Resource Rich Countries and Weak Institutions: The Resource Curse Effect By Mohammed Ali Alayli Professor Karp EEP 131 December 4, 2005 Abstract: The natural resource curse represents an enormous impediment to development. Yet it is important to realize that it is not natural resources that are the problem; rather, it is lack of good governance and democracy. Remedying this institutional failure requires changes of law and practice but does not require huge resource investments. The most interesting aspect of the resource curse is not that natural resource wealth on average reduces growth, but that the economic and political outcome is so different in different resource abundant countries. To understand the resource curse one needs to study how economic factors shape institutions and how institutions shape economic factors. By increasing the transparency of resource payments by firms to governments, increasing government transparency in the management of resource revenues, encouraging preventive diplomacy, restricting the trade of high-risk, and conflict-related commodities, income from these natural resources can be used to support growth and development.One of the puzzling regularities of economic growth is that many countries rich in natural resources have such poor growth performance. This occurs because the income from these resources is often misappropriated by corrupt leaders and officials instead of being used to support growth and development. Moreover, such wealth often fuels internal grievances that cause conflict and civil war. This pattern is widely referred to as the “natural resource curse” -- natural resource wealth creates stagnation and conflict, rather than economic growth and development. The most interesting aspect of the resource curse is not that natural resource wealth on average reduces growth, but that the economic and political outcome is so different in different resource abundant countries. To understand the resource curse one needs to study how economic factors shape institutions and how institutions shape economic factors. The natural resource curse hypothesis maintains that rather than fueling growth and development, natural resource wealth can become the cause of economic stagnation, corruption, and civil war. The possible explanations of the natural resource curse largely fall into two classes: Economic factors and political or political economy factors. The economic phenomenon behind a negative growth effect of natural resource dependence is termed the Dutch disease. Named after the negative effects on the Dutch manufacturing sector of Holland’s natural gas revenues from the North Sea, it is the contraction of other tradable sectors as a result of a boom in the natural resource sector (Sachs, 1995). The real exchange rate appreciates as capital flows into a country in response to a natural resource boom. This appreciation renders domestic manufacturing and agriculture uncompetitive, causing lost jobs and higher unemployment. These lost jobs are not compensated for by growth in the natural resource sector, which is capital-intensive. Thedecline of manufacturing and agriculture also makes the economy dependent on natural resources, contributing to economic volatility since natural resource earnings are highly volatile (Angrist, 2005). I. Problems The natural resource curse undermines governance and democracy. For example, oil generates large streams of foreign exchange, and these flows become the basis for patronage that supports dictatorship and autocracy. Natural resources and oil wealth should be of benefit to countries. The fact that they often are not is because of failures of governance that are connected with failures of democracy and public accountability. Evidence shows that natural resources can drive civil conflict as parties struggle to gain control of over resource revenues (Fearon, 2002). Excluded groups have an incentive to try and wrest control, while dominant groups have an incentive to take a disproportionate share of benefits. Creating a system in which all receive an equal, pre-determined share can alleviate these tensions. Once the resource is seen as belonging to the public, the incentive to wrest government control for personal benefit is reduced as the value of control over government is diminished. Beyond these political economy benefits are also more standard economic gains from such funds. Firstly, the whole state may be subject to a ‘rentier effect’. States with abundant mineral and oil reserves extract their revenues from resources that are concentrated geographically in terms of ownership. This reduces their incentive to develop the governance mechanisms that enable general taxation. On the other end of the spectrum side, since the state sector tends to dominate, citizens have less incentive to form a healthy ‘civil society,’ an independent middle class fails to develop, and technocratic andentrepreneurial talent remains captive of state largesse in terms of employment and advancement opportunities (Manzano, 2001). In addition, the government can rely on its resource revenues to repress dissent, either through buying off opposition (often with high-profile infrastructure projects) or through violence. As a result of this, democracy often fails to develop (Karl, 1997; Ross, 2001). More importantly in this context, stifling technocratic and entrepreneurial talent, as well as making unproductive investments, will harm the economy. Secondly, political elites find it relatively easy to control resources and maintain their wealth in a point resource-led economy, but face the prospect of losing their grip through industrialization and urbanization (Dietz, 2005). It follows that political elites in resource-rich countries resist modernization pressures for as long as possible, especially investment in the manufacturing sector. Again, in this case civil society fails to develop. The main reason for this is that the concentration of capital ownership among political elites, together with production methods that favor the use of expert (foreign) labor and that are capital-intensive (Leite, 1999); reproduce social inequalities between those inside the elite and those outside it. The effect of resource rents on growth may depend on the strength of institutions, but the institutions may in turn depend on the existence of rents. The works of (Ross, 1999)
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