This submission is made to the Parliamentary Portfolio Committee on Minerals and Energy by the Free Market Foundation of Southern Africa, which is an independent non-profit public policy research and educational organisation founded in 1975 to promote the principles of limited government, economic freedom, and individual liberty. It is financed by membership subscriptions and sponsorships.
The submission concentrates on the economic implications of the existing legislation, the proposed amendments, and their effects on the future economic growth of South Africa and the well being of its citizens. The submission further gives specific attention to those proposed amendments to the Diamonds Act 56 of 1986, which will have the most far-reaching economic consequences. It also carefully analyses the stated purpose of the Bill and background information as contained in the Memorandum on the Objects of the Diamond Amendment Bill as set out at the end of the Bill.
The Bill has four principal objectives:
In this submission we address principles and theory in Part 1 and comment on specific provisions and aspects of the Bill in Part 2.
Principles and Theory
Notwithstanding popular rhetoric to the contrary there is only one logical case to be made for “beneficiation”, namely that its benefits for a country exceed costs. Popular beneficiation rhetoric makes all sorts of claims, which are simply not justified by logic, economic theory or experience in the real world.
A regulatory impact assessment should be carried out
The main reason for the support for beneficiation is that its protagonists, usually narrow vested interests seeking benefits for themselves at the expense of others and the country in general, articulate only primary benefits as if benefits can be achieved without costs – and conceal, perhaps inadvertently, considerable costs implied by artificial beneficiation. Before the government considers promoting beneficiation in excess of what profitable market conditions dictate, it should, at the very least, have a proper and independent regulatory impact assessment done, including a cost benefit analysis. Indeed, in keeping with modern international regulatory practice, it should require such analyses as an absolute precondition for any form of market intervention or other regulation.
In this submission we do not do a RIA or CBA simply because a sophisticated and elaborate exercise is needed including considerable data capture for a measure of this complexity and importance. Instead, we indicate what economic theory and experience predicts an objective assessment would reveal, namely that diamond beneficiation in South Africa entails, and will continue to entail, costs far in excess of probable benefits.
There are two reasons why beneficiation occurs:
- It is profitable to do so on a level playing field where a country’s resource allocation is determined by markets.
- It is profitable to do so because government intervention distorts market so as to divert resources from more to less profitable activities.
In other words, market-determined beneficiation yields more benefits than costs for a country whereas artificially imposed beneficiation incurs more costs than benefits in direct proportion to the extent to which the economy is distorted and resources misallocated.
The evidence worldwide is that freer markets enable governments to achieve all their policy objectives more substantially than unfree markets to the point where there is no longer room for informed debate. The objective evidence is now so overwhelming as to settle the matter with the highest degree of certainly obtainable in social science. See, for instance, the empirical research on www.freetheworld.com.
Diamonds are not a special case
Seductive though arguments to the contrary appear to be when presented and viewed superficially, beneficiation is no special case, and diamonds in particular are not a special case. There is no reason why distorting markets to promote beneficiation artificially and excessively should be regarded as any different from promoting anything else excessively. It would be counter-productive for a government to promote the manufacture of bicycles at twice the cost of importing them, rather than have producers manufacture something else that can be exported competitively. Very simple elementary economics and arithmetic makes it clear that diverting resources from what countries do efficiently and competitively to what they do inefficiently and uncompetitively shifts the country from wealth-producing to wealth-consuming activities, which makes everyone poorer on average.
Regardless of whether the government is considering the diamond industry or any other industry it can and should promote beneficiation by producing optimal economic conditions – the so-called “enabling environment”. Internationally competitive and sustainable industries in the world’s winning nations are those where the industries are not over-regulated or over-taxed. To increase diamond and other forms of beneficiation the government should deregulate the diamond market, including exports of cut and uncut diamonds, and reduce taxes on diamond processing. If, having brought the diamond industry in line with other industries that are internationally competitive, beneficiation does not take place spontaneously it means that the country’s resources are best allocated elsewhere where they will generate more wealth and jobs.
The diamond legislation constitutes a form of expropriation
An important point about beneficiation-by-regulation which we have not seen mentioned in any discourse on the matter in South Africa, is that forcing a producer to sell into local markets at lower prices than are available internationally – in other words to create conditions where buyers get special treatment because they are local – is a form of expropriation, called a “taking” in America and some international jurisdictions. The constitution may therefore require, under the property rights clause, that the government compensate diamond producers to the extent that they have been expropriated. That would be a further artificial cost to the country and subsidy to down-line processing.
The point becomes clear if one presupposes taking the measures proposed in the Bill to their logical conclusion. If it makes sense to penalise producers for not selling at less than international prices to local buyers, it makes sense to increase the penalty. The measure only appears to make sense when it is modest. To understand the logic of the law and the cost it imposes in excess of benefits one should imagine what would happen if it were absolute, if it provided that all diamonds produced in South Africa must be processed completely to final product stage domestically. That would mean that all diamonds would have to be finally mounted in consumer-ready jewellery, industrial equipment and the like. It would mean that it would be so costly to produce and process diamonds to the point where they can be sold internationally that it would be possible to do so only in rare instances or with massive subsidies. The consequence would obviously be the virtual if not total destruction of the country’s diamond industry in all its forms.
Countries should do what they can do best
The optimal thing for any country to do is to do what it does well and refrain from what it does not do competitively without market distortion.
What we wish to draw to the government’s attention is the well-established principle of “comparative advantage” in economics on which there is virtual unanimity amongst economists. The “law of comparative advantage” states essentially that people and countries should confine themselves to doing that in which they have the greatest comparative advantage. It may be true, for instance, that you, the reader, are better at cleaning your office than the cleaners who are now employed to do so. However, the degree to which you are better at office cleaning is less than the degree to which you are better than the cleaning staff at doing whatever you do instead – i.e. your present occupation. Countries, like individuals, maximise their welfare by identifying their areas of greatest comparative advantage – which freely competitive markets do automatically.
The beneficiation argument makes even less sense than it does for bosses to fire cleaning staff and do office cleaning themselves because it does not amount to doing that for which there is a smaller comparative advantage, but actually that for which there is a disadvantage. It is like employers cleaning their own offices instead of doing what they do best, even though the office cleaner is better at office cleaning than they are.
South Africa is in the top 40% of economically free countries
In the newly released Economic Freedom of the World: 2005 Annual Report South Africa is listed joint 38th in the economic freedom ratings, together with Cyprus, France, Greece, Jamaica and Peru. The rating improved from 5.3 (out of 10) in 1990 to 6.9 in 2003, reflecting that the improvement has occurred since 1994, much of it because of the greater freedoms brought about by the displacement of apartheid by the current democratic government, but also as a result of improved monetary management, vastly improved property rights and access to justice, and greater freedom to trade.
All South Africans, irrespective of political or other affiliations, should jealously guard our current status and attempt as far as possible to improve it. The reasons are pragmatic and have nothing to do with adherence to any form of ideology. All the evidence shows that free economies function better and deliver a better quality of life to all their citizens, including the poorest of the poor. Consider the following impressive list of benefits provided to citizens by free economies according to the latest research:
- Higher per capita incomes – an average of $25,062 (R159,000) in the freest economies and $2,409 (R15,300) in the least free (PPP constant 2000 international $)
- Higher growth rates – an average GDP growth of 2.5% for the most free and 0,6% for the least free (Average Growth Rate of Real GDP per Capita 1994-2003)
- Higher levels of investment per capita – $4,983 (R31,640) for the freest and $195 (R1,240) for the least free.
- Lower unemployment – 5.2% for the freest and 13.0% for the least free (2000-2002).
- Longer life expectancy – 77.7 years for the most free and 52.5 years for the least free. (2003)
- Higher incomes for the poorest 10% of the population – $6,451 (R40,950) versus $1,185 (R7,525) – (1999-2003).
- Lower infant mortality – 5.4 per thousand versus 81.2 per thousand (2003).
- Lower adult mortality – 103 versus 406 per thousand (2000).
- Share of income earned by the poorest 10% of the population – 2.7% versus 2.7% –the same percentage in the freest and most unfree countries but $6,451 (R40,950) versus $1.185 (R7,525).
There is consequently much to be said for striving to make South Africa as economically free as possible. If an individual can choose where to be poor, the place to be is in a free economy. South Africa is in the second quintile (1/5th) of economically free countries, which had average per capita incomes of $13,789 (R87,560) – (PPP constant 2000 international $), which is considerably higher than that of South Africa. However, the entrepreneurial energy created by the current level of freedom is visible all around us. South Africa will catch up rapidly as long as that energy is not dimmed or even extinguished.
This brings us to the reason for raising this issue. The current Diamond Bill will reduce the level of economic freedom in South Africa. It will specifically reduce the economic freedom of all the people involved in the production of diamonds, which includes the employees working in the mines. The cumulative effect of legislation that chips away at South Africa’s level of economic freedom, also chips away at South Africa’s overall GDP, and chips away at the potential incomes of the people working in the mines.
The rights of the miners
In formulating policy, and instituting legislation based on such policy, government officials are all too often inclined to forget the consequences for the employees of firms engaged in a particular industry. According to our information there are more than 13,000 people employed in diamond mining in South Africa. These employees probably support in the order of another 50,000 people. Anything that is done that impacts negatively on the diamond-mining firms will inescapably impact negatively on the diamond miners, their support staff, and their families.
In the case of the Diamonds Act, 1986, instituted by the apartheid government, a lack of concern for diamond miners and their families tended to be consistent with overall government policy. However, in our post-1994 democracy, such a lack of concern is inconsistent with the country’s constitution, which states in section 9(1) that: “Everyone is equal before the law and has the right to equal benefit and protection of the law.” Naturally, the firms employing the miners have a right to similar protection against unequal treatment under government legislation.
In this instance we have legislation that imposes costs on the diamond-mining firms and the 13,000-plus people employed in the diamond mining industry (an estimated 60,000-plus people taking into account their dependents) in order to benefit just over 2,000 people employed in the cutting and polishing industry. The matter is further complicated by reports that some of the diamond mines are already unprofitable and face possible closure without the additional costs that the current Bill intends to impose on the producers. Miners could lose their jobs if this should occur. Diamond miners are therefore justified in asking whether the proposals contained in the Bill are not in conflict with section 33(1) of the Constitution, which states that “Everyone has the right to administrative action that is lawful, reasonable and procedurally fair.”
The role of South Africa’s major diamond firm in the diamond industry
South Africa’s policy makers should take care not to disturb any further the delicate balance that the Central Selling Organisation (CSO), created by a South African diamond firm, managed to establish in the worldwide diamond industry. Governments of other countries have already mistakenly compelled the diamond industry to alter its methods of operation and the South African government, in its own interests as a tax-gatherer and in the interests of its citizens-as-mine-employees should not exacerbate the risks already faced by the industry.
Economist Duncan Reekie showed clearly that the traditional trading methods followed in the diamond industry are in the best interests of all concerned. Professor Reekie showed in the monograph Diamonds: The Competitive Cartel, published by the Free Market Foundation, that no one will benefit from low prices for diamonds: not the producers, not their employees, not the current owners of diamonds and diamond jewellery, not the potential future purchasers of diamonds, not the cutters and polishers of diamonds, not the jewellers, and certainly not the governments of diamond-producing countries like South Africa.
In his conclusion, Reekie said: “The CSO, of course, would be easy to break up. Legislative rulings to that effect would be quite enough. This, in turn would impact on the entire industry. If the argument is correct viz., that diamonds are a Veblen* good, there could be very great hardship indeed for all industry members, miners, cutters and polishers, and consumers.” He could have added that governments of diamond-producing countries would lose a considerable amount of revenue.
(* named after Veblen’s theory of conspicuous consumption – the higher the conspicuous price, the more people are impressed, and so the greater the satisfaction of the purchaser.)
Essentially, what Professor Reekie warned was: Don’t destroy the goose that lays the golden eggs. Don’t tamper with something you don’t understand and that nobody understands totally. The South African government should, if nothing else, have consideration for the interests of the miners and for its own future tax income. And if government officials are too stubborn to appreciate the dangers of meddling with the delicate mechanisms of the diamond industry, then Parliament should step in to protect the interests of the miners.
South Africa is currently enduring a deluge of regulation that is needlessly distorting the economy towards less efficiency and competitiveness, and imposing enormous costs, which no one is quantifying. This means that the government has no way of knowing whether the flood of new regulations is generating benefits exceeding direct and secondary costs.
The regulatory imperative is such that regulations are often justified without even the slightest attempt to compare benefits with costs. In many cases the sole argument for regulation is that a given activity is supposedly unregulated. Of course, all activity is regulated in many ways, starting with common law, and invariably by way of numerous forms of legislation. There is and has been nothing in South Africa that is “unregulated”. The question is at which point regulation becomes counter-productive.
The incontestable fact is that highly regulated economies do not produce intended benefits, even primary benefits, to the extent that freer economies achieve.
Black Economic Empowerment (BEE)
With BEE there is a tendency towards considerable confusion and lack of coherent analysis because it is such a sensitive issue. The problem is that any criticism of a single proposed form of BEE is presumed to be a criticism of BEE in principle. It should be obvious that a criticism of some aspect of BEE does not represent opposition to black advancement but unfortunately for South Africa it has become virtually impossible to criticise individual ill-conceived BEE proposals. It is not in the government’s interests to allow this policy myopia to continue, nor is it in the interests of BEE beneficiaries.
Those arguments and fallacies relating to BEE are similar to the arguments that characterise the beneficiation debate. Every resource allocated to one form of BEE is at the expense of other forms of BEE. In other words the contest is not necessarily between BEE and non-BEE resource allocation but between efficient and inefficient forms of BEE.
There is obviously an important consideration for government policy regarding the extent to which it wants to generate BEE benefits at the expense of alternative benefits but we do not concern ourselves with it here.
BEE in diamond processing is probably a sub-optimal form of BEE. The government has at its disposal BEE alternatives where more substantial BEE can be achieved at less cost, ideally with net profits for the country. Artificial BEE, as with artificial beneficiation, happens when resources are diverted from producing more substantial opportunities for black South Africans than are possible in areas where BEE occurs only if it is forced on the economy – for example, in areas where there is a lack of skills, capital and competitive advantage. Indeed, the BEE benefits envisaged by this Bill are indistinguishable in economic theory from the benefits envisaged for beneficiation, in that the costs of achieving these benefits will far exceed the value gained.
Comment on specific provisions and aspects of the Bill
In our submission and oral evidence to the Commission of Enquiry into the South African Diamond Industry in October 1997 we proposed, giving detailed reasons, that the Diamonds Act, 1986, should be repealed. The fundamental reasons for that proposal and views on the matter have not changed.
This submission nevertheless deliberately concentrates on discussing the fundamental principles involved in the proposals contained in this Bill and also some of the content of the original legislation However, there are certain specific changes contained in this Bill that require special comment:
Government neutrality in the economy
Government should be totally neutral in the economy. A neutral government concentrates its attention on providing the best possible environment for the achievement of high economic growth. Personal choice, protected property rights and freedom of exchange are key ingredients of such an environment. An important characteristic of the highest growth economies is that government involvement is limited.
- Do the producers currently supply diamonds to local cutters and polishers?
- Is the Diamond Board dominated by the industry?
- Is the Board in a position to frustrate government initiatives?
- Does the existing Act, or does it not, result in the supply of rough diamonds to the local diamond cutting and polishing industry?
- Section 59 agreements is what the government intended should result from the threat of imposing a punitive 15% levy
- Do section 59 agreements hamper local beneficiation?
- Concluding remarks on the “Purpose of Bill and Background Information”
Comments on Submission on Diamonds Bill