European Economic Perspectives 21

Eat the Riches

Many developing and transition countries have appalling growth records despite wonderful economic endowments. New CEPR research blames the ‘voracity effect’.

A curious and depressing phenomenon is that many developing countries that are rich in natural resources or enjoy high export prices have failed to exploit their good fortune. Oil-rich countries like Nigeria and Venezuela have actually become poorer during the past 25 years, and others, such as Mexico, have dissipated much of the potential gain. Russia today is another graphic illustration of a resource-rich economy performing far below its potential. It seems that windfalls are often a curse.

A recent CEPR Discussion Paper by Aaron Tornell and Philip Lane tries to explain this phenomenon. These researchers note that common features of these societies are multiple power blocs alongside weak countervailing legal-political institutions. The power blocs may include regional or provincial governments within a federal system; tribal or ethnic leaders; labour unions or industrial conglomerates (private or public); parties within a coalition; or individual ministers within a cabinet. An inadequate legal-political infrastructure means that private property rights are insecure and income streams are vulnerable to appropriation.

In well-ordered economies, there are a variety of controls that prevent interest groups from arbitrarily obtaining resource transfers from the rest of society. But in fragmented societies, where legal or political restrictions are absent, powerful groups may appropriate resources through their control of the fiscal process - receiving transfers financed by taxation - or by lobbying for government interventions that redistribute rents within the economy.

Tornell and Lane argue that the policy environment of a fragmented society generates not only a subpar rate of economic growth but also perverse responses to positive macroeconomic shocks, such as resource discoveries or terms of trade improvements. Consider the appropriation decision made by each powerful group with effective access to the fiscal process. Each group wants to appropriate resources for its own private gain. Yet each group also realises that excessive taxation is a self-defeating policy, deterring investment and shrinking the size of the economic pie available for appropriation in the future. In other words, the productive economy is the ‘golden goose’ that feeds the various fiscal groups and hence deserves protection.

But since the overall tax rate is determined by the sum of the appropriations sought by all of the fiscal groups, there is a classic ‘collective action’ problem. Each group prefers to maintain a high rate of appropriation and see taxes reduced by greater self-discipline on the part of other participants in the fiscal process. Since no group has the incentive to take the lead in achieving fiscal prudence, the outcome is an excessive rate of appropriation and taxation - and consequently, a slow rate of output growth.

A good analogy is the fishing industry: the oceans are ‘common property’ and individual fishermen do not consider resource renewal their individual responsibility. As a result, in the absence of regulation, there is overfishing. Similarly, allocation decisions in a fragmented society without institutions to protect the common good can lead to inefficient outcomes.

The same mechanism leads to a perverse response to macroeconomic shocks. For example, an increase in fiscal revenues arising from higher export prices means that each group feels able to increase its appropriation rate. But since their common interest is not taken into account, the aggregate level of appropriation increases more than proportionally relative to the increased revenues, requiring an actual increase in the tax burden. Tornell and Lane label this overspending phenomenon the ‘voracity effect’.

There are many cases of resource booms being dissipated through intensified appropriation. During the commodity price booms of the 1970s, for example, several oil-producing countries went on spending binges, with those favoured groups with access to fiscal revenues borrowing to finance conspicuous consumption and wasteful prestige investment projects or to accumulate safe overseas assets immune from domestic taxation. Similarly, although the 1975-8 coffee boom was clearly temporary - the result of a frost in Brazil - a number of coffee producers not only failed to save the windfall but actually ran current account deficits during the high-revenue period.

Foreign aid is another powerful example of a windfall gain that can unleash the voracity effect. It is well-known that aid has often been wasted by recipient countries, either diverted by corruption or wasted on ‘white elephant’ projects, as various domestic interest groups seek to obtain their share of the foreign transfer via ‘rent-seeking’ activities.

The research suggests that the scale of the voracity problem depends on the extent to which control of the fiscal process is fragmented. The ideal situation is one in which the fiscal process is controlled in the common interest or by one powerful group: in either case, the policy-maker has an incentive to ensure that fiscal discipline is achieved and that the country responds efficiently to macroeconomic shocks. A highly polarized society in which fiscal control is split between two opposing groups is the worst of all possible worlds: each group is powerful enough to extract large transfers but wants to pass the adjustment burden to the other group.

Surprisingly, a more fractionalized fiscal process, in which many groups engage in rent-seeking, is preferable to the two-group case. This is because each group realises that the overall economic pie must be split among many, leading to moderation in the transfer requests of any individual group. Not only is growth performance better than in the two-group case, but the voracity effect in response to revenue shocks is muted.

Tornell and Lane’s findings are important for evaluating the growth prospects of developing and transition countries undergoing economic and political reform. According to their analysis, the impact on growth of a switch from autocracy to a more decentralized system will depend on the effect the shift has on the ability of powerful groups to extract transfers.

If the collapse of an autocracy relaxes restrictions on the behaviour of powerful groups within a society, decentralization may actually intensify the rent-distribution struggle in these countries. This will lead to slower growth and poorer adjustment to shocks. In contrast, if the shift to decentralization brings with it the destruction of entrenched interest groups, and power becomes more diffused, then growth performance and adjustment to shocks will improve.

The implication is that for sustainable development, legal-political institutions that protect the common interest must be built in tandem with liberalization. Furthermore, pro-competition policies - making market entry easier or exposing domestic behemoths to foreign rivals - may be as important in terms of altering a country’s propensity to engage in rent-seeking as in their direct impact on efficiency.

This highlights the importance of avoiding the creation of very big conglomerates as has happened in Russia. Since a small number of individuals wield immense economic power, they can influence the political process and, as a result, acquire effective access to fiscal revenues. This implies that it is undesirable to implement a privatization process that simply allows the creation of behemoths which pursue fiscal rents rather than economic efficiency.

This article reviews research reported in ‘Voracity and Growth’ by Aaron Tornell and Philip Lane, CEPR Discussion Paper No. 2001 (October 1998). Tornell is at Harvard University; Lane is at Trinity College, Dublin, and a Research Affiliate in CEPR’s International Macroeconomics and International Trade programmes.

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