The impacts of windfall profits such as foreign aid or hydrocarbon revenues depend crucially on how the money is spent and/or invested. There are basically the following three options:
1)True Public Goods:
Theoretically, the most growth and welfare enhancing option is for the government to invest the money in true public goods. True public goods are goods/services which enhance the productivity and welfare of everybody by making life and business easier. A classic example is a road which allows goods and persons to move around much easier, and, importantly, the fact that one person uses the road does not preclude others from also using the road (1).
This is in contrast to a washing machine which is a private productivity enhancing good, but which usually benefits only one family. Another classic example is research: Once that malaria vaccine has been invented, hundreds of millions of people can benefit from it, hopefully at very low cost.
The Internet and most other networks, such as telephone networks, electricity networks, road networks, and natural gas networks also function as true public goods. You may have to pay a fee to get connected to the network, but this fee is incredibly small compared to the cost of building your own private pipeline to the gas plant or lay your own private telephone lines to all the people you want to speak with. Investing in public goods is not always a public sector job. Private companies may do it very efficiently, but the initial investments are huge, so it is typically a job for big, multinational companies or consortia, rather than small, credit constrained Bolivian companies, or even state companies.
Many true public goods, such as research on tropical diseases and the development of new technologies, require much more investment than the Bolivian government can handle, but there are still many public goods that only the Bolivian government can provide. For example, most Bolivians spend an inordinate amount of time on bureaucracy because there is no well-functioning central register of people and landholdings. Such simple things as opening a bank account, obtaining a passport, receiving your pension payment, or getting a building permit may turn into month-, year- or decade-long nightmares if you can’t produce the right documents. When identifying true public goods, you just have to think about what would make life and business easier for a lot of Bolivians at the same time.
Instead of investing in public goods, the government could distribute the money directly to the people, and each person could decide how best to spend/invest his share of the windfall. Many people might prefer private consumption goods such as food, clothes and shelter rather than a road between Rurrenabaque and Cobija or a central register of land holdings. If people buy locally produced goods and services, this may have a positive effect on the economy through the multiplier effect: If one person uses his money to hire a nanny, the nanny can use the money to buy clothes, and the clothes maker can use the money to invest in a new sewing machine, etc. The money keeps circulating and creating more economic activity, until it escapes abroad, for example by the purchase of an imported sewing machine, or until it is hidden under a mattress.
How growth enhancing it would be to distribute the money directly to the people depends a lot on how people react to receiving windfall profits. Some people celebrate and throw a party, and that’s it. Other people consider a regular flow of windfall incomes much more pleasant than hard work, and stop or reduce their normal productive activities, in which case the transfers would have a distinctly negative effect on growth. Finally, some people decide to invest the money productively, for example in their children’s education, in which case there may be a positive growth effect in the future. Some recent papers have studied the effects of remittances in order to investigate how recipients respond to windfall incomes, and the results are not very encouraging (2).
In an economy that depends heavily on foreign aid and natural resource rents, there are not a wide variety of attractive local products to consume, so people tend to spend a relatively large share of their incomes on imported goods. A large inflow of imported goods has two negative effects on the local economy. First, it stops the multiplier effect mentioned above, as the money escapes abroad. Second, imported goods compete with local products and thus depress local production and GDP growth. The government might try to counteract this by putting restrictions on imports, but that hurts the consumers, who have to settle for inferior, locally produced goods. Most productivity enhancing goods and machinery are not produced locally at all, and thus have to be imported, if the economy is to grow. Probably the best thing would be to put an import tax on luxury goods, but not on productivity enhancing and educational goods, such as machinery and books. However, it is not always easy to decide which is which. Some people may consider a washing machine a luxury good, whereas I consider it incredibly productivity enhancing.
In sum, it is not at all obvious how hydrocarbon revenues or aid money is best spent. Some kinds of spending may increase inequality or decrease growth, or both (3). The least damaging or distorting option is probably to spend it on the children (4).
Know of any inspiring ways to best use hydrocarbon revenues and aid money? Leave a reply below.
(*) Director, Institute for Advanced Development Studies, La Paz, Bolivia. The author happily receives comments at the following e-mail: firstname.lastname@example.org.
(1) Blocking of existing roads may thus be considered a negative public good, or the act of unblocking roads a positive public good.
(2) See Andersen, Christensen & Molina (2005) “The Impact of Aid on Recipient Behavior: A Micro-Level Dynamic Analysis of Remittances, Schooling, Work, Consumption, Investment and Social Mobility in Nicaragua“Institute for Advanced Development Studies. Development Research Working Paper Series No. 02/2005.
(3) See, for example, Andersen, Caro, Faris & Medinaceli (2006) “Natural Gas and Inequality after Nationalization” Institute for Advanced Development Studies. Development Research Working Paper Series No. 05/2006.
(4) See “Do Your Aid Projects Hurt the Poor?”