1. The Natural Resource Curse and How to Avoid It Jeffrey Frankel Part I: Channels of the commodity curse Part II: Policies & institutions to avoid the pitfalls Monetary Policy & Commodity Prices Study Center Gerzensee, 23-25 June, 2014

2. 2 The Natural Resource Curse Part I: Channels Some seminal references: Some seminal references: Auty (1990, 2001, 2007) Auty (1990, 2001, 2007) Sachs & Warner (1995, 2001). Sachs & Warner (1995, 2001). By now there is a large body of research, By now there is a large body of research, which I have surveyed (2011, 2012a, b). which I have surveyed (2011, 2012a, b).

3. Many countries that are richly endowed with oil, minerals, or fertile land have failed to grow more rapidly than those without. Example: Some studies find a negative effect of oil in particular, on economic performance: Some 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). Some oil producers in Africa & the Middle East have relatively little to show for their resources.

4. Meanwhile, East Asian economies achieved western-level standards of living despite having virtually no exportable natural resources: Japan, Singapore, Hong Kong, Korea & Taiwan, rocky islands or peninsulas; followed by China.

5. 5 Growth falls with fuel & mineral exports

6. 6 Are natural resources necessarily bad? Commodity wealth need not necessarily lead to inferior economic or political development. Commodity 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 should be on identifying ways The priority should be on identifying ways to sidestep the pitfalls that have afflicted commodity producers in the past, to find the path of success. No, of course not.

7. 7 Some developing countries have avoided the pitfalls of commodity wealth. Some developing countries have avoided the pitfalls of commodity wealth. E.g., Chile (copper) E.g., Chile (copper) Botswana (diamonds) Botswana (diamonds) Some of their innovations are worth emulating. Some of their innovations are worth emulating. The 2 nd half of the lecture will offer some policies & institutional innovations to avoid the curse: The 2 nd half of the lecture will offer some policies & institutional innovations to avoid the curse: especially ways of managing price volatility. especially ways of managing price volatility. Some lessons apply to commodity importers too. Some lessons apply to commodity importers too. Including lessons of policies to avoid. Including lessons of policies to avoid.

8. 8 But, 1 st : How could abundance of commodity wealth be a curse? But, 1 st : How could abundance of commodity wealth be a curse? What is the mechanism What is the mechanism for this counter-intuitive relationship? for this counter-intuitive relationship? At least 5 categories of explanations. At least 5 categories of explanations.

9. 9 1. Volatility 2. Crowding-out of manufacturing 2. Crowding-out of manufacturing 3. Autocratic Institutions 4. Anarchic Institutions 5. Procyclicality including 1. Procyclical capital flows 2. Procyclical monetary policy 3. Procyclical fiscal policy. 5 Possible Natural Resource Curse Channels

10. 10 (1) Volatility (1) Volatility

11. 11 Effects of Volatility Volatility per se can be bad for economic growth. Volatility per se can be bad for economic growth. Hausmann & Rigobon (2003), Blattman, Hwang, & Williamson (2007), and Poelhekke & van der Ploeg (2007). Hausmann & Rigobon (2003), Blattman, Hwang, & Williamson (2007), and Poelhekke & van der Ploeg (2007). Risk inhibits private investment. Risk inhibits private investment. Cyclical shifts of labor, land & capital back & forth across sectors may incur needless costs. Cyclical shifts of labor, land & capital back & forth across sectors may incur needless costs. => role for government intervention? => role for government intervention? On the one hand, the private sector dislikes risk as much as government does & takes steps to mitigate it. On the one hand, the private sector dislikes risk as much as government does & takes steps to mitigate it. On the other hand the government cannot entirely ignore the issue of volatility; On the other hand the government cannot entirely ignore the issue of volatility; e.g., exchange rate policy. e.g., exchange rate policy.

12. 2. Natural resources may crowd out manufacturing, and manufacturing could be the sector that experiences learning-by-doing and manufacturing could be the sector that experiences learning-by-doing or dynamic productivity gains from spillover. or dynamic productivity gains from spillover. Matsuyama (1992), van Wijnbergen (1984) and Sachs & Warner (1995). Matsuyama (1992), van Wijnbergen (1984) and Sachs & Warner (1995). So commodities could in theory be a dead-end sector. So commodities could in theory be a dead-end sector. My own view: a country need not repress the commodity sector to develop the manufacturing sector. My own view: a country need not repress the commodity sector to develop the manufacturing sector. It can foster growth in both. It can foster growth in both. E.g. Canada, Australia, Norway… Now Malaysia, Chile, Brazil… E.g. Canada, Australia, Norway… Now Malaysia, Chile, Brazil…

13. Econometric findings that oil and other “point-source resources” lead to poor institutions Isham, Woolcock, Pritchett, & Busby (2005) Sala-I-Martin & Subramanian (2003) Bulte, Damania & Deacon (2005) Mehlum, Moene & Torvik (2006) Arezki & Brückner (2009).

14. What are poor institutions? A typical list: inequality, corruption, rent-seeking, intermittent dictatorship, ineffective judiciary branch, and lack of constraints to prevent elites & politicians from plundering the country.

15. An example, from economic historians Engerman & Sokoloff (1997, 2000, 2002) Why did industrialization take place in North America, not the South? Lands endowed with extractive industries & plantation crops developed slavery, inequality, dictatorship, and state control, whereas those climates suited to small farms & fishing developed institutions of individualism, democracy, egalitarianism & capitalism. 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, because society had come to depend on class structure & authoritarianism, rather than on individual incentive & decentralized decision-making.

16. 16 4. Anarchic institutions 1. Unsustainably rapid depletion of resources 1. Unsustainably rapid depletion of resources 2. Unenforceable property rights 3. Civil war See Appendix 2 for elaboration on each.

17. 17 (5) Procyclicality The Dutch Disease describes unwanted side-effects of a commodity boom. The Dutch Disease describes unwanted side-effects of a commodity boom. Developing countries are historically prone to procyclicality, Developing countries are historically prone to procyclicality, especially commodity producers. especially commodity producers. Procyclicality in: Procyclicality in: Capital inflows; Monetary policy; Capital inflows; Monetary policy; Real exchange rate; Nontraded Goods Real exchange rate; Nontraded Goods Fiscal Policy Fiscal Policy

18. 18 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 production out of manufactured goods 4) A resultant shift of production out of manufactured goods 5) Sometimes a current account deficit 5) Sometimes a current account deficit

19. 19 The Dutch Disease: The 5 effects elaborated 1) Real appreciation in the currency 1) 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, credit & inflation if the exchange rate is fixed; or the form of money inflows, credit & inflation if the exchange rate is fixed; 2) A rise in government spending 2) A rise in government spending in response to availability of tax receipts or royalties. in response to availability of tax receipts or royalties.

20. 20 The Dutch Disease: 5 side-effects of a commodity boom 3) An increase in nontraded goods prices relative to internationally traded goods 3) An increase in nontraded goods prices relative to internationally traded goods 4) A resultant shift out of non-commodity traded goods, 4) A resultant shift out of non-commodity traded goods, esp. manufactures, esp. manufactures, 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.

21. 21 The Dutch Disease: 5 side-effects of a commodity boom 5) A current account deficit, 5) A current account deficit, as booming countries attract capital flows, as booming countries attract capital flows, thereby incurring international debt that is hard to service when the boom ends. thereby incurring international debt that is hard to service when the boom ends. Manzano & Rigobon (2008): the negative Sachs-Warner effect of resources on growth rates during 1970-1990 was mediated through international debt incurred when commodity prices were high. Arezki & Brückner (2010a, b): commodity price booms lead to higher government spending, external debt & default risk in autocracies, but do not have those effects in democracies.

22. Procyclical capital flows According to intertemporal optimization theory, capital flows should be countercyclical: net capital inflows when exports are doing badly and net capital outflows when exports do well. In practice, it does not always work this way. Capital flows are more procyclical than countercyclical. Gavin, Hausmann, Perotti & Talvi (1996) ; Kaminsky, Reinhart & Vegh (2005) ; Reinhart & Reinhart (2009); and Mendoza & Terrones (2008). Invalidates much of existing theory, though certainly not all. Theories to explain this involve capital market imperfections, e.g., asymmetric information or the need for collateral.

23. Procyclical monetary policy If the exchange rate is fixed, surpluses during commodity booms lead to rising reserves & money supply. possibly delayed by sterilization attempts. Example: Gulf States during recent oil booms. Floating can help, accommodating trade shock. But, under pure floating: appreciation can be excessive. under IT: CPI rule says to tighten money & appreciate when import commodity price goes up (or other adverse supply shock). That’s backwards. (E.g., oil importers in 2008.) Should appreciate when export commodity price goes up.

24. Procyclical real exchange rate Countries undergoing a commodity boom experience real appreciation of their currency taking the form of nominal currency appreciation taking the form of nominal currency appreciation for floating-rate commodity exporters, Colombia, Kazakhstan, Russia, S.Africa, Chile, Brazil…. for floating-rate commodity exporters, Colombia, Kazakhstan, Russia, S.Africa, Chile, Brazil…. or the form of money inflows & inflation or the form of money inflows & inflation for fixed-rate commodity exporters, Saudi Arabia & UAE…. for fixed-rate commodity exporters, Saudi Arabia & UAE…. OK. But real appreciation adds to boom in NTGs.

25. Procyclical fiscal policy Fiscal policy has historically tended to be procyclical in developing countries Fiscal policy has historically tended to be procyclical in developing countries especially among commodity exporters: especially among commodity exporters: 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), Gavin & Perotti (1997). 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), Gavin & Perotti (1997). Correlation of income & spending mostly positive – Correlation of income & spending mostly positive – particularly in comparison with industrialized countries. particularly in comparison with industrialized countries.

26. 26 The procyclicality of fiscal policy The procyclicality of fiscal policy A reason for procyclical public spending: receipts from taxes & royalties rise in booms. The government cannot resist the temptation to increase spending proportionately, or more. A reason for procyclical public spending: receipts from taxes & royalties rise in booms. The government cannot resist the temptation to increase spending proportionately, or more. Then it is forced to contract in recessions, Then it is forced to contract in recessions, thereby exacerbating the swings. thereby exacerbating the swings.

27. 27 Two budget items account for much of the spending from oil booms: (i) Investment projects. (i) Investment projects. Investment in practice may be “white elephant” projects, Investment in practice may be “white elephant” projects, which are stranded without funds for completion or maintenance when the oil price goes back down. which are stranded without funds for completion or maintenance when the oil price goes back down. Gelb (1986). Gelb (1986). (ii) The government wage bill. (ii) The government wage bill. Oil windfalls are often spent on public sector wages. Oil windfalls are often spent on public sector wages. Medas & Zakharova (2009) Medas & Zakharova (2009) Arezki & Ismail (2010) : Arezki & Ismail (2010) : government spending rises in booms, but is downward-sticky. Rumbi Sithole took this photo in “Bayelsa State in the Niger Delta,in Nigeria. The state government received a windfall of money and didn't have the capacity to have it all absorbed in social services so they decided to build a Hilton Hotel. The construction company did a shoddy job, so the tower is leaning to its right and it’s unsalvageable..”

28. Correlations between Gov.t Spending & GDP 1960-1999 procyclical } G always used to be pro-cyclical for most developing countries. countercyclical Adapted from Kaminsky, Reinhart & Vegh (2004)

29. 29 An important development -- some developing countries, including commodity producers, were able to break the historic pattern in the most recent decade: An important development -- some developing countries, including commodity producers, were able to break the historic pattern in the most recent decade: taking advantage of the boom of 2002-2008 taking advantage of the boom of 2002-2008 to run budget surpluses & build reserves, to run budget surpluses & 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. Also Botswana, China, Indonesia, Korea… Also Botswana, China, Indonesia, Korea… The procyclicality of fiscal policy, cont.

30. Correlations between Government spending & GDP 2000-2009 In the last decade, about 1/3 developing countries switched to countercyclical fiscal policy: Negative correlation of G & GDP. Frankel, Vegh & Vuletin (2012) procyclical countercyclical

31. Summary of NRC, Part I Five broad categories of hypothesized channels whereby natural resources can lead to poor economic performance: commodity price volatility, crowding out of manufacturing, autocratic institutions, anarchic institutions, and procyclical macroeconomic policy, including capital flows, monetary policy and fiscal policy. But the important question is how to avoid the pitfalls, to achieve resource blessing instead of resource curse.

32. 32

33. Appendix 1: I exclude a 6 th channel, The Prebisch-Singer (1950) Hypothesis that commodities supposedly suffer a long-run downward relative price trend. Theoretical reasoning: world demand for primary products is inelastic with respect to income. Vs. persuasive theoretical arguments that we should expect commodity prices to show upward trends in the long run Malthus (esp. for food) Hotelling (for depletable resources).

34. The up trend idea goes back to Malthus (1798) and early fears of environmental scarcity: Demand grows with population (geometrically), Supply does not. What could be clearer in economics than the prediction that price will rise?

35. Hotelling (1931) Firms choose how fast to extract oil or minerals King Abdullah of Saudi Arabia, with interest rates ≈ 0 in 2008, apparently believed that the rate of return on oil reserves was higher if he didn't pump than if he did: "Let them remain in the ground for our children and grandchildren..." Arbitrage => expected rate of price increase = interest rate.

36. The empirical evidence With strong theoretical arguments on both sides, either for an upward trend or for a downward trend, it is an empirical question. Terms of trade for commodity producers had a slight up trend from 1870 to World War I, a down trend in the inter-war period, up in the 1970s, down in the 1980s and 1990s, and up in the first decade of the 21st century.

37. What is the overall statistical trend in commodity prices in the long run? Some authors find a slight upward trend, some a slight downward trend. [1] [1] The answer depends on the date of the end of the sample. [1][1] Cuddington (1992), Cuddington, Ludema & Jayasuriya (2007), Cuddington & Urzua (1989), Grilli & Yang (1988), Pindyck (1999), Reinhart & Wickham (1994), Hadass & Williamson (2003), Kellard & Wohar (2005), Balagtas & Holt (2009), Cuddington & Jerrett (2008), and Harvey, Kellard, Madsen & Wohar (2010).

38. 38 4.1 Unsustainably rapid depletion 4.1 Unsustainably rapid depletion When exhaustible resources are in fact exhausted, the country may be left with nothing. When exhaustible resources are in fact exhausted, the country may be left with nothing. Three concerns: Three concerns: Protection of environmental quality. Protection of environmental quality. A motivation for a strategy of economic diversification. A motivation for a strategy of economic diversification. The need to save for the day of depletion The need to save for the day of depletion Invest rents from exhaustible resources in other assets. Invest rents from exhaustible resources in other assets. Hartwick (1977) and Solow (1986). Appendix 2: Elaboration on Anarchy: insufficient protection of property rights

39. The example of Nauru phosphate mining

40. 40 4.2 Unenforceable property rights Depletion would be much less of a problem if full property rights could be enforced, Depletion would be much less of a problem if full property rights could be enforced, thereby giving the owners incentive to conserve the resource in question. thereby giving the owners incentive to conserve the resource in question. But often this is not possible But often this is not possible especially under frontier conditions. especially under frontier conditions. Overfishing, overgrazing, & over-logging are classic examples of the “tragedy of the commons.” Overfishing, overgrazing, & over-logging are classic examples of the “tragedy of the commons.” Individual fisherman, ranchers, loggers, or miners, have no incentive to restrain themselves, while the fisheries, pastureland or forests are collectively depleted. Individual fisherman, ranchers, loggers, or miners, have no incentive to restrain themselves, while the fisheries, pastureland or forests are collectively depleted.

41. Madre de Dios region of the Amazon rainforest in Peru, the left-hand side stripped by illegal gold mining. http://indiancountrytodaymedianetwork.com/2011/02/27/amazon-gold-rush-laying-waste-to-peruvian-rainforest%E2%80%99s-madre-de-dios-20021

42. 42 4.3 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. Fearon & Laitin (2003), Collier & Hoeffler (2004), Humphreys (2005) and Collier (2007). Fearon & Laitin (2003), Collier & Hoeffler (2004), Humphreys (2005) and Collier (2007). Chronic conflict in places such as Sudan comes to mind. Chronic conflict in places such as Sudan comes to mind. Civil war is, in turn, very bad for economic development. Civil war is, in turn, very bad for economic development.

43. Appendix 3: The NRC Skeptics Which comes first, oil or institutions? 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. Norman (2009): the discovery & development of oil is not purely exogenous, but rather is endogenous with respect to the efficiency of the economy.

44. in which case it is put to use for the national welfare, instead of the welfare of an elite. Mehlum, Moene & Torvik (2006), Robinson, Torvik & Verdier (2006), McSherry (2006), Smith (2007) and Collier & Goderis (2007). The important determinant is whether the country already has good institutions at the time that oil is discovered,

45. Skeptics argue that commodity exports are endogenous. 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, invalidating the common inference that minerals are bad for growth. Maloney (2002) and Wright & Czelusta (2003, 04, 06).

46. 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. 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 David & Wright (1997). 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 lifting restrictions on foreign mining participation in 1995. Wright & Czelusta (2003, pp. 4-7, 12-13, 18-22 ).

47. Commodity exports are endogenous, continued. Examples of countries that were equally well- endowed geologically but that failed to develop their natural resources efficiently include: Chile & Australia before World War I, and Venezuela since the 1980s. 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?”

48. Addendum: Countries with high resource revenue tend to have high government spending (as % of GDP) 48 IMF blog June 9, 2014

49. But countries with high resource rents (as % of GDP ) tend to have lower student math performance (statistically significant at the.003 level) 49 Source: OECD education data featured in Knowledge and skills are infinite – oil is not by Andreas Schleicher.dataKnowledge and skills are infinite – oil is not

50. 50

51. Part II Some that are not recommended: Institutions that try to suppress price volatility. Recommended: Devices to hedge risk. Ideas to reduce macroeconomic procyclicality. Institutions for better governance. Policies & institutions to avoid pitfalls of the Natural Resource Curse

52. 52 The Natural Resource Curse should not be interpreted as a rule that commodity- rich countries are doomed to fail. The question is what policies to adopt The question is what policies to adopt to avoid the pitfalls and improve the chances of prosperity. to avoid the pitfalls and improve the chances of prosperity. A wide variety of measures have been tried by commodity-exporters cope with volatility. A wide variety of measures have been tried by commodity-exporters cope with volatility. Some work better than others. Some work better than others.

53. Many of the policies that have been intended to suppress commodity volatility do not work out so well Many of the policies that have been intended to suppress commodity volatility do not work out so well Producer subsidies Stockpiles Marketing boards Price controls Export controls Blaming derivatives Resource nationalism Nationalization Banning foreign participation

54. Devices to share risks 1. Index contracts with foreign companies (royalties…) to the world commodity price. 2. Hedge commodity revenues in options markets 3. Link debt to the commodity price 7 recommendations for commodity-exporting countries

55. 4. Allow some currency appreciation in response to a commodity boom, but not a free float. - Accumulate some forex reserves first. - Raise banks’ reserve requirements, esp. on $ liabilities. 5. If the monetary anchor is to be Inflation Targeting, consider using as the target, in place of the CPI, a measure that puts weight on the export commodity. 6. Emulate Chile: to avoid over-spending in boom times, allow deviations from a target surplus only in response to permanent commodity price rises. 7 recommendations for commodity producers continued Countercyclical macroeconomic policy PPT

56. 7. Manage commodity funds professionally. Invest them abroad Invest them abroad like Norway’s Pension Fund, like Norway’s Pension Fund, Reasons: Reasons: (1) for diversification, (1) for diversification, (2) to avoid cronyism in investments. (2) to avoid cronyism in investments. but insulated from politics but insulated from politics like Botswana’s Pula Fund. like Botswana’s Pula Fund. Professionally managed, to optimize financially. Professionally managed, to optimize financially. 7 recommendations for commodity producers, concluded Good governance institutions

57. Elaboration on two proposals to reduce the procyclicality of macroeconomic policy for commodity exporters I) To make monetary policy less procyclical: P roduct P rice T argeting II) To make fiscal policy less procyclical: emulate Chile. PPT

58. I) The challenge of designing a currency regime for countries where terms of trade shocks dominate the cycle Fixing the exchange rate leads to procyclical monetary policy: credit expands in commodity booms. Floating accommodates terms of trade shocks. But volatility can be excessive; also floating does not provide a nominal anchor. Inflation Targeting, in terms of the CPI, provides a nominal anchor; but can react perversely to terms of trade shocks. Needed : an anchor that accommodates trade shocks

59. P roduct P rice T argeting : Target an index of domestic production prices [1] such as the GDP deflator Include export commodities in the index and exclude import commodities, so money tightens & the currency appreciates when world prices of export commodities rise accommodating the terms of trade -- not when world prices of import commodities rise. The CPI does it backwards: It calls for appreciation when import prices rise, not when export prices rise ! [1] Frankel (2011, 2012). PPT

60. Appendix II: Who achieves counter-cyclical fiscal policy? Countries with “good institutions” ”On Graduation from Fiscal Procyclicality” 2013, Frankel with C.Végh & G.Vuletin; J.Dev.Economics.

61. What, specifically, are good institutions? 1 st rule – Governments must set a budget target, 1 st rule – Governments must set a budget target, set = 0 in 2008 under Pres. Bachelet. set = 0 in 2008 under Pres. Bachelet. 2 nd rule – The target is structural: Deficits allowed only to the extent that 2 nd rule – The target is structural: Deficits allowed only to the extent that (1) output falls short of trend, in a recession, or (1) output falls short of trend, in a recession, or (2) the price of copper is below its trend. (2) the price of copper is below its trend. 3 rd rule – The trends are projected by 2 panels of independent experts, outside the political process. 3 rd rule – The trends are projected by 2 panels of independent experts, outside the political process. Result: Chile avoids the pattern of 32 other governments, Result: Chile avoids the pattern of 32 other governments, where forecasts in booms are biased toward over-optimism. where forecasts in booms are biased toward over-optimism. Chile ran surpluses in the 2003-07 boom, Chile ran surpluses in the 2003-07 boom, while the U.S. & Europe failed to do so. while the U.S. & Europe failed to do so. The example of Chile since 2000

62. Appendices on recommendations for dealing with the natural resource curse Appendix 4: Policies not recommended Appendix 5: Elaboration on proposal to make monetary policy less procyclical – PPT, using GDP deflator to set annual inflation target. Appendix 6: Elaboration on proposal to make fiscal policy less procyclical – emulate Chile, setting structural targets with independent fiscal forecasts

63. Appendix 4: Policies that have been tried but that are not recommended Appendix 4: Policies that have been tried but that are not recommended Producer subsidies Stockpiles Marketing boards Price controls Export controls Blaming derivatives Resource nationalism Nationalization Banning foreign participation

64. Unsuccessful policies to reduce commodity price volatility: 1) Producer subsidies to “ stabilize ” prices at high levels, 1) Producer subsidies to “ stabilize ” prices at high levels, often via wasteful stockpiles & protectionist import barriers. often via wasteful stockpiles & protectionist import barriers. Examples: Examples: The EU’s Common Agricultural Policy The EU’s Common Agricultural Policy Bad for EU budgets, economic efficiency, international trade & consumer pocketbooks. Bad for EU budgets, economic efficiency, international trade & consumer pocketbooks. Or fossil fuel subsidies Or fossil fuel subsidies which are equally distortionary & budget-busting, which are equally distortionary & budget-busting, and disastrous for the environment as well. and disastrous for the environment as well. Or US corn-based ethanol subsidies, Or US corn-based ethanol subsidies, with tariffs on Brazilian sugar-based ethanol. with tariffs on Brazilian sugar-based ethanol.

65. Unsuccessful policies, continued 2) Price controls to “stabilize” prices at low levels 2) Price controls to “stabilize” prices at low levels Discourage investment & production. Discourage investment & production. Example: African countries adopted commodity boards for coffee & cocoa at the time of independence. Example: African countries adopted commodity boards for coffee & cocoa at the time of independence. The original rationale: to buy the crop in years of excess supply and sell in years of excess demand. The original rationale: to buy the crop in years of excess supply and sell in years of excess demand. In practice the price paid to cocoa & coffee farmers was always below the world price. In practice the price paid to cocoa & coffee farmers was always below the world price. As a result, production fell. As a result, production fell.

66. Microeconomic policies, continued Often the goal of price controls is to shield consumers of staple foods & fuel from increases. Often the goal of price controls is to shield consumers of staple foods & fuel from increases. But the artificially suppressed price But the artificially suppressed price discourages domestic supply, and discourages domestic supply, and requires rationing to domestic households. requires rationing to domestic households. Shortages & long lines can fuel political rage as well as higher prices can. Shortages & long lines can fuel political rage as well as higher prices can. Not to mention when the government is forced by huge gaps to raise prices. Not to mention when the government is forced by huge gaps to raise prices. Price controls can also require imports, to satisfy excess demand. Price controls can also require imports, to satisfy excess demand. Then they raise the world price even more. Then they raise the world price even more.

67. Microeconomic policies, continued 3) In producing countries, prices are artificially suppressed by means of export controls 3) In producing countries, prices are artificially suppressed by means of export controls to insulate domestic consumers from a price rise. to insulate domestic consumers from a price rise. In 2008, India capped rice exports. In 2008, India capped rice exports. Argentina did the same for wheat exports, Argentina did the same for wheat exports, as did Russia in 2010. as did Russia in 2010. India banned cotton exports in March 2012. India banned cotton exports in March 2012. Results: Results: Domestic supply is discouraged. Domestic supply is discouraged. World prices go even higher. World prices go even higher.

68. An initiative at the G20 meetings in France in 2011 deserved to succeed: Producers and consuming countries in grain markets should cooperatively agree to refrain from export controls and price controls. Producers and consuming countries in grain markets should cooperatively agree to refrain from export controls and price controls. The result would be lower world price volatility. The result would be lower world price volatility. One hopes for steps in this direction, perhaps working through the WTO. One hopes for steps in this direction, perhaps working through the WTO.

69. An initiative that has less merit: 4) Attempts to blame speculation for volatility and so to ban derivatives markets. Yes, speculative bubbles sometimes hit prices. But in commodity markets, prices are more often the signal for fundamentals. Don’t shoot the messenger. Also, derivatives are useful for hedgers.

70. The overall lesson for microeconomic policy Attempts to prevent commodity prices from fluctuating generally fail. Attempts to prevent commodity prices from fluctuating generally fail. Even though enacted in the name of reducing volatility & income inequality, their effect is often different. Even though enacted in the name of reducing volatility & income inequality, their effect is often different. Better to accept volatility and cope with it. Better to accept volatility and cope with it. For the poor: well-designed transfers, For the poor: well-designed transfers, along the lines of Oportunidades or Bolsa Familia. along the lines of Oportunidades or Bolsa Familia.

71. “Resource nationalism” Another motive for commodity export controls: 5) To subsidize downstream industries. E.g., “beneficiation” in South African diamonds But it didn’t make diamond-cutting competitive, and it hurt mining exports. 6) Nationalization of foreign companies. Like price controls, it discourages investment.

72. “Resource nationalism” continued 7) Keeping out foreign companies altogether. But often they have the needed technical expertise. Examples: declining oil production in Mexico & Venezuela. 8) Going around “locking up” resource supplies. China must think that this strategy will protect it in case of a commodity price shock. But global commodity markets are increasingly integrated. If conflict in the Persian Gulf doubles world oil prices, the effect will be pretty much the same for those who buy on the spot market and those who have bilateral arrangements.

73. The overall lesson for microeconomic policy Attempts to prevent commodity prices from fluctuating generally fail. Attempts to prevent commodity prices from fluctuating generally fail. Even though enacted in the name of reducing volatility & income inequality, their effect is often different. Even though enacted in the name of reducing volatility & income inequality, their effect is often different. Better to accept volatility and cope with it. Better to accept volatility and cope with it. For the poor: well-designed transfers, For the poor: well-designed transfers, along the lines of Oportunidades or Bolsa Familia. along the lines of Oportunidades or Bolsa Familia.

74. Appendix 5: P roduct P rice T argeting Each of the traditional candidates for nominal anchor has an Achilles heel. The CPI anchor does not accommodate terms of trade changes: IT tightens M & appreciates when import prices rise not when export prices rise, which is backwards. Targeting core CPI does not much help.

75. Professor Jeffrey Frankel 6 proposed nominal targets and the Achilles heel of each: Vulnerability

76. Why is PPT better than a fixed exchange rate for countries with volatile export prices ? Better response to trade shocks (countercyclical): If the $ price of the export commodity goes up, the currency automatically appreciates, moderating the boom. If the $ price of the export commodity goes down, the currency automatically depreciates, moderating the downturn & improving the balance of payments. PPT

77. Why is PPT better than CPI-targeting for countries with volatile terms of trade ? Better response to trade shocks (accommodating): If the $ price of imported commodity goes up, CPI target says to tighten monetary policy enough to appreciate the currency. Wrong response. (E.g., oil-importers in 2007-08.) PPT does not have this flaw. If the $ price of the export commodity goes up, PPT says to tighten money enough to appreciate. Right response. (E.g., Gulf currencies in 2007-08.) CPI targeting does not have this advantage. PPT

78. Empirical findings Simulations of 1970-2000 Gold producers: Burkino Faso, Ghana, Mali, South Africa Other commodities: Ethiopia (coffee), Nigeria (oil), S.Africa (platinum) General finding: Under Product Price Targets, their currencies would have depreciated automatically in 1990s when commodity prices declined, perhaps avoiding messy balance of payments crises. Sources: Frankel (2002, 03a, 05), Frankel & Saiki (2003)

79. Price indices CPI & GDP deflator each include: an international good import good in the CPI, export good in GDP deflator; And the non-traded good, with weights f and (1-f), respectively: cpi = (f)p im +(1-f)p n, p = (f)p x + (1-f) p n.

80. Estimation for each country of weights in national price index on 3 sectors: non tradable goods, leading commodity export, & other tradable goods Argentina is relatively closed; The leading export commodity usually has a higher weight in the country’s PPI than in its CPI, as expected. (Jamaicans don’t eat bauxite.) Mexico is relatively open. “A Comparison of Product Price Targeting and Other Monetary Anchor Options, for Commodity- Exporters in Latin America," Economia, vol.11, 2011 (Brookings), NBER WP 16362. A Comparison of Product Price Targeting and Other Monetary Anchor Options, for Commodity- Exporters in Latin America EconomiaBrookings16362

81. In practice, IT proponents agree central banks should not tighten to offset oil price shocks They want focus on core CPI, excluding food & energy. But food & energy ≠ all supply shocks. Use of core CPI sacrifices some credibility: If core CPI is the explicit goal ex ante, the public feels confused. If it is an excuse for missing targets ex post, the public feels tricked. Perhaps for that reason, IT central banks apparently do respond to oil shocks by tightening/appreciating, as the following correlations suggests….

82. Table 1: LACA Countries ’ Current Regimes and Monthly Correlations of Exchange Rate Changes ($/local currency) with Dollar Import Price Changes Import price changes are changes in the dollar price of oil. Exchange Rate RegimeMonetary Policy1970-19992000-20081970-2008 ARG Managed floatingMonetary aggregate target -0.0212-0.0591-0.0266 BOL Other conventional fixed pegAgainst a single currency -0.01390.0156-0.0057 BRA Independently floatingInflation targeting framework (1999) 0.03660.09610.0551 CHL Independently floatingInflation targeting framework (1990)* -0.06950.0524-0.0484 CRI Crawling pegsExchange rate anchor 0.0123-0.03270.0076 GTM Managed floatingInflation targeting framework -0.00290.24280.0149 GUY Other conventional fixed pegMonetary aggregate target -0.03350.0119-0.0274 HND Other conventional fixed pegAgainst a single currency -0.0203-0.0734-0.0176 JAM Managed floatingMonetary aggregate target 0.02570.26720.0417 NIC Crawling pegsExchange rate anchor -0.06440.0324-0.0412 PER Managed floatingInflation targeting framework (2002) -0.31380.1895-0.2015 PRY Managed floating IMF-supported or other monetary program -0.0230.34240.0543 SLV DollarExchange rate anchor 0.10400.05300.0862 URY Managed floatingMonetary aggregate target 0.04380.11680.0564 Oil Exporters COL Managed floatingInflation targeting framework (1999) -0.02970.04890.0046 MEX Independently floatingInflation targeting framework (1995) 0.10700.16190.1086 TTO Other conventional fixed pegAgainst a single currency 0.06980.20250.0698 VEN Other conventional fixed pegAgainst a single currency -0.05210.0064-0.0382 * Chile declared an inflation target as early as 1990; but it also had an exchange rate target, under an explicit band-basket-crawl regime, until 1999. LAC Countries ’ Current Regimes and Monthly Correlations of Exchange Rate Changes ($/local currency) with $ Import Price Changes Table 1 IT coun- tries show correl- ations > 0.

83. The 4 inflation-targeters in Latin America show correlation (currency value in $, import prices in $ ) > 0 ; > correlation before they adopted IT; > correlation shown by non-IT Latin American oil-importing countries.

84. Why is the correlation between the import price and the currency value revealing? The currency of an oil importer should not respond to an increase in the world oil price by appreciating, to the extent that these central banks target core CPI. When these IT currencies respond by appreciating instead, it suggests that the central bank is tightening money to reduce upward pressure on headline CPI.

85. Appendix 6: Chilean fiscal policy In 2000 Chile instituted its structural budget rule. The institution was formalized in law in 2006. The structural budget deficit must be zero, originally BS > 1% of GDP, then cut to ½ %, then 0 -- where structural is defined by output & copper price equal to their long-run trend values. I.e., in a boom the government can only spend increased revenues that are deemed permanent; any temporary copper bonanzas must be saved.

86. The crucial institutional innovation in Chile How has Chile avoided over-optimistic official forecasts? especially the historic pattern of over-exuberance in commodity booms? The estimation of the long-term path for GDP & the copper price is made by two panels of independent experts, and thus is insulated from political pressure & wishful thinking. Other countries might usefully emulate Chile ’ s innovation or in other ways delegate to independent agencies estimation of structural budget deficit paths.

87. Chile ’ s fiscal position strengthened immediately: Public saving rose from 2.5 % of GDP in 2000 to 7.9 % in 2005 allowing national saving to rise from 21 % to 24 %. Government debt fell sharply as a share of GDP and the sovereign spread gradually declined. By 2006, Chile achieved a sovereign debt rating of A, several notches ahead of Latin American peers. By 2007 it had become a net creditor. By 2010, Chile ’ s sovereign rating had climbed to A+, ahead of some advanced countries. => It was able to respond to the 2008-09 recession via fiscal expansion. The Pay-off

88. In 2008, with copper prices spiking up, the government of President Bachelet had been under intense pressure to spend the revenue. She & Fin.Min.Velasco held to the rule, saving most of it. Their popularity ratings fell sharply. When the recession hit and the copper price came back down, the government increased spending, mitigating the downturn. Bachelet & Velasco ’ s popularity reached historic highs in 2009.

89. Evolution of approval and disapproval of four Chilean presidents Presidents Patricio Aylwin, Eduardo Frei, Ricardo Lagos and Michelle Bachelet Data: CEP, Encuesta Nacional de Opinion Publica, October 2009, www.cepchile.cl. Source: Engel et al (2011).

90. 5 econometric findings regarding bias toward optimism in official budget forecasts. Official forecasts in a sample of 33 countries on average are overly optimistic, for : (1) budgets & (2) GDP. The bias toward optimism is: (3) stronger the longer the forecast horizon; (4) greater in booms (5) greater for euro governments under SGP budget rules;

91. (4) The optimism in official budget forecasts is stronger at the 3-year horizon, stronger among countries with budget rules, & stronger in booms. Frankel, 2012, “A Solution to Fiscal Procyclicality: The Structural Budget Institutions Pioneered by Chile.”

92. Budget balance forecast error as % of GDP, Full dataset (1)(2)(3) One year aheadTwo years aheadThree years ahead GDP relative to trend 0.093*** (0.019) 0.258*** (0.040 ) 0.289*** (0.063 ) Constant0.2010.649***1.364*** (0.197)(0.231)(0.348) Observations398300179 Variable is lagged so that it lines up with the year in which the forecast was made. *** p<0.01 Robust standard errors in parentheses, clustered by country. (4) Official budget forecasts are biased more if GDP is currently high & especially at longer horizons 33 countries

93. Budget balance forecast error as a % of GDP, Full Dataset (1)(2)(3)(4) One year ahead Two years ahead One year ahead Two years ahead SGPdummy0.6580.905**0.4070.276 (0.398)(0.406)(0.355)(0.438) SGP dummy * (GDP - trend) 0.189** (0.0828) 0.497*** (0.107) Constant0.0330.466*0.0330.466* (0.228)(0.248)(0.229)(0.249) Observations399300398300 (5) Official budget forecasts are more optimistically biased in countries subject to a budget deficit rule (SGP) *** p<0.01, ** p<0.05, * p<0.1 Robust standard errors in parentheses, clustered by country. 33 countries

94. 5 more econometric findings regarding bias toward optimism in official budget forecasts. (6) The key macroeconomic input for budget forecasting in most countries : GDP. In Chile : the copper price. (7) Real copper prices revert to trend in the long run. But this is not always readily perceived: (8) 30 years of data are not enough to reject a random walk statistically; 200 years of data are needed. (9) U ncertainty (option-implied volatility) is higher when copper prices are toward the top of the cycle. (10) Chile ’ s official forecasts are not overly optimistic. It has apparently avoided the problem of forecasts that unrealistically extrapolate in boom times.

95. In sum, institutions recommended to make fiscal policy less procyclical : Official growth & budget forecasts tend toward wishful thinking : unrealistic extrapolation of booms 3 years into the future. The bias is worse among the European countries supposedly subject to the budget rules of the SGP, presumably because government forecasters feel pressured to announce they are on track to meet budget targets even if they are not. Chile is not subject to the same bias toward over-optimism in forecasts of the budget, growth, or the all-important copper price. The key innovation that has allowed Chile to achieve countercyclical fiscal policy: not just a structural budget rule in itself, but rather the regime that entrusts to two panels of experts estimation of the long-run trends of copper prices & GDP.

96. Application to other countries Any country could adopt the Chilean mechanism. Suggestion: give the panels more institutional independence as is familiar from central banking: laws protecting them from being fired. Open questions: Are the budget rules to be interpreted as ex ante or ex post? How much of the structural budget calculations are to be delegated to the independent panels of experts? Minimalist approach: they compute only 10-year moving averages. Can one guard against subversion of the institutions (CBO) ?

97. 97

98. References by the author Project Syndicate, Project Syndicate, Project Syndicate Project Syndicate “Escaping the Oil Curse,” Dec.9, 2011. “Escaping the Oil Curse,” Dec.9, 2011.Escaping the Oil CurseEscaping the Oil Curse "Barrels, Bushels & Bonds: How Commodity Exporters Can Hedge Volatility," Oct.17, 2011. "Barrels, Bushels & Bonds: How Commodity Exporters Can Hedge Volatility," Oct.17, 2011. Barrels, Bushels & Bonds How Commodity Exporters Can Hedge VolatilityBarrels, Bushels & Bonds How Commodity Exporters Can Hedge Volatility “The Natural Resource Curse: A Survey of Diagnoses and Some Prescriptions,” 2012, Commodity Price Volatility and Inclusive Growth in Low-Income Countries, R.Arezki & Z.Min, eds.. HKS RWP12-014. High Level Seminar, IMF Annual Meetings, DC, Sept.2011. “The Natural Resource Curse: A Survey of Diagnoses and Some Prescriptions,” 2012, Commodity Price Volatility and Inclusive Growth in Low-Income Countries, R.Arezki & Z.Min, eds.. HKS RWP12-014. High Level Seminar, IMF Annual Meetings, DC, Sept.2011.The Natural Resource Curse: A Survey of Diagnoses and Some PrescriptionsRWP12-014High Level SeminarThe Natural Resource Curse: A Survey of Diagnoses and Some PrescriptionsRWP12-014High Level Seminar "The Curse: Why Natural Resources Are Not Always a Good Thing,” Milken Institute Review, vol.13, 4 th quarter 2011. "The Curse: Why Natural Resources Are Not Always a Good Thing,” Milken Institute Review, vol.13, 4 th quarter 2011.The Curse: Why Natural Resources Are Not Always a Good ThingReview2011The Curse: Why Natural Resources Are Not Always a Good ThingReview2011 “The Natural Resource Curse: A Survey,” 2012, Chapter 2 in Beyond the Resource Curse, B.Shaffer & T. Ziyadov, eds. (U.Penn. Press); proofs & notes; Summary. CID WP195, 2011. “The Natural Resource Curse: A Survey,” 2012, Chapter 2 in Beyond the Resource Curse, B.Shaffer & T. Ziyadov, eds. (U.Penn. Press); proofs & notes; Summary. CID WP195, 2011.The Natural Resource Curse: A Survey Chapter 2Beyond the Resource CurseU.Penn. Pressproofs notesSummaryCID WP195The Natural Resource Curse: A Survey Chapter 2Beyond the Resource CurseU.Penn. Pressproofs notesSummaryCID WP195 “How Can Commodity Exporters Make Fiscal and Monetary Policy Less Procyclical?” Natural Resources, Finance & Development, R.Arezki, T.Gylfason & A.Sy, eds. (IMF), 2011. HKS RWP 11-015. “How Can Commodity Exporters Make Fiscal and Monetary Policy Less Procyclical?” Natural Resources, Finance & Development, R.Arezki, T.Gylfason & A.Sy, eds. (IMF), 2011. HKS RWP 11-015.How Can Commodity Exporters Make Fiscal and Monetary Policy Less Procyclical?T.Gylfason HKS RWP 11-015How Can Commodity Exporters Make Fiscal and Monetary Policy Less Procyclical?T.Gylfason HKS RWP 11-015 “On Graduation from Procyclicality,” 2012, with C.Végh & G.Vuletin; J. Dev. Economics. “On Graduation from Procyclicality,” 2012, with C.Végh & G.Vuletin; J. Dev. Economics. On Graduation from ProcyclicalityOn Graduation from Procyclicality “Chile’s Solution to Fiscal Procyclicality,” 2012, Transitions blog, Foreign Policy. “Chile’s Solution to Fiscal Procyclicality,” 2012, Transitions blog, Foreign Policy.Chile’s Solution to Fiscal ProcyclicalityTransitionsChile’s Solution to Fiscal ProcyclicalityTransitions “A Solution to Fiscal Procyclicality: The Structural Budget Institutions Pioneered by Chile,” in Fiscal Policy and Macroeconomic Performance, 2012. Central Bank of Chile WP 604, 2011. “A Solution to Fiscal Procyclicality: The Structural Budget Institutions Pioneered by Chile,” in Fiscal Policy and Macroeconomic Performance, 2012. Central Bank of Chile WP 604, 2011.A Solution to Fiscal Procyclicality: The Structural Budget Institutions Pioneered by ChileCentral Bank of ChileWP 604,2011A Solution to Fiscal Procyclicality: The Structural Budget Institutions Pioneered by ChileCentral Bank of ChileWP 604,2011 "Product Price Targeting -- A New Improved Way of Inflation Targeting," in MAS Monetary Review Vol.XI, issue 1, April 2012 (Monetary Authority of Singapore). "Product Price Targeting -- A New Improved Way of Inflation Targeting," in MAS Monetary Review Vol.XI, issue 1, April 2012 (Monetary Authority of Singapore).Product Price Targeting -- A New Improved Way of Inflation TargetinginVol.XI, issue 1Product Price Targeting -- A New Improved Way of Inflation TargetinginVol.XI, issue 1 “A Comparison of Product Price Targeting and Other Monetary Anchor Options, for Commodity-Exporters in Latin America," Economia, vol.11, 2011 (Brookings ), NBER WP 16362. A Comparison of Product Price Targeting and Other Monetary Anchor Options, for Commodity-Exporters in Latin America EconomiaBrookings16362