Wednesday, November 26, 2014

The Real Raw Material of Wealth

TIRANA – Poor countries export raw materials such as cocoa, iron ore, and raw diamonds. Rich countries export – often to those same poor countries – more complex products such as chocolate, cars, and jewels. If poor countries want to get rich, they should stop exporting their resources in raw form and concentrate on adding value to them. Otherwise, rich countries will get the lion’s share of the value and all of the good jobs.

Poor countries could follow the example of South Africa and Botswana and use their natural wealth to force industrialization by restricting the export of minerals in raw form (a policy known locally as “beneficiation”). But should they?

Some ideas are worse than wrong: they are castrating, because they interpret the world in a way that emphasizes secondary issues – say, the availability of raw materials – and blinds societies to the more promising opportunities that may lie elsewhere.

Consider Finland, a Nordic country endowed with many trees for its small population. A classical economist would argue that, given this, the country should export wood, which Finland has done. By contrast, a traditional development economist would argue that it should not export wood; instead, it should add value by transforming the wood into paper or furniture – something that Finland also does. But all wood-related products represent barely 20% of Finland’s exports.

The reason is that wood opened up a different and much richer path to development. As the Finns were chopping wood, their axes and saws would become dull and break down, and they would have to be repaired or replaced. This eventually led them to become good at producing machines that chop and cut wood.

Finnish businessmen soon realized that they could make machines that cut other materials, because not everything that can be cut is made out of wood. Next, they automated the machines that cut, because cutting everything by hand can become boring. From here, they went into other automated machines, because there is more to life than cutting, after all. From automated machines, they eventually ended up in Nokia. Today, machines of different types account for more than 40% of Finland’s goods exports.

The moral of the story is that adding value to raw materials is one path to diversification, but not necessarily a long or fruitful one. Countries are not limited by the raw materials they have. After all, Switzerland has no cocoa, and China does not make advanced memory chips. That has not prevented these countries from taking a dominant position in the market for chocolate and computers, respectively.

Having the raw material nearby is only an advantage if it is very costly to move that input around, which is more true of wood than it is of diamonds or even iron ore. Australia, despite its remoteness, is a major exporter of iron ore, but not of steel, while South Korea is an exporter of steel, though it must import iron ore.

What the Finnish story indicates is that the more promising paths to development do not involve adding value to your raw materials – but adding capabilities to your capabilities. That means mixing new capabilities (for example, automation) with ones that you already have (say, cutting machines) to enter completely different markets. To get raw materials, by contrast, you only need to travel as far as the nearest port.

Thinking about the future on the basis of the differential transport-cost advantage of one input limits countries to products that intensively use only locally available raw materials. This turns out to be enormously restrictive. Proximity to which particular raw material makes a country competitive in producing cars, printers, antibiotics, or movies? Most products require many inputs, and, in most cases, one raw material will just not make a large enough difference.

Beneficiation forces extractive industries to sell locally below their export price, thus operating as an implicit tax that serves to subsidize downstream activities. In principle, efficient taxation of extractive industries should enable societies to maximize the benefits of nature’s bounty. But there is no reason to use the capacity to tax to favor downstream industries. As my colleagues and I have shown, these activities are neither the nearest in terms of capabilities, nor the most valuable as stepping-stones to further development.

Arguably, the biggest economic impact of Britain’s coal industry in the late seventeenth century was that it encouraged the development of the steam engine as a way to pump water out of mines. But the steam engine went on to revolutionize manufacturing and transportation, changing world history and Britain’s place in it – and increasing the usefulness to Britain of having coal in the first place.

By contrast, developing petrochemical or steel plants, or moving low-wage diamond-cutting jobs from India or Vietnam to Botswana – a country that is more than four times richer – is as unimaginative as it is constricting. Much greater creativity can be found in the UAE, which has used its oil revenues to invest in infrastructure and amenities, thus transforming Dubai into a successful tourism and business hub.

There is a lesson here for the United States, which has had a major beneficiation policy since the 1973 oil embargo, when it restricted the export of crude oil and natural gas. As the US increasingly became an energy importer, its leaders never found any reason to abandon this policy. But the recent shale-energy revolution has dramatically increased the output of oil and gas in the last five years. As a result, the domestic natural-gas price is well below the export price.

This is an implicit subsidy to the industries that use oil and gas intensively and may attract some inward foreign investment. But is this the best use of the government’s capacity to tax or regulate trade? Would the US not be better off by using its capacity to tax natural gas to stimulate the development of the contemporary technological equivalent of the revolutionary engine?

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    1. CommentedKenzie McNeil

      Thought-provoking article. Not the easiest to follow with the emphasis on the production side however. Traditional wisdom would indicate that value-added production to resource rich countries is a catalyst to economic development. That said, value added production of raw materials should not be the end game. As was previously mentioned, Canada is currently facing such a predicament. The oil rich province of Alberta drives most economic growth and job creation in Canada with a Canadian Government that doesn't capitalize on other growth opportunities that sector could provide. How do resource rich countries avoid the cliche resource curse? Part of the problem is regressive tax policy by government and misuse of natural resource spinoffs to benefit other growth areas.

    2. CommentedAlessandro Daliana

      Stimulating article. Thanks so much for such thought provoking analysis. However, I did have a bit of problem fully understanding your argument because of its focus on production. I think a more robust argument can be developed with a more balanced production-consumption approach. I only say this because of the number of business people I work with who focus on producing goods and services without considering the cost of getting them to market and consumed.

      In my view, economic development is not only the result of what resources are available but possibly even more so a consequence of what can be consumed. Chopping wood does indeed wear down tools making this a ready market for anyone who can sharpen them or automate the process.

      South Korea makes steel because their shipwrights use so much of it - an internal consumer - and exports it to reduce the unit price. 17th Century England engine manufacturers found a ready market in the coal industry allowing other industries to adopt their products.

      In all of these examples there is one common theme, the producer reduces the uncertainty of their consumer achieving a certain task. Once that uncertainty is reduced to an acceptable level other markets can be developed.

      This is where US energy policy makes sense. In the face of the uncertainties created by the oil embargo of '73, US policy became one of restriction. But not only. You cannot understand US energy policy in isolation. It has to be viewed within the greater context of de-industrialization. Both the US and UK - followed to differing degrees by other developed nations - pursued very strong policies that moved their economies from production to consumption. Until the Great Recession this was a successful policy that reduced uncertainties for large swaths of the population.

      Today, not so much.

    3. CommentedGerald Silverberg

      Once again, from wherever you start, the best path to development is manufacturing machinery (unless you're Dubai). And that's exatly what Hausmann's product space tells us (surpirse surprise).
      Incidentally, Nokia's path was not from wood cutting machinery at all. It started from a wood pulp mill, then diversified into rubber products (boots) and cables, consumer and military electronics, then telecommunciations and mobile phones. Not a pattern anyone could reproduce elsewhere, nor would they be tempted to after its inglorious exit from mobile phones.

    4. CommentedPaul Jefferson

      A broader context is worth considering. This article recommends that a country should outsource the processing of raw materials to whichever other country can add value most efficiently. Then pick an appealing sector where there is potential to excel, and nurture that instead.

      This advice assumes that the resource-rich country has any potential to excel. Consider the Canadian economy, for example. If the Keystone pipeline is eventually approved, the Canadian dollar could conceivably rise high enough to decimate Canada's struggling industrial base. Will Canadians then wish they had leveraged their ownership of a scarce resource -- tar-sands oil -- to insist that it be refined domestically? This would at least have allowed them to retain one valued-added industry.

      Contrasting with that, the author would argue that Canada should instead use its new oil wealth to develop more promising industries. But what advantage can Canada enjoy if the currency is 10 or 20% overvalued -- by Dutch disease? Should Canadians resign themselves to becoming merely a tourist destination, like Dubai? When the oil finally runs out, what kind of economy will be left?

    5. CommentedMoctar Aboubacar

      A very insightful piece. creating the competitiveness to enter new markets through an expansion of capabilities as opposed to simply adding value to raw material exports is well taken.
      The question now is what the state's role is in this process. In some developing countries, the business environment is just not there to allow for the Finnish-style ventures that are described.

      The other issue, which drives countries to focus on adding value to existing materials is that there is a clear market for these goods, and they already have the connections to know that market well. How do you create the environment that allows firms to take the risks of branching out and playing capabilities?

    6. CommentedJon Quirk

      Excellent and interesting article.

      One of the key differentiators is motivation; in Southern Africa the move to beneficiation is driven not by economic analysis but the belief that "someone else" is stealing our resources and getting rich at our expense - a beggar my neighbour approach.

      In the examples you have quoted successful industries, drawing on resources from elsewhere, great industries have developed because, with no natural advantages, the peoples in those countries have worked hard; harder than their competitors exactly because they had no natural advantage.

      Countries with all the resources in the world will never be successful if they believe that having been so bestowed they have some almost god-given right to succeed - which is why beneficiation in these countries is unlikely to be a successful strategy because the motivation for going into such was flawed and that absolutely key ingredients necessary for success, drive, knowledge, skills and energy, will be lacking or tepid.

    7. CommentedMarina Alexander

      Interesting article and theoretically sound from an economic theory point of view. However, from a broader sustainable development lens there are valid reasons for locally integrative industries. Some of these are listed below.

      If inputs are sourced locally, transport related externalities (e.g. pollution) is minimized. Transport pollution is the leading cause of greenhouse gas emissions leading to anthropogenic climate change.

      International markets for raw materials can lead to unforeseen or ignored consequences. For instance, following an ideology of seeking the lowest price encourages a reduction in regulatory domestic policies. Poor regulation can lead to a lack of fair working conditions, a disregard for human rights including property rights, and low levels of environmental and biodiversity safeguards.

      I agree with Ricardo Hausmann that innovation is important to overcome poverty and build new technologies to solve today’s many problems. However, rather than innovating without a view to the future, a more sustainable approach is to allow societies and communities to have a say in how their resources are used and who benefits from them.

    8. CommentedMelissa Fry

      Excellent piece. I agree with the comments as well and wonder how we can use these insights to think about the case of the U.S. coal industry in Appalachia.

      This piece suggests the importance of utilizing policy tools (including taxes on raw material extraction) to leverage raw material wealth. In the case of Central Appalachia, I might argue that those same types of tools have divested the region as opposed to creating opportunities. In the case of Kentucky, subsidies significantly reduce the net gain from severance tax and use of severance tax revenue in the state's General Fund has meant that very little has been used to build opportunities for extraction communities.

    9. CommentedAlamanach .

      This is one of the best articles I've read in Project Syndicate in a while, and this paragraph in particular was a joy to read. Great job.

      I've worked in development, and I've long been frustrated by the impetus to central planning that seems to underlie lost development programs. Nobody could have predicted that Finland's trees would have led to cell phone production, but there you have it. If we want to help a country develop, we need to leave it to the people we're helping to decide which opportunities they want to pursue.

    10. Portrait of Michael Heller

      CommentedMichael Heller

      Very thought-provoking article from Ricardo Hausmann. But, upstream and downstream - isn't this conceptually reminiscent of the disappointing Latin American structuralism? I'm not so convinced that governments will be much good at deciding which upsteam -- oops I meant upstream -- activity to productively invest the precious tax revenue in.

      Even so, I wholeheartedly agree that the ambition to process raw materials, or create and add value in new activities using domestic capital accumulated via raw materials, is one that all developing countries must be thinking about constantly.

      When they are ready -- ideologically and institutionally -- they will do it naturally. There's the double 'i' 'i' policy driven by the third 'i' intelligence that *precedes* the fourth 'i' industrial policy. I say.