Natural resources, manufacturing and trade: a long-run perspective

(pages 5-9 of printed journal)

By Ronald Findlay

Introduction

It is a pleasure and an honour to give this lecture in honour of Max Corden. We have known each other for over fifty years, beginning with our contributions to the 'growth and trade' discussion of the 1950s that was set off by Hicks's Inaugural Address on the long-run dollar problem and further shaped by the seminal work of Harry Johnson, an inspiring mentor to both of us. Long before the invention of email we exchanged 'air letters' commenting on each other's work but did not meet until much later, resulting in our joint paper on wage differentials and urban unemployment (Corden-Findlay, 1975). Tonight's topic is one that has long interested Max, the so-called 'Dutch Disease' problem, on which he has written two classic papers (Corden-Neary, 1982 and Corden, 1984). The reason for Max's interest in this problem is not hard to find since Australia has always had a vast abundance and variety of natural resources, from wool and gold to coal and iron ore, which has contributed greatly to both its foreign trade and economic development. Whether these gifts of nature are a 'blessing' or a 'curse', if not handled appropriately, is the question that the Dutch Disease literature has been concerned with and that I shall attempt to pursue further here.

Natural resources and economic development

Over the long sweep of economic history this fear that natural resources are a curse on development does not appear to be well-founded. Many now highly-developed countries began their economic ascent as successful primary exporters before diversifying into manufacturing, often by moving up the value-added chain by further processing of their raw material exports. Witness Sweden and Finland, with their timber exports transformed into pulp and paper, or even medieval England, long an exporter of raw wool before converting it into woollen cloth, partly as a consequence of Edward III's export tax to finance the Hundred Years War in the fourteenth century, incidentally a problem that I analysed in a 1987 Festschrift for Max (Findlay, 1987). The US itself was mainly a primary exporter well into the early twentieth century before rich deposits of coal and iron ore were discovered and exploited so intensively (Wright, 1990).

Transport costs, in particular the relative transport costs of finished products and their raw-materials inputs, is obviously a key aspect of the story. With 'heavy industry', such as iron and steel, metallurgy and machine-building, the factories had to be close to the coal and iron ore that fed their furnaces. In the early days of the Industrial Revolution this was what gave Britain, Belgium, France and Germany the basis of their comparative advantage. Industrialisation was inconceivable without coal and iron ore deposits within one's borders or very close to them, so geology, if not geography, was destiny. Thus when the US found massive supplies of coal and iron ore around 1900 these could not profitably be exported to factories in Europe, as raw cotton had long been, but had to be embodied in finished products, whether for domestic use or export.

The development of bulk carriers, since about the middle of the last century, has changed the situation entirely. Thus Australia in 2011, unlike the US in 1911, can simply ship vast quantities of industrial raw materials cheaply to China, Japan and Korea, without converting them into manufactured products. As a consequence of the precipitous decline in transport costs, this 'globalisation' has meant that geography no longer is destiny as far as industrialisation is concerned. Capital accumulation, both physical and human, and technological progress now determine where this global pool of industrial raw materials will be directed. The East Asian economies, with their huge saving rates and strong commitment to education, are increasingly where global manufacturing production and exports will be concentrated, with countries like Australia, Brazil and Russia providing the necessary primary exports of coal, iron ore and other intermediate resource inputs.

But should these resource-abundant countries continue to simply follow the path of being exporters of industrial raw materials, or rather follow the path of the US 100 years ago, absorbing these materials into manufacturing production and exporting of the final product. One obvious consideration is population size, in other words not just resource-abundance but per capita resource-abundance. I have seen no estimates of this indicator for the three countries, but cannot imagine that Brazil (population about 180 million) and Russia (about 160 million) – however well endowed they are – have nine and eight times the natural resource assets of Australia (population 22 million). This consideration alone suggests that resource-intensive export specialisation would continue to be a better bet for Australia than for Brazil and Russia. It might not necessarily be prudent for Brazil and Russia to simply continue following the current Australian path and avoid making any strong commitment to the alternative strategy of diverting natural resource exports into intermediate inputs for domestic industrialisation and manufactured exports. That many aspects of past import-substitution industrialisation strategies were too costly or misguided should not prevent us from reaching this conclusion for Brazil and Russia, or for that matter even Australia itself.

Put this way the problem becomes one of pricing these industrial intermediate inputs within the resource-abundant countries. Should their factories have to pay the world price – that is, whatever China, Japan and Korea are willing to pay for them on the open market – or instead should these countries follow the lead of Edward III and put an export tax on them, simultaneously collecting revenue that could be used for developmental or other public purposes, while cheapening the inputs for domestic manufacturing? As I teased Max when visiting him at Nuffield in 1976, the economic historian Eileen Power had referred in her classic study on the medieval English wool trade to this policy as providing a 'most effective protection' for manufacturing woollen cloth in England. To quote her directly: 'It is not difficult to see at once that this immense margin between the domestic and the foreign prices of wool provided most effective protection (my italics) for an infant industry' (Power, 1941, p 101). Under this version of the classic 'optimum tariff' argument, since export and import taxes are equivalent by the Lerner 'symmetry theorem', the domestic relative price of resource products will fall, stimulating domestic final consumption and intermediate use in manufacturing, while reducing exports of the resource product and imports of final manufactures, and possibly even resulting in net exports of the latter, as eventually happened in medieval England.

Modelling the problem

At this point one badly needs an explicit model in order to proceed any further, but which model? Let me propose one that I presented in my Ohlin Lectures (Findlay, 1995), which unsurprisingly builds on an ingenious contribution by Max himself and that other fine Australian economist, Fred Gruen (Gruen and Corden, 1970). Imagine an economy that can produce three goods – X, Y and Z – with production functions that have constant returns to scale and the usual well-behaved neoclassical properties. Assume that X and Y use capital and labour as inputs, while Z uses labour and a specific natural resource endowment – N – that is fixed in quantity. N is like 'land' in a Ricardian model, yielding a continuous flow output of Z, the volume of which depends on the amount of labour allocated to it. Z is therefore not treated as an exhaustible resource input, even though we will think of it as coal and/or iron ore, a loss of realism necessary in the interest of tractability. Each unit of X requires a fixed input of 'a' units of Z, so that we have X=aZ, in addition to the capital and labour required. We can think of X and Y as together constituting the 'manufacturing sector', in which X is more capital-intensive than Y, in the usual Heckscher-Ohlin-Samuelson sense, in addition to requiring its fixed input of aZ per unit of output. The total labour force is given at L=Lx+Ly+Lz. The capital stock K=Kx+Ky is not given but has to be endogenously determined by a process that will shortly be explained. The model thus has three goods (X, Y, Z) and three factors (K, L, N). Taking X as the numeraire we have five relative prices Py/Px, Pz/Px, w, r and q, where w is the real wage, and r and q are the rentals per unit of capital K and the natural resource N respectively. We set the nominal price Px equal to unity, and think of X as a composite consumer-cum-capital good as in the Solow growth model, so that r has the dimension of a pure number per unit of time, allowing us to interpret it as the rate of interest. Consumers have identical and homothetic utility functions with the amounts of X and Y consumed per capita, denoted x and y, as arguments so that we have u=(x, y) as the instantaneous utility function of the representative consumer. All markets are perfectly competitive. All that remains is to explain how the capital stock K is to be determined endogenously.

Imagine a diagram in which a negatively-sloped curve RR' shows the relation between the rate of interest r and the steady state per capita utility u(x, y) associated with it, or u=f(r) with f'(r)<0. The lower the rate of interest the more capital would be demanded in the economy, raising the relative output of the capital-intensive good X, the relative prices Py and Pz of Y and Z, and the real wage w. More K with L and N fixed means a higher national income and thus a higher u(x, y) as r is lowered, giving us the negative slope of RR'. Imagine now a positively-sloped curve VV' showing the endogenous rate of time preference v as an increasing function of the instantaneous utility level u, or v=v(u) with v'(u)>0, as argued by Uzawa (1968). Long-run equilibrium is where these two curves RR' and VV' intersect to determine the rate of interest r* and steady state utility level u*, as well as the endogenous capital stock K* at which the demand and supply of capital are equal, as are all other equilibrium prices and quantities. At any uv so agents will have an incentive to accumulate more capital, while at any u>u* the fact that v>r would cause them to decumulate capital, so that the long-run equilibrium at (r*, u*) is stable.

Let us now do the simple comparative statics exercise of increasing the natural resource endowment N of the economy, with all else unchanged. This will shift the negatively-sloped RR' curve to the right, resulting in a new equilibrium with a higher r* and a higher u* and, incidentally, a higher endogenously determined K* to provide the manufacturing capacity in the X sector necessary to absorb the greater availability of the natural resource input Z made possible by the greater endowment of N. Thus, in this case the greater natural resource wealth resulting from the exogenous increase in N is augmented by an induced increase in the capital stock K* as well, so that the more resource-rich economy, which we will henceforth call B (say 'Brazil'), is 'twice blessed' by comparison with the original economy, that we will henceforth call A (say 'Asia'), since the greater abundance of natural resources also induces a greater supply of capital.

To introduce international trade between A and B, suppose that trade is only in the final manufactured goods X and Y, with Z not traded either because of prohibitive transport costs, as before the age of bulk carriers, or because it is simply prohibited by the government of B. The greater cheapness of the non-traded raw material Z in B will give her a comparative advantage in the capital-intensive good X, which she will export to A in return for imports of the labour-intensive good Y. The relative price Py of Y will rise in A and fall in B to the world price Py*. What will happen to the three factor prices w, r and q in the two countries? Note that we will not have factor price equalisation since there are three factors but only two goods traded. But Stolper-Samuelson will operate with the real wage rising and the interest rate falling in A, while the opposite happens in B, with the real wage falling and the rate of interest rising. The gains from trade increase the stationary utility level u(x, y) in A, and hence the rate of time preference v by the Uzawa hypothesis, inducing a decumulation of capital there, since r is now less than v; while in B, free trade also raises the stationary utility level but in addition induces a further accumulation of capital, because Stolper-Samuelson has raised the rate of interest there as a consequence of the rise in the relative price of the capital-intensive good 1/Py* (assuming that the rise in the rate of interest exceeds the rise in the rate of time preference). Both countries gain in the long run from free trade since A enjoys extra consumption while running down her capital stock, while B is rewarded for her sacrifice of consumption along the transition path by higher steady state utility in the long run. B, already 'twice blessed' in our account under autarky, now appears thrice blessed because of free trade in manufactured goods allowing her to exploit her cheap natural resource inputs that are not themselves tradable. In terms of the steady state comparisons B appears to gain even more from her natural resource abundance, while A appears not to be able to overcome her relative poverty of natural resources by exporting her labour-intensive manufactures.

Finally, let us consider the most relevant contemporary case of free trade in all three goods X, Y and Z, unhindered by transport costs or trade restrictions. With three tradable goods and three factors and the same constant returns to scale technology everywhere we are assured of full factor price equalisation at w*, r* and q* so long as all three goods are produced in both countries. Since both countries have the same Uzawa function v(u) and v'(u)>0, free trade in all three goods must result not only in equalising each of the three factor prices but also the instantaneous utility level, and hence per capita income and wealth, as well. Because the interest rate falls in B and the rate of time preference increases because of the gains from trade and the assumption that v'(u)>0, she must now decumulate capital to attain a lower capital stock and a lower steady state per capita utility, while A now does the opposite, with the rise to the common r* inducing accumulation of capital to attain the common level of steady state utility u*(x*, y*) that both countries now enjoy in the full free-trade equilibrium.

What happens to comparative advantage? Note that per capita wealth must be the same in both countries, but B has greater natural resource wealth than A because Nb > Na and the asset price q*/r* is exactly the same because of factor price equalisation. For total per capita wealth to be the same it must be the case that K*a>K*b. In other words, A must now be more capital-abundant than B since we are assuming that the labour forces are equal. The advantage of a lower Pz that B enjoyed when trade was only in final manufactured goods is now gone since Pz equals Pz* in both countries, levelling the playing field in access to natural resource inputs all around the globe. The conclusion is inescapable that A will now export the capital-intensive good X to B in return for imports of the raw material Z and the labour-intensive manufactured good Y. In other words there has been a reversal of comparative advantage in the manufacturing sector as a result of opening trade in the raw material Z.

Thus far we have a stationary model, albeit one with an endogenous capital stock. It would not be too difficult however to introduce an 'effective' labour force growing at the rate (n+m) because of population growth and technical progress respectively, as in the Solow growth model. To preserve a steady state, however, we would also have to assume that the stock of natural resources N is also increasing along with labour L and capital K at the same rate (n+m) because of new discoveries and increasing technical efficiency. Most steady state properties of the model would essentially be preserved, though the Uzawa hypothesis of endogenous time preference would have to be modified.

If natural resource availability does not increase at the same rate (n+m) as effective labour the terms of trade would move secularly in favour of the resource exporters, as envisaged in the Ricardian tradition by many British economists up to the time of Keynes and Beveridge, pending any breakthroughs in 'green' energy.

We now turn briefly to economic policy considerations on the basis of the original stationary model. How could B mitigate the impact of free trade in Z? The most obvious answer is the Edward III solution – an optimal export tax on Z. In addition to improving the terms of trade, this would preserve cheaper intermediate inputs for the capital-intensive sector X in B and prevent full factor price equalisation by the divergence in the relative price of the raw material between the trading partners, so that the interest rate will not have to fall to complete equality, thereby reducing the extent of induced capital decumulation and raising steady state per capita utility. The problem of course is that A would have every incentive to retaliate, raising the spectre of a mutually destructive trade war. An alternative approach would be a tax on wealth from ownership of natural resources, thereby inducing more accumulation of manufacturing capital than under the laissez faire solution and shifting comparative advantage back towards the capital-intensive good X. There are clearly a great number of other measures that might be considered.

Conclusion

My intention in this lecture was not to make specific policy proposals but to contribute a little towards developing a conceptual framework within which we can discuss these highly-relevant issues regarding resource-intensive exports and economic growth in the rapidly evolving world economy of the twenty-first century. I hope it is clear that whatever clarity or relevance this lecture has been able to provide on these matters is due entirely to our hero Max, who thought so deeply and penetratingly about them long before the world was as aware of their full importance as it is today.

References

Corden, WM 1984 'Booming sector and Dutch Disease economics: survey and consolidation', Oxford Economic Papers, 36, p.359-80.

Corden, WM and Findlay, R 1975 'Urban unemployment, intersectoral capital mobility and development policy', Economica, February, p.59-78.

Corden, WM and Neary JP 1982 'Booming sector and de-industrialization in a small open economy', Economic Journal, 92, p.825-48.

Findlay, R 1987 'Intermediate goods, export taxation and resource-based industrialization' in Kierzkowski H (ed) Protection and Competition in International Trade: Essays in Honour of Max Corden, Basil Blackwell, Oxford, p.162-71.

Findlay, R 1995 Factor Proportions, Trade and Growth, MIT Press, Cambridge MA.

Gruen, F and Corden WM 1970 'A tariff that worsens the terms of trade' in MacDougall IA and Snape R (eds) Studies in International Economics, North-Holland, Amsterdam.

Power, E 1941 The Medieval English Wool Trade, Oxford.

Uzawa, H 1968 'Time preference, the consumption function and optimum asset holdings' in Wolfe JN (ed) Value, Capital and Growth, Aldine, Chicago.

Wright, G 1990 'The origins of American industrial success,' American Economic Review, 80, p.651-68.