Back in June, I wrote a post about the 'Little Divergence', based on a paper that showed that the divergence in economic fortunes between England and the Netherlands (which experienced an increase in prosperity), and Spain and Portugal (which experienced a relative decline) was not explained by differences in institutions. So, what does explain the difference in fortunes between northwestern Europe and southwestern Europe in the Little Divergence?
This new paper by Davis Kedrosky (University of California, Berkeley) and Nuno Palma (University of Manchester) may provide an answer. Kedrosky and Palma look at the case of Portugal, and investigate whether Portugal experienced a 'resource curse' due to large production of gold in the Brazilian colony. Gold was discovered in Minas Gerais province in Brazil in the 1690s, and by the 1730s there were 140,000kg of gold mined there, of which 80 percent was sent to Portugal (mostly into private hands). The resource curse (sometimes referred to as 'Dutch disease') occurs when a country's resource wealth leads to an exchange rate appreciation, making its other export sectors uncompetitive internationally, and paradoxically making the country worse off. As Kedrosky and Palma explain in the case of Portugal:
The economy, inclusive of Brazil, can be divided into the expected three sectors: gold is the booming sector, directly augmenting incomes and providing a high marginal product of labor; manufacturing, viticulture, and cereal agriculture constitute the lagging traded sector; and animal and forest production form the land-intensive non-traded sector. Increasing gold production in Brazil enriched Portuguese nationals in the colonies, who either remitted their funds home or exchanged them directly for the durable goods arriving on the thrice-annual treasure fleets. Newly-expanded incomes would necessarily increase demand in the non-traded sector, causing a real appreciation and a consequent withdrawal of resources from the lagging sector through the spending effect... With the collapse of the traded export sector and the increased purchasing power of the currency, exports would decline and imports surge, increasing the trade deficit. Gold re-exportation would then be required to pay the outstanding balances, as the proceeds of domestic industry no longer earn foreign exchange.
In the long run, the decades-long influx of gold would tend to continue the compression of the traded sector (or at least arrest its expansion). Skilled-based productivity advances, which depend on industry and cereal agriculture, would be persistently stifled, removing the principal driver of expansion. After an initial boom, therefore, GDP growth rates would tend to slow, or even reverse, with critical sectors of the economy being replaced by imports.
Using data on prices in three Portuguese cities from 1650 to 1825, Kedrosky and Palma calculate the ratio of traded good prices (including wheat/maize, wine, olive oil, linen, and candles) to non-traded good prices (meat, hens, eggs, soap, and charcoal). If Portugal suffered from the resource curse, then the price of non-traded goods should increase relative to the price of traded goods. Indeed, that is what they find, as shown in their Figure 4:
Of course, an increase in relative prices doesn't constitute on its own evidence that the resource curse was the cause of Portugal's relative decline. However, Kedrosky and Palma collate some additional evidence, concluding that:
While GDP rose in the short run, the longer-term effects of the gold shock were negative — contractions in industry and cereal production slowed the accumulation of technical progress, causing stagnant growth in successive years. Even if manufacturing’s share of employment converged to pre-shock levels, income was permanently reduced. Over the eighteenth century, the country de-industrialized, and in fact the percentage of the population working outside of agriculture declined from around 46% in 1750 to only 33% a year later.
Clearly, there is more work to do in this area, but the case against institutions as being determinative of the 'Little Divergence' is becoming clearer.
[HT: Marginal Revolution]
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