Analysis: How Libya can make sure oil wealth is a blessing, not a curse

Libyans have a new lease of life, a feeling that, at long last, they are the masters of their own fate. Perhaps Iraqis, after a decade of warfare, feel the same way. Both countries are oil producers, and there is widespread expectation among their citizens that that wealth will be a big advantage in rebuilding their societies.

Indeed, from West Africa to Mongolia, countries are experiencing windfalls from new discoveries of oil and mineral wealth. Many countries have been in this position before, exhilarated by natural-resource bonanzas, only to see the boom end in disappointment and the opportunity squandered, with little pay-off in terms of a better quality of life for their people.

To prescribe a cure, one must first diagnose the illness. Why do oil riches turn out to be a curse as often as they are a blessing? Economists have identified six pitfalls that can afflict natural-resource exporters: commodity-price volatility; crowding out of manufacturing; “Dutch disease” (a booming export industry causes rapid currency appreciation, which undermines other exporters’ competitiveness); inhibited institutional development; civil war; and excessively rapid resource depletion.

Oil prices are especially volatile, as the large swings over the past five years remind us. Volatility itself is costly, leaving economies unable to respond effectively to price signals. Temporary commodity booms typically pull workers, capital and land away from fledgling manufacturing sectors. The pattern also includes an exuberant expansion of government spending.

Even if an increase in oil prices turns out to be permanent, pitfalls abound. Governments that can finance themselves simply by retaining physical control over oil or mineral deposits often fail to develop institutions that are conducive to economic development. Such countries evolve an authoritarian society in which the only incentive is to compete for privileged access to commodity rents.

What can countries do to ensure that natural resources are a blessing rather than a curse? Some policies and institutions have been tried and failed. These include, in particular, attempts to suppress the fluctuations of the global marketplace by imposing price controls, export controls, marketing boards and cartels.

But some countries have succeeded, and their strategies could be useful models. These include: hedging export earnings – for example, via the oil options market, as Mexico does; ensuring counter-cyclical fiscal policy; or delegating sovereign wealth funds to professional managers, as Botswana’s Pula Fund does.

Finally, some promising ideas have almost never been tried at all: denominating bonds in oil prices instead of dollars, to protect against a price decline; choosing commodity-price targeting as an alternative to inflation targeting or exchange-rate targeting for anchoring monetary policy; and distributing oil revenues on a nationwide per capita basis.

Leaders have free will. Oil exporters need not be victims of a curse that has felled others.

• Jeffrey Frankel is professor of capital formation and growth at Harvard University.