The recent, precipitous decline in oil prices (35 percent so far this year) has revived the question of how oil-exporting countries should manage their budgets. These countries’ governments rely on oil revenues for 60-90 percent of their spending. In light of the price drop, should governments cut expenditures, including growth-promoting investment expenditures? Or should they dip into the money they saved when oil prices were high, and keep expenditures on an even keel? Since oil prices fluctuate up and down, governments are looking for rules that guide expenditure decisions, rather than leaving it to the politicians in power at the time to decide whenever there is a price shock. The successful experience of Norway and Chile, which used strict fiscal rules to make sure that resource windfalls are saved and not subject to the irresistible temptation to spend, is often contrasted with countries such as Nigeria and Cameroon, which didn’t.
Even if we agree that a rule is better than discretion, what should that rule be? A rule that says whenever the price of oil exceeds a certain threshold, all the windfall revenues should be saved (in a sovereign wealth fund, for example) is tempting, since it would allow the country to draw down these savings when the price falls. But many oil-exporting countries, especially in Africa, have huge infrastructure and other investment needs. Rather than saving the windfall revenues, shouldn’t they invest them in the country and stimulate economic growth? Remember that oil prices are highly uncertain—when the price falls, we don’t know how far it will fall and for how long—so any rule should take into account this uncertainty.
In a recent paper, three colleagues and I try to answer this question by subjecting a simple model of a resource-rich economy to random price shocks, and testing different budget rules in terms of how well they benefit consumers in the long run. [I am particularly proud of this paper because two of my co-authors, Yazid Dissou and Delfin Go, are former students of mine, and the third, Sherman Robinson, is a former professor—the academic equivalent of an extended family]. In the model, governments can spend on public investment such as roads, electricity or water, which crowds-in private investment; or on direct cash transfers to consumers (as Alaska and Alberta do), who then choose how much to spend or save. Our objective is to maximize the welfare of consumers over time.
For a favorable price shock, we find that it’s best for the government to save the windfall revenues, and transfer the interest income from the sovereign fund to consumers. When the price declines, we find that it’s better for governments to cut public investment—even though it is productive and crowds-in private investment—rather than public consumption. The reason is that government spending on investment raises the price of domestic goods (construction, etc.), which means there is less money left over to transfer to consumers and help them weather the negative price shock. In this context, the finding that public investment in the West African Economic and Monetary Union (WAEMU) countries is pro-cyclical may not be so disturbing.
Since, as mentioned earlier, oil prices go up and down, a budget rule should encompass both possibilities. We therefore subject the model to 100 random price shocks and test four possible budget rules: (i) consume everything; (ii) invest everything; (iii) save everything; and (iv) invest half and save half. [The rules are expressed here in terms of a favorable price shock, but they apply symmetrically to an unfavorable shock. That is, when the price declines, rule (i) corresponds to cutting consumption, rule (ii) to cutting investment, etc.] We find that, like most things in life, the “balanced approach” of investing half and saving half (rule (iv)) is the best of the four. Such a rule provides a natural insurance against the possibility of both favorable and unfavorable price shocks, enabling citizens to smooth consumption over time by drawing on the interest income from sovereign funds in bad times, while increasing the level of their consumption thanks to the growth-enhancing effects of public investment during good times.
To be sure, the paper is a modeling exercise that, by definition, simplifies many aspects of the real world. For instance, the preferred rule that half the windfall is invested and half saved is dependent on the parameters of the model; a different configuration of parameters would indicate a different proportion. Nevertheless, the basic result that governments should respond to price shocks with a mix of public investment at home and saving abroad is not only robust to the model’s parameters but also consistent with common sense.