1. Energy Economics – II Jeffrey Frankel Harpel Professor, Harvard University ADA Summer School, Baku, Azerbaijan 7-9 July, 2010

2. 2 The Natural Resource Curse The NRC is often phrased broadly to include not just oil, but other minerals, & sometime agricultural commodities too. The NRC is often phrased broadly to include not just oil, but other minerals, & sometime agricultural commodities too. Seminal references: Seminal references: Auty (1990, 2001, 07, 09) Auty (1990, 2001, 07, 09) Sachs & Warner (1995, 2001) Sachs & Warner (1995, 2001) Other studies find a negative effect of oil, in particular, on economic performance: Other studies find a negative effect of oil, in particular, on economic performance: including Kaldor, Karl & Said (2007); Ross (2001); Sala-i-Martin & Subramanian (2003); and Smith (2004). including Kaldor, Karl & Said (2007); Ross (2001); Sala-i-Martin & Subramanian (2003); and Smith (2004). Survey: Frankel, “The Natural Resource Curse,” forthcoming in Export Perils, edited by Brenda Shaffer (University of Pennsylvania Press). Survey: Frankel, “The Natural Resource Curse,” forthcoming in Export Perils, edited by Brenda Shaffer (University of Pennsylvania Press).

3. 3 Examples Conspicuously high in oil resources and low in growth: Venezuela & Gabon. Conspicuously high in oil resources and low in growth: Venezuela & Gabon. Conspicuously high in growth and low in natural resources: China & other Asian countries. Conspicuously high in growth and low in natural resources: China & other Asian countries. The overall relationship on average is slightly negative: The overall relationship on average is slightly negative:

4. 4 Growth falls with oil & mineral exports

5. 5 Are natural resources necessarily bad? Oil or mineral wealth need not necessarily lead to inferior economic or political development. Oil or mineral wealth need not necessarily lead to inferior economic or political development. Rather, it is a double-edged sword, with both benefits and dangers. Rather, it is a double-edged sword, with both benefits and dangers. It can be used for ill as easily as for good. It can be used for ill as easily as for good. The priority for any country should be on identifying ways to sidestep the pitfalls that have afflicted other mineral producers in the past, to find the path of success. The priority for any country should be on identifying ways to sidestep the pitfalls that have afflicted other mineral producers in the past, to find the path of success. No, of course not.

6. 6 The goal is to enjoy the success of The goal is to enjoy the success of a Chile, not a Bolivia a Chile, not a Bolivia a Botswana, not a Congo a Botswana, not a Congo a Norway, not a Nigeria. a Norway, not a Nigeria. The last section of the paper (Frankel, 2010) explores some of the institutional innovations that might help avoid the natural resource curse and achieve natural resource blessings instead. The last section of the paper (Frankel, 2010) explores some of the institutional innovations that might help avoid the natural resource curse and achieve natural resource blessings instead.

7. 7 How could abundance of oil be a curse? How could abundance of oil be a curse? What is the mechanism What is the mechanism for this counter-intuitive relationship? for this counter-intuitive relationship? There are at least 7 lines of argument: There are at least 7 lines of argument:

8. 8 1. Downward price trend 2. Price volatility 3. Crowding-out manufacturing 4. Inhibited development of institutions 5. Unsustainably rapid depletion as a result of unenforceable property rights 6. Proclivity for armed conflict 7. The Dutch Disease 7 Possible Natural Resource Curse Channels

9. 9 1. World commodity price trend could be downward (Prebisch-Singer); 1. World commodity price trend could be downward (Prebisch-Singer); 2. High volatility of oil prices could be problematic ; 3. Natural resources could be dead-end sectors (Matsuyama): they may crowd out manufacturing, 1. which may be the home of dynamic benefits & spillovers. 2. “Industrialization” could be the essence of development. The 7 NRC Channels Elaborated

10. 10 The 7 NRC Channels continued 4. Countries where physical command of mineral deposits by the government or a hereditary elite automatically confers wealth on the holders may be less likely to develop the institutions that are conducive to economic development (Engerman-Sokoloff …), e.g., rule of law & decentralization of decision-making, e.g., rule of law & decentralization of decision-making, as compared to countries where moderate taxation of a thriving market economy is the only way to finance government. as compared to countries where moderate taxation of a thriving market economy is the only way to finance government.

11. 11 The 7 NRC Channels continued 5. Non-renewable resources are depleted too fast, where it is difficult to enforce property rights, as under frontier conditions. 6. Countries that are endowed with minerals may have a proclivity for armed conflict, which is inimical to economic growth. 7. Swings in commodity prices can engender macroeconomic instability (Dutch Disease), via the real exchange rate and government spending.

12. 12 We now go through the 7 possible NRC channels (1) The claim of a negative trend in commodity prices on world markets was already dealt with: the data do not suggest a robust long-term trend, certainly not a negative one if updated to 2010.

13. 13 (2) Effects of Volatility Is volatility per se bad for economic growth? Is volatility per se bad for economic growth? Cyclical shifts of resources back & forth across sectors may incur needless transaction costs. Cyclical shifts of resources back & forth across sectors may incur needless transaction costs. A diversified country may indeed be better than one 100% specialized in oil. A diversified country may indeed be better than one 100% specialized in oil. On the other hand, the private sector dislikes risk as much as the government does, and will take steps to mitigate it; On the other hand, the private sector dislikes risk as much as the government does, and will take steps to mitigate it; thus one must think where the market failure lies before assuming that a policy of deliberate diversification is necessarily justified. thus one must think where the market failure lies before assuming that a policy of deliberate diversification is necessarily justified.

14. 14 Effects of volatility, continued Policy-makers may not be better than individual private agents at discerning whether a commodity boom is temporary or not. Policy-makers may not be better than individual private agents at discerning whether a commodity boom is temporary or not. But the government cannot ignore the issue of volatility: But the government cannot ignore the issue of volatility: When it comes to exchange rate or fiscal policy, governments must necessarily make judgments about the likely permanence of shocks. When it comes to exchange rate or fiscal policy, governments must necessarily make judgments about the likely permanence of shocks. More on medium-term cycles when we get to the Dutch Disease More on medium-term cycles when we get to the Dutch Disease

15. 15 (3) Do natural resources crowd out manufacturing? Matsuyama (1992) provided an influential model formalizing this intuition: Matsuyama (1992) provided an influential model formalizing this intuition: the manufacturing sector is assumed to be characterized by learning by doing, while the primary sector (agriculture, in his paper) is not. the manufacturing sector is assumed to be characterized by learning by doing, while the primary sector (agriculture, in his paper) is not. The implication: The implication: deliberate policy-induced diversification out of primary products into manufacturing is justified, and deliberate policy-induced diversification out of primary products into manufacturing is justified, and a permanent commodity boom that crowds out manufacturing can indeed be harmful. a permanent commodity boom that crowds out manufacturing can indeed be harmful.

16. 16 Counterarguments There is no reason why learning by doing should occur exclusively in manufacturing tradables. There is no reason why learning by doing should occur exclusively in manufacturing tradables. Nontradable goods can enjoy learning by doing. [1] Nontradable goods can enjoy learning by doing. [1] [1] The oil sector can as well. The oil sector can as well. The USA is one example of a country that has enjoyed big productivity growth in commodity sectors. The USA is one example of a country that has enjoyed big productivity growth in commodity sectors. Productivity gains have been aided by American public investment, Productivity gains have been aided by American public investment, since the late 19th century, in such knowledge infrastructure institutions as the U.S. Geological Survey, School of Mines, and Land-Grant Colleges. [2] since the late 19th century, in such knowledge infrastructure institutions as the U.S. Geological Survey, School of Mines, and Land-Grant Colleges. [2][2] [1] Torvik (2001). [1] Torvik (2001). [1] [2] Wright & Czelusta (2003, p.6, 25; 18-21). [2] Wright & Czelusta (2003, p.6, 25; 18-21). [2]

17. 17 Counterarguments, continued Public investment in knowledge infrastructure ≠ government ownership of the resources themselves. Public investment in knowledge infrastructure ≠ government ownership of the resources themselves. In Latin America, e.g., public monopoly ownership and prohibition on importing foreign expertise or capital has often stunted development of the mineral sector, whereas privatization has set it free. In Latin America, e.g., public monopoly ownership and prohibition on importing foreign expertise or capital has often stunted development of the mineral sector, whereas privatization has set it free. Attempts by governments to force linkages between the mineral sector and processing industries have often failed. Attempts by governments to force linkages between the mineral sector and processing industries have often failed.

18. 18 (4) Institutions Recent thinking in economic development: The quality of institutions is the deep fundamental factor that determines which countries experience good performance. [1] The quality of institutions is the deep fundamental factor that determines which countries experience good performance. [1] [1] It is futile (e.g., for the IMF & World Bank) to recommend good macroeconomic or microeconomic policies if the institutional structure is not there to support them. It is futile (e.g., for the IMF & World Bank) to recommend good macroeconomic or microeconomic policies if the institutional structure is not there to support them. [1][1] Barro (1991) and North (1994). [1]

19. 19 What are weak institutions? A typical list: A typical list: inequality, inequality, corruption, corruption, insecure property rights, insecure property rights, intermittent dictatorship, intermittent dictatorship, ineffective judiciary branch, and ineffective judiciary branch, and lack of any constraints to prevent elites & politicians from plundering the country. lack of any constraints to prevent elites & politicians from plundering the country. “Quality of institutions” has been quantified by World Bank, Freedom House, Transparency International, and others. “Quality of institutions” has been quantified by World Bank, Freedom House, Transparency International, and others. Rodrik, Subramanian & Trebbi (2003) use a rule of law indicator and protection of property rights (taken from Kaufmann, Kraay & Zoido-Lobaton, 2002). Rodrik, Subramanian & Trebbi (2003) use a rule of law indicator and protection of property rights (taken from Kaufmann, Kraay & Zoido-Lobaton, 2002). Acemoglu, Johnson, & Robinson (2001) use a measure of expropriation risk to investors. Acemoglu, Johnson, & Robinson (2001) use a measure of expropriation risk to investors. Acemoglu, Johnson, Robinson, & Thaicharoen (2003) use the extent of constraints on the executive. Acemoglu, Johnson, Robinson, & Thaicharoen (2003) use the extent of constraints on the executive.

20. 20 Institutions can be endogenous: the result of economic growth rather than the cause. the result of economic growth rather than the cause. The same problem is encountered with other proposed fundamental determinants of growth, e.g., openness to trade and freedom from tropical diseases. The same problem is encountered with other proposed fundamental determinants of growth, e.g., openness to trade and freedom from tropical diseases. Many institutions tend to evolve endogenously, in response to the level of income, Many institutions tend to evolve endogenously, in response to the level of income, such as the structure of financial markets, such as the structure of financial markets, mechanisms of income redistribution & social safety nets, tax systems, and intellectual property rules… mechanisms of income redistribution & social safety nets, tax systems, and intellectual property rules…

21. 21 Addressing endogeneity of institutions econometrically Econometricians address the problem of endogeneity by means of the technique of instrumental variables. Econometricians address the problem of endogeneity by means of the technique of instrumental variables. What is a good instrumental variable for institutions, an exogenous determinant? What is a good instrumental variable for institutions, an exogenous determinant? Acemoglu, Johnson & Robinson (2001) introduced the mortality rates of colonial settlers. Acemoglu, Johnson & Robinson (2001) introduced the mortality rates of colonial settlers. The theory is that, out of all the lands that Europeans colonized, only those where Europeans actually settled were given good European institutions. The theory is that, out of all the lands that Europeans colonized, only those where Europeans actually settled were given good European institutions. Acemoglu et al figured that initial settler mortality determined whether Europeans settled in large numbers.[1] Acemoglu et al figured that initial settler mortality determined whether Europeans settled in large numbers.[1][1] [1] Glaeser, et al, (2004) argue against the settler variable. Hall & Jones (1999) consider latitude and the speaking of English or other European languages as proxies for European institutions. [1] Glaeser, et al, (2004) argue against the settler variable. Hall & Jones (1999) consider latitude and the speaking of English or other European languages as proxies for European institutions. [1]

22. 22 Institutions: Econometric findings The finding is the same, regardless of IV: The finding is the same, regardless of IV: “Institutions trump everything else” – Rodrik et al (2002) “Institutions trump everything else” – Rodrik et al (2002) Acemoglu et al (2002) Acemoglu et al (2002) Easterly & Levine (2002) Easterly & Levine (2002) Hall & Jones (1999) Hall & Jones (1999) Geography and history matter mainly as determinants of institutions; Geography and history matter mainly as determinants of institutions; which is not to say that institutions don’t also have other important determinants. which is not to say that institutions don’t also have other important determinants. In any case, institutions are important. In any case, institutions are important.

23. 23 The “rent cycling theory” as enunciated by Auty (1990, 2001, 07, 09) : Economic growth requires recycling rents via markets rather than via patronage. Economic growth requires recycling rents via markets rather than via patronage. In oil countries the rents elicit a political contest to capture ownership, In oil countries the rents elicit a political contest to capture ownership, whereas in low-rent countries the government must motivate people to create wealth, whereas in low-rent countries the government must motivate people to create wealth, e.g., by pursuing comparative advantage, promoting equality, & fostering civil society. e.g., by pursuing comparative advantage, promoting equality, & fostering civil society.

24. 24 A related view by economic historians Engerman & Sokoloff (1997, 2000, 2002) Why did industrialization take place in North America, Why did industrialization take place in North America, not Latin America? not Latin America? Lands endowed with extractive industries & plantation crops developed slavery, inequality, dictatorship, and state control, Lands endowed with extractive industries & plantation crops developed slavery, inequality, dictatorship, and state control, whereas those climates suited to fishing & small farms developed institutions of individualism, democracy, egalitarianism, and capitalism. whereas those climates suited to fishing & small farms developed institutions of individualism, democracy, egalitarianism, and capitalism. When the Industrial Revolution came, the latter areas were well-suited to make the most of it. When the Industrial Revolution came, the latter areas were well-suited to make the most of it. Those that had specialized in extractive industries were not, Those that had specialized in extractive industries were not, because society had come to depend on class structure & authoritarianism, rather than on individual incentive and decentralized decision-making. because society had come to depend on class structure & authoritarianism, rather than on individual incentive and decentralized decision-making.

25. 25 Econometric findings that oil and other “point-source resources lead to poor institutions Isham, Woolcock, Pritchett, & Busby (2005) Isham, Woolcock, Pritchett, & Busby (2005) Sala-I-Martin & Subramanian (2003) Sala-I-Martin & Subramanian (2003) Bulte, Damania & Deacon (2005) Bulte, Damania & Deacon (2005) Mehlum, Moene & Torvik (2006) Mehlum, Moene & Torvik (2006) Arezki & Brückner (2009). Arezki & Brückner (2009). The theory is thought to fit Middle Eastern oil exporters well. E.g., Iran. Mahdavi (1970), Skocpol (1982, p. 269 ), and Smith (2007). E.g., Iran. Mahdavi (1970), Skocpol (1982, p. 269 ), and Smith (2007).

26. 26 Which comes first, oil or institutions? Some question the assumption that oil discoveries are exogenous and institutions endogenous. Some question the assumption that oil discoveries are exogenous and institutions endogenous. Oil wealth is not necessarily the cause and institutions the effect, rather than the other way around. Oil wealth is not necessarily the cause and institutions the effect, rather than the other way around. Norman (2009): the discovery & development of oil is not purely exogenous, but rather is endogenous with respect to the efficiency of the economy. Norman (2009): the discovery & development of oil is not purely exogenous, but rather is endogenous with respect to the efficiency of the economy.

27. 27 The important determinant is whether the country already has good institutions at the time that oil is discovered, in which case it is put to use for the national welfare, instead of the welfare of an elite, on average. Mehlum, Moene & Torvik (2006), Mehlum, Moene & Torvik (2006), Robinson, Torvik & Verdier (2006), Robinson, Torvik & Verdier (2006), McSherry (2006), McSherry (2006), Smith (2007) and Smith (2007) and Collier & Goderis (2007). Collier & Goderis (2007). Luong & Weinthal (2010), in a study of the 5 oil-producing former Soviet republics: the choice of ownership structure makes the difference as to whether oil turns out a blessing rather than a curse. Luong & Weinthal (2010), in a study of the 5 oil-producing former Soviet republics: the choice of ownership structure makes the difference as to whether oil turns out a blessing rather than a curse.

28. 28 (5) Unsustainably rapid depletion What happens when a depletable natural resource is indeed depleted? What happens when a depletable natural resource is indeed depleted? This question is important for 3 reasons: This question is important for 3 reasons: Protection of environmental quality. Protection of environmental quality. A motivation for the strategy of economic diversification. A motivation for the strategy of economic diversification. A motivation for the “Hartwick rule”: A motivation for the “Hartwick rule”: All rents from exhaustible natural resources should be invested in other assets, so that future generations do not suffer a diminution in total wealth (natural resource plus reproducible capital) and therefore in the flow of consumption. All rents from exhaustible natural resources should be invested in other assets, so that future generations do not suffer a diminution in total wealth (natural resource plus reproducible capital) and therefore in the flow of consumption. Hartwick (1977) and Solow (1986). Hartwick (1977) and Solow (1986).

29. 29 Rapid depletion, continued Each of these problems would be much less severe if full assignment of property rights were possible, Each of these problems would be much less severe if full assignment of property rights were possible, thereby giving the owners adequate incentive to conserve the resource in question. thereby giving the owners adequate incentive to conserve the resource in question. But often this is not possible, But often this is not possible, either physically either physically or politically. or politically. Especially in a frontier situation. Especially in a frontier situation. The difficulty in enforcing property rights over some non-renewable resources constitutes a category of natural resource curse of its own. The difficulty in enforcing property rights over some non-renewable resources constitutes a category of natural resource curse of its own.

30. 30 Unenforceable property rights over depletable resources Unenforceable property rights over depletable resources Some natural resources do not lend themselves to property rights, whether the government wants to apply them or not. Some natural resources do not lend themselves to property rights, whether the government wants to apply them or not. Very different from the theory that the physical possession of point- source mineral wealth undermines the motivation for the government to establish a regime of property rights for the rest of the economy. Very different from the theory that the physical possession of point- source mineral wealth undermines the motivation for the government to establish a regime of property rights for the rest of the economy. Overfishing, overgrazing, & over-use of water are classic examples of the “tragedy of the commons” that applies to “open access” resources. Overfishing, overgrazing, & over-use of water are classic examples of the “tragedy of the commons” that applies to “open access” resources. Individual fisherman or farmers have no incentive to restrain themselves, while the fisheries or pastureland or water aquifers are collectively depleted. Individual fisherman or farmers have no incentive to restrain themselves, while the fisheries or pastureland or water aquifers are collectively depleted.

31. 31 Unenforceable property rights, continued The difficulty in imposing property rights is particularly severe when the resource is The difficulty in imposing property rights is particularly severe when the resource is dispersed over a wide area, as timberland. area, as timberland. But even the classic point-source resource, oil, can suffer the problem, especially when wells drilled from different plots of land hit the same underground deposit. But even the classic point-source resource, oil, can suffer the problem, especially when wells drilled from different plots of land hit the same underground deposit.

32. 32 Unenforceable property rights, continued This market failure can invalidate some standard neoclassical economic theorems in the case of open access resources. This market failure can invalidate some standard neoclassical economic theorems in the case of open access resources. The resource will be depleted more rapidly than the optimization of the Hotelling calculation calls for. [1] The resource will be depleted more rapidly than the optimization of the Hotelling calculation calls for. [1] [1] The benefits of free trade may be another casualty: The benefits of free trade may be another casualty: If exports exacerbate the excess rate of exploitation, If exports exacerbate the excess rate of exploitation, the country might be better worse off. [2] [1] E.g., Dasgupta & Heal (1985). [2] Brander & Taylor (1997). the country might be better worse off. [2] [1] E.g., Dasgupta & Heal (1985). [2] Brander & Taylor (1997). [2] [1] [2] [1] [2]

33. 33 (6) War Where a valuable resource such as oil or diamonds is there for the taking, factions will likely fight over it. Where a valuable resource such as oil or diamonds is there for the taking, factions will likely fight over it. Oil & minerals are correlated with civil war. Oil & minerals are correlated with civil war. Collier & Hoeffler (2004), Collier (2007), Fearon & Laitin (2003) and Humphreys (2005). Collier & Hoeffler (2004), Collier (2007), Fearon & Laitin (2003) and Humphreys (2005). Chronic conflict in such oil-rich countries as Angola & Sudan comes to mind. Chronic conflict in such oil-rich countries as Angola & Sudan comes to mind. Civil war is, in turn, very bad for economic development. Civil war is, in turn, very bad for economic development.

34. 34 (7) The Dutch Disease and Procyclicality Developing countries have historically been prone to procyclicality: Developing countries have historically been prone to procyclicality: Procyclical capital inflows Procyclical capital inflows Procyclical government spending. Procyclical government spending. This is particularly true of commodity producers. This is particularly true of commodity producers. The Dutch Disease describes unwanted side- effects from a strong, but perhaps temporary, upward swing in the world price of the export commodity. The Dutch Disease describes unwanted side- effects from a strong, but perhaps temporary, upward swing in the world price of the export commodity.

35. 35 Procyclicality Volatility in developing countries arises both from foreign shocks, arises both from foreign shocks, including export commodity price fluctuations, including export commodity price fluctuations, and from domestic shocks and from domestic shocks including macroeconomic & political instability. including macroeconomic & political instability.

36. 36 Procyclicality Volatility in developing countries Most developing countries in the 1990s brought under control the chronic runaway budget deficits, money creation, & inflation, that they experienced in the preceding two decades, Most developing countries in the 1990s brought under control the chronic runaway budget deficits, money creation, & inflation, that they experienced in the preceding two decades, but many still showed monetary & fiscal policy that was procyclical rather than countercyclical: but many still showed monetary & fiscal policy that was procyclical rather than countercyclical: They tend to be expansionary in booms They tend to be expansionary in booms and contractionary in recessions, and contractionary in recessions, thereby exacerbating the magnitudes of the swings. thereby exacerbating the magnitudes of the swings. The aim should be to moderate swings The aim should be to moderate swings -- the countercyclical pattern that economists, after the Great Depression, originally hoped discretionary policy would take. -- the countercyclical pattern that economists, after the Great Depression, originally hoped discretionary policy would take.

37. 37 Procyclicality in developing countries Procyclical capital flows According to theory (“intertemporal optimization”), countries should borrow during temporary downturns, According to theory (“intertemporal optimization”), countries should borrow during temporary downturns, to sustain consumption & investment, and should repay or accumulate net foreign assets during temporary upturns. In practice, it does not always work this way. Capital flows are more procyclical than countercyclical. [1] In practice, it does not always work this way. Capital flows are more procyclical than countercyclical. [1] [1] Theories to explain this involve capital market imperfections, Theories to explain this involve capital market imperfections, e.g., asymmetric information or the need for collateral. e.g., asymmetric information or the need for collateral. [1][1] Kaminsky, Reinhart, & Vegh (2005); Reinhart & Reinhart (2009); Gavin, Hausmann, Perotti & Talvi (1996); and Mendoza & Terrones (2008). [1]

38. 38 Procyclicality in developing countries Procyclical capital flows, continued As countries evolve more market-oriented financial systems, the capital inflows during the boom phase show up in prices for land & buildings, and also in prices of financial assets. As countries evolve more market-oriented financial systems, the capital inflows during the boom phase show up in prices for land & buildings, and also in prices of financial assets. Prices of equities & bonds are summary measures of the extent of speculative enthusiasm, Prices of equities & bonds are summary measures of the extent of speculative enthusiasm, often useful for predicting which countries are vulnerable to crises in the future. often useful for predicting which countries are vulnerable to crises in the future.

39. 39 Procyclical capital flows, continued Procyclical capital flows, continued In the commodity & emerging market boom of 2003-08, net capital flows typically went to countries with current account surpluses, especially Asians and commodity producers in the Middle East & Latin America, In the commodity & emerging market boom of 2003-08, net capital flows typically went to countries with current account surpluses, especially Asians and commodity producers in the Middle East & Latin America, where they showed up in record accumulation of foreign exchange reserves. where they showed up in record accumulation of foreign exchange reserves. This was in contrast to the two previous cycles, 1975-1981 and 1990-97, when the capital flows to developing countries largely went to finance current account deficits. This was in contrast to the two previous cycles, 1975-1981 and 1990-97, when the capital flows to developing countries largely went to finance current account deficits. Procyclicality in developing countries

40. 40 One interpretation of procyclical capital flows is that they result from procyclical fiscal policy: One interpretation of procyclical capital flows is that they result from procyclical fiscal policy: when governments increase spending in booms, the deficit is financed by borrowing from abroad. when governments increase spending in booms, the deficit is financed by borrowing from abroad. When they are forced to cut spending in downturns, it is to repay the excessive debt incurred during the upturn. When they are forced to cut spending in downturns, it is to repay the excessive debt incurred during the upturn. Another interpretation of procyclical capital flows to developing countries is that they pertain especially to oil exporters. Another interpretation of procyclical capital flows to developing countries is that they pertain especially to oil exporters. We consider procyclical fiscal policy in the next sub-section, return to the commodity cycle (Dutch disease) in the one after. We consider procyclical fiscal policy in the next sub-section, return to the commodity cycle (Dutch disease) in the one after. Procyclicality in developing countries

41. 41 Procyclicality in developing countries The procyclicality of fiscal policy Many authors have shown that fiscal policy has tended to be procyclical in developing countries, Many authors have shown that fiscal policy has tended to be procyclical in developing countries, especially in comparison with industrialized countries. [1] especially in comparison with industrialized countries. [1][1] A major reason for procyclical public spending: receipts from taxes or royalties rise in booms. The government cannot resist the temptation or political pressure to increase spending proportionately, or more. A major reason for procyclical public spending: receipts from taxes or royalties rise in booms. The government cannot resist the temptation or political pressure to increase spending proportionately, or more. [1][1] Cuddington (1989), Tornell & Lane (1999), Kaminsky, Reinhart, & Vegh (2004), Talvi & Végh (2005), Alesina, Campante & Tabellini (2008), Mendoza & Oviedo (2006), Ilzetski & Vegh (2008), Medas & Zakharova (2009) and Gavin & Perotti (1997). [1]

42. 42 The procyclicality of fiscal policy, continued Procyclicality is especially pronounced in countries with natural resources and where income from those resources tends to dominate the business cycle. Procyclicality is especially pronounced in countries with natural resources and where income from those resources tends to dominate the business cycle. Cuddington (1989) and Sinnott (2009) Cuddington (1989) and Sinnott (2009) An important recent development: some developing countries, including commodity producers, have been able to break the historic pattern in the most recent cycle: An important recent development: some developing countries, including commodity producers, have been able to break the historic pattern in the most recent cycle: Using the boom of 2002-2008 to run budget surplus & build reserves, Using the boom of 2002-2008 to run budget surplus & build reserves, thereby earning the ability to expand fiscally in the 2008-09 crisis. thereby earning the ability to expand fiscally in the 2008-09 crisis. Chile is the outstanding model. Chile is the outstanding model. Procyclicality in developing countries

43. 43 (i) Public investment projects Two large budget items that account for much of the increased spending from oil booms: Two large budget items that account for much of the increased spending from oil booms: (i) investment projects and (i) investment projects and (ii) the government wage bill. (ii) the government wage bill. Regarding the 1 st budget item, investment in infrastructure can have large long-term pay-off if it is well designed; too often in practice, however, it takes the form of white elephant projects, which are stranded without funds for completion or maintenance, when the oil price goes back down. Regarding the 1 st budget item, investment in infrastructure can have large long-term pay-off if it is well designed; too often in practice, however, it takes the form of white elephant projects, which are stranded without funds for completion or maintenance, when the oil price goes back down. Gelb (1986). Gelb (1986).

44. 44 (ii) Public sector wage bills Regarding the 2nd budget item, oil windfalls have often been spent on higher public sector wages -- Medas & Zakharova (2009 ). Regarding the 2nd budget item, oil windfalls have often been spent on higher public sector wages -- Medas & Zakharova (2009 ). They can also go to increasing the number of workers employed by the government. They can also go to increasing the number of workers employed by the government. Either way, they raise the total public sector wage bill, which is hard to reverse when oil prices go back down. Either way, they raise the total public sector wage bill, which is hard to reverse when oil prices go back down. Figures 2 & 3 plot the public sector wage bill, for two oil producers, Iran & Indonesia. Figures 2 & 3 plot the public sector wage bill, for two oil producers, Iran & Indonesia. against primary product prices over the preceding 3 years. against primary product prices over the preceding 3 years.

45. 45 Figure 2: Iran’s Government Wage Bill Is Influenced by Oil Prices Over Preceding 3 Years (1974, 1977-1997.) Source: Frankel (2005b)

46. 46 Figure 3: Indonesia’s Government Wage Bill Is Influenced by Oil Prices Over Preceding 3 Years (1974, 1977-1997.) Source: Frankel (2005b)

47. 47 Public sector wage bills, continued There is a clear positive relationship. There is a clear positive relationship. That the relationship is strong with a 3-year lag shows the problem: oil prices may have fallen over 3 years, but public sector wages cannot easily be cut nor workers laid off. That the relationship is strong with a 3-year lag shows the problem: oil prices may have fallen over 3 years, but public sector wages cannot easily be cut nor workers laid off. Arezki & Ismail (2010) find that current government spending increases in boom times, but is downward-sticky. Arezki & Ismail (2010) find that current government spending increases in boom times, but is downward-sticky.

48. 48 The Dutch Disease: 5 side-effects of a commodity boom 1) A real appreciation in the currency 1) A real appreciation in the currency 2) A rise in government spending 2) A rise in government spending 3) A rise in nontraded goods prices 3) A rise in nontraded goods prices 4) A resultant shift of resources out of non-export-commodity traded goods 4) A resultant shift of resources out of non-export-commodity traded goods 5) A current account deficit 5) A current account deficit

49. 49 The Dutch Disease: The 5 effects elaborated 1) A real appreciation in the currency 1) A real appreciation in the currency taking the form of nominal currency appreciation if the exchange rate floats taking the form of nominal currency appreciation if the exchange rate floats or the form of money inflows & inflation if the exchange rate is fixed [1]; or the form of money inflows & inflation if the exchange rate is fixed [1]; [1] 2) An increase in government spending 2) An increase in government spending in response to increased availability of tax receipts or royalties; in response to increased availability of tax receipts or royalties; [1] E.g., Edwards (1986). During the boom of 2001-2008, fixed-rate oil-producing countries where real appreciation came via money inflows & inflation: Saudi Arabia & the UAE. E.g., Edwards (1986). During the boom of 2001-2008, fixed-rate oil-producing countries where real appreciation came via money inflows & inflation: Saudi Arabia & the UAE. Floating-rate oil exporters where real appreciation took the form of nominal currency appreciation: Kazakhstan, Mexico, Norway, & Russia. Floating-rate oil exporters where real appreciation took the form of nominal currency appreciation: Kazakhstan, Mexico, Norway, & Russia.

50. 50 The Dutch Disease: 5 side-effects of a commodity boom 3) An increase in nontraded goods prices (goods & services such as housing that are not internationally traded), 3) An increase in nontraded goods prices (goods & services such as housing that are not internationally traded), relative to traded goods (manufactures & other internationally traded goods other than the export commodity). relative to traded goods (manufactures & other internationally traded goods other than the export commodity). 4) A resultant shift of resources out of non-export-commodity traded goods 4) A resultant shift of resources out of non-export-commodity traded goods pulled by the more attractive returns in the export commodity and in non-traded goods. pulled by the more attractive returns in the export commodity and in non-traded goods.

51. 51 The Dutch Disease: 5 side-effects of a commodity boom 5) A current account deficit (thereby incurring international debt that may be difficult to service when the commodity boom ends [2] ). 5) A current account deficit (thereby incurring international debt that may be difficult to service when the commodity boom ends [2] ). [2] [2] Manzano & Rigobon (2008): the negative Sachs-Warner effect of resource dependence on growth rates during 1970-1990 was mediated through international debt incurred when commodity prices were high. [2] Manzano & Rigobon (2008): the negative Sachs-Warner effect of resource dependence on growth rates during 1970-1990 was mediated through international debt incurred when commodity prices were high. [2] Arezki & Brückner (2010a): commodity price booms lead to increased government spending, external debt & default risk in autocracies, Arezki & Brückner (2010a): commodity price booms lead to increased government spending, external debt & default risk in autocracies, but do not have those effects in democracies. but do not have those effects in democracies. Arezki & Brückner (2010b): the dichotomy extends also to effects on sovereign bond spreads paid by autocratic vs, democratic commodity producers. Arezki & Brückner (2010b): the dichotomy extends also to effects on sovereign bond spreads paid by autocratic vs, democratic commodity producers.

52. 52 Summary: Channels of the NRC (1) Commodity price volatility is high, imposing risk & costs. (1) Commodity price volatility is high, imposing risk & costs. (2) Specialization in oil can crowd out the manufacturing sector. (2) Specialization in oil can crowd out the manufacturing sector. (3) Depletion can be unsustainably rapid, (3) Depletion can be unsustainably rapid, especially if property rights are not adequately protected. especially if property rights are not adequately protected. (4) Mineral riches can lead to civil war. (4) Mineral riches can lead to civil war. (5) Oil endowments can lead to poor institutions, such as corruption, inequality, class structure, chronic power struggles, and absence of rule of law and property rights. (5) Oil endowments can lead to poor institutions, such as corruption, inequality, class structure, chronic power struggles, and absence of rule of law and property rights. (6) The Dutch Disease. A commodity boom: => real currency appreciation and increased government spending, => which expand nontraded sector and render uncompetitive non- commodity export sectors such as manufactures (6) The Dutch Disease. A commodity boom: => real currency appreciation and increased government spending, => which expand nontraded sector and render uncompetitive non- commodity export sectors such as manufactures => debt. => debt.

53. 53 The Natural Resource Curse should not be interpreted as a rule that resource- rich countries are doomed to failure. The question is what policies to adopt to improve the chances of prosperity. The question is what policies to adopt to improve the chances of prosperity. Destruction or renunciation of resource endowments, to avoid dangers such as the corruption of leaders, will not be one of these policies. Destruction or renunciation of resource endowments, to avoid dangers such as the corruption of leaders, will not be one of these policies. Even if such a drastic action would on average leave the country better off, which seems unlikely, who would be the policy-maker to whom one would deliver such advice? Even if such a drastic action would on average leave the country better off, which seems unlikely, who would be the policy-maker to whom one would deliver such advice? The paper concludes with ideas for institutions designed to address aspects of the resource curse and thereby increase the chance of economic success. The paper concludes with ideas for institutions designed to address aspects of the resource curse and thereby increase the chance of economic success.

54. 54

55. 55 Addenda: 1) 3 cycles of capital flows to developing countries 2)Skeptics of the NRC

56. 56 What characteristics have helped emerging markets resist financial contagion? High FX reserves and/or floating currency High FX reserves and/or floating currency Low foreign-denominated debt (currency mismatch) Low foreign-denominated debt (currency mismatch) Low short-term debt (maturity mis-match) Low short-term debt (maturity mis-match) High Foreign Direct Investment High Foreign Direct Investment Strong initial budget, allowing room to ease. Strong initial budget, allowing room to ease. High export/GDP ratio, High export/GDP ratio, Sachs (1985); Eaton & Gersovitz (1981), Rose (2002); Calvo, Izquierdo & Talvi (2003); Edwards (2004); Cavallo & Frankel ( 2008). Sachs (1985); Eaton & Gersovitz (1981), Rose (2002); Calvo, Izquierdo & Talvi (2003); Edwards (2004); Cavallo & Frankel ( 2008). In the 2008-09 crisis, many of the historical Early Warning Indicators worked, especially reserves In the 2008-09 crisis, many of the historical Early Warning Indicators worked, especially reserves Frankel & Saravelos (2010) Frankel & Saravelos (2010)

57. 57 Procyclical capital flows, continued 3 cycles in capital flows to emerging markets 1 st developing country lending boom (“recycling petro dollars”): 1975-1981 1 st developing country lending boom (“recycling petro dollars”): 1975-1981 Ended in international debt crisis 1982 Ended in international debt crisis 1982 7 Lean years (“Lost Decade”): 1982-1989 7 Lean years (“Lost Decade”): 1982-1989 2 nd lending boom (“emerging markets”): 1990-96 2 nd lending boom (“emerging markets”): 1990-96 Ended in East Asia crisis 1997 Ended in East Asia crisis 1997 7 Lean years: 1997-2003 7 Lean years: 1997-2003 3 rd boom (incl. China & India this time): 2003-2008 3 rd boom (incl. China & India this time): 2003-2008

58. 58 This time, many countries used the inflows to build up forex reserves, rather than to finance Current Account deficits 2003-07 boom 1991-97 boom

59. 59 Skeptics argue that commodity exports are endogenous. [1] [1] On the one hand, basic trade theory says: A country may show a high mineral share in exports, not necessarily because it has a higher endowment of minerals than others (absolute advantage) but because it does not have the ability to export manufactures (comparative advantage). On the one hand, basic trade theory says: A country may show a high mineral share in exports, not necessarily because it has a higher endowment of minerals than others (absolute advantage) but because it does not have the ability to export manufactures (comparative advantage). This could explain negative statistical correlations between mineral exports and economic development, This could explain negative statistical correlations between mineral exports and economic development, invalidating the common inference that minerals are bad for growth. invalidating the common inference that minerals are bad for growth. [1] Maloney (2002) and Wright & Czelusta (2003, 04, 06). [1] Maloney (2002) and Wright & Czelusta (2003, 04, 06). [1]

60. 60 Commodity exports are endogenous, continued. On the other hand, skeptics also have plenty of examples where successful institutions and industrialization went hand in hand with rapid development of mineral resources. On the other hand, skeptics also have plenty of examples where successful institutions and industrialization went hand in hand with rapid development of mineral resources. Countries that were able to develop efficiently their resource endowments as part of strong economy-wide growth include: Countries that were able to develop efficiently their resource endowments as part of strong economy-wide growth include: the USA during its pre-war industrialization period [1], the USA during its pre-war industrialization period [1], [1] Venezuela from the 1920s to the 1970s, Australia since the 1960s, Norway since 1969 oil discoveries, Chile since adoption of a new mining code in 1983, Peru since a privatization program in 1992, and Brazil since the lifting of restrictions on foreign mining participation in 1995. [2] Venezuela from the 1920s to the 1970s, Australia since the 1960s, Norway since 1969 oil discoveries, Chile since adoption of a new mining code in 1983, Peru since a privatization program in 1992, and Brazil since the lifting of restrictions on foreign mining participation in 1995. [2] [2] [1] David & Wright (1997). [1] David & Wright (1997). [1] [2] Wright & Czelusta (2003, pp. 4-7, 12-13, 18-22 ). [2] Wright & Czelusta (2003, pp. 4-7, 12-13, 18-22 ). [2]

61. 61 Commodity exports are endogenous, continued. Examples of countries that were equally well-endowed geologically but that failed to develop their natural resources efficiently include: Examples of countries that were equally well-endowed geologically but that failed to develop their natural resources efficiently include: Chile and Australia before World War I, Chile and Australia before World War I, and Venezuela since the 1980s.[3] and Venezuela since the 1980s.[3][3] [3] Hausmann (2003, p.246 ): “Venezuela’s growth collapse took place after 60 years of expansion, fueled by oil. If oil explains slow growth, what explains the previous fast growth?” [3] Hausmann (2003, p.246 ): “Venezuela’s growth collapse took place after 60 years of expansion, fueled by oil. If oil explains slow growth, what explains the previous fast growth?” [3]