Institutional Quality And The Curse Of Natural Resources

The quality of a country''s political institutions determines whether an endowment of natural resources turns out to be a curse or a blessing. Where governments and regulators are weak and corruption widespread, natural resources will have a negative relationship with the ''human capital'' or educational attainment of the population, a key indicator of economic development. But where institutions are strong, the relationship between natural resources and human capital is positive.

These are the central findings of research by Professors Antonio Cabrales and Esther Hauk, published in the March 2011 issue of the Economic Journal. Their analysis also explains why natural resources not only reduce growth when institutions are weak, but they can also weaken political competition, further reducing institutional quality. This is most likely to happen when the country has high levels of natural wealth per capita.

The study suggests that the relationship between natural resources and education is determined by the threats to a country''s rulers'' hold on power. If the main threat comes from electoral competition, rulers'' incentives will be to provide more education for the population as that will win votes. But if the main threat is from violent revolution, rulers'' incentives will be exactly the opposite since educated people are more likely to rebel.

The research focuses on what is often called the ''curse'' of natural resources, which refers to the evidence that countries with greater natural endowments grew more slowly than the rest in the second half of the twentieth century. A related phenomenon is ''Dutch disease'', a term apparently invented by The Economist to describe stagnation in the Netherlands as a result of the discovery of a large natural gas field.

The standard explanation of Dutch disease is that the discovery and exploitation of natural resources usually leads to large profits. These profits then induce entry into the mining industry at the expense of other sectors, increasing national income and demand, which creates inflationary pressures.

At the same time, a trade surplus is generated by capital inflows and the real exchange rate appreciates. This makes the profits of other exporters fall sharply, which attracts even more capacity into the natural resources sector. The long-term consequences, once the boom ends, are stagflation and an overvalued real exchange rate.

The problem is that the curse does not affect all countries homogeneously. Some countries, including the Netherlands, seem to be immune to the disease. And Australia, Botswana, Canada and Norway have all developed without serious problems despite having abundant natural resources.

This study presents empirical evidence showing that the quality of institutions determines whether natural resources are a curse or a blessing. The authors find that the correlation between natural resources and human capital is negative for countries with low levels of institutional quality and positive for countries with high institutional quality.

To measure institutional quality, the researchers use indicators developed by the World Bank, such as government effectiveness, control of corruption and regulatory quality. Human capital is measured by the population''s average number of years of schooling.

To explain their observations, the authors develop a political theory that connects natural resources with education. They posit that in any country, the current rulers face two types of potential threats to their power. The first comes from elections.

In the presence of vigorous electoral competition, parties compete on the basis of providing training opportunities to the population, the efficient way to provide extra resources.

But when electoral competition is not a sufficiently strong threat (either because there are no elections or because the opposition is made ineffective in various ways), rulers are more worried about violent revolution. In that case, the powerful are afraid of education: an educated population is more prone to rebellion, because they know that if they do revolt successfully, they will manage resources more efficiently.

In that scenario, rulers prefer to offer panem et circenses rather than a good mathematics course to keep competition – that is, revolution – at bay.

This analysis can also explain why natural resources not only reduce growth when institutions are weak, but they can also weaken political competition itself, making the circle even more vicious. This is not always the case, because there are several forces at work.

As resources increase, the government can pay higher direct transfers, thus increasing its chances of winning. On the other hand, the competitors can also offer better terms, especially through higher human capital.

The effect of higher direct transfers (that is, when resources are worse for competition) tends to dominate for high levels of per capita natural wealth, whereas the effect of human capital (so that resources improve competition) tends to dominate for lower levels of per capita natural wealth.

''The Quality of Political Institutions and the Curse of Natural Resources'' by Antonio Cabrales and Esther Hauk is published in the March 2011 issue of the Economic Journal.