The resources curse

Australia’s current terms of trade boom is a media darling.  This widely quoted statistic has provided a degree of comfort to those who proclaim the robustness of Australia’s economy due to close trade connections with Asia, and China in particular.

Most readers would not be aware that macroeconomic researchers have built up a solid evidence base demonstrating that terms of trade volatility leads to volatile outcomes for output growth and inflation, a lower average rate of growth, and reduced welfare.  A temporary income boost from a terms of trade effect has been shown numerous times to be a double-edged sword as the disruptive impact on production patterns filters through the wider economy.

But what is the terms of trade?  How is it calculated? Can we better understand the economic impact of this oft-quoted figure by dissecting it into constituent parts? And what policy options exist to deal with the volitility?  This post explores these questions in detail and shows that our terms of trade driven income boom is not an excuse for policy makers to do sit on their hands, but is instead an opportune time to implement policies that improve the durability and diversity of the economy.

Let us begin.  The terms of trade is a simple enough calculation.  It is the ratio of the price index of exports over the price index of imports.  Like all price indexes, these are generated by a weighted average of prices in the basket of export goods and import goods.  The weighting for these baskets of traded goods is derived from the input-output tables in the National Accounts and revised quarterly.

An increasing terms of trade means that prices for the basket of export goods are increasing more than the price of import goods.  We can therefore import more goods for the same amount of exports and maintain a trade balance.

Australia’s export mix in heavily dominated by coal, iron ore, and other primary resource (including agricultural commodities). The Prebisch-Singer Hypothesis suggests that over the long run the price of primary goods declines in proportion to manufactured, or final consumption, goods.  In 1998, Hans Singer reiterated the advice to policy makers than stem from historical observations.  He warned that countries with exports dominated by primary resources must:

 … be prudent even when export prices are temporarily favourable and to guard against currency overvaluation and Dutch Disease, with all the unfavourable impact on the rest of the economy and all the dangers of macroeconomic instability which a sudden boom in a major export sector could imply. They are warned to remember that the outlook for commodity prices is not favourable and that windfalls will tend to be temporary, with the subsequent relapse likely to be greater than the temporary windfall.

Singer’s advice is usually aimed at resource rich developing countries, but it applies equally to any country with a large resource export base.

The RBA recently showed this pattern to be true over the 20th century in Australia, with Glenn Stevens himself noting the Prebisch-Singer Hypothesis explains the historical pattern of Australia’s terms of trade:

 There have been a number of big booms. They all ended. The really high peaks were quite temporary – just one or two observations in this annual time series, such as in the mid 1920s or the early 1950s. Periods of pretty high terms of trade lasted for some years in several instances – as shown by the five-year average – but so far they have all been followed by a return to trend, or even a fall well below trend.

There is also a statistical explanation for the volatility of the terms of trade, particularly when it measure is favourable.  Price increases of one commodity lead to increased basket weights for those groups.  The basic reason for this problem is that you can’t aggregate tonnes of difference products together – you can only aggregate prices.  So if the price goes up its share of exports in terms of price increases.  This new share is then used as the weighting of the price change over the next period.

We can see how this has played out in the Australian measure.  Unfortunately what we need to do is using a second-best technique that applies the trade price indexes, rather than the indexes derived from the National Accounts.  But as the graph below shows, this is a reasonable approximation of the official measure.

The two graphs below show the pattern of increasing prices and increasing weights to the trade price indexes.  The first shows that our two main exports increased in price by 200% since 2004, while the second graph shows that the weighting applied to these two commodities, coal and metal ores, almost doubled to their current 49% share of the export basket weight.

This essentially means is that the higher the terms of trade, the more volatile it will be as the basket of export goods become less diversified.  The pattern is easy enough to see when eye-balling the official figures.  In the chart below we can see that when the terms of trade is low, say between 1975 and 2000, the volatility is low.  When it is a little higher, say between 1960 and 1975, the volatility is a little higher.  And when the terms of trade breaks out into the stratosphere, it becomes so taut that relatively small price changes have dramatic effects.

As an example, coal and metal ores price indexes increased 20% between 1996 and 2001 yet the terms of trade was flat (partly due to import prices rising 10%).  They also increased in price by 30% between 2006 and now, but the terms of trade almost doubled (while the import price index was flat).

The strong relationship between the value of the Aussie dollar and global commodity prices also results in volatility in the terms of trade.  A decline in the dollar will increase the price of imports, while a contemporaneous adjustment in the price of commodities will reduce the price of exports. As a demonstration, a 15% decline in the AUD (in trade weighted terms, which is where the dollar was at in Sept 2009), coupled with a 30% decline in iron ore and coal only, would result in a 30% decline in the terms of trade.

What does this all mean for policy makers looking to promote a stable and prosperous economy? Singer has his view:

Hence the conclusion emphasises the importance of education, development of skills, and of technological capacity. In the light of recent mainstream thinking on growth and trade there is nothing startling about this conclusion

I certainly agree that government should play a role in raising the bar on education and positioning itself as an enabler for new business.  I see the NBN as one example of an enabler that is justified on these grounds (despite what you may believe about the opportunities for more cost-effective provision of broadband technology).

Government can also act as an enabler by intervening in the currency market, as the Swiss have done, or even play a role in funding start-up businesses, with favourable lending conditions, especially if they target an export market.  Even if the terms of trade soon falls back to historical norms, these are not bad policies to have in place in any case. Remember, volatility itself is a problem.

What the above analysis doesn’t favour is the wait-and-see approach that seems to be the only one on the table at the moment.

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  1. There is a lot of food for thought there Cameron. I wouldn’t favour direct intervention in the currency market, but they could force a lower dollar by introducing the MMRT and by using other measures.

    Short term earnings should be saved. A period of higher income even of just a few years causes an imbalance that will last much longer than the period of higher earnings.


  2. +1 Great insight!
    I’m hoping that the difficult years ahead will lead the governments in Australia and in other developed economies to boost funding for inventions and new business ventures. Those would create the much needed jobs and growth. IMHO the years of China being the factory of the world are probably over and local manufacturing is going to be back in. Unfortunately this may well lead to protectionism and more tensions in global trade at least temporarily.
    However, putting all bets on one card namely China needing resources has seemed risky all along.
    Just thoughts from main street.

  3. Not too sure how applicable the Prebisch-Singer observations are to a developed economy experiencing record ToT due to a resources boom!

    It would appear far more pertinent to an emerging economy with no/minor manufacturing base and somewhat formative domestic economies. His advice to develop educational opportunities and technological ability may be something to aspire to in a developing economy, but is already accomplished in economies like Australia and Canada.

    I can’t see that the P-S theory really explains much in regard to economies such the two above, both commodity economies at core but equally with reasonably diverse, reasonably robust sophisticated domestic economies.

    More generally there are threads of recognition in P-S theory that when applied to Australia and Canada appear little more than a variation on Dutch Disease and the tendency for commodity based economies to experience at times significant fluctuations in ToT, aligning with commodity price cycles. I fail to see any more than that here. Of course there is increased volatility when ToT is largely dependent on a specialised grouping of (anything). A developing economy has nothing else to fall-back on when the commodity price cycle declines hence major volatility associated with record ToT, when ToT collapses very often the economy of the country will also! Hence a reduction in welfare (if it existed) and so on.

    Here the boom-bust nature of a resources based economy is the stuff of legend. (Wool, wheat, ore, coal etc). But when the commodity cycle ends the effects of the volatility experienced are generally far more moderate than that of a developing country (African, some South American countries). We retain a comparatively diversified base. Indeed, globalisation may have contributed more to reduce diversity in individual economies than any outcomes explained by P-S theory!

    All of which brings me back to the “What should we do?” question you raise. Will we intervene on behalf of the currency. No. There has been outright rejection of this, unlikely to happen, not currently acceptable position in the theory! Should government support start-ups, I don’t think so, at least not solely as an arm of some sort of government financing. Supporting start-ups with export focus would surely need the companion of currency control. Start ups are highly risky with the majority failing within a matter of years – it seems more appropriate to me to allow these businesses to follow normal commercial channels but perhaps there is room from something like a reduced interest rate period (the balance of the interest due subsidised by government).

    Pity we were not in the position to save a little from the boom. Unfortunately it may come to pass that this commodity cycle ends simultaneous with a major slowing in a wide section of the economy, retail, property and manufacturing. Or the commodity cycle may continue forward, limping a little on occasion as China adjusts. Who knows. My preference is for the latter.

    Global economic volatility ensures we will sit on our hands and let it happen. Our current dependence on the ‘cycle’ itself limiting options…

    My 2c.

      • The very simple explanation is the rents from resource extraction need to be captured domestically and invested in value adding and diversifying the production base. This can be achieved with investing in enabling infrastructure – roads, electricity, water supply etc, and even direct government investment in various complementary manufacturing capital.

        Colonialism in Africa was essentially foreign interestes catpuring rents and reinvesting them in their home countries. Under these conditions it is impossible to get ahead, or even play catch up.

        The same principles apply to Australia as to any resource dependent nation. While we do have a head start in terms of a diverse economy, we shouldn’t be complacent about foreign capture of natural resource rents, nor about maintaining a degree of diversity in our productive abilities.

        • Agree. Brings the debate back to the best method of ‘capture’, containment and redistribution! Something much debated here at MB.

          Had rather hoped the P-S theory provided concrete answers and solutions but suspect not – and not directly applicable to developed economies in any case. I defer to your greater knowledge of the theory and would gladly be advised.

      • I do believe, however, that our existing mechanism for collecting resource rents is adequate for this purpose. Perhaps the State’s should be tweaking the exact number a little.

  4. Good article and some good comments here. I agree that currency intervention is a non-starter. Insufficient firepower is available (the Swiss have had that problem as well, IIRC).

    Re 3D1K’s comment on not saving from the boom – at least it has stopped us going into huge debt, like most developed nations. And there has been some private sector saving (or deleveraging) happening. It could have been a whole lot worse.

    What happens from here depends on both commodity prices and export volumes. If the volumes hold up (as they should, with our miners being in the most favourable part of the cost curve) the impact of reduced prices will be cushioned.

    • Agree, without the boom it would have been a whole lot worse. Many don’t seem to acknowledge this, rather focusing on the challenges presented by the reliance on and management of the boom, tending to see it as predominantly a problem rather than a benefit. (Rumple has chosen ‘The Resources Curse’, could have been The Resources Blessing, if negatives eventuate they will be largely post boom!)

      • As Rumple makes clear, it is how you manage the boom that determines its value. You can’t keep pointing back to the credit bubble and saying that mining bailed us out. It may be true but it’s history. What’s happening now is the failure to manage the boom, which sets you up for just another bust later, from which there will be no rescue.

        In fact, it’s kind of hypocritical.

        • ‘You can’t keep pointing back to the credit bubble and saying that mining bailed us out. It may be true but it’s history.’

          Of course you can! We always tend to refer back to evidential support for a position taken. Time honoured practice.

          I agree that the boom could be better managed however I increasingly struggle to see a genuine practical way to do it.

          A SWF or stabilisation fund negated by sectoral imbalance (not to mention lack of political will). A strongly expressed rejection of intervention of any kind. A negotiated MRRT of questionable merit/efficacy. An insatiable bureaucratic welfare entrenched economy (achieves good but at great expense) and so on.

          Basically ‘the nation’ (read government revenues) needs and wants this boom and will not thwart it in any way. Alas, global forces are beyond our control. We remain at core a boom bust commodity economy.

      • Whether we would be better off without the commodity price boom is a debatable point. In the very short run, perhaps we might be. But in the long run, probably not.

        This short-run / long-run trade-off is why the impact of this circumstance on national economies is such a focal point for researchers.

        • Well, sometimes wonderful things rise from the ashes once times get tough and one has to think outside the box.
          In Finland the booming paper exports to Russia went bust around the early nineties, but a small company called NOKIA started to evolve (it was founded much earlier) and succeed. The government created start up incentives for small businesses and new telecommunication & manufacturing businesses turned up as mushrooms from the forest floor, becoming contractors for NOKIA. Some of the most successful businesses of that time were created in small towns up in northern Finland. You know how big that small company grew until recent troubles. This success story came from a country with a population of 5 million in total!

          My point is that one should not under estimate the power of supporting small business, research and innovation.

  5. Would a logarithmic graph take out some of the extreme values overshadowing the low volatility periods? Not sure if that’d work at this kind of scale, or even if it’d be meaningful in the context, just a thought.

  6. I love MB and I read it with great interest and respect, but I am amazed how the people who have lived all their life in the Western world know so little about capitalism and its evolution. It amazes me how they are shocked or surprised to learn unpleasant facts and truth about economy in general and its prospects. Using graphs and data can give us the picture of the past and maybe some near forecast. Using our mind and logic, our power to think and see the big picture and the invisible under the surface of political and economic events, can give us the truth. Very few people in history had this intellectual power of seeing the big picture and evolution of reality, the meaning of small steps, which through time make the big changes. We are surprised when those changes become obvious for all of us, but we are unable to see behind the small, marginal, but numerous and sometimes, insignificant changes, the new quality which will emerge later to slap us in the face with all unpleasant and unexpected consequences. We always wait for some data to be ready and then to comment on economy. The economy is not an equation, but a system driven by human group interests. We don’t need much data to be able to understand what is going on and where is going to.

  7. Would reforming the tax system to favour business that produce physical products, or provide services, ahead of speculative type investment help?

    It just seems that everything is tilted against , for want of a better word, ‘real’ businesses in this country, and it’s the FIRE sector, not mining that is the real problem here.

  8. I could not agree more about a diversified economy smoothing out the volatility of terms of trade that apply to an economy that sticks to only a few things. Another major yet overlooked factor in this, is that inflated urban land prices and obstructive urban planning, cause urban based industry (i.e. most of the stuff that wealth creation actually depends most on these days) to lose productivity, have higher costs, and generally under-perform.
    The McKinsey Institute pointed this out in 1998 in “Driving Productivity and Growth in the UK Economy”. They blamed the UK’s “Town and Country Planning” system for the UK’s productivity being 20% below Germany, France, and the Netherlands, and 40% below the USA.
    Australia is probably in the process of doing similar things to ITS urban producers, if we interpret the data intelligently. The recent OECD Report on Australia certainly seemed to share this concern.