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Oil is Bad, M’kay: The Resource Curse

Oil and natural gas are bad. Their use causes climate change, on which most of us agree is one of our biggest current problems. Their use also pollutes our air and water supplies, causing all kinds of health issues. The way oil and gas are acquired destroys ecosystems, think of the devastating effects of fracking, how oil spills fill up whole seas with crude oil and how the people in the Niger delta now have to live with heavily polluted water due to mismanagement by Shell.

However, some would argue, for a lot of countries this is the only way to get their population out of poverty. Many developing countries don’t have a well-diversified economy, they can’t just stop exporting fossil fuels and other natural resources because that would benefit the environment. Although this sounds correct, empirics show that in many cases, natural resources don’t help the population get more wealthy.

This may sound very counter-intuitive. Why would countries with an abundance of natural wealth under their soils not profit from these, and even grow slower on average that resource-poor countries. It’s an issue that has occupied economists since Adam Smith. A large body of research was conducted on the topic, and the reasons for this phenomenon are, as is common in economics, wide ranging. In this article I’ll focus on the possible causes, and I will mainly focus on the natural resource that fuels the world economy: oil.

A very economic reason is that of the ‘Dutch Disease’, which is when countries export a lot of natural resources, their currency appreciates to the point their other exports become noncompetitive. Add to what economist Dani Rodrik calls premature deindustrialization, which is the fact that recently a lot of developing countries are actually deindustrializating instead of building up industries. This upholds the mono-culture of resources. Not only does this make the economy more sensitive to changes in the business cycle, resource exports tend to have low added value, thus low employment opportunities.

Although quite convincing, the Dutch Disease is only a part of the problem. Economists must always remember that while they use quantitative research methods, they still study social phenomenon. This means that politics has to be taken into account. And if you take a look at the average resource-export dependent county, it quickly becomes clear why.

SOURCE: World bank (WITS and democracy index, both data from 2013)

 As you can see, the top-15 countries with the highest fuel-to-export ratio all score, apart from Brunei and Qatar, very low on the average democracy index (an average of scores on democratic indicators like democratic rights, political stability and upkeep of the rule of law.) This doesn’t mean having oil reserves makes a country a (semi-) dictatorship. There are plenty of countries that are resource-poor and have undemocratic or ill-functioning governments such as Somalia, Afghanistan or the Central African Republic. On the other hand, Norway’s export consists for 55,2% out of fossil fuels, but it is the second-strongest democracy in the world. As always with statistics, it’s important not to conflate correlation with correlation.

However, the table above still shows some remarkable results. Economists and political scientists have come up with a couple of theories to explain this tendency of resource-rich countries to have bad governance. The two economists Daron Acemoglu and James A. Robinson have come up with a broad theory which tries to explain economic failure, and it can be summarized by one word: institutions. In their book Why Nations Fail, they describe that differences in economic and political institutions can have a major effect on growth in the long run. They looked at countries that were very similar in terms of natural resources. However, in some countries innovation and entrepreneurship was encouraged whereas in the other country the government was mainly extractive. In the long run, they claim, this is the reason that for example, The United States and Canada are wealthier than Latin America.

But how does this theory explain the resource curse? Well, institutions are shaped by the incentives of those in power. When the Iraqi government can extract a very large portion of its income from selling crude oil, it’s less incentivized to set up institutions that promote the growth of it’s citizens. This is because the Iraqi government isn’t dependent on taxes for its income. A country like Japan, which only gets 2,14% of its exports out of fuels, has no option other than to invest in the productivity of its people. Following from Acemoglu and Robinson’s theory is why Japan is now a highly developed industrialized country while Iraq still lags far behind in terms of development. Thus, the incentives for development given by the stock of natural resources plays an important role.

The lack of strong institutions explains another cause for the bad governance: corruption. Oil rich countries often have a small group of really rich people, oligarchs, that have a massive effect on how policy is shaped. These people have worked their way up the ladder in the fuel-industry and through their influence have gotten themselves very rich. Take for instance the close ties the Brazilian state-owned company Petrobras and Brazilian politicians have to each other. Petrobras paid out 449 million dollars in bribes, which makes it easy to understand why the lawmakers receiving these bribes are less inclined to direct the oil company’s funds to its people. While it could increase overall economic growth, those in power would simply not profit as much. For those of us who have a grim image of mankind and expect that money and power would make anyone corrupt, this paints a depressive picture, since no law-maker will do something to improve the situation.

Politics can also play an important role if the well-being of the people is taken in consideration, albeit for electoral reasons. When countries take populist measures to provide short-term well-being to its people, this often doesn’t help them in the long run. Take Venezuela. Here a lot of anti-poverty programs were funded with its oil income. These programs were very successful and the amount of people living in poverty were halved, however due to the cyclical character of the spending (meaning they spend more when the world economy is doing well and thus government income is high) they now have serious problems paying off their debts. This is because oil prices went down in 2008 and 2014, resulting in staggering budget deficits. Due to limited access to capital markets and import restrictions, inflation is estimated to reach 13000 percent this year with many terrible effects for the Venezuelan people. The oil proceeds weren’t used to invest in a broader export sector to make the country’s economy less sensitive to declines in demand of oil. The luxury of having oil often makes governments lazy when it comes to looking ahead.

Luckily, if your country happens to find oil under its soil, you’re not doomed. Norway founded a national investment fund in 1990 in which they deposit capital they get from selling oil. The fund is property of the Norwegian people and it’s proceeds are used to foster their well-being in the long run. With its investments the fund focuses on issues like climate change and human rights.

Norway is an example of how a country can use its natural resources to the benefit of economic well-being. For this, it’s imperative that the government acts for the benefit for its people in both the short and long run. A country needs strong and transparent democratic and economic institutions. However, history proves that these are hard to build up. Especially for many countries that have a colonial past, corruption seems to be baked into their institutions. So if you are from one of these countries, educate yourself and be very critical of how your government conducts its business, because your country’s natural wealth might go to waste.


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