Friday, July 6, 2012

What should a country do with a windfall?

You live in a country with a poor population and little infrastructure. Assume you are benevolent and the country gets a sudden, but temporary, windfall, say from the discovery of some natural resources. How should you allocate this windfall? The simple growth model with subsistence consumption would tell you to put as much as possible into capital. This would get the country above the unstable equilibrium and out of the development trap. But if you are already above, you can put some income towards current consumption, taking time preference into account.

Frederick van der Ploeg refines this on several dimensions. First, the efficiency of investment is not that high in a country that is not used to it, and there are decreasing returns. This would call to put more into consumption and especially into debt reduction. This is reinforced by the Dutch disease, which is the tendency of a country with abundant resources to turn into an economy that all revolves around these resources. It is very difficult to invest in anything else. It may thus be good to put some money into a sovereign wealth fund until the non-traded sector is ready to accept more investment. Also, additional consumption should be concentrated towards the poorest.

As some would say, this is very nice in theory, but practice should that resource-rich economies have a dismal growth record, largely due to mis-allocation. But it is worth thinking how this could be done better

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