Randomness, risk and uncertainty: How do we know what we don’t know?

Being a habitual sceptic (and an economist), the insights offered by Nassim Nicholas Taleb in The Black Swan have struck a chord. I have never found a receptive audience in academia for my dislike of the assumptions of the characteristics of randomness that determine the probability density function (amongst other assumptions) in most statistical analysis – especially in social phenomenon. But finally I have a wing man.

The general attitude I face is that if we don’t make these (sometime radical) assumptions, we can’t do any analysis of the data, and draw any conclusions. My response is; what use are conclusions based on flawed assumptions?

The book poses the challenge to think rationally about probabilities, and the impact of improbable events. In particular, Taleb challenges us to acknowledge the limits of knowledge. Real risks and randomness come from the unknown unknowns.

He uses an example of casino to explain the difference between known risks that occur in a world he calls mediocrastan, and the wild unknowns and events from the world of extremistan. The mediocristan risks are those involving the gambling itself. Each individual bet has a risk that is essentially Gaussian, so with a large number of bets taking place, and limits on the size of each bet, these risks are eliminated.

Taleb suggests that most of our concerns about risk, and the high impacts of improbable events, are from the world of extremistan, where complex systems result in variations at all scales. The point is that in extremistan, large variations and extreme events WILL HAPPEN, and much more often than we think. Such large complex systems include financial markets, the global economy, and the climate.

While attending a statistical conference at a Las Vegas casino, Taleb discovered that the four largest losses incurred by the casino did not involve the gambling itself (whether cheating or otherwise). The first was when a tiger performing in a stage act maimed one of the performers. The next was when a disgruntled contractor who became injured on job threatened to blow up the casino with dynamite because he was insulted by the settlement offered. The third was when an employee failed to mail paperwork to the Internal Revenue Service for a number of years, which ended in a monstrous fine. And finally, the casino owner’s daughter was kidnapped and held ransom, which forced the owner to dip into casino funds.

These events are Black Swans. Unpredictable, outside the scope of expectations, and have massive consequences.

He makes a number of interesting points that I want to share. These are particularly relevant in current environmental debates. For example, where I work we try to estimate the environmental impacts from changes to stream flow in rivers. The number of assumptions in unbelievable, and any output from this type of modelling has to be taken with a grain of salt. It is merely some background information that either confirms or challenges the experiences on the ground. When I write about the economic impacts of changing water regimes I repeatedly make the point of acknowledging the unknowns and the limitations of my analysis. Can you imagine the complexity of climate models, and the staggering number of assumption built into them? One wonders whether climate scientists understand statistics at all.

The first point of interest may be familiar for those who are statistically inclined. It is the statistical regress argument and it is a cause for concern. It goes as follows:

Say you need past data to discover whether the probability distribution is Gaussian, fractal, or something else. You will need to establish whether you have enough data to back up your claim. How do we know when we have enough data? From the distribution – a distribution tells you whether you have enough data to “build confidence” about what you are inferring. If it is a Gaussian bell curve, then a few points will suffice. And how do you know if the distribution is Gaussian? Well, from the data. So we need the data to tells us what the probability distribution is, and a probability distribution to tell us how much data we need. This causes a severe regress argument.

Given that our data samples for global temperatures are extremely limited, climate scientists face this problem at the outset.

Another interesting point is how the nature of Black Swan events, and the resulting silent evidence distort our interpretation of history. Any act that aims to prevent a Black Swan event goes unnoticed because its success can never be observed. Imagine there is a bureaucrat who decides to implement aviation rules in August 2001 that would have prevented the September 11 events in New York. We could never judge the success of these measures in preventing terrorist attacks, and the bureaucrat would never gained any credit for the measures. Possibly, due to the complexity, cost and frustration of travellers, he would have had to overturn the rules in 2002. He would be labelled as someone whose best skill is to waste time and money. Learning from history is very, very distorted due to silent evidence. I can imagine in the not too distant future that the history book will explain how we should have seen an event like September 11 coming, due to such things as ‘rising tensions between terrorist groups and the US’, but they would simply be wrong. The crashing planes were the sign of rising tension!

Another great insight is the problem of induction. He uses an analogy of a melting ice cube. If we know the shape of the ice-cube, we can fairly well predict the size of the puddle of water when it melts. But, if we have the puddle of water as our source of information, there is not much we can say about the shape of the ice-cube. In economics we constantly go about measuring puddles of water, and through flawed statistics, try and make outrageous claims about the shape of the ice-cube. The herd mentality of the global economics profession and media seem to have induced that overzealous lending in a few sub-prime locations in the US has led the whole world into a massive recession. My question is, the given how many other more significant events were happening around the globe during this time, how can anyone be so sure of that the ice-cube was shaped like a few bad loans, and not like a oil shock? Or why was the cause not simply a unique combination of unforeseeable events? This same question can be applied to climate change. If we agree that the climate is changing (which itself is questionable due to the previous two reasons), how can we isolate a single cause in a complex system?

I will stop now because I don’t really think I can do justice to the ideas of Taleb and his philosophical predecessors here. I just want to reiterate that we know a lot less than we think we know.

My main concern is that for someone who preaches a precautionary approach to making claims of knowledge, Taleb is a devoutly religious man who has used arguments such as ‘religion has not killed so many people as the concept of the nation state’. So, if religion is the root cause of, say, 10 million premature deaths, while fighting for or defending a nation state (which coincidently have often been religious states) has killed, say, 20million people prematurely, does this mean that religion is good for society? Taking this argument elsewhere and we get such things as ‘murder kills 100 people annually, but motor vehicle accidents kill 300 people’. For a guy who we are meant to believe has a solid grasp of logic, reason, argument, and science, this seems a rather appalling justification for his beliefs. But of course, nobody is perfect, and we need to judge each argument on its merits.

Tagcrowd - heard of it?

I recently ran across a very interesting website called Tagcrowd. It counts word frequency in text and presents a neat cloud of words that provides a good visual summary. I did it with my whole blog and got the following result. Seems to sum it up nicely.

Can governments be more innovative than private enterprise?

I have had some interesting thoughts lately regarding the trends towards the privatisation of infrastructure and the user pays principle which underpins this trend. My theory suggests that private infrastructure based on user pays principles locks society into a particular path of development which becomes increasingly self-reinforcing, thus excluding innovative solutions to transport, communications, energy and water supply.

Let me explain in more detail.

Consider two countries, A and B. Previous governments of country A have spent the past century investing heavily in a rail network for both passengers and freight, while country B has spent the past century ignoring rail and building roads as the major land transport system.

Now imagine that a technology, X, is developed that can massively increase the efficiency of rail transport, but not road transport. Think along the lines of mag-lev trains or some such thing.

Now both country A and B believe that this technology is superior to their current land transport system and aim to develop a network based on private investment. Country A already has the land, the stations, and the infrastructure in place, while country B has none of it. One would expect that the compared with country B, country A is more likely to find potential private investment for such a project given the likely lower costs but equal benefits.

Thus due to historical capital investment, country A continues along a rail based path towards the most efficient outcome available with technology X, while country B continues along a road based path and will never reach technology X through private investment alone and will remain 'stuck' with a less efficient land transport network. This is the problem of path dependence, a situation encountered in both evolutionary theory and economics –“the cheapest manufacturing method may not be achievable by “evolutionary steps” but may require a complete change in method”.

The question then arises that if country B is ‘stuck’ on a more costly trajectory of land transport development, how does it become ‘unstuck’. This is where I believe governments can intervene to make the decision to become unstuck by directing investment into the superior new infrastructure. Rather than the user pays principle of privatisation, the government can justify funding such scheme due to benefits to the user, but also benefits to non-users in society.

For example, if a rail line is established along a popular road corridor, both the rail users and the road users benefit - the rail users from cheaper transportation, and the road users from less congestion. Unless a private enterprise can charge the road users for the rail line, a publicly funded outcome is far superior.

The inability for private infrastructure owners to capture external benefits limits their opportunity to innovate and provide broad social benefits.

Governments on the other hand can consider all external benefits and consciously ‘invest’ a region out of their current development trajectory on the basis of providing indirect social benefits.

The problem then is getting a government to even perceive these potential social benefits, let alone act on them.

The other problem is that if governments do ‘invest’ a region out a of a particular development path, they are now stuck in the new path, unless they invest heavily once again. For example, Brisbane ditched trams back in the 1960s, and successive governments ever since have been considering getting them back. But each change in trajectory is more expensive than the last.

So what then should a government do to maximise social welfare? Should they just stick to the path they are on and hope that future technologies are advantageous, or should they embrace innovation and change the development path?

On Andrew Bolt

I must say that until recently I have had little exposure to the writings of Andrew Bolt. A short snippet of him on telly once seemed to highlight for me that this guy was a headline grabbing voice of the extreme ‘right-wing’ (whatever that is anyway) political agenda. However in the past few days I have been reading his blog, and now finally have read his book Still not sorry. And I must say, although he can fall into the trap of making illogical assertions, just as can the left on many occasions, he writes quite a bit of commonsense that seems to raise much less publicity. His book provides snippets of his basic opinion on particular issues, so let me please take the time to highlight this commonsense on various issues.

1. Australia is divided into the ‘elites’ who get much of the air time, and whose opinions are out of step with the average Aussie. The elites believe that people need such things as racial sensitivity training, and as a group give a disproportionately loud voice to left wing agendas. The majority of us think things are pretty good and we just like to get on with enjoying life.

I must say that the more exposure I’m having to many academic and intellectual types trying to make a difference to policy, the more I am beginning to see the total disconnection with reality of many of these said ‘intellectuals’.

2. Australia is a great country, and we shouldn’t sacrifice our fundamental freedoms and opportunities for fringe issues of minority interest groups.

Many of the problems we face in Australia today are, in comparison to the rest of the world and to recent history, very trivial. Economic research is a good guide. These days economists can theorise about happiness coefficients, gender implications of armed conflict. If there were real issues to tackle, economists would not get sidetracked like this. Compared to historical standards we are living in a utopia. The message from Andrew Bolt is that we should get some perspective and be thankful for the opportunities provided to us in our society.

3. Racism is not the issue it is made out to be, and we could do much better if we didn’t promote policy based on race, gender or any other ‘ist’ feature.

Along these lines, there has been further frustration for me this week. The Wild Rivers Act allows the government to protect the natural flow of waters courses if they meet certain criteria for being natural environments. No problems there, it is the type of policy I think delivers tangible benefits. But Indigenous leader Noel Pearson had now started complaining that the legislation will lock up land from development, taking away opportunities for local indigenous communities. But most indigenous groups surveyed by the department found widespread support. So what is the real opinion of indigenous people in the Cape?

I think our mistake here is to segregate people by race. Can’t they just be two opinions of groups in the Cape? Why should race imply a set opinion about a policy?

In France it has been illegal for quite some time to classify people by race. The government does not even collect statistics about racial identity (since gathering that data is illegal). This, I believe, should be the target for us. If we can’t classify people by race, we can’t write racist policies.

The French elite are typical targets of Bolts critique. They say such things as, ‘Every time we want to study the divisions of society we are accused of dividing society’. That is exactly the point.

Bolt also stole my idea about irrational women in positions of power – about 7 years before I had it! I have recently attended a workshop with Australian academics and experts on environmental economic assessment, and was shocked at the illogical and often conflicting theories that underpin sociology – a discipline, that from my experience, is populated with highly ‘educated’ middle aged women who believe in astrology and alternative medicine. Are these ‘elites’ the people we want advising our decision makers?

4. Help people help themselves.

Bolt also repeatedly claims that handouts are not long term solutions to poverty. There is nothing controversial here. While we as a society have decided that in times of need people who cannot support themselves will be supported by the rest of us, no one believes that this support CAUSES, or provides incentives to, those who are provided with it to begin to look after themselves again. Economists know that such support inadvertently provides incentives to not return to work. So why should we continue to throw good money after bad in supporting communities such as Palm Island?

Where Bolt gets himself into strife is when he allows himself to effortlessly drop his evidence-based critical line of argument and get down in the gutter, spruiking pro-Howard pro-liberal rhetoric, when there are obvious flaws in both Green and LIberal sides of the argument. He lets fly with ‘facts’ without citations, which actually quite bugs me, as it is easy enough to find ‘reliable’ evidence both ways in the world of grey that is politics.

What does it mean to 'save a life'?

I have been reading some great articles about poor science journalism, and gross misrepresentation of the facts. These articles got me thinking about what it actually means when a new drug, vaccine, surgery, or other medical intervention has the possibility of ‘saving thousands of lives’. What exactly does the phrase ‘save a life’ mean?

My starting point for this analysis is that everyone dies. Therefore, we cannot save someone from death; at best we can postpone death – from being the direct result of condition X, to being the result of some unknown future event.

The question is further complicated if we consider the flow on effects from death. For example, a child (A) may die from disease X, but the flow on effect from this one death is the birth of another child (B) by the couple, who would not have chosen not to have that child (B), had the first child (A) not died young.

So here we have a theoretical conundrum. In the previous case if child A had be ‘saved’ by a new drug or surgery, child B would never had been born. Imagine then comparing two hypothetical scenarios:

Scenario 1 -
Child A is ‘saved’ by a new drug or surgery.
Child B is never born
Child A lives until the age of 60.

Scenario 2 –
Child A is not saved and dies
Child B is born
Child B lives until the age of 90

If we consider a year of life to have an equal value amongst all individuals, we can say that Scenario 2 provides more life. The net effect of the drug/surgery is to postpone the death of Child A by, say 55 years, and eliminate the chance of Child B being born. Scenario 1 provides 35 years less combined life years than Scenario 2.

In a more general sense, do we need some death to create life?

Another hypothetical can let us examine this question. Imagine a new drug is invented that, for example, promotes tissue repair, and the life expectancy of the population rises dramatically over just a few years. Does this prolonged life of existing generations come at the expense of future generations? If the birth rate did not slow as a reaction to this, population growth would also see a dramatic spike in population growth.

We can think about the ambiguity of ‘save a life’ more when we consider treatments for the elderly. If a drug cures one life threatening disease in an 80 year old, and they die a year later from a different disease, did the drug still ‘save a life’? Again, I would say that we can just postpone death. In this case, the drug postponed death by one year.

But if the same drug could be used on a child, it may postpone death by quite a number of years. Does it then ‘save a life’?

Economists know that a very large chunk of government health expenditure goes to treatments in the last 30 days of someone’s life. All we can derive from this is that we are getting some very poor ‘life returns’ on our health investments. It is a much better investment in terms of ‘life returns’ to fund medical care for the young.

I guess my point is that if we don’t think about saving lives, but rather about postponing death, we get a much better perspective on the effectiveness, and usefulness of various medical claims. We also need to consider that postponing death is not inherently a good thing for society as a whole, although it often is for the individual person whose life is prolonged. I hope anti-abortion and anti-euthanasia activists can think deeply about these issues before launching their next hysterical propaganda campaign.

Sunburnt cows and daylight saving time

I am shocked. Really. The amount of time and energy devoted to ridiculous ‘social issues’ like daylight saving time could be devoted to so many other worthy causes.

The DS (or is the BS) debate has seen the light of day again this week (sorry about that) in WA, where farmers have cited an obscure 1996 study by Stanley Coren that shows an extra hour of daylight contributes to fatigue and therefore road accidents. Apparently the study found an 8% increase in road crashes the first Monday after the introduction of daylight savings time, compared to the previous Monday.

While it is quite obviously a scare campaign by the WA Farmers Federation (WAFF), their website appears not to be a spoof, and contains the following important questions for the concerned public to consider. I have reproduced them below with my personal response to each.

• Does it make it harder to put your children to bed, while it is still light outside?
Do you mean like when they have a daytime nap?

• Are people becoming more fatigued, as they are inclined to stay awake an hour later at night, and what safety concerns does this raise (i.e. accidents while driving)
Are they also inclined to stay up later because they can use lights? Why aren’t they inclined to sleep in longer?

• Does it make sense to be driving to work in the dark during the daylight saving period?
Like the rest of the year you mean?

• Does it put businesses out with their key trading partners in Asia, given that WA’s normal time zone is the most populist time zone in the world?
Get real. By this logic we should all have the same time zone. And while phone calls are instant (and business hours will still overlap for 7 hours a day) transportation of goods takes time – a lot longer than the one hour we are so concerned about. Oh, not mentioning that by changing time by and hour you get a whole lot of other regions in on the same time – you win some, you lose some.

• Are you concerned that children may be in the sun during the hotter and more dangerous part of the day during daylight saving?
They’ll be sleeping because they are fatigued from staying up late. Is that why it wouldn’t be safe? Wouldn’t want tired children playing.

• Are there animal welfare issues, from farmers being forced to work livestock during a hotter period of the day?
No one tells you how to run your business. You can do it at the same ‘sun time’ if you like.

• Is daylight saving convenient?
Depends who you are.

Apart from the fact that literally hundreds of millions of people across the world quite comfortably handle a change in timekeeping twice a year, there is further scientific evidence to show the fallacious nature of the WAFF claims.

Four months after the cited Coren study was published, a response citing a plethora of existing studies using much more detailed data was published that put the debate to rest. They find a reduction in the number of evening road accidents, but and increase dawn accidents, with a net effect 900 fewer fatal crashes based on data for Virginia. In fact they cite a rigorous natural experiment in the UK where daylight savings time was kept year round in a 3 year experiment, where a reduction road fatalities by 1100 a year was attributed to more evening hours of light.

Oh, and I forgot to mention that the favourite study of the WAFF also showed that there is an 8% decline in road accidents on the first Monday upon a return to non-daylight saving time, leaving the net effect on road accidents to be… zero, zip, none.

So the question I have is this. Why are the members of the WAFF so upset about daylight savings time as to spend $10,000 and plenty of their own time and effort on a scare campaign? Further, in the US, farmers are having much the same issue, and citing the same study by Coren to ditch daylight savings time. In fact most web sites against DS time cite this research.

I wonder if we did the reverse, and called DS time standard time, and called standard time daylight wasting (DW) time, would we have the same anti-DS campaigners join the anti-DW brigade? Don’t waste our winter daylight because it causes traffic accidents.

What if we flipped it around and had DS time in winter in QLD? We could then have the same summer evenings (sunset around 6:45pm), and longer winter evenings, with the latest sunrise in winter being 7:39am, but the earliest sunset delayed from 5pm to 6pm (with twilight for half and hour before sunrise and after sunset).

Personally I prefer winter DS time. But daylight savings or not I’ll be fine. Can we just stick to our decisions and stop filling the airwaves with nonsensical rubbish that confuses and intentionally deceives people for narrow-minded agendas?

I’ll leave you all with a quote:

Of course, anyone who really doesn’t like daylight saving could leave their watch unchanged, stick to their old schedules as far as possible, and just bear in mind that everyone else is using a different time. The reverse is true in the present situation if you really like daylight saving.

Oh, yes I get the irony about the waste of time and effort on DS debate, and the effort I spent writing this blog. That’s just how frustrated I am with intentional deception by farmer lobby groups.

The construction of value

My title is yet another rip off. This time from Dan Ariely et al.’s 2006 paper Tom Sawyer and the construction of value. In my opinion, this paper lifts the lid on economics. Let me explain.

The majority of economists (there are exceptions) take the preferences of individuals as a given. I prefer watermelons to rockmelons if I am willing to pay more for watermelons. The study of economics can then be seen to answer the following question – given a group of individuals with given preferences, how are resources allocated?

Determining how these preferences are formed in the first place, and how they can be manipulated is an entirely different question, and one economists are only now beginning to grapple with. Psychologists and marketing departments have known for a long time how to influence peoples preferences, but economists have thus far remained quite ignorant.

Personally, I see a serious issues with overlooking the formation of individual preferences by economists. Ignoring the ability to manipulate preferences ignores an important feedback loop when attempting to explain inequalities of wealth. Not only does wealth provide the ability to accumulate more wealth, it provides the ability to manipulate the preferences of others in society. In fact, it is quite interesting to theorise about the impacts of a tradable commodity called a 'preference manipulation service' in a market economy. How would such a theoretical economy compare to one in which all preferences are fixed through time?

But getting back to the main point, that our preferences are revealed by our decisions, how then would we quantify preferences for non-market goods? Non-market goods are those which we cannot directly buy and sell such as air quality, clean oceans and other such things. This is a real dilemma for environmental policy makers.

The problem with surveying peoples’ willingness to pay is that they don’t actually have to pay, and can respond consistently with social expectations. For example a recent ABS survey found that "around one-third of households who were aware of GreenPower were willing to pay extra for electricity generated from renewable sources, but not all of them were using it, with around 10% of households paying for GreenPower electricity". Maybe if we use a conversion factor for such surveys, such as one third or one quarter, we might be close to the truth (if there is a truth).

There is a clear link between Dan Arierly's paper and the methods for surveying peoples preferences. For example, there are substantial priming effects. As a general rule, the more information supplied to the survey participant, the more they are willing to pay for anything! Tell them all the intricate details about the plight of penguins and we will admit that they are more valuable to us. A one liner that penguins are in danger and we won't take too much notice.

The economists dilemma then is whether or not we even have a preference unless we are forced into making the decision. Are preferences up for grabs until the last moment when we commit ourselves to a purchase? Are preferences the quantum mechanics of economics - not really there until observed?

Then again, maybe we shouldn't delve to deeply into this or we might find out just how easily we can all be manipulated and how little we know about ourselves.

Happiness, facebook style

Although spiritual leaders would suggest that happiness comes from within, recent research is suggesting it may also come from without.

You know the feeling, when someone laughs uncontrollably, you just start laughing as well for no reason – simply because they are laughing. Well this type of reaction is known as ‘emotional contagion’ and may describe why some groups of people always seem to throw a great party while others seem to be able to spoil the mood every time. A group of dominant and happy people can actually make others in the room happier.

Thinking of friends of mine I know there are some who are constantly happy, and probably part of bond between us is the mutual benefits of happy emotional contagion. And of course, this is likely to result in a feedback loop where one happy person makes others happy, and others who are now happy make the original superstar even happier.

Just throwing it out there, it probably happens in reverse as well. Unhappiness rubs off too. Maybe try whistling in the streets and see if you can rub off some happiness.

Hedonic price indexes - not only in America

If you recall a previous blog which linked to a crash course in global economics, you would remember a part about hedonic price adjustments when measuring the Consumer Price Index (CPI). Unfortunately, these methods are being adopted in Australia. For personal computers a hedonic price index was introduced into the Producer Price Indexes in 2003 and into the Consumer Price Index and the National Accounts in 2005.

That means that although prices for computer may be steady, they are falling in ‘real terms’ according to the ABS, thus we are all experiencing cheaper computing. The following graph shows that computers declined in price by 30% from July 2007-08. The same models only dropped in price 15%. So the question is: do we include the extra 15% decline in our price index?

I would suggest that the methods used by the ABS misinterpret the term hedonic. Hedonic psychology is concerned with the attributes of good or service from which we derive pleasure. By breaking down a single product into hedonic attributes we can determine the willingness to pay for component parts.

Hedonic analysis has been happening in property valuation since it first began. To compare heterogeneous goods we break them down into characteristics such as location, views, noise, number of bedrooms, and so on. We can then estimate how much a person may be willing to pay for an identical apartment in a different area, or with different views.

In terms of the computer price index, they have taken factors such as CPU speed, RAM, memory, as the characteristics from which we derive value. But clearly this is not the case. Many people have no idea of these specifics. They just care what it can do – save music, photos, word processing, internet etc. If I write this blog on an old computer, and I getting less satisfaction than writing it on a new computer? Unlikely.

A good that seems to me to be more suitable for hedonic pricing is housing. While house prices have dramatically increased, so have their quality. The renovation boom of the past decade has turned many suburbs into backyardless air-conditioned wonderlands. We can use hedonic methods to easily determine the potential price or rent of a house of apartment based on its features (this is how real estate agents do it in their heads). Now unlike computers, these features closely relate to the benefits we actually derive from the home. An extra bedroom of a given size has a number of possible uses from which we derive benefits. Adjusting for an extra room is prefereable, adjusting for the type of materials on the wall is probably not as good. Just because a more modern material is used (read faster processor, or bigger hardrive) doesn’t mean I can actually use the room (computer) for more purposes than I previously could.

Since housing is a large part of household expenditure (20%+) this type of adjustment might provide interesting results.

Anyway, it’s a slippery slope of political misdirection from here with hedonics. Let’s hope that PCs are just a pet project for now (they are not - one of the desired outcomes of the review of the desktop computer price index is the development of techniques to be applied to hedonic price indexes for other consumer durables), until their methods align a little better with the theory. This may involved surveys of consumers see which attributes provide them with benefits.

Why are the poor, poor?

Economists have tried to determine the reason some countries are wealthy while, relatively speaking, others are poor. They have eliminated a number of reasons that at first seem very logical.

1. Endowment of natural resources.
2. Quality of government and rule of law

However one major flaw is that studies comparing the endowment of natural resources compare current day reserves of resources currently in demand. If they had instead compared endowment of natural resources of use during the rise of agriculture some thousands of years ago, the answer may have been quite different.

I would propose that the reason some countries are poor, despite their current resource endowment, is that they were too slow to take advantage of those resources.

Consider the colonial powers of Europe during the 1600 and 1700s, namely the Dutch, German, English, the Spanish earlier on, the Italians a thousand year earlier, and the Greeks before that. The wealth of these nations grew from their own natural resources AND the quality of their government and rule of law. If there are rival tribes within a State, so many resources are devoted to war, that the accumulation of capital in the form of buildings, ship and machines is impossible.

Given time, any part of Africa could have achieved this type of emergence of civilization and wealth by developing cooperative States. In fact any less developed, or less wealthy, society could have followed this path. But there is a key reason why this did not occur.

The already wealthy European nations began trading, mostly through coercive force, with these less developed countries. Now trade itself is fine if we all start from equal positions and enter into it voluntarily, but history has shown that such ‘perfect markets’ are rare. Often one side has a clear advantage. And so it was with European traders.

If you have zoned out from reading, now is the time to pay attention. The reason trade between the already wealthy nation and the poor nation was not going to improve the situation of each player equally is because the wealthy nations brought with them capital. That is, they had tools, ships, weapons, and all manner of goods (and the knowledge of how to build them) that could be brought to the party, whereas the poor nation merely had labour and natural resources.

Since investment in capital generates a return, the wealthy country could maintain returns on the poor country’s endowment of natural resources. If they were wise (and most were very savvy) they would reinvest in the land itself. Thus the wealthy country would continue to preserve its wealth through the ownership of land and capital of other countries.

In absolute terms, the poor country would probably become ‘less poor’, but in relative terms, the gap in wealth between the rich and poor countries would in fact grow, not diminish. This is capitalism.

However, that is not to say that such a situation is inevitable. With an improved knowledge of the nature of capitalism, the Asian Tigers have been able to adopt the same strategies as the British colonial capitalists once did. By smartly investing in capital, both domestic and abroad, they have broken this historical trend.

Even as I type, China is making moves to acquire Australia’s mineral reserves. They are seeking to begin owning the capital, the physical means of production, by acquiring large shares of mining companies. Thus, they will generate a profit stream back to China from the use of Australia’s natural endowment of resources.

The same thing happens on a domestic level. Those who inherit wealth have a distinct advantage as they preserve their wealth in capital which can generate future returns, thus reinforcing the cycle. But that is not to say that those who start life relatively poor can never prosper. If they follow the simple rule of saving their earnings on labour and investing in capital, they too can prosper.

If economists could take a history lesson and broaden their perspectives a little they would see the simple explanation for the observed divergence in wealth. Given a stable political environment, rules could be attached to foreign aid that might require a proportion of domestic reinvestment in capital works. Poor nations, desperate for foreign capital, might want to rethink the advantages of allowing foreign investment in their natural resources, and instead promote the extraction and use by government owned companies that can keep profits within the country for further reinvestment.