against identifiable institutions.  Incentives or more specifically, pigouvian penalties can then be designed to help shift behaviours and actions in line policy positions.

Incentive: a moral, coercive or remunerative motive behind an individual’s particular course of action (Johnson, 2005). Incentives do not have to provide positive motivations.

 Pigouvian penalties: is a tax to deter or counterbalance market activities that generate negative externalities (the Economist, 1017).

 Examples:

  • Public transport: Policies to promote public or physical transport uptake may only become effective when society recognises that cars have a negative impact on the environment and are willing to change their behaviour to protect the environment. Policy practitioners may needs to consider the individual rational choice, self-interests and historic institutions that support people to drive cars. For example, if parking was increased in the CBD to support institutional change around driving, does it just push people in to suburban areas where driving is still more cost-efficient? Is advertising to change values and perspectives (self-interests) on driving required? Are additional services or upgrades required to change the efficiency of public transport in addition to car and parking taxes?
  • Welfare: Income welfare that supports disadvantaged people can be relatively ineffective in enabling long term dependents to transition into the mainstream economy when the alternative is low skilled and repetitive work. Thereby dis-incentivising people to transition to employment. Policy practitioners may need to consider if the community, formally or informally, agrees that welfare is a right? If individuals have intergenerational dependency and therefore share similar aspirations? And what are the real incentives that encourage employment and discourage unemployment? Otherwise actions that just consider capabilities will have limited impact.
  • Innovation and technology adoption: for societies wishing to promote innovation and technology adoption, it is also important to look at existing intuitions that may disincentive action. For example what are the red tape barriers (costs) to setting up a business and commercialising ideas? Are there any Government Trading Enterprises that crowd-out the private sector innovations? Are technology rebates and R&D subsidies promoted widely and easily accessed? Does the government have a consistent view and is their machinery (departments and agencies) progressive in their policies?

Finally, strong institutions may not ensure robust growth in the short term but in the long term, a society cannot expect to prosper without them. Thus the policy practitioners need to consider institutional environment when designing interventions.

North, D. C., 1990. Institutions, Institutional Change and Economic Performance, New York, Cambridge University Press.