- Email: [email protected]
Price stability or resource transfer?
Conference rep&Book reviews ses of recent years in his paper on ‘Mining in jeopardy’. Written, as it was, before the 19 October stock market crash, his paper was as prescient as ever. In essence, he was optimistic that there will be a return to investment in tangibles and economic growth in the early or mid-1990s that
will greatly benefit the mining industry. All those involved in that industry can only hope that his projections are more firmly based than the more gloomy views of several other speakers at this fascinating conference. Most of the papers are published in Copper 87, Vol 1, Perspectives of the
Book reviews Price stability or resource transfer? STABILIZING SPECULATIVE COMMODITY MARKETS S. Ghosh, C.I. Hughes Hallett Clarendon pp, f39.50
Gilbert
Press, Oxford,
and
A.J.
1987, 448
Professional economists, policy makers and students will find this well founded and comprehensive study, based on the application of econometric analysis to recent advances in economic theory, a useful contribution to an understanding of the functioning and outcome of commodity markets. The prescriptive part of the book will be of special interest to policy makers because it deals with a central but confrontational element in international economic relations between commodity exporting developing countries and developed market economy countries. It is unlikely, however, that the authors’ arguments for an interventionist policy will succeed in changing the current policy on commodity agreements for two reasons. The first is that since the argument that the markets are not Pareto optimal could apply to all markets, thus bringing into question the foundations of the market economy system, it needs to be more compelling than it is. Second, it is not clear how intervention will necessarily improve the market outcome, even in cases where the authors consider that the market is not Pareto optimal, simply because the criterion for evaluating the resulting normative income
RESOURCES
POLICY March
1988
distribution is changed so that it can be considered a priori a ‘public good’. The analysis in the book explains the lack of uniformity in current policy in respect of commodity agreements and throws light on the contrasting features of the two types of commodity agreements with economic objectives currently in force. The first type consists of those agreements that support and stabilize prices such as the International Coffee Agreement (ICA) (the International Tin Agreement (ITA) is another example). The second type includes those that correspond to the market - market duplicating agreements - such as the International Cocoa Agreement (ICCA) and the International Natural Rubber Agreement (INRA). The main features of price supporting agreements are that prices are normatively set and the means to support them within a very narrow range are open ended. The main implications of these features are that prices are stable, are not set competitively, resource transfers occur - since the price level is not ‘about its longterm equilibrium level’ - and intervention is continuous. Because the economic circumstances of individual producing and consuming countries concerned differ widely, such transfer is rightly considered ‘an inefficient means of redistributing world’s resources’. The main features of market duplicating agreements are that prices are determined by the market and set within a wide parametric price range which, if the market price moves
Copper Industry and Physical Metallurgy of Copper, University of Chile, 1987.
P. C. F. 0-o wson The RTZ Corporation London
outside it, is adjusted so that the market price is once again within the revised parametric price range. This revision allows intervention which occurs only when the price is outside the parametric range to be both temporary and modest. Second, the means to support prices are limited and conditional on revisions of the price range. The essential implications of this type of agreement are first, that the market price trend is in line with the long-term equilibrium trend since this is not obscured by open ended and prolonged intervention so that resource transfers are either avoided or significantly reduced. Second, the degree of price stability is not different from that determined by market fluctuations since the parametric price range is updated almost continuously in line with market changes. Thus intervention temporarily suppresses fluctuations, which does not necessarily mean that it reduces them. Market duplicating agreements, therefore, avoid resource transfers by ensuring that the price level is ‘about its longterm equilibrium level or trend’, but are not able simultaneously to reduce fluctuations. The analytical framework in the book highlights the dilemma in respect of policy regarding commodity agreements which underlies the lack of uniformity. If price stability is the objective then the measures to achieve it entail resource transfers. If the objective is to avoid resource transfers then measures to this end are incompatible with price stability. This is because it is not possible ‘to reduce fluctuations of a commodity price about its long-term equilibrium level or trend’ since this trend cannot be determined ex ante while, ex post, intervention to reduce fluctuations entails a change in the price trend from that set under market conditions and
61
Book reviews so obscures the equilibrium price trend, making updating price adjustments, in the absence of an objective indicator of market equilibrium, a political matter entailing resource transfers. The authors recognize that the central but divisive issue in respect of commodity agreements is one of resource transfers and that unless prices are updated so as to correspond to market conditions resource transfers will occur. They examine the use of econometric analysis to update prices but conclude that the ‘econometric models within commodity agreements is not a proposal that can be taken very seriously’. None the less they opt for intervention on the grounds that though markets are relatively competitive, the outcome is not Pareto optimal and, second, that access to capital markets essential to developing countries is limited. The assumptions underpinning these conclusions are contestable. The practical question from the point of view of policy is whether the authors’ reservation regarding the Pareto optimal outcome and the limitation of access to capital markets will be decisive in resolving the dilemma between price stability combined with resource transfers, and its avoidance combined with indeterminate price stability, and so replace the basis of choice which hitherto depended on a balance of political interests by intervention.
Underinvestment The reservation regarding the Pareto optimal outcome is necessary because markets are not continuous, by which the authors mean that a full set of markets is not available so that ‘agents can buy and sell at all future dates in all contingent states of the world’. In this respect commodity markets, like most markets, are deficient, although most of the other preconditions for market equilibrium are met. Therefore, the authors conclude that if markets are not Pareto efficient the market distribution can be improved by a normative distribution and that consequently there is no basis for market duplicating agreements in which it is presumed that the market
62
outcome is Pareto optimal. The implication of this reservation is that less risky investments will be preferred to investments with higher risk yielding higher incomes. If higher incomes are considered a public good then a policy to intervene to bring about a different distribution of income could be justified on grounds other than those of redistributive equity. The main assumption underlying the reservation is that risk is a function of price instability. An implicit consequence of this assumption is that there should be underinvestment in the commodity sector. There are several difficulties with this argument. Among these, the reservation is limited to a technical precondition and the policy response is still uncertain, partly because it is not clear whether the normative distribution will improve on the market outcome globally and whether the reallocation of costs will be in line with the principles of redistributive justice. Second, the evidence for the assumption that risk is related to price instability is weak, and the evidence - if it exists - regarding underinvestment points in the opposite direction. Third, it is not a simple matter to extend the notion of a public good from the context of national interest to the wider context of relations between states. The arguments against indiscriminate resource transfers will apply to the public good criterion on the grounds that they are improperly targeted because the levels of income of both individual producing and consuming countries are widely different. Last, in the light of the conclusion that ‘notional profits from buffer stock transactions may not offset cost of intervention and the entire world community will be worse off’ and the probability that these notional profits could be further eroded by the restrictive rules under which buffer stocking operations take place, the case for intervention is weakened since even the benefit of higher incomes may be offset by the higher cost of buffer stock intervention resulting from the erosion of notional profits. The authors’ second argument for intervention is that developing countries do not have adequate access to capital markets to undertake hedging
as an alternative means of risk avoidance. Since not all producers are from developing countries, intervention to raise prices in international markets will also benefit producers in developed market economy countries.
Small-scale
operations
Hence such a policy will not be selective so as to channel support to those most requiring it. Moreover, since not all individual developing countries have disadvantaged access to capital markets, the objective of increasing the resources of all these countries to ease bottlenecks of entry into capital markets is too global. Another reason which weakens this argument is that the main obstacle to hedging is not the lack of capital but the scale of operations in developing countries, which is typically small and rural. Since alternative risk avoidance policies, such as diversification, are feasible options, the financing and benefits of such alternatives should be examined with a view to assessing their costeffectiveness against that of intervention. On balance, therefore, it does not seem that these arguments will be decisive in bringing about a change in the present attitude towards commodity agreements. However, since market duplicating agreements are not cost-effective, especially in the light of the financial analysis on stocking, this type of agreement is less likely to be a viable option for accommodating the political pressures to which it responds, and so the choice will be either a price support type of agreement in which political benefits outweigh the economic cost of distributive misallocation or no agreement at all. The book implicitly demonstrates that price stabilization attempts will founder because, in the context of a market economy, a norm constrained by an overriding objective of avoiding resource transfers does not exist in principle, thus making the ideal combination of price stability without resource transfers impossible to implement. The clarification of the implications of price stabilization which results from this book may help to remove the topic of intervention in
RESOURCES
POLICY March 1988
Book
commodity markets from the political agenda. Examined in the context of economic policy, it will be evident that the economic grounds for market duplicating agreements are not sound and that, over the past many years, commodity policy has addressed the wrong questions in respect of the relationship between commodity markets and the needs of developing
countries and that the economic concern about fluctuations in commodity markets was the consequence and not the cause of modest economic growth in commodity dependent developing countries.
P. N. Kirthisingha UNCTAD, Geneva
Intellectually appealing? TOWARDS A NEW IRON AGE? QUANTITATIVE MODELING OF RESOURCE EXHAUSTION Robert B. Gordon, Tjalling C. Koopmans, William B. Nordhaus and Brian J. Skinner Harvard University Press, Cambridge MA, 1987, 184 pp, f 19.95 A colleague of mine on the editorial board of Resources Policy once distinguished between science on the one hand and economics on the other by noting that the purpose of the former is to understand how the world functions, while the latter is concerned with understanding how economic models function. The present book fits neatly into economics when this classification is employed. The authors construct a fairly elaborate model of resource exhaustion and apply it on copper to explore what will happen to copper prices, to the costs of the functions performed with the help of copper and to the macroeconomy over the next century and beyond. The exercise has a distinct smell of the Club of Rome, though admittedly at a considerably higher level of sophistication.
Copper reserves A number of assumptions, some less realistic than others, determine the structure and parameters of the model. Consideration is given only to the USA, and all international trade flows are assumed away. Unexploited copper deposits are assessed at 90 million tons of metal and classified in accord-
RESOURCES
POLICY March
1988
ante with their economic quality. Following the Hotelling rule, the value of these deposits is taken to increase by the rate of interest over the period studied. Old scrap constitutes an additional copper reserve. Common rock is seen as a backstop resource from which copper is extracted after the deposits have been exhausted, but the cost of doing so amounts to $45 per lb. (All values are expressed in constant 1978 dollars. The price of copper in that year was $0.92 per lb.) There is no technological advance and the demand for the services produced with the help of copper is taken to be inelastic to price. Copper substitutes eg aluminium, titanium, iron and silicon are assumed inexhaustible. As the copper price rises over time, an increasing proportion of the services for which copper is used are produced with the help of these substitutes. Substitution in favour of the abundant materials explains the title of the book. The results of the base case model run suggest that by the year 2075 the price of copper will be $51 per lb, 55 times more than in 1978. By that time, substitute materials will have taken over some 90% of the services currently provided with the help of copper. Because of such substitution, the average price of these services need not rise more than sixfold. By altering the assumptions of the base case, the model generates a variety of copper prices in 2075, ranging from $2.7 to $108 per lb. When conceivable rates of technical change in the copper-related industries are introduced, and the time horizon is extended to 2100, the range
reviews
of future copper prices emerging from the model widens to between $0.33 and $199 per lb. The model is also used to test for the macroeconomic impact of copper scarcity. In the base case, the discounted cost of copper exhaustion over 180 years works out at $419 billion. This equals about 1% of the discounted value of the net national product in the USA over the corresponding period. On the alternative assumption that ‘copper disappears, and all copper-equivalent services must be met with substitute materials’, the corresponding cost rises to an incredible 22% of the discounted national product. In my view, the analyses contained in this book can be described as very elegant and intellectually appealing nonsense. Several of the key assumptions of the model have very little relation to the real world as we know it from history. The entire approach to study copper exhaustion in isolation - seems unwarranted. If exhaustion, as defined in the book, will in fact occur, it will affect not only copper, but also substitutes like aluminium, because of the intensive use of energy in producing the latter. The extreme range of results makes the model exercises completely useless, except in satisfying the curiosity of the model constructors. Impressive amounts of high quality intellectual energy have been expended over the past 15 years in the elaboration and refinement of the theory of natural resource exhaustion and the present book is one more example of such efforts. The theoretical constructs have tended to lead their life in separation from the real world. Even where the logic was impeccable, their relevance and usefulness has been highly doubtful. We have yet to see the empirical vindication of any of the key propositions from this branch of economic theory.
Marian Radetzki Institute for International Economic Studies University of Stockholm; and Mineral Economics Department Colorado School of Mines, USA
63
will greatly benefit the mining industry. All those involved in that industry can only hope that his projections are more firmly based than the more gloomy views of several other speakers at this fascinating conference. Most of the papers are published in Copper 87, Vol 1, Perspectives of the
Book reviews Price stability or resource transfer? STABILIZING SPECULATIVE COMMODITY MARKETS S. Ghosh, C.I. Hughes Hallett Clarendon pp, f39.50
Gilbert
Press, Oxford,
and
A.J.
1987, 448
Professional economists, policy makers and students will find this well founded and comprehensive study, based on the application of econometric analysis to recent advances in economic theory, a useful contribution to an understanding of the functioning and outcome of commodity markets. The prescriptive part of the book will be of special interest to policy makers because it deals with a central but confrontational element in international economic relations between commodity exporting developing countries and developed market economy countries. It is unlikely, however, that the authors’ arguments for an interventionist policy will succeed in changing the current policy on commodity agreements for two reasons. The first is that since the argument that the markets are not Pareto optimal could apply to all markets, thus bringing into question the foundations of the market economy system, it needs to be more compelling than it is. Second, it is not clear how intervention will necessarily improve the market outcome, even in cases where the authors consider that the market is not Pareto optimal, simply because the criterion for evaluating the resulting normative income
RESOURCES
POLICY March
1988
distribution is changed so that it can be considered a priori a ‘public good’. The analysis in the book explains the lack of uniformity in current policy in respect of commodity agreements and throws light on the contrasting features of the two types of commodity agreements with economic objectives currently in force. The first type consists of those agreements that support and stabilize prices such as the International Coffee Agreement (ICA) (the International Tin Agreement (ITA) is another example). The second type includes those that correspond to the market - market duplicating agreements - such as the International Cocoa Agreement (ICCA) and the International Natural Rubber Agreement (INRA). The main features of price supporting agreements are that prices are normatively set and the means to support them within a very narrow range are open ended. The main implications of these features are that prices are stable, are not set competitively, resource transfers occur - since the price level is not ‘about its longterm equilibrium level’ - and intervention is continuous. Because the economic circumstances of individual producing and consuming countries concerned differ widely, such transfer is rightly considered ‘an inefficient means of redistributing world’s resources’. The main features of market duplicating agreements are that prices are determined by the market and set within a wide parametric price range which, if the market price moves
Copper Industry and Physical Metallurgy of Copper, University of Chile, 1987.
P. C. F. 0-o wson The RTZ Corporation London
outside it, is adjusted so that the market price is once again within the revised parametric price range. This revision allows intervention which occurs only when the price is outside the parametric range to be both temporary and modest. Second, the means to support prices are limited and conditional on revisions of the price range. The essential implications of this type of agreement are first, that the market price trend is in line with the long-term equilibrium trend since this is not obscured by open ended and prolonged intervention so that resource transfers are either avoided or significantly reduced. Second, the degree of price stability is not different from that determined by market fluctuations since the parametric price range is updated almost continuously in line with market changes. Thus intervention temporarily suppresses fluctuations, which does not necessarily mean that it reduces them. Market duplicating agreements, therefore, avoid resource transfers by ensuring that the price level is ‘about its longterm equilibrium level or trend’, but are not able simultaneously to reduce fluctuations. The analytical framework in the book highlights the dilemma in respect of policy regarding commodity agreements which underlies the lack of uniformity. If price stability is the objective then the measures to achieve it entail resource transfers. If the objective is to avoid resource transfers then measures to this end are incompatible with price stability. This is because it is not possible ‘to reduce fluctuations of a commodity price about its long-term equilibrium level or trend’ since this trend cannot be determined ex ante while, ex post, intervention to reduce fluctuations entails a change in the price trend from that set under market conditions and
61
Book reviews so obscures the equilibrium price trend, making updating price adjustments, in the absence of an objective indicator of market equilibrium, a political matter entailing resource transfers. The authors recognize that the central but divisive issue in respect of commodity agreements is one of resource transfers and that unless prices are updated so as to correspond to market conditions resource transfers will occur. They examine the use of econometric analysis to update prices but conclude that the ‘econometric models within commodity agreements is not a proposal that can be taken very seriously’. None the less they opt for intervention on the grounds that though markets are relatively competitive, the outcome is not Pareto optimal and, second, that access to capital markets essential to developing countries is limited. The assumptions underpinning these conclusions are contestable. The practical question from the point of view of policy is whether the authors’ reservation regarding the Pareto optimal outcome and the limitation of access to capital markets will be decisive in resolving the dilemma between price stability combined with resource transfers, and its avoidance combined with indeterminate price stability, and so replace the basis of choice which hitherto depended on a balance of political interests by intervention.
Underinvestment The reservation regarding the Pareto optimal outcome is necessary because markets are not continuous, by which the authors mean that a full set of markets is not available so that ‘agents can buy and sell at all future dates in all contingent states of the world’. In this respect commodity markets, like most markets, are deficient, although most of the other preconditions for market equilibrium are met. Therefore, the authors conclude that if markets are not Pareto efficient the market distribution can be improved by a normative distribution and that consequently there is no basis for market duplicating agreements in which it is presumed that the market
62
outcome is Pareto optimal. The implication of this reservation is that less risky investments will be preferred to investments with higher risk yielding higher incomes. If higher incomes are considered a public good then a policy to intervene to bring about a different distribution of income could be justified on grounds other than those of redistributive equity. The main assumption underlying the reservation is that risk is a function of price instability. An implicit consequence of this assumption is that there should be underinvestment in the commodity sector. There are several difficulties with this argument. Among these, the reservation is limited to a technical precondition and the policy response is still uncertain, partly because it is not clear whether the normative distribution will improve on the market outcome globally and whether the reallocation of costs will be in line with the principles of redistributive justice. Second, the evidence for the assumption that risk is related to price instability is weak, and the evidence - if it exists - regarding underinvestment points in the opposite direction. Third, it is not a simple matter to extend the notion of a public good from the context of national interest to the wider context of relations between states. The arguments against indiscriminate resource transfers will apply to the public good criterion on the grounds that they are improperly targeted because the levels of income of both individual producing and consuming countries are widely different. Last, in the light of the conclusion that ‘notional profits from buffer stock transactions may not offset cost of intervention and the entire world community will be worse off’ and the probability that these notional profits could be further eroded by the restrictive rules under which buffer stocking operations take place, the case for intervention is weakened since even the benefit of higher incomes may be offset by the higher cost of buffer stock intervention resulting from the erosion of notional profits. The authors’ second argument for intervention is that developing countries do not have adequate access to capital markets to undertake hedging
as an alternative means of risk avoidance. Since not all producers are from developing countries, intervention to raise prices in international markets will also benefit producers in developed market economy countries.
Small-scale
operations
Hence such a policy will not be selective so as to channel support to those most requiring it. Moreover, since not all individual developing countries have disadvantaged access to capital markets, the objective of increasing the resources of all these countries to ease bottlenecks of entry into capital markets is too global. Another reason which weakens this argument is that the main obstacle to hedging is not the lack of capital but the scale of operations in developing countries, which is typically small and rural. Since alternative risk avoidance policies, such as diversification, are feasible options, the financing and benefits of such alternatives should be examined with a view to assessing their costeffectiveness against that of intervention. On balance, therefore, it does not seem that these arguments will be decisive in bringing about a change in the present attitude towards commodity agreements. However, since market duplicating agreements are not cost-effective, especially in the light of the financial analysis on stocking, this type of agreement is less likely to be a viable option for accommodating the political pressures to which it responds, and so the choice will be either a price support type of agreement in which political benefits outweigh the economic cost of distributive misallocation or no agreement at all. The book implicitly demonstrates that price stabilization attempts will founder because, in the context of a market economy, a norm constrained by an overriding objective of avoiding resource transfers does not exist in principle, thus making the ideal combination of price stability without resource transfers impossible to implement. The clarification of the implications of price stabilization which results from this book may help to remove the topic of intervention in
RESOURCES
POLICY March 1988
Book
commodity markets from the political agenda. Examined in the context of economic policy, it will be evident that the economic grounds for market duplicating agreements are not sound and that, over the past many years, commodity policy has addressed the wrong questions in respect of the relationship between commodity markets and the needs of developing
countries and that the economic concern about fluctuations in commodity markets was the consequence and not the cause of modest economic growth in commodity dependent developing countries.
P. N. Kirthisingha UNCTAD, Geneva
Intellectually appealing? TOWARDS A NEW IRON AGE? QUANTITATIVE MODELING OF RESOURCE EXHAUSTION Robert B. Gordon, Tjalling C. Koopmans, William B. Nordhaus and Brian J. Skinner Harvard University Press, Cambridge MA, 1987, 184 pp, f 19.95 A colleague of mine on the editorial board of Resources Policy once distinguished between science on the one hand and economics on the other by noting that the purpose of the former is to understand how the world functions, while the latter is concerned with understanding how economic models function. The present book fits neatly into economics when this classification is employed. The authors construct a fairly elaborate model of resource exhaustion and apply it on copper to explore what will happen to copper prices, to the costs of the functions performed with the help of copper and to the macroeconomy over the next century and beyond. The exercise has a distinct smell of the Club of Rome, though admittedly at a considerably higher level of sophistication.
Copper reserves A number of assumptions, some less realistic than others, determine the structure and parameters of the model. Consideration is given only to the USA, and all international trade flows are assumed away. Unexploited copper deposits are assessed at 90 million tons of metal and classified in accord-
RESOURCES
POLICY March
1988
ante with their economic quality. Following the Hotelling rule, the value of these deposits is taken to increase by the rate of interest over the period studied. Old scrap constitutes an additional copper reserve. Common rock is seen as a backstop resource from which copper is extracted after the deposits have been exhausted, but the cost of doing so amounts to $45 per lb. (All values are expressed in constant 1978 dollars. The price of copper in that year was $0.92 per lb.) There is no technological advance and the demand for the services produced with the help of copper is taken to be inelastic to price. Copper substitutes eg aluminium, titanium, iron and silicon are assumed inexhaustible. As the copper price rises over time, an increasing proportion of the services for which copper is used are produced with the help of these substitutes. Substitution in favour of the abundant materials explains the title of the book. The results of the base case model run suggest that by the year 2075 the price of copper will be $51 per lb, 55 times more than in 1978. By that time, substitute materials will have taken over some 90% of the services currently provided with the help of copper. Because of such substitution, the average price of these services need not rise more than sixfold. By altering the assumptions of the base case, the model generates a variety of copper prices in 2075, ranging from $2.7 to $108 per lb. When conceivable rates of technical change in the copper-related industries are introduced, and the time horizon is extended to 2100, the range
reviews
of future copper prices emerging from the model widens to between $0.33 and $199 per lb. The model is also used to test for the macroeconomic impact of copper scarcity. In the base case, the discounted cost of copper exhaustion over 180 years works out at $419 billion. This equals about 1% of the discounted value of the net national product in the USA over the corresponding period. On the alternative assumption that ‘copper disappears, and all copper-equivalent services must be met with substitute materials’, the corresponding cost rises to an incredible 22% of the discounted national product. In my view, the analyses contained in this book can be described as very elegant and intellectually appealing nonsense. Several of the key assumptions of the model have very little relation to the real world as we know it from history. The entire approach to study copper exhaustion in isolation - seems unwarranted. If exhaustion, as defined in the book, will in fact occur, it will affect not only copper, but also substitutes like aluminium, because of the intensive use of energy in producing the latter. The extreme range of results makes the model exercises completely useless, except in satisfying the curiosity of the model constructors. Impressive amounts of high quality intellectual energy have been expended over the past 15 years in the elaboration and refinement of the theory of natural resource exhaustion and the present book is one more example of such efforts. The theoretical constructs have tended to lead their life in separation from the real world. Even where the logic was impeccable, their relevance and usefulness has been highly doubtful. We have yet to see the empirical vindication of any of the key propositions from this branch of economic theory.
Marian Radetzki Institute for International Economic Studies University of Stockholm; and Mineral Economics Department Colorado School of Mines, USA
63