Natural Resources and the Terms of Trade

I stumbled on this while looking for something else – the Singer-Prebisch thesis. What Singer and Prebisch found (separately and concurrently) is that the terms of trade between primary commodities and manufactures was declining over time. If true, this empirical observation has profound implications for economic development.

Let me explain that in English.

The terms of trade, put simply, is the amount of imports you can “buy” with one unit of exports. In other words, it measures the purchasing power of exports.

If your terms of trade are declining over time, you have to keep producing more and more just to be able to afford the same quantity and value of imports. But commodity production is subject to inelastic supply – it’s extremely difficult to continually ramp up production.

Oil exploration is an expensive, time-consuming and highly speculative business – other minerals no less so. Agriculture (such as palm oil) is subject to weather, the availability of land, and other supply constraints such as irrigation and fertiliser supply. Both primary sectors also have long lag times between initiating production and actually producing anything.

So commodity producers are always playing catch-up, more so since commodity prices are much more volatile than that for manufactured articles. The bottom line implication is – a development strategy based on natural resource exploitation or agriculture production is doomed to fail.

It was that realisation (along with related ideologies such as dependency theory) that prompted the shift to a development strategy based on import substitution industries (ISI) for much of the developing world in the 1950s and 1960s, based on the seeming success of the Soviet model of development with its five year plans and heavy government intervention. A coterie of countries in East Asia went the other way, adopting an export oriented (EOI) strategy. That one approach was a success and the other a failure doesn’t invalidate the initial impetus, that primary commodity production wasn’t the way to prosperity.

But is the Singer-Prebisch thesis true? From what I’ve seen from a quick search of the literature (here for example), the answer is yes and no.

For one, at the risk of over-generalising, the thesis is true of some commodities but not of others. Food doesn’t appear to have the problem of declining terms of trade, while the opposite is true of minerals and agricultural commodities used in industry – the evidence does indeed show a decline in the terms of trade over time. Another finding is that there is in fact no secular downward “trend”, but instead a series of downward shifts, with relative stability in between. But this latter finding doesn’t invalidate the Singer-Prebisch thesis, only allowing a closer examination of its underlying causes.

Whatever the case, here’s one more reason why having natural resources won’t make you rich.