I J Macfarlane: Geography, resources or institutions?
Talk by Mr I J Macfarlane, Governor of the Reserve Bank of Australia, to "The Bottom Line" Luncheon,
Melbourne, 25 August 2004.
* * *
It is always a pleasure to be in Melbourne, particularly when I am in these gracious and peaceful
surroundings and contributing to such a good cause as the Bottom Line Luncheon. By a strange
coincidence the Patron of the Foundation is Hugh Morgan, my fellow Board Member of the Reserve
Bank, and the Chairman is Professor Adrian Polglase, an old school friend. How could I refuse the
invitation to speak today?
I notice on the invitation that I am listed as speaking about the economic outlook. I am afraid the
author of the invitation took a few liberties here, and so I will disappoint those who are expecting an
analysis of current economic conditions and prospects. We at the Reserve Bank put out an exhaustive
account of these earlier in the month and my deputy elaborated on them a week ago. A third rendition
within a month would be counter-productive, so I will speak on a different topic, although it could be
considered my views on the economic outlook in a very long-term sense.
I would like to look at the factors that shape the economic success of a country in the very long run -
that is, over the centuries - and, of course, I will pay particular attention to Australia. I propose to do
this by briefly examining four factors which influence growth, and which can be summarised by four
distinctive catchphrases: the tyranny of distance, geography is destiny, the resource curse, and
institutions matter.
(a) The tyranny of distance
The first factor is a country's position on the map - its distance from other countries or its degree of
isolation. My remarks on this will necessarily be heavily influenced by Geoffrey Blainey's classic study
which originated the term.
We have always assumed that Australia was at a disadvantage because of its relative isolation from
the world's great centres of commerce. This has certainly been true from the beginning. The late start
of European settlement was not just because they took so long to find us, or that for the first two
hundred years Europeans only sighted the barren north west coast. Even if they had found the
temperate east coast two hundred years before Cook, there would not have been an economic reason
to occupy the land. There were no valuables to be exchanged with the native population, such as
precious metals and spices, and no case for permanent settlement because the American continent
offered everything we could offer and was much closer. It was only a couple of coincidences that
caused the British Government to take the extraordinary decision to establish a settlement at a place
only once visited, and at the other end of the earth.
This isolation continued to disadvantage us economically despite our abundant resources and
relatively small population. Transport costs were enormous and delays immense. It took five months to
reach England by sail, and even when steam replaced sail and modern ocean liners replaced steam, it
still took about four weeks for the journey. Air travel has shortened it to about 24 hours, but it took
ages for us to forget our old attitudes.
We were accustomed to an overseas trip, even a business trip, being a long drawn-out affair. We had
occasions before air travel when Australian Prime Ministers would spend more than a year at a time in
London. Going over old Reserve Bank records of the 1960s and 1970s, I noticed earlier Governors
going on business trips that lasted seven weeks. Today a one-week business trip is a long one.
Modern transport and communications have enormously reduced the tyranny of distance, even if it has
made our lives more hurried.
The other factor that has reduced the tyranny of distance for us is the growth of Asia. The Atlantic
Ocean, with Europe and America on each side, is no longer the undisputed centre of world economic
activity. Asia and the Pacific Rim, while not as rich as the Atlantic, are clearly the area of fastest
growth and largest population. This has presented enormous opportunities for Australia and, by and
large, we have been adaptable enough to seize the chances offered. But it still has not completely
dispelled the tyranny of distance. For example, many international companies headquartered in the
United States or Europe still find it more convenient to put their Asian headquarters in Singapore,
Hong Kong or Tokyo because they are only one flight away from headquarters, whereas major
Australian cities are two flights away. We should also remember that Australia's capital cities are in its
southern half, while the capitals of our big trading partners - Tokyo, Seoul and Beijing - are in northern
Asia. It would be easier if we were talking about Darwin and Jakarta, but that is not where the real
action is.
(b) Geography is destiny
It is widely believed that geography determines whether a country will be rich or poor. This is because
most of the world's poorest countries are nearer to the equator than the richer ones. Being in the
tropics is thus regarded as condemning a country to relative poverty. Of course, this does not have
much relevance for Australia because the populous two-thirds of our country is in the temperate zone.
But it is also interesting to reflect on the question of why we should expect a hot climate to be
associated with poverty. It certainly was not always so; in fact it was the opposite. For example, in
pre-Columbian America, it was the hot areas populated by Aztecs, Incas and Mayans that were richer
than the temperate areas. In 1667, under the Treaty of Breda, the Dutch gave up their claims on
Manhattan to the English in order to retain the island of Run (in what is now Indonesia). The superior
value they placed on Run was due to its being the world's principal source of nutmeg. In the
18th century, France had only enough armed forces to protect one of its two main American
possessions - Canada and Haiti. It chose the latter because it was more valuable, being a major
producer of sugar.
Even in recent years, some of the success stories among developing economies have been in tropical
climates - Singapore, Hong Kong, Thailand, Malaysia and, until recently, Indonesia. Certainly, a
tropical climate does not condemn a country to poverty, even if most of the world's poverty is in the
tropics. As I will explain later, the correlation between geography and poverty can be explained at a
deeper level by institutional factors and the incentives that businesses and workers face. There is,
however, a lot of evidence suggesting that to be landlocked and in the tropics is so big a disadvantage
that no country has yet overcome it. Sub-Saharan Africa is the best example of this.
(c) The resource curse
There is a widespread view that countries with abundant resources (particularly of minerals and oil)
under-perform resource-poor countries. There is even some statistical evidence to suggest that this
on average
has happened over the post-war period.1
The arguments behind this relationship are based on the belief that:
•
possession of resources is a windfall which makes the community less energetic in pursuing
other economic activities;
•
resource extraction is a low-tech/low value-added activity; and
•
the price of resources inevitably falls relative to the price of manufactured goods.
on average
The first response to this thesis is to recognise that, even if true, it only applies and that
there are many cases where the opposite applies. We are all aware of the failure of countries such as
Nigeria and Venezuela to capitalise on their oil reserves, the Congo (Democratic Republic) on its
copper, or Argentina on its pastoral resources. But could anyone suggest that rich countries such as
Australia or Canada have been disadvantaged by their possession of mineral wealth. A better
example still is the United States, "which was the world's leading mineral economy in the very
historical period during which it became the world's leader in manufacturing (roughly between 1890
and 1910)."2 The answer again is that economic success or failure depends on the institutions and
incentives. Those countries that get these right will not suffer a resource curse, but those that get them
wrong and allow policy to be dominated by a self-defeating battle over economic rents will
under-perform.
The assumption that the extractive industries are low-tech is also quite wrong. If they are conducted
efficiently, they are very knowledge intensive and research is continuing to lead to many technological
breakthroughs. Of course, it was not always so. "Australia was a leading gold-mining country in the
nineteenth century, but was an under-achiever with respect to virtually every other mineral, particularly
coal, iron ore and bauxite. . . . Australia's share of world production lagged well behind its actual share
of mineral wealth (based on modern estimates). In a nation with a strong mining sector and a cultural
heritage similar to that of the United States, why should this have been so?"3
The answer is that we did not have the right set of institutions or sufficient technical know-how to
compete with the world's best. That is no longer the case since a complete change of mindset in the
1960s. For example, R & D expenditure by the mining sector now accounts for almost 20 per cent of
R & D by all industries in Australia, and we lead the world in mining software, with one estimate
suggesting we now supply 60 to 70 per cent of mining software worldwide.4
On the third point about the prices of resources falling relative to the prices of manufactured goods, I
will say little because I have covered this point so many times before. Suffice to say that after an
80-year trend-fall, Australia's Terms of Trade - which is the ratio of our resource-intensive export
prices to our manufacturing-intensive import prices - bottomed in 1985 but have on average risen
since. More importantly, few now doubt that it is manufacturing prices which are under continued
downward pressure as a result of the rapid expansion of capacity in Asia, particularly in China.
(d) Institutions matter
More and more, development economists and economic historians are coming to the conclusion that,
at the deepest level, a sound institutional framework is the crucial ingredient for sustained economic
performance, and that it is far more important than distance, geography or the presence of resources.
One only has to look at the extreme differences in economic performance between South and North
Korea, or West and (formerly) East Germany to see how different institutions can outweigh the same
geography, culture and resources. The different economic performance of Australia and Argentina is
another clear case, as is the more general economic superiority of the former British colonies over the
former Spanish colonies, which has been a subject of recent studies emphasising the importance of
institutions over geography.5
What are the "deep" institutions that are conducive to sustained economic performance?
•
The first one is the enforcement of property rights. No-one will venture capital for an
economic project if success leads to confiscation by the government or other powerful
forces. Thus, the enforcement of property rights means a strong body of commercial law
(particularly the law of contract), impartial courts, honest police force, etc. It also means
eliminating, or at least minimising, corruption. It often used to be thought that corruption
"greased the wheels of commerce" and helped things get done. But modern research has
unequivocally shown the higher the level of corruption, the worse the economic
performance.6
• The second institutional requirement is constraints on the ability of government or other
elites to exercise arbitrary power. This usually means an open society, democratic political
system and a free press, but I would also add institutions that encourage competition by
challenging monopoly powers. An important ally in this is the openness of the economy to
international trade in goods and ideas, which has been shown to have a significant
correlation with economic performance.7
•
Some degree of equal opportunity so that people can invest in human capital formation. In
this area, by far the most important component is access to education and an economic
structure where positions of importance and authority are open to all comers on the basis of
merit.
The term "deep" is used to describe the above institutions because they are embedded in laws,
constitutions and culture and are not amenable to quick change. In addition to the deep institutional
framework, there are a number of other practices and policies that a country has to get right in order to
achieve sustained growth in living standards. The most obvious ones, from my perspective, are sound
monetary and fiscal policy and a resilient exchange rate regime, but there are many more that space
does not permit me to list.
It takes decades, or perhaps centuries, for deep institutions to evolve, and many attempts to simply
impose these institutions in developing countries have failed. But that does not mean the process
should not be continued, only that it needs to be done more sympathetically whereby the local
population become more involved and can feel they own the reforms.
For countries like Australia, that start with basically good deep institutions, the job of maintaining the
standard is easier, but it still requires constant attention and change. For every reform that protects the
weak against the strong, there are other reforms that break down some cosy arrangement and thus
reduce the level of security for the weak or for the weak and strong alike. Useful reforms will often be
opposed by either organised labour or organised business, and sometimes the one reform will be
simultaneously opposed by both. It is always difficult when a reform has major distributional
consequences.
Fortunately, in my own area the distributional consequences are of secondary importance, and with
the benefit of hindsight, reform has been easier than in many other areas. The transition from a
monetary policy regime that had quite short horizons, a multitude of aims and where daily decisions
were taken politically as in the 1970s and 1980s, to the one we have today was achieved within a
decade. It is often the case that reforms that seemed difficult at the time are well accepted in
retrospect, and may even come to be seen as inevitable. The present monetary policy regime based
on central bank independence and an inflation target was controversial a decade ago, but with good
results now on the board it has undoubted bilateral political and community support. Similarly, the
floating of the exchange rate was a decision that was hotly debated over a long period, but does
anyone want to go back to any of the variants on a fixed exchange rate regime that preceded it? More
controversial were the reductions in tariffs that have occurred over the past thirty years, but here again
there are few voices that would wish to turn the clock back. Or would we wish to go back to the
immigration policy we had during the first half of the twentieth century? The list could go on and on.
It is the nature of a first-rate democratic country that it will constantly be involved in economic reforms,
or at least constant updating of its economic framework, and that the changes involved will generate
political uncertainty and resistance. But that is the price of achieving and maintaining a first-rate set of
institutions, and that is an essential condition for our continuing economic prosperity.
Bibiliography
Acemoglu, D., Johnson, S. and Robinson, J., "Reversal of Fortune: Geography and Institutions in the
Making of the Modern World Income Distribution", Quarterly Journal of Economics, November 2002.
Auty, R., "The Political Economy of Resource-Driven Growth", European Economic Review, 45, 2001.
Baldwin, R.E., "Openness and Growth: What's the Empirical Relationship?", NBER Working Paper
9578, 2003.
Blainey, G., The Tyranny of Distance, Macmillan, revised edition 2001.
Dowrick, S., "Openness and Growth", in International Integration of the Australian Economy, Reserve
Bank of Australia, July 1994.
Gylfason, T., "Institutions and Economic Performance", CESifo DICE Report 2/2004.
Quarterly Journal of
Mauro, P., "Corruption and Growth", Economics, Vol. 110, No. 3, 1995.
Sachs, J. and Warner, A., "The Curse of Natural Resources", European Economic Review, May 2001.
Sachs, J., "Institutions Matter, But Not for Everything", Finance and Development, June 2003.
Stoeckel, A., Minerals: Our Wealth Down Under, Canberra, Centre for International Economics, 1994.
Wright, G. and Czelusta, J., "The Myth of the Resource Curse", Challenge, March/April 2004.