Transcript Energy Economics – II Jeffrey Frankel Harpel

The Natural Resource Curse
and How to Avoid It
Part I: Channels of the commodity curse
Part II: Policies & institutions to avoid the pitfalls
Jeffrey Frankel
MPA/ID extra lecture, Dec. 18, 2013
The Natural Resource Curse
Part I: Channels
 Some

seminal references:

Auty (1990, 2001, 2007)

Sachs & Warner (1995, 2001),
By now there is a large body of research,

which I have surveyed
(2011, 2012a, b).
2

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:


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.

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.
Growth falls with fuel & mineral exports
5
Are natural resources necessarily bad?
No, of course not.


Commodity wealth need not necessarily lead
to inferior economic or political development.
Rather, it is a double-edged sword,
with both benefits and dangers.


It can be used for ill as easily as for good.
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.
6




Some developing countries have avoided
the pitfalls of commodity wealth.

E.g., Chile (copper)

Botswana (diamonds)
Some of their innovations are worth emulating.
The 2nd half of the lecture will offer some policies
& institutional innovations to avoid the curse:
especially ways of managing price volatility.


Some lessons apply to commodity importers too.
Including lessons of policies to avoid.
7



But, 1st: How could abundance
of commodity wealth be a curse?
What is the mechanism
for this counter-intuitive relationship?
At least 5 categories of explanations.
8
5 Possible Natural Resource Curse Channels
1.
Volatility
2.
Crowding-out of manufacturing
3.
Autocratic Institutions
4.
Anarchic Institutions
5.
Procyclicality
1.
2.
3.
including
Procyclical capital flows
Procyclical monetary policy
Procyclical fiscal policy.
9
(1) Volatility
in global commodity
prices arises because
supply & demand are
inelastic in the short run.
10
Commodity prices have been especially
volatile over the last decade
Source: UNCTAD
Effects of Volatility

Volatility per se can be bad for economic growth.




Hausmann & Rigobon (2003), Blattman, Hwang, & Williamson (2007),
and Poelhekke & van der Ploeg (2007).
Risk inhibits private investment.
Cyclical shifts of labor, land & capital back &
forth across sectors may incur needless costs.
=> 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 other hand the government
cannot entirely ignore the issue of volatility;

e.g., exchange rate policy.
12
2. Natural resources may
crowd out manufacturing,



and manufacturing could be the sector
that experiences learning-by-doing

or dynamic productivity gains from spillover.

Matsuyama (1992), van Wijnbergen (1984)
and
Sachs & Warner (1995).
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.

It can foster growth in both .

E.g. Canada, Australia, Norway… Now Malaysia, Chile, Brazil…
Econometric findings that oil
and other “point-source resources”
lead to poor institutions





Isham, Woolcock, Pritchett, & Busby
Sala-I-Martin & Subramanian (2003)
Bulte, Damania & Deacon (2005)
Mehlum, Moene & Torvik (2006)
Arezki & Brückner (2009).
(2005)
The theory is thought to fit Mideastern oil exporters well.
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.
An example, from economic historians
Engerman & Sokoloff

Why did industrialization take place in North America,





(1997, 2000, 2002)
not the South?
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.
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 and decentralized decision-making.
4. Anarchic institutions
1.
2.
3.
Unsustainably rapid
depletion of resources
Unenforceable
property rights
Civil war
See Appendix 2 for
elaboration on each.
17
(5) Procyclicality


The Dutch Disease describes unwanted
side-effects of a commodity boom.
Developing countries are
historically prone to procyclicality,


especially commodity producers.
Procyclicality in:



Capital inflows; Monetary policy;
Real exchange rate; Nontraded Goods
Fiscal Policy
18
The Dutch Disease:
5 side-effects of a commodity boom

1) A real appreciation in the currency

2) A rise in government spending

3) A rise in nontraded goods prices

4) A resultant shift of production
out of manufactured goods

5) Sometimes a current account deficit
19
The Dutch Disease: The 5 effects elaborated
 1)


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;
 2)

Real appreciation in the currency
A rise in government spending
in response to availability of tax receipts or royalties.
20
The Dutch Disease: 5 side-effects of a commodity boom

3) An increase in nontraded goods prices
relative to internationally traded goods

4) A resultant shift out of
non-commodity traded goods,


esp. manufactures,
pulled by the more
attractive returns
in the export commodity
and in non-traded goods.
21
The Dutch Disease: 5 side-effects of a commodity boom

5) A current account deficit,

as booming countries attract capital flows,
 thereby
incurring international debt that
is hard to service when the boom ends.

Manzano & Rigobon (2008): the negative Sachs-Warner effect of

Arezki & Brückner (2010a, b): commodity price booms lead to higher
resources on growth rates during 1970-1990 was mediated through
international debt incurred when commodity prices were high.
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:



In practice, it does not always work this way.
Capital flows are more procyclical than countercyclical.


net capital inflows when exports are doing badly
and net capital outflows when exports do well.
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.
Procyclical monetary policy

If the exchange rate is fixed,

surpluses during commodity booms
lead to rising reserves and 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.
Procyclical real exchange rate
Countries undergoing a commodity boom
experience real appreciation of their currency

taking the form of nominal currency appreciation

for floating-rate commodity exporters,
Colombia, Kazakhstan, Russia, S.Africa, Chile, Brazil….

or the form of money inflows & inflation

for fixed-rate commodity exporters,
Saudi Arabia & UAE….
OK. But real appreciation adds to boom in NTGs.
Procyclical fiscal policy

Fiscal policy has historically tended
to be procyclical in developing countries

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).


Correlation of income & spending mostly positive –

particularly in comparison with industrialized countries.
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.

Then it is forced to contract in recessions,

thereby exacerbating the swings.
27
Two budget items account for much
of the spending from oil booms:

(i) Investment 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.


Gelb (1986).
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..”
(ii) The government wage bill.

Oil windfalls are often spent on public sector wages.


Medas & Zakharova (2009)
Arezki & Ismail (2010):
government spending rises in booms, but is downward-sticky.
28
Correlations between Gov.t Spending & GDP
1960-1999
procyclical
Adapted from Kaminsky, Reinhart & Vegh (2004)
countercyclical
G always used to be pro-cyclical
for most developing countries.
The procyclicality of fiscal policy, cont.

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



to run budget surpluses & build reserves,
thereby earning the ability to expand
fiscally in the 2008-09 crisis.
Chile is the outstanding model.

Also Botswana, China, Indonesia, Korea…
30
Correlations between Government spending & GDP
2000-2009
procyclical
Frankel, Vegh & Vuletin (2012)
countercyclical
In the last decade,
about 1/3 developing countries
switched to countercyclical fiscal policy:
Negative correlation of G & GDP.
Summary of 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.
33
Appendix 1: I exclude a 6th 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).

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?

Hotelling

Firms choose how fast to extract oil or minerals



(1931)
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.
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.
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]
The answer depends on the date
of the end of the sample.
[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).
Appendix 2: Elaboration on Anarchy:
insufficient protection of property rights
4.1 Unsustainably
rapid depletion
When exhaustible resources
are in fact exhausted,
the country may be left with nothing.

Three concerns:


Protection of environmental quality.

A motivation for a strategy of economic diversification.

The need to save for the day of depletion

Invest rents from exhaustible resources in other assets.

Hartwick (1977) and Solow (1986).
39
The example of Nauru
phosphate mining
4.2 Unenforceable property rights

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.
But often this is not possible
 especially under frontier conditions.
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.
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
4.3 War

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.

Fearon & Laitin (2003), Collier & Hoeffler (2004),
Humphreys (2005) and Collier (2007).

Chronic conflict in places
such as Sudan comes to mind.

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.
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.





Mehlum, Moene & Torvik (2006),
Robinson, Torvik & Verdier (2006),
McSherry (2006),
Smith (2007) and
Collier & Goderis (2007).
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).
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).
Commodity exports are endogenous,

continued.
Examples of countries that were equally wellendowed 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?”
Addendum: Countries with high resource rents (as % of GDP)
tend to have lower student math performance
(statistically significant at the .003 level)
Source: OECD education data featured in Knowledge and skills are infinite – oil is not by Andreas Schleicher.
49
Part II
Policies & institutions to avoid
pitfalls of the Natural Resource Curse

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.
The Natural Resource Curse should not
be interpreted as a rule that commodityrich countries are doomed to fail.

The question is what policies to adopt



to avoid the pitfalls and improve the chances of prosperity.
A wide variety of measures have been tried
by commodity-exporters cope with volatility.
Some work better than others.
51
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
7 recommendations
for commodity-exporting countries
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 producers
continued
Countercyclical macroeconomic policy
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 price measure that puts weight
PPT
on the export commodity (Product Price Targeting).
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,
concluded
Good governance institutions
7. Manage commodity funds professionally.
Invest them abroad



like Norway’s Pension Fund,
Reasons:
 (1) for diversification,
 (2) to avoid cronyism in investments.
but insulated from politics



like Botswana’s Pula Fund.
Professionally managed, to optimize financially.
Elaboration on two proposals to reduce
the procyclicality of macroeconomic policy
for commodity exporters
 I)
To make monetary policy less
procyclical: Product Price Targeting
PPT
 II)
To make fiscal policy less
procyclical: emulate Chile.
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.



Inflation Targeting, in terms of the CPI,



But volatility can be excessive;
also floating does not provide a nominal anchor.
provides a nominal anchor;
but can react perversely to terms of trade shocks.
Needed: an anchor that accommodates trade shocks
Product Price Targeting:
PPT
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).
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.
What, specifically, are good institutions?
The example of Chile since 2000

1st rule – Governments must set a budget target,


2nd rule – The target is structural:
Deficits allowed only to the extent that



set = 0 in 2008 under Pres. Bachelet.
(1) output falls short of trend, in a recession, or
(2) the price of copper is below its trend.
3rd rule – The trends are projected by 2 panels
of independent experts, outside the political process.
 Result: Chile avoids the pattern of 32 other governments,


where forecasts in booms are biased toward over-optimism.
Chile ran surpluses in the 2003-07 boom,

while the U.S. & Europe failed to do so.
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
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
Unsuccessful policies to reduce commodity price volatility:

1) Producer subsidies to “stabilize” prices at high levels,


often via wasteful stockpiles & protectionist import barriers.
Examples:

The EU’s Common Agricultural Policy


Or fossil fuel subsidies



Bad for EU budgets, economic efficiency,
international trade & consumer pocketbooks.
which are equally distortionary & budget-busting,
and disastrous for the environment as well.
Or US corn-based ethanol subsidies,

with tariffs on Brazilian sugar-based ethanol.
Unsuccessful policies, continued

2) Price controls to “stabilize” prices at low levels


Discourage investment & production.
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.
In practice the price paid to cocoa & coffee farmers
was always below the world price.

As a result, production fell.
Microeconomic policies,

continued
Often the goal of price controls is to shield
consumers of staple foods & fuel from increases.

But the artificially suppressed price
discourages domestic supply, and
 requires rationing to domestic households.




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.
Price controls can also require imports,
to satisfy excess demand.

Then they raise the world price even more.
Microeconomic policies, continued

3) In producing countries, prices are artificially
suppressed by means of export controls

to insulate domestic consumers from a price rise.
In 2008, India capped rice exports.
 Argentina did the same for wheat exports,
 as did Russia in 2010.
 India banned cotton exports in March 2012.


Results:


Domestic supply is discouraged.
World prices go even higher.
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.


The result would be lower world price volatility.
One hopes for steps in this direction,
perhaps working through the WTO.
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.
An example of commodity speculation



In the 1955 movie version
of East of Eden, the legendary
James Dean plays Cal.
Like Cain in Genesis, he
competes with his brother for
the love of his father.
Cal “goes long” in the market
for beans, in anticipation of
a rise in demand if the US
enters WWI.
An example of commodity speculation, cont.


Sure enough, the price of beans goes sky high,
Cal makes a bundle, and offers it to his father,
a moralizing patriarch.
But the father is morally offended by Cal’s speculation,
not wanting to profit
from others’ misfortunes,
and tells him he will have
to “give the money back.”
An example of commodity speculation, cont.

Cal has been the agent of
Adam Smith’s famous invisible hand:



By betting on his hunch about
the future, he has contributed
to upward pressure on the price
of beans in the present,
thereby increasing the supply so that more
is available precisely when needed (by the Army).
The movie even treats us to a scene where Cal
watches the beans grow in a farmer’s field,
something real-life speculators seldom get to see.
The overall lesson for microeconomic policy



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.
Better to accept volatility and cope with it.
“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.
“Resource nationalism”

7) Keeping out foreign companies altogether.



continued
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.
The overall lesson for
microeconomic policy



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.
Better to accept volatility and cope with it.

For the poor: well-designed transfers,

along the lines of Oportunidades or Bolsa Familia.
Appendix 5:
Product Price Targeting


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.

6 proposed nominal targets and the Achilles heel of each:
Vulnerability
Targeted
variable
Gold standard
Commodity
standard
Price
of gold
Price of agric.
& mineral
basket
Vulnerability
Example
Vagaries of world
1849 boom;
gold market
1873-96 bust
Shocks in
Oil shocks of
imported
1973-80, 2000-11
commodity
Monetarist rule
M1
Velocity shocks
US 1982
Nominal income
targeting
Fixed
exchange rate
Nominal
GDP
$
Measurement
problems
Appreciation of $
Less developed
countries
(or €)
(or € )
CPI
Terms of trade
shocks
Inflation targeting
EM currency crises
1995-2001
Oil shocks of
1973-80, 2000-11
Professor Jeffrey Frankel
Why is PPT better than a fixed exchange rate
for countries with volatile export prices?
PPT
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.
Why is PPT better than CPI-targeting
for countries with volatile terms of trade?
PPT
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.

PPT does not have this flaw .
(E.g., oil-importers in 2007-08.)
If the $ price of the export commodity goes up,
PPT says to tighten money enough to appreciate.

Right response.

CPI targeting does not have this advantage.
(E.g., Gulf currencies in 2007-08.)
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)
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)pim +(1-f)pn ,
p = (f)px + (1-f) pn .
Estimation for each country of weights in national price index on 3 sectors:
non tradable goods, leading commodity export, & other tradable goods
Leading
Non
Other
Comm.
Oil
Tradables
Tradables
Export
CPI
0.6939
0.0063
0.0431
0.2567
ARG
PPI
0.6939
0.0391
0.0230
0.2440
CPI
0.5782
0.0163
0.0141
0.3914
BOL
PPI
0.5782
0.1471
0.0235
0.2512
CPI
0.5235
0.0079
0.0608
0.4078
CHL
PPI
0.5235
0.0100
0.1334
0.3332
CPI
0.5985
-0.0168
0.3847
COL*
PPI
0.5985
-0.0407
0.3608
CPI
0.6413
0.0002
0.0234
0.3351
JAM
PPI
0.6413
0.1212
0.0303
0.2072
CPI
0.3749
-0.0366
0.5885
MEX*
PPI
0.3749
-0.0247
0.6003
CPI
0.3929
0.1058
0.0676
0.4338
PRY
PPI
0.3929
0.0880
0.0988
0.4204
CPI
0.6697
0.0114
0.0393
0.2796
PER
PPI
0.6697
0.040504
0.021228
0.268568
CPI
0.6230
0.0518
0.0357
0.2895
URY
PPI
0.6230
0.2234
0.1158
0.0378
* Oil is the leading commodity export.
Total
1.000
1.000
1.000
1.000
1.000
1.000
1.000
1.000
1.000
1.000
1.000
1.000
1.000
1.000
1.000
1.000
1.000
1.000
“A Comparison of Product Price
Targeting and Other Monetary
Anchor Options, for CommodityExporters in Latin America,"
Economia, vol.11, 2011
(Brookings), NBER WP 16362.
Argentina is
relatively closed;
Mexico is
relatively open.
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.)
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….
Table 1
LAC Countries’ Current Regimes and Monthly Correlations
Exchange
($/local
currency)
withcurrency)
$ Import
Price
Table 1: of
LACA
Countries’ CurrentRate
Regimes Changes
and Monthly Correlations
of Exchange
Rate Changes ($/local
with Dollar Import
PriceChanges
Changes
Import price changes are changes in the dollar price of oil.
Exchange Rate Regime
Monetary Policy
1970-1999
2000-2008
1970-2008
ARG
Managed floating
Monetary aggregate target
-0.0212
-0.0591
-0.0266
BOL
Other conventional fixed peg
Against a single currency
-0.0139
0.0156
-0.0057
BRA
Independently floating
Inflation targeting framework (1999)
0.0366
0.0961
0.0551
0.0524
-0.0484
CHL
Independently floating
Inflation targeting framework (1990)*
-0.0695
CRI
Crawling pegs
Exchange rate anchor
0.0123
-0.0327
0.0076
GTM
Managed floating
Inflation targeting framework
-0.0029
0.2428
0.0149
GUY
Other conventional fixed peg
Monetary aggregate target
-0.0335
0.0119
-0.0274
HND
Other conventional fixed peg
Against a single currency
-0.0203
-0.0734
-0.0176
JAM
Managed floating
Monetary aggregate target
0.0257
0.2672
0.0417
NIC
Crawling pegs
Exchange rate anchor
-0.0644
0.0324
-0.0412
PER
Managed floating
Inflation targeting framework (2002)
-0.3138
0.1895
-0.2015
PRY
Managed floating
IMF-supported or other monetary program
-0.023
0.3424
0.0543
SLV
Dollar
Exchange rate anchor
0.1040
0.0530
0.0862
URY
Managed floating
Monetary aggregate target
0.0438
0.1168
0.0564
Oil Exporters
COL
Managed floating
Inflation targeting framework (1999)
-0.0297
0.0489
0.0046
MEX
Independently floating
Inflation targeting framework (1995)
0.1070
0.1619
0.1086
TTO
Other conventional fixed peg
Against a single currency
0.0698
0.2025
0.0698
VEN
Other conventional fixed peg
Against a single currency
-0.0521
0.0064
-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.
IT
countries
show
correlations
> 0.
The 4 inflation-targeters in Latin America
show correlation (currency value
in $
, import prices

>0;

> correlation before they adopted IT;

> correlation shown by non-IT
Latin American oil-importing countries.
in $)
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.
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.
The crucial institutional innovation in Chile

How has Chile avoided over-optimistic official forecasts?


The estimation of the long-term path
for GDP & the copper price
is made by two panels of independent experts,


especially the historic pattern of
over-exuberance in commodity booms?
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.
The Pay-off

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.

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.
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).
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;
(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.”
(4) Official budget forecasts are biased
more if GDP is currently high & especially at longer horizons
Budget balance forecast error
as % of GDP, Full dataset
(1)
(2)
(3)
33 countries
One year ahead
Two years ahead
Three years
ahead
GDP relative
to trend
0.093***
0.258***
0.289***
(0.040)
(0.063)
0.201
0.649***
1.364***
(0.197)
(0.231)
(0.348)
Constant
(0.019)
Observations
398 up with the year 300
Variable is lagged so that it lines
in which the forecast 179
was made.
*** p<0.01
Robust standard errors in parentheses, clustered by country.
(5) Official budget forecasts are more optimistically biased
in countries subject to a budget deficit rule (SGP)
Budget balance forecast error
33 countries
SGPdummy
as a % of GDP, Full Dataset
(1)
(2)
(3)
One year
ahead
Two years
ahead
One year
ahead
Two years
ahead
0.658
0.905**
0.407
0.276
(0.398)
(0.406)
(0.355)
(0.438)
0.189**
0.497***
(0.0828)
(0.107)
SGP dummy *
(GDP - trend)
Constant
Observations
(4)
0.033
0.466*
0.033
0.466*
(0.228)
(0.248)
(0.229)
(0.249)
399
300
398
300
*** p<0.01, ** p<0.05, * p<0.1
Robust standard errors in parentheses, clustered by country.
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) Uncertainty (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.
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.
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) ?
References by the author

Project Syndicate,


“Escaping the Oil Curse,” Dec.9, 2011.
"Barrels, Bushels & Bonds: How Commodity Exporters Can Hedge Volatility," Oct.17, 2011.

“The Natural Resource Curse: A Survey of Diagnoses and Some Prescriptions,”

"The Curse: Why Natural Resources Are Not Always a Good Thing,”

“The Natural Resource Curse: A Survey,” 2012,

“How Can Commodity Exporters Make Fiscal and Monetary Policy Less Procyclical?”

“On Graduation from Procyclicality,” 2012, with C.Végh & G.Vuletin; J. Dev. Economics.

“Chile’s Solution to Fiscal Procyclicality,”

“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.


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.
Milken Institute Review, vol.13, 4th quarter 2011.
Chapter 2 in Beyond the Resource Curse,
B.Shaffer & T. Ziyadov, eds. (U.Penn. Press); proofs & notes; Summary. CID WP195, 2011.
Natural Resources, Finance & Development, R.Arezki, T.Gylfason & A.Sy, eds. (IMF), 2011. HKS RWP 11-015.
2012, Transitions blog, Foreign Policy.
"Product Price Targeting -- A New Improved Way of Inflation Targeting," in MAS
Monetary Review Vol.XI, issue 1, April 2012 (Monetary Authority of Singapore).
“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.