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     Nov 5, '13

Economic complexity pays
By Martin Hutchinson

John Authers, writing in the Financial Times on October 28, suggests societies succeed, not because of their resources but because of their knowledge and the economic complexity to which it leads. MIT's Atlas of Economic Complexity reinforces this thesis, producing visually very attractive graphics of such matters as a country's exports, showing where its economic strengths truly lie.

Although like all "single cause" theories this is over-simplified, I think this is in essence right; it has a number of interesting implications for international investment and governance.

There is not one factor that enables a country to become rich, there are three: resources, governance and

knowledge/complexity. As is well known, resources alone are normally not enough; the world is full of examples of the "resource curse" in which resource-rich countries fail to develop properly and become state-dominated kleptocracies.

The problem here is the state. If the resources are truly bountiful and the state fairly small, development may occur anyway. The Gulf States are a good example of this; by developing world-class educational institutions with the resource bounty and by avoiding massive welfare schemes in the early stages, those countries have developed a substantial educated middle class that is able to produce a genuinely wealthy country. Dubai is not a chimaera as a business center; it is able to compete with Singapore as an entrepot because the oil money from the region was used to develop non-oil businesses.

Resources were also genuinely helpful to enrichment in the colonial era, when relatively disinterested and uncorrupt governments were keen to attract a workforce to exploit the resources without that workforce controlling its own destiny. Thus colonial America, once it got properly under way, was the richest society of its time, according to Adam Smith - and from Pennsylvania northwards, slave labor played little direct part in that wealth. Similarly, nineteenth-century Australia and Argentina were among their era's richest societies; economic decline (relative only, in Australia's case) occurred only after they gave the workforce the vote.

Enrichment by resources alone thus appears to be more or less incompatible with democracy - though as Africa has shown, democracy may be the least bad alternative even in these cases if there is no colonial ruler.

The problem is that the resources, either controlled by the state or subject to large royalty payments to it, make the state the principal source of wealth and influence, inhibiting development of local businesses and fostering corruption of many different kinds. It doesn't matter whether the regime is nominally a "right-wing" dictatorship, a left-wing democracy as in Venezuela and Argentina, or a mixture of the two, as in Russia - the state keeps people poor, by whatever means.

At the other extreme, societies with few resources, which have had to develop extensive networks of capabilities, are much more difficult for the public sector to dominate. Here there is no wealth, other than what's produced by private sector manufacturing, services and agriculture (and agriculture is not completely dominant, as in Argentina). Hence the state only gets money by extracting it from local people, which is unpopular and beyond a certain point difficult.

What's more, whereas the state can easily hire miners or oilmen to extract resources, it finds it much more difficult to run manufacturing or service business effectively. France proved in the 1980s that the state was incapable of running nationalized banks, while innumerable examples, not least Britain, but also the old Soviet bloc, have proved that the state is incapable of running even the simplest heavy industry, let alone light industry or services.

The triangle of resources, skills and governance is thus easily explained: resources sap the quality of governance, whereas skills nurture it, not least by producing a property-owning middle and skilled working class with a stake in the system and enough savvy to spot at least some of the nastier sorts of politicians running for office. Even if nasty politicians are elected, unless they're homicidal maniacs (a caveat made necessary by the very high-skill German electorate's brainstorm in 1933) there's not too much damage they can do; when they're gone the economy remains high-skill and economic growth can resume.

There are of course a couple of exceptions. Chile is the most developed economy in Latin America, with the best governance, in spite of its heavy domination by resources, though to be fair its agriculture, consisting largely of fruit and wine, is relatively high-skill and not easily dominated by the state. That's because it was lucky enough to get an un-corrupt and capable dictator in Augusto Pinochet, who set up governance systems that survived the transition to democracy and have served Chile well to this day.

Norway, too, gained its resource endowment after becoming relatively rich, and has managed to prevent it being frittered away in Nordic welfare schemes that could have enervated its populace.

At the other extreme India, a highly sophisticated economy by contemporary standards before the British arrival, has been bedeviled by an overblown government since 1947, and has been unable to break through into prosperity even though much of its economy is very high skill indeed. If its people are foolish enough to continue the Congress party in power, India will deserve to remain mired in poverty. My guess is that in 2014 the Indian electorate will do the right thing; it remains to be seen whether the current opposition will have the capability and vision of the great Atal Bihari Vajpayee, who in 1998-2004 put India temporarily on the road to free-market prosperity before being disgracefully voted out of power.

For investors, the message is clear. Avoid resource-based economies, unless like Canada and Australia they are already rich - the local government needs your money and will be only too willing to seize it.

Conversely, the best investments are in those countries that, though still relatively poor (thus with competitive labor costs) have developed a broad industrial base that can be built upon. As Authers points out, Mexico has recently become a good example of such an economy. Since the 1980s, its resource base has stagnated, as the state has sucked all the revenues out of the national oil company Pemex and starved it of both capability and investment.

However, the passage of the North American Free Trade Agreement in 1994 has led innumerable US companies to set up manufacturing facilities in Mexico to take advantage of its lower labor costs. After 20 years of this, Mexican workers and managers have developed a capability of their own that can be and is being used to develop a stand-alone manufacturing capability in many areas.

Another country where a stagnant, even declining resource base has given way to a vibrant non-resource economy is Nigeria. Here the oil sector is actually declining, but the remaining economy is growing at around 8%, fast enough to get ahead of even the country's African rate of population growth (which in any case is beginning to decline at last).

The risks in Nigeria remain high; a collapse in oil prices could de-stabilize the country's finances, while a 2008-type oil price spike could intensify even Nigeria's level of corruption by giving the government more money than is good for it. Still, if you see the right opportunity, the opportunities for growth are sufficiently exciting to make it worth the risk.

Ghana, conversely, may be going in the wrong direction as the result of the opening of its large Jubilee offshore oil field. Public spending is rising at a staggering rate, while the private sector is being starved by a surge in the exchange rate and fly-by-night foreign investment. Effectively, if current trends continue, the economy's current quite-high rate of knowledge and manufacturing breadth will decay, and it will revert to domination by commodity sectors.

Eastern Europe is another region where a considerable level of technological sophistication should make the region richer than it is today. Here the problem is that before 1990, much of the region's capability was hopelessly uncompetitive in terms of cost or product - the engineering skill to manufacture the former East German Trabant automobile is not in much demand. However, with the passage of time, the underlying skills in the region have been redeployed into more useful areas, aided by massive cross-border investment from the West.

That gives Ukraine great potential also, if it can get its political act together. Unlike Russia, it cannot rely on immense oil and gas reserves, and its high-level engineering skills require updating, probably through massive foreign investment. Hence a wise Ukrainian government would exert every effort to form a free trade treaty with the European Union, allowing investment to flood in and skills to be upgraded. Conversely, alignment with the backward, commodity-dependent Russia is a dead end.

As always, brains and skills beat natural endowments, and may even produce the better governance to make good use of them.

Martin Hutchinson is the author of Great Conservatives (Academica Press, 2005) - details can be found on the website www.greatconservatives.com - and co-author with Professor Kevin Dowd of Alchemists of Loss (Wiley, 2010). Both are now available on Amazon.com, Great Conservatives only in a Kindle edition, Alchemists of Loss in both Kindle and print editions.

(Republished with permission from PrudentBear.com. Copyright 2005-13 David W Tice & Associates.)




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