Finding Oil Is Frequently Bad News

A country discovers a large oil field. This should be straightforwardly good: an asset it did not have, saleable for foreign currency, requiring only that the revenue be spent sensibly.

Jeffrey Sachs and Andrew Warner found in the 1990s that countries with high natural resource exports subsequently grew more slowly than resource-poor ones. The relationship is a tendency rather than a law, the specification has been argued over for thirty years, and the pattern is real enough to require an explanation.

Three mechanisms, and they operate simultaneously and reinforce each other.

The first is purely a price effect and requires nobody to behave badly. To buy a country's oil, foreigners must buy its currency, which appreciates. An appreciated currency makes every other export more expensive abroad and every import cheaper at home, so manufacturing and commercial agriculture shrink. The resource sector expands and everything else tradeable contracts.

This is Dutch disease, named after what happened to Dutch manufacturing following the Groningen gas discoveries. It matters more than it first appears, because the sectors being squeezed are the ones that generate learning, accumulate capability and employ large numbers of people. Oil extraction employs very few and teaches the economy almost nothing.

The second mechanism is fiscal, and it is the one with the deepest consequences.

A government that funds itself by taxing its population has to negotiate with that population. Historically, this is where representative institutions came from: a crown that needed money convened whoever could grant it, and the people granting it attached conditions. No taxation without representation runs in both directions.

A government funded by royalties from a hole in the ground needs nothing from its citizens. It does not need their consent, their cooperation or their productivity in order to be paid. The bargain inverts: instead of taxation exchanged for a say, you get spending distributed to purchase quiescence. Political scientists call this a rentier state, and the empirical association between resource revenue and durable authoritarianism is one of the stronger findings in the literature.

The third is conflict. Paul Collier and Anke Hoeffler found primary commodity dependence among the strongest predictors of civil war onset, and there are two channels. Controlling the state becomes far more valuable when the state controls an oil field, which raises the prize for anyone contemplating a coup or an insurgency. And lootable resources (alluvial diamonds, coltan, timber) can fund a rebel army directly, with no need for popular support, taxation or a political programme.

This is why the type of resource matters. Point-source resources in fixed locations with concentrated rents are worse than diffuse agricultural production, because they can be captured by whoever controls one place.

So much for the curse. The exceptions are what tell you it is not destiny.

Norway found oil in 1969. It already had a functioning democracy, a capable and honest bureaucracy, strong rule of law, and a diversified economy. It set up a sovereign wealth fund that now holds well over a trillion dollars, invests it entirely abroad (which prevents the currency appreciation) and operates a fiscal rule permitting the government to spend only the expected real return rather than the capital or the income.

Botswana did something comparable with diamonds, maintaining decades of high growth and relatively clean government from a position of considerable poverty at independence.

The pattern in both is that the institutions came first. Discovering resources strains weak institutions and is managed by strong ones, which means the curse is conditional. This is not an encouraging conclusion for a poor country with weak courts that has just found oil, because it says the thing that would protect it is exactly what it does not have and cannot quickly build.

What can be done at the margin is known and is mostly about commitment devices: a sovereign wealth fund with a spending rule written into law, revenue transparency so citizens can see what was received, investing abroad rather than domestically to hold the currency down, and in some proposals distributing a portion directly to citizens as a dividend and then taxing it, which deliberately recreates the fiscal link that the resource revenue destroyed.

Each of these requires the current government to bind its own hands, which is precisely the thing a government enjoying a resource windfall has the least reason to do.