The Impact of Easy Rents

Contents

1 Introduction

2 The Model
2.1 Fundamentals
2.2 Dynamics

3 Easy Rents
3.1 Basics
3.2 Natural Resources
3.3 Development Aid
3.4 Remittances
3.5 Dutch Disease
3.6 The culprit “tau”

4 Reality Check

5 Concluding Remarks

References

A Data, Graphs and Analysis

1 Introduction

“More money than we ever in our wildest dreams thought possible.”¹. That is something most ordinary people and even more so the leaders of countries would like to be able to say about their purse or respectively about their fiscal situation, especially with today’s increasing shortages of budgets and soaring prices in mind. The man who was actually able to make the statement was probably very glad to be in a position to do so. It was Hector Hurtado, Minister of Finance of Venezuela in 1978 and he was referring to thitherto unseen and unexpected amounts of money generated by Venezuela and other oil-exporting countries after the OPEC-countries used the 1973 oil-crisis to seize price-setting power and increase the cost for oil roughly ten-fold. This rush of “easy money” awoke great hopes for an economic catch-up of the countries enjoying it. The same holds true for all discoveries of other valu­able resources and “bounties of nature” before and after the OPEC-boom. Such expectations of future welfare seemed sound and reasonable, as abound­ing funds gave governments plenty of means to invest into development and ensure the economic well-being of their nations.

However, to the astonishment of the scientific community, including both economists and political scientists, such expectations did not become reality and today a rather different outcome can be observed even by a layman’s eye. When crosschecking the economic situation of states, there is almost no overlap between the set of countries with high level of GDP per Capita, which is the usual measure of real welfare, and the set of countries with an abundance of natural resources. Moreover most commodity economies do not even appear to be on the right track towards this goal at all. Allowing for the mostly shorter period of economic development in resource abundant countries², compared to the western industrialised sates, one might expect to observe at least a promising start-phase of development. But rather than inducing persisting economic growth and permanent welfare gains, the re­source richness seems for the most part to have caused economic stagnation or even decline³. This unexpected negative impact of natural resources on growth has been noted and described as early as 1977 in “The Economist”⁴ in connection with the economic slump of the Netherlands after the discovery of natural gas in 1959 and has duly been termed “Dutch Disease”. In the last decades this observations have been confirmed by notable scientists such as Jeffery Sachs, Andrew Warner and Terry Lynn Karl⁵ and another couple of not very flattering names such as “Resource Curse” and “The Paradox of Plenty”⁶ have been come up with.

But not only natural resources seem to have deterring effects on the per­formance of economies. More recently another issue has emerged on the scopes of development researchers and in the public eye⁷ which shows a strik­ing resemblance to the observations made above: Foreign Aid’s impact on economic development. William Easterly asked in 2003 “Can foreign aid buy growth?”, Simeon Djankov et al. discussed the “Curse of Aid” in 2005 and both presented well supported doubts on the enhancement of growth through aid. Since the middle of the last century ever increasing sums of money have been transferred from the so called first world to the developing countries, following Harry S. Truman’s ideas of a “bold new program for making the benefits of our scientific advances and industrial progress available for the improvement and growth of underdeveloped areas”⁸. But today, despite the flow of billions⁹ of dollars so far, there seems to be more poverty and under­development in the world than ever before. Although many of the recipient countries have been supported for over half a century most have not been capable of achieving sustained growth and are still or even increasingly de­pendent on foreign assistance; another case of “easy money” not doing the job?

How is it possible that generally positive elements like high resource rev­enues and monetary support through foreign aid can have such adverse effects on economic performance, whereas normally one would expect a positive im­pact of additional funds? Do countries experience a “spoiled-child-syndrome” due to the generosity of nature and foreign donors? This questions have a highly up-to-date relevance considering today’s surge in resource prices¹⁰, which will bring further windfall gains for the exporting countries, and the UN’s ongoing Millennium Project¹¹, which aims at multiplying the aid ex­penses for the third world. What lies ahead for the countries in question? A big push of development as advocated by Sachs and resource induced growth like the norwegian example? Or are the increasing windfall gains a catalyst for future trouble, which will lead to the crumbling of economies and insti­tutions? Of course this are the two opposite ends on the scale of possible development paths, but the gist of the problem is captured quite nicely.

In this paper I will try to develop a rough idea how windfall gains may af­fect an economy through their peculiar characteristics and created incentives. The windfall sources of revenue, such as resource rents and foreign aid, are subsumed under their common trait of “easiness”, introducing the concept of “Easy Rents”. Migrants remittances are also scrutinised for their growth implications, as they also share certain characteristics associated with “Easy Rents”

I believe that “Easy Rents”, connected by their relative effortless gener­ation and accessibility, induce a biased price appreciation by influencing the economic and political processes of recipient countries, causing the decline of the growth-driving tradable sector and thus hindering sustainable economic growth.

This main proposal sets the tone for the conduction of the analysis, which focuses on possible price effects through windfall gains. Further an attempt is made on modeling this “curse to easy riches”¹² with a crude adaptation of William Easterly’s ideas on price distortions’ impact on economic growth¹³. The purpose of the model is mainly to provide an inside to the mechanism at work, rather than delivering quantifiable results, leaving the main variable a theoretical construct. The proposed influences are put to the test through a number of basic statistical regressions using cross-country data on economic growth and the assumed influence factors.

The paper proceeds in four steps, beginning with the introduction of the model in section two, continuing with the descriptive analysis of the revenue forms and their implications, before the examination of the empirical results. The fifth and final section summarises the findings.

2 The Model

2.1 Fundamentals

In this chapter a model is laid out to illustrate the impact of easy revenues on economic growth through price and allocation distortions. Ahead of any detailed empirical findings and case studies this will give a basic idea about the theoretical mechanics of the proposed influence. For the sake of simplic­ity, this will happen in a highly stylised environment with the inclusion of some obviously non-realistic assumptions and a very generalised approach. In the usage of such a mere hint at the effects of easy rents lies a fundamental weakness common to all works on the issue of resource influence and maybe even developmental economics as a whole, although the last might be a bit impudent to propose: There is no comprehensive theory to explain what ex­actly determines the developmental performance of a country¹⁴, making exact modeling quite difficult. Although there are countless explanations provided in literature which explain the observed reality, they all do so for different sets of countries, while having to capitulate before a equally high number of exceptions. This uncertainty has prompted my decision to use a very general model in order to gain a broader view on the impact of easy rents. Obviously the downside of this decision is an inability to explain individual country differences and detailed development paths.

At the heart of the model lies the effect of the distortion “τ” and its in­fluence on the allocation of capital in the economy. This variable remains a mere concept, explained only in theory and will in detail be handled in section 3.6. of this paper. The model is, of course, not entirely innovative. Its basic structure, maths and dynamics have been taken from existing proposals and have been fitted to the case at hand. The underlying concept is a text-book endogenous AK-model with non-diminishing marginal returns¹⁵. This fun­damental framework has already been used and adapted by William Easterly in 1993¹⁶ to capture the effects of distortions of relative input prices and re­source allocations on growth and welfare, especially in developing countries. This is the connection point between the paper’s questions and Mr. East-erly’s model. The impact of easy rents is assumed to work through additional costs for the growth important tradeables sector, which pose a price and al­location distortion for the economy making the model suitable. With this similarity in mind the freedom was taken to apply Easterly’s ideas slightly modified with τ representing the additional burden induced by easy rents. A major downside of the used model is a build-in difficulty to compute a real outcome. The assumptions are very crude and the distortional variable τ is very hard to quantify. This makes for the model to be a mere hint at the mechanics of easy rents and leaves actual amounts open to discussion.

The posited economy is populated by identical, immortal producer-consumer dynasties, who produce and consume a single output. In order to avoid unnecessary complication the population is presumed to be fixed. Production takes place under constant returns to scale using very broadly defined capital that includes the physical and human element. There are two distinct sectors, which each employ a different type of capital that can both be formed from the single output without conversion costs. One sector is the traded manufacturing sector working under perfect competition and serving the world market. The other is the non-traded sector, producing domesti­cally. The distortions are assumed to derive from an exogenous advent of windfall gains. The economy is financially insulated, although international trade in goods is permitted¹⁷.

2.2 Dynamics

With the setting of the model laid out, the following describes its maths and mechanism beginning with the production function and moving from there to the dynamics of growth¹⁸.

Equation (¹) depicts the production function in terms of the two capi­tal types, with elasticity of substitution [illustration not visible in this excerpt]. Capital type one depicts the tradable sector.

illustration not visible in this excerpt

The producer/consumers maximise their utility using today’s discounted value of future consumption.

illustration not visible in this excerpt

Equation (2) is an isoelastic function of total consumption C with inter-temporal elasticity of substitution [illustration not visible in this excerpt] and rate of time preference ρ. Con­sumption C is given by the share of Y not invested.

illustration not visible in this excerpt

I ₁ and I ₂ are the investments undertaken in the respective sectors and τ is initially defined as the additional costs of investment in the disadvantaged sector, posing a distortion to the economic processes.

Capital is accumulated through investment minus depreciation with level δ, presumed to be equal across all capital for now.

illustration not visible in this excerpt

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The easy rents costs τ come into play in the capital ratio, as they induce an increased share of capital type 2 to be held.

illustration not visible in this excerpt

The magnitude of the capital ratio’s reaction is determined by the elasticity of substitution [illustration not visible in this excerpt]. The capital ratio Φ reappears in the net marginal product of K ₂, which is give by

illustration not visible in this excerpt

The MPC ratio is distorted by τ because the additional costs influence the marginal profitability of capital type 1.

illustration not visible in this excerpt

The model analyses the steady state, where the growth rates of output and consumption are identical. The optimal growth rate g is equal to the dif­ference between the net marginal product of capital and the rate of time preference, times the inter-temporal elasticity of substitution ¹⁹:

illustration not visible in this excerpt

The final growth equation does not incorporate r ,, as in the extreme K , is crowded out by K 2, rendering the marginal product of K₁ insignificant.

With the optimum defined it is now possible to asses the effect of the distortion on growth in the steady state. The marginal product of type 2 capital diminishes with an increase of Φ which in turn is dependent on τ. So equations (6), (7) and (9) show clearly that the growth rate is a negative function of τ. However, the size of the growth effect is determined through the elasticity of substitution of the two types of capital in production. If the elasticity is high the distortion’s impact is of no serious dimension, as in this case neither type of capital is essential for production and each of them can be used to fully produce the output of the economy. The opposite is the case with elasticity declining towards zero. Now the output and the marginal product of capital also approach zero, pulling the growth rate down on the way. Under an elasticity of substitution less than one, the growth rate quickly drops below zero ²⁰ with an increasing distortion τ. The model established that the distortional element τ does indeed have a negative influence on the allocation and hence on growth in an economy, provided the elasticity of substitution is sufficiently low. The next section will deal with the questions if easy rents really pose such a distortion and therefore influence growth negatively.

3 Easy Rents

3.1 Basics

The introduction already allowed a glimpse at the idea of “Easy Rents” and their, to say the least, ambivalent impact on economic performance. In this section the concept is developed and explained in depth. Further a deeper insight is given into the effects and implications of abundant funds for the economic and political processes and, at last, the variable τ is explained.

The term “”Easy Rents“” itself was found and taken from a World Bank paper, dealing with the effects of natural resources²¹ and it referred to the effortlessly generated revenues from resource booms. A similar notion is in­troduced by Alan Gelb²² with the usage of the term “Windfall Gains” for the revenues of oil-exporting countries²³ and by Djankov et al. in a 2005 paper, who described foreign aid as “windfall resources to recipient countries”²⁴. Another type of inflows, migrants’ remittances²⁵, is also considered a wind­fall earning by McCormick and Wahba (2005) and is looked at for its growth implications. All three pose a notable share of GDP in a lot of developing countries and can therefore be considered as factors of some impact on the economic exploits.

Up to here the entry card for being at least considered an Easy Rent was effort of generation relative to the amount yielded. However, a few more conditions are to be met to actually qualify under the assumptions brought forward. The label “easy” was so far applied to the object of easiness, the funds and their generation, e.g. the gain of revenues from nationalised re­source sectors versus the relatively tedious business of running a fiscal system to finance the operation of a nation. Although this is a necessary condition, it is not sufficient. A matter of concern are also governments and/or ma­jor influence groups and their ability to influence the monetary assets of an economy. Any windfall gains which cannot be administered to some sort of relatively easy centralised command, do not fit the notion of easy rents as it is used in this paper. Core characteristics of such controllable rents are the emergence of a separate sector of economy and channeled, centralised finan­cial flows and institutions. The importance of sectoral influences is stressed by both²⁶ Terry L. Karl in her influential The Paradox of Plenty and Michael Shafer in Winners and Loosers, who argue for economic distress caused by favourable price changes in one sector alone. The centralisation aspect is de­rived from corruption studies and the proposal that the extend of corruption is determined by bureaucratic centralisation²⁷. Due to the similar effects at work in rent-seeking and corruption, I expanded the notion to easy rents in general and claim that windfall rents without a certain degree of centrali­sation do not pose a distortional element. Only with the second condition fulfilled can individuals, institutions and interest groups come into play and make use of the revenues with relative effortlessness, thus avoiding unpopu­lar and less profitable measures like taxation²⁸. The avoidance of official and accountable instruments of national financing has, apart from saving trouble for the decision maker, deteriorating consequences for the financial moral, decision quality and subsequently growth.

The following delivers an individual analysis of the proposed elements according to the conditions imposed to define easy rents, points out trans­mission channels and effects, gives special attention to the “Dutch Disease” and brings the findings together to gain a composite view on easy rents and the distortional element caused by them.

3.2 Natural Resources

The first element to be dealt with is of course natural resources, which is the oldest and by far the most thoroughly researched form of windfall rents paradoxically associated with impeding growth effects. Since the middle of the 20th century scientists were concerned with the underperformance of natural resource dominated economies, a fate which allegedly already befell gold-spoiled Spain in the 16th century²⁹. In the 1950s the issue began to emerge around the adverse effects of the deterioration of commodities’ terms of trade and the possible impact on the mostly commodity based economies of the third world. But by the 1970s and the birth of the “Dutch Disease” notion the focus was on the resource rents themselves. In 1993 the term “resource curse” was introduced by Richard M. Auty³⁰, marking the abundance of commodities as the culprit for economic difficulties.

Following Jeffrey Sachs, Andrew Warner³¹ and Thorvaldur Gylfason³² natural resources are defined as fuels, minerals, forestry, fishery and cash-crop agriculture. All of these provide a country with a constant and more or less permanent supply of sellable commodities and should therefore gen­erate the monetary means for economic development and increasing welfare. However, as a number of studies suggest, high resource intensity is negatively correlated with per capita GDP growth. Between 1970 and 2000 commodity states have done significantly worse than their “poorer” counterparts. This failure to perform has been examined in depth by Alan Gelb, Richard Auty, Jeffrey Sachs and Andrew Warner³³. “A statistically significant, inverse and robust association between natural resource intensity and growth”³⁴ has been established by all and especially Sachs and Warner put much effort into con­trolling for a large number of additional growth important variables such as initial GDP, trade policy, investment rates, terms of trade volatility, in­equality and effectiveness of bureaucracy and found the results remaining significant. The “resource curse” hypothesis had gained momentum. Al­though these result remain merely a strong tendency, its existence is for the most part consensus view. However, there are as many suggestions to why it occurs, as there are theories about the agents of growth themselves.

Recent literature does not deny the fundamental benefits of abundant resource rents in so far as they are a direct positive income effect and pro­vide potential means to invest and develop a nation. The problem is that often “the negative indirect effects of natural resources on growth...outweigh the positive direct effect by a magnitude”³⁵ and decision-makers seem rarely able to make use of the potential at their hands. Most prominently, the explanations for the resource curse follow a crowding-out logic with an over­whelming resource sector pushing away growth driving elements of economy and state. Additionally there are a number of economic and socio-political transmission channels such as rent-seeking, external effects, trade-volatility and institutional quality who aggravate the crowding-out influence.

The basic idea is that a strong resource sector causes an increase in de­mand for non-tradeables and boosts prices for scarce inputs and work³⁶, following the logic that the resource industry is able and willing to pay more in order to claim the needed inputs. This in turn drives the non-resource traded manufacturing sector into decline as it cannot maintain competitive­ness at world market prices under increased input costs. Sachs and Warner tested the propositions and came to the conclusion that resource intensive economies do indeed display appreciated price levels inducing higher costs for non-resource businesses and that “a wage premium in [the] natural re­source sector” can be observed. Another finding supporting this view is the negative relation between high resource intensity and manufactures exports also found by Sachs and Warner in a cross-country regression, indicating a decline of growth driving export industries³⁷. Also of inhibiting quality is the prevalence of sunk capital in the primary sector. Resource related physical capital, e.g. mining infrastructure and oil rigs, is often confined to the sector and has no sustainable long-term productivity effects outside the primary sector, thereby “sinking” the invested funds³⁸.

Likewise affected by an overpowering primary sector is human capital and subsequently innovation and entrepreneurial activity, which are all asso­ciated with a country’s successful economic performance. Major research on this issue was done by Thorvaldur Gylfason³⁹ who modeled and tested the connection between a sizable primary sector and human capital. He claims that “the primary sector,..., may need - and also generates - less human cap­ital than services and manufacturing.” Of course the primary sector cannot function without at least some highly trained personnel, but those are often specialists who are confined to the sector, comparable to the above mentioned sunk physical capital. The generation of human capital is further inhibited by reduced incentives to invest in it, as resource rich economies may un­derestimate the long-run merit of education and put overly optimistic trust into the continued blessings of nature⁴⁰, which is especially true for low-skill, high labour-intensity sectors like cash-crop agriculture. In such economies employment opportunities for low-skilled workers are abundant and incen- tives are low to invest in education. Empirical evidence shows that “school enrolment at all levels is inversely related to natural resource abundance or intensity”⁴¹, as are other education related variables. This decline of human capital aggravates the crowding-out of manufacturing and services because those thrive on high levels of human capital and in turn pose demand for more. With human capital becoming a scarce resource its price, i.e. wages, further increase, adding to input costs. The depression of manufacturing and human capital, which in itself inhibits growth, makes things worse as train­ing and learning-by-doing in the secondary sector create external knowledge spill-overs which also contribute to growth. Such productive externalities are absent or at least scarce in the primary sector⁴².

A large portion of the resource curse effects is attributed to socio-political elements, which follow a comparable pattern and are entangled with the so far discussed economic issues. Michael Ross and James Robinson et al.⁴³ both argue for a strong tendency towards resource rich governments not suc­ceeding or not willing to put in growth supporting policies and a disability to introduce and maintain functioning institutions in such states. “Most resource abundant countries engender a political state that is factional or predatory and distorts the economy in the pursuit of rents⁴⁴” as the easy money coming from the primary sector creates compelling incentives to pur­sue growth impeding economic policy and engage in massive rent-seeking. Fractionalisation is a major factor and the negative impact of resource rents through fighting activities to control rents seems to be especially bad in eth­nically or socially divided countries⁴⁵. Homogeneous countries with sound institutions appear to be able to deal with the adverse effects of windfall rents through their unity. Hodler gives Norway and Botswana as convincing examples. However, as described by other authors (e.g. Terry L. Karl (1997): Venezuela and Sachs/Warner (2001): United Arab Emirates), fractionalisation is not a necessary condition for poor economic performance, although it is striking that true catastrophic outcomes, e.g. Nigeria or Angola, often correlate with the presence of rivaling interest groups.

[...]

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¹ Hector Hurtado, Minister of Finance of Venezuela, Caracas11978. Cited in Karl (1997)

² Most resource states are so called developing countries.

³ cp. Sachs/Warner (2001)

⁴ Economist, (Nov. 1977), 82f

⁵ Sachs/Warner (1995), Karl (1997)

⁶ Auty (1994), Karl (1997)

⁷ Dietrich, johannes, “Plan Paradox”, Brand Eins Magazin, April 2004 - German Lan- guage Business Magazine

⁸ Harry S Truman, Inaugural Address, Washington DC, January 20, 1949

⁹ In this paper a Billion is defined as 109.

¹⁰ Most obviously the oil price.

¹¹ “Investing in Development - UN Millennium Project”, United Nations (2005)

¹² Sachs/Warner (1995)

¹³ Easterly, (1993)

¹⁴ cp. “From Curse to Blessing”, Environment Matters, World Bank (2006), Paragraph 3 and Sachs/Warner (2001), Section 2: “Just as we lack an universally accepted theory of economic growth in general, we lack a universally accepted theory of the curse of natural resources.”

¹⁵ cp. Barro, Sala-i-Martin, (2004), pp. 63ff1205ff

¹⁶ cp. Easterly, (1993), Section II

¹⁷ cp. Easterly (1993), Section II

¹⁸ cp. Easterly (1993)

¹⁹ cp. Easterly (1993), Section II; Barro, Sala-i-Martin (2004), pp.. 207ff

²⁰ cp. Easterly (1993), Figure 1

²¹ cp. “From Curse to Blessing”, Environment Matters, World Bank (2006)

²² cp. Neary/van Wijnbergen (1987), pg. 54

²³ “Windfalls” are profits gained without a corresponding economic effort. See “Meyer’s Lexikon Online”, http://lexikon.meyers.de/meyers/Windfall-Profit (10.10.2007, German language)

²⁴ cp. Djankov et al. (2005)

²⁵ Remittances are money transfers from non-resident households/workers to resident households in their home country.

²⁶ cp. Karl (1997) pp. 5ff, Shafer (1994), pp. 22ff

²⁷ cp. Leite, Weidmann, “Does mother nature corrupt? Natural Resources, Corruption and Economic Growth”, IMF WP/99/85, (1999)

²⁸ cp. Djankov et al. (2005), Section 2

²⁹ cp. Karl (1997)

³⁰ Auty (1994)

³¹ cp. Sachs and Warner (1995)

³² cp. Gylfason et al. (1999)

³³ Gelb (1988), Auty (1994), Sachs/Warner (1995)

³⁴ Sachs/Warner (1995)

³⁵ Papyrakis and Gerlagh (2004)

³⁶ cp. Sachs/Warner (2001), Gylfason (2001)

³⁷ for all cp. Sachs and Warner (2001)

³⁸ cp. Shafer (1994), pp. 63ff

³⁹ Gylfason, A mixed blessing, (1999)

⁴⁰ A positive exception is Botswana who used resource rents for massive investment in human capital - the share in national income of expenditures for education is among the highest in the world; cp. Gylfason (2001)

⁴¹ cp. Gylfason (2001)

⁴² cp. Ross (1999), Stevens (2003)

⁴³ cp. Ross (1999), Robinson et al. (2005)

⁴⁴ Auty (2001)

⁴⁵ cp. Hodler (2006)