Libyans have a new lease on 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.

Meanwhile, in Africa, Ghana has begun pumping oil for the first time, and Uganda is about to do so as well. Indeed, from West Africa to Mongolia, countries are experiencing windfalls from new sources of oil and mineral wealth. Adding to the euphoria are the historic highs that oil and mineral prices have reached on world markets over the last four years.

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 payoff in terms of a better quality of life for their people. But, whether in Libya or Ghana, these countries’ current leaders have an advantage: most are well aware of history, and want to know how to avoid the infamous natural-resource “curse.”

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), excessively rapid resource depletion, inhibition of institutional development, and civil war.

Oil prices are especially volatile, as the large swings over the last five years remind us. The recent oil boom could easily turn to bust, especially if global economic activity slows.

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 and production of other internationally traded goods. This reallocation can damage long-term economic development if those sectors are the ones that nurture learning by doing and fuel broader productivity gains.

The problem is not just that workers, capital, and land are sucked into the booming commodity sector. They also are frequently lured away from manufacturing by booms in construction and other non-tradable goods and services. The pattern also includes an exuberant expansion of government spending, which can result in bloated public payrolls and large infrastructure projects, both of which are found to be unsustainable when oil prices fall. If the manufacturing sector has been “hollowed out” in the meantime, so much the worse.

Another pitfall is excessively rapid depletion of oil or mineral deposits, in violation of optimal rates of saving, let alone preservation of the environment.   

Even if high oil revenues turn out to be permanent, pitfalls nonetheless abound. Governments that can finance themselves simply by retaining physical control over the oil or mineral deposits located within their borders often fail in the long run to develop institutions that are conducive to economic development.  Such countries evolve a hierarchical authoritarian society where the only incentive is to compete for privileged access to commodity rents. In the extreme case, this competition can take the form of civil war. In a country without resource wealth, by contrast, elites have little alternative but to nurture a decentralized economy in which individuals have incentives to work and save. These are the economies that industrialize.

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 artificially 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 for Libya, Iraq, Ghana, Mongolia, and others to emulate. These include: hedging export earnings - for example, via the oil options market, as Mexico does; ensuring countercyclical fiscal policy - for example via Chile’s kind of structural budget rule; and delegating sovereign wealth funds to professional managers, as Botswana’s Pula Fund does.

Finally, some promising ideas have virtually never been tried at all: linking bonds to oil prices instead of dollars, to protect against the risk of a price decline; choosing Product Price Targeting as an alternative to either inflation targeting or exchange-rate targeting, to play the role of anchor for monetary policy; and distributing oil revenues on a nationwide per capita basis, to ensure that they do not wind up in elites’ Swiss bank accounts.

Leaders have free will. Oil exporters need not be prisoners of a curse that has befallen others. Countries can choose to use their resource bonanzas for the long-term economic advancement of their peoples.

[This column originally appeared at Project Syndicate.  Comments can be posted there.]

The prices of minerals, hydrocarbons, and agricultural commodities have been on a veritable roller coaster. Although commodity prices are always more variable than those for manufactured goods and services, commodity markets over the last five years have seen extraordinary volatility.

Countries that specialize in the export of oil, copper, iron ore, wheat, coffee, or other commodities have boomed.  But they are highly vulnerable. Dollar commodity prices could plunge at any time, as a result of a new global recession, a hard landing in China, an increase in real interest rates in the United States, fluctuations in climate, or random sector-specific factors.

Countries that have outstanding debt in dollars or other foreign currencies are especially vulnerable. If their export revenues were to plunge relative to their debt-service obligations, the result could be crashes reminiscent of Latin America’s debt crisis in 1982 or the Asian and Russian currency crises of 1997-1998.

Many developing countries have made progress since the 1990’s in shifting from dollar-denominated debt toward foreign direct investment and other types of capital inflows, or in paying down their liabilities altogether. But some commodity exporters still seek ways to borrow that won’t expose them to excessive risk.

Commodity bonds may offer a neat way to circumvent these risks. Exporters of any particular commodity should issue debt that is denominated in terms of the price of that commodity, rather than in dollars or any other currency. Jamaica, for example, would issue alumina bonds; Nigeria would issue oil bonds; Sierra Leone would issue iron-ore bonds; and Mongolia would issue copper bonds. Investors would be able to buy Guatemala’s coffee bonds, Côte d’Ivoire’s cocoa bonds, Liberia’s rubber bonds, Mali’s cotton bonds; and Ghana’s gold bonds.

The advantage of such bonds is that in the event of a decline in the world price of the underlying commodity, the country’s debt-to-export ratio need not rise. The cost of debt service adjusts automatically, without the severe disruption that results from loss of confidence, crisis, debt restructuring, and so forth.

The idea is not new. (The oldest reference I know is Lessard & Williamson, 1985.)  So, why has it not been tried before? When one asks finance ministers in commodity-exporting debtor countries, they frequently reply that they fear insufficient demand for commodity bonds.

That is a surprising proposition, given that commodity bonds have an obvious latent market, rooted in real economic fundamentals. After all, steel companies have an inherent need to hedge against fluctuations in the price of iron ore, just as airlines and utilities have an inherent need to hedge against fluctuations in the price of oil.  Each of these commodities is an important input for major corporations. Surely there is at least as much natural demand for commodity bonds as there is for credit-default swaps and some of the bizarrely complicated derivatives that are currently traded!

It takes liquidity to make a market successful, and it can be difficult to get a new one started until it achieves a certain critical mass. The problem may be that there are not many investors who want to take a long position on oil and Nigerian credit risk simultaneously.

A multilateral agency such as the World Bank could play a critical role in launching a market in commodity bonds. The fit would be particularly good in those countries where the Bank is already lending money.

Here is how it would work. Instead of denominating a loan to Nigeria in terms of dollars, the Bank would denominate it in terms of the price of oil; it would then turn around and lay off its exposure to the world oil price by issuing that same quantity of bonds denominated in oil. If the Bank lends to multiple oil-exporting countries, the market for oil bonds that it creates would be that much larger and more liquid. It can serve an additional important pooling function in cases where there are different grades or varieties of the product (as with oil or coffee), and where prices can diverge enough to make an important difference to the exporters.  The Bank could link the bond it issues to an oil price index, a weighted average of various product grades.

An alternative for some commodity exporters is to hedge their risk by selling on the futures market. But an important disadvantage of derivatives is their short maturity. A West African country with newly discovered oil reserves needs to finance exploration, drilling, and pipeline construction, which means that it needs to hedge at a time horizon of 10-20 years, not 90 days.

Another disadvantage of derivatives is that they require a high degree of sophistication –both technical and political. In the event of an increase in a commodity’s price, a finance minister who has done a perfect job ex ante of hedging export-price risk on the futures market will suddenly find himself accused ex post of having gambled away the national patrimony. This principal-agent problem is much diminished in the case of commodity bonds.

If the international financial wizards can get together and act on this idea now, commodity exporters might be able to avoid calamity the next time the world price of their product takes a plunge.  The World Bank should take up the cause.

Under French President Nicolas Sarkozy’s leadership, the G-20 has made addressing food-price volatility a top priority this year, with member states’ agriculture ministers meeting recently in Paris to come up with solutions. The choice of priorities has turned out to be timely: world food prices reached a record high earlier in 2011, recalling a similar price spike in 2008.

Consumers are hurting worldwide, especially the poor, for whom food takes a major bite out of household budgets. Popular discontent over food prices has fueled political instability in some countries, most notably in Egypt and Tunisia. Even agricultural producers would prefer some price stability over the wild ups and downs of the last five years.

The G-20’s efforts will culminate in the Cannes Summit in November. But, when it comes to specific policies, caution will be very much in order, for there is a long history of measures aimed at reducing commodity-price volatility that have ended up doing more harm than good.

For example, some inflation-targeting central banks have reacted to increases in prices of imported commodities by tightening monetary policy and thereby increasing the value of the currency. But adverse movements in the terms of trade must be accommodated; they cannot be fought with monetary policy.

Producing countries have also tried to contain price volatility by forming international cartels. But these have seldom worked.  

In theory, government stockpiles might be able to smooth price fluctuations, releasing commodities in times of shortage and adding to stocks when prices are low.   A free-marketer will point out that they can undermine the incentive for the private sector to hold stockpiles.  A valid response is that this incentive is undermined regardless, because political economy never allows “hoarders” to “price gouge” in times of food crisis.    It all depends on how stockpiles are administered.  The record in practice is not encouraging.

In rich countries, where the primary producing sector usually has political power, stockpiles of food products are used as a means of keeping prices high rather than low. The European Union’s Common Agricultural Policy is a classic example – and has been disastrous for EU budgets, economic efficiency, and consumer pocketbooks.

In many developing countries, on the other hand, farmers lack political power.  Some African countries adopted commodity boards for coffee and cocoa at the time of independence. Although the original rationale was to buy the crop in years of excess supply and sell in years of excess demand, thereby stabilizing prices, in practice the price paid to cocoa and coffee farmers, who were politically weak, was always below the world price.  In response, production fell.

Politicians often seek to shield consumers through price controls on staple foods and energy.  But the artificially suppressed price usually requires rationing to domestic households. (Shortages and long lines can fuel political rage as well as higher prices can.). Otherwise, the policy can require increased imports in order to satisfy the excess demand, and so can raise the world price even more.

If the country is a producer of the commodity in question, it may use export controls  to insulate domestic consumers from increases in the world price. In 2008, India capped rice exports, and Argentina did the same for wheat exports, as did Russia in 2010.

Export restrictions in producing countries and price controls in importing countries both serve to exacerbate the magnitude of the world price upswing, owing to the artificially reduced quantity that is still internationally traded. If producing and consuming countries in grain markets could cooperatively agree to refrain from such government intervention, working through the World Trade Organization, world price volatility could be lower.

In the meantime, some obvious steps should be taken.  It is too bad that the G20 attempt to do away with bio-fuel subsidies has failed, so far. Ethanol subsidies, such as those paid to American corn farmers, do not accomplish policymakers’ avowed environmental goals, but do divert grain and thus help drive up world food prices. By now this should be clear to everybody. But one cannot really expect the G-20 agriculture ministers to be able to fix the problem. After all, their constituents, the farmers, are the ones pocketing the money. The US, it must be said, is the biggest obstacle here.

What the G-20 farm ministers — meeting for the first time June 23 — have agreed is to forge an Agricultural Market Information System to improve transparency in agricultural markets, including information about production, stocks, and prices. More complete and timely information might indeed help.

But speculation is not necessarily destabilizing. Sarkozy is right that leverage is not necessarily good just because the free market allows it.  And that speculators occasionally act in a destabilizing way. But speculators more often act as detectors of changes in economic fundamentals and provide the signals that smooth fluctuations. In other words, they often are a stabilizing force.

The French have not yet been able to obtain agreement from the other G-20 members on measures aimed at regulating commodity speculators, such as limits on the size of their investment positions. I hope it stays that way. Shooting the messenger is no way to respond to the message.

[This op-ed appeared via Project Syndicate.  Comments can be posted at that site.]

It is time for the Managing Director of the International Monetary Fund to come from an emerging market country. But that has been said often before. Whining about the injustice of the 65-year duopoly under which the IMF MD comes from Europe and the World Bank President comes from the US won’t change anything. Only if emerging market countries were to unify quickly behind a single strong candidate would they have a shot at the post. They are evidently too fragmented even to make an effort to come together in this way. Thus the job will probably go to a European yet again.

Why should the person come from the South instead of Europe?  After all, the oft-repeated principle that the IMF Managing Director should be chosen on merit rather than nationality need not necessarily mean a departure from the past practice of choosing Europeans. Europe of course has some well-qualified candidates. Christine Lagarde is very impressive and capable (though I would ideally have preferred someone with economics training for this job rather than a lawyer).

But the proposition that the ongoing sovereign debt troubles in Europe’s periphery are a reason to appoint a European is wrong. Ms. Lagarde herself seems to acknowledge this.   If anything, someone without a stake in Europe might be better situated to deal with the Greeks and the others.

The important point is that Europe has by now lost its implicit claim to be the best source of serious sober adults with the experience required to run the world monetary system. There may have been a time when the adult-child metaphor had a kernel of truth. In the 1980s, for example, the Fund was run by highly capable Managing Directors from France, during a period when huge budget deficits and even hyperinflations ran wild in the developing world. But that time is past.

There are three respects in which Europe can no longer claim to be the special seat of wisdom and responsibility. In the first place, many of the emerging market governments have done better jobs running their economies over the last decade than has Europe. I refer in particular to excessive debts that many European countries accumulated during the last expansion, culminating in the mis-managed sovereign debt crisis of the last year or two. In the second place the Europeans now have three strikes in a row in choosing Managing Directors for the IMF: Each of the last three MDs resigned before the end of his term. True, neither of Dominique Strauss-Kahn’s two predecessors left in the sort of scandal that he faces. But both of their resignations revealed that the men in question had not been taking the job seriously enough.  (Incidentally, over the last decade the US has screwed up as badly as Europe: enacting fiscally reckless policies during the last economic expansion and installing an inappropriate president of the World Bank in 2005.)

Thirdly, and most importantly, it so happens that many of the best candidates this time are not from Europe nor from the United States, but rather from emerging markets. So the merit criterion happens to coincide well with the much-recognized but never-honored need to give emerging market countries more weight in the governance of the IMF, in line with their new weight in the world economy.

Indeed, it is remarkable how many excellent candidates there are now from emerging markets. That is not to say that everyone put forward by his or her government is in truth a good prospect. When Turkey’s leaders say they have at least ten good candidates, they illustrate that politicians often don’t know what qualifications are required for the job. (No country has ten good candidates.)

I count ten emerging market individuals who are unusually well-qualified for the post.  Seven of them appear to be live candidates. They come from every part of the globe.
• Agustin Carstens, current governor of Mexico’s central bank, is described as the leading prospect among the group – because his government lost no time nominating him. He indeed would be good.  And has IMF experience, which is desirable whatever the critics say. But even Latin America is not unifying behind him (for example Brazil has not been supportive), let alone other developing countries. He may be perceived as too close to the US by developing countries to get their support – and also by the Americans who might worry that having him as head of the IMF would undermine their claim to the World Bank presidency.
• Arminio Fraga, former governor of Brazil’s central bank, is another good candidate, with extensive experience. But, again, it is not clear that governments even within Latin America are prepared to unify behind someone from the region’s largest country. Perhaps as a general matter any candidate who is identified with a large regional power is more likely to provoke jealousy than solidarity from the neighbors.  Mexico is unlikely to support a candidate from Brazil and vice versa.    India is unlikely to support a candidate from China, and vice versa.
• Tharman Shanmugaratnam is my favorite candidate. He has excelled as Singapore’s Finance Minister and was just promoted to Deputy Prime Minister. In March he was chosen to head the International Monetary and Financial Committee, the panel of ministers that advise the IMF on strategy twice a year. (The incumbent was forced to leave in a hurry, because he had been Egypt’s finance minister.) I can attest to Shanmugaratnam’s intelligence.  He was my student at Harvard in 1988-89. (He caught a number of errors in a draft of my textbook.)  He also has great political skills. I think he is the sort of candidate behind whom emerging market countries might be able to unify; they need not feel threatened by Singapore.
• Sri Mulyani Indrawati is another candidate from Southeast Asia with all the right credentials. She became one of the three Managing Directors of the World Bank last year, after apparently having been forced out as Indonesia’s Finance Minister for doing too good a job. Incidentally, she is young and could be a good candidate next time around too (as could the first three).
• Leszek Balcerowicz (Poland’s former Finance Minister, deputy PM, central bank governor, and Mr. Shock Therapy) is a credible candidate. Poland would be a compromise with respect to nationality, because it is both an EU country and an emerging market.
• Trevor Manuel was a great success as South African Finance Minister, and it would be good to make better use of him than the current government seems to be doing.
• Zhu Min, former Deputy Governor of the People’s Bank of China and currently a high-ranking IMF official, is another obvious candidate.

I can think of at least three others who would also do a great job, but are apparently not as actively in contention.
• Kemal Dervis (Turkey’s former Minister of Economic Affairs) would have been excellent, but he took himself out of the running early.
• I thought they should have picked Stanley Fischer for Managing Director in 2000. A stellar economist and manager, he was Deputy Managing Director of the Fund at the time. It would have been a first step toward accommodating the legitimate desire of developing countries to break the monopoly of Europe-born and US-born officials on the top jobs in the IMF and World Bank, as Fischer was born in Zambia and had the support of a surprising number of African countries. (Disclosure: He was a professor of mine at MIT in the 1970s.) The US was not prepared to oppose Europe in support of his candidacy because in practice it would have meant having to give up the US claim on the World Bank presidency.  But he would have been the best person for the job, and still is.
• Montek Ahluwalia, the last of the ten, is Deputy Chairman of India’s Planning Commission, a position that is far more important than it sounds. But there is a presumption that the candidate should not be over 65, which would let him out if followed (and Fischer).

June 10 is the deadline for nominations. Any of the ten would do a good job. Personally, I would urge emerging market governments to unite behind Shanmugaratnam. More likely, they will remain disunited. And then it will go to Lagarde.

Comments can be posted on the sites of Project Syndicate (which holds the copyright to the op-ed), the East Asia Forum, or SeekingAlpha.

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[Crosstalk debate, "What the Fund?" May 30.]

     Two decades ago, many thought the lesson of the 1980s had been that Japan’s variant of capitalism was the best model, that other countries around the world should and would follow it.   The Japanese model quickly lost its luster in the 1990s.  

     One decade ago, many thought that the lesson of the 1990s had been that the US variant of capitalism was the best model, that other countries should and would follow.   The American model in turn lost its attractiveness in the decade of the 2000s.   

     Where should countries look for a model, now, in 2010?  Many small countries on the periphery have experimented with policies and institutions that could usefully be adopted by others.  

     A panoply of innovations has helped Chile to outperform its South American neighbors.   Chile’s fiscal institutions - structural budget balance with the parameters estimated by independent expert panels — insure a countercyclical budget.  They are among the mechanisms that are particularly worthy of emulation by other commodity exporting countries, to defeat the Natural Resource Curse.  

     Costa Rica in Central America and Mauritius in Africa each pulled ahead of its peers some time ago.  Among many other decisions that worked out well for them, both countries have foregone a standing army. The result in both cases has been histories with no coups, and financial savings that can be used for education, investment, and other good things.  Singapore achieved rich country status with a unique development strategy.  Among its many innovations were a paternalistic approach to saving and use of the price mechanism to defeat urban traffic congestion (now emulated by London). 

     Some small advanced countries also have lessons to offer.   New Zealand led the way with Inflation Targeting, along with many liberalization reforms in the late 1980s.   (Perhaps its Labor Party should even be given credit for pioneering the principle that left-of-center governments can sometimes achieve economic liberalization better than their right-of-center opponents.)   Ireland showed the importance of Foreign Direct Investment.  Estonia led the way in simplifying its tax system by means of a successful flat tax in 1994, followed by Slovakia and other small countries in Central/Eastern Europe and elsewhere (including Mauritius again).   

     Mexico pioneered the idea of Conditional Cash Transfers (the OPORTUNIDADES program — originally PROGRESA, launched in 1998).  CCT programs have subsequently been emulated by many developing countries.  This was two revolutions in one:  (1) the specific idea of making poverty transfers contingent on child school attendance (which has been emulated even in New York City) and (2) the methodological idea of conducting controlled experiments to find out what policies work or don’t work in developing countries (which has fed into the exciting Randomized Control Trials movement in development economics).  Also in the 1990s, largely thanks to the leadership of President Ernesto Zedillo, Mexico adopted non-partisan federal electoral institutions that were subsequently in 2006 able to resolve successfully a disputed election.   (In contrast, it turned out in November 2000 that the United States had no mechanism to resolve such disputes, other than the preferences of political appointees.)  Mexico undertook health reform in 2004.  More recently, President Felipe Calderon has shut down the entrenched electric utility and pursued much-needed reforms in tax, pension, and other areas.

     In highlighting some very specific institutions that could be usefully applied elsewhere, I don’t mean to suggest that they can be effortlessly translated from one national context to another.   Nor do I mean to suggest that these examples are entirely responsible for the success of the economies identified.  (Indeed a few of these countries have recently been wrestling with severe problems.)  But a country doesn’t have to be large like the United States to serve as a model for others.  Small countries tend to be trade-dependent, and open to new ideas.  They are often more free to experiment than are large countries. The results of the experiments include some useful lessons.

[TV interview on BNN.]

By roughly the five-year mark after the launch of the euro in 1999, enough data had accumulated to allow an analysis of the early effects of the euro on European trade patterns. Studies include Micco, Ordoñez and Stein (2003), Bun and Klaassen (2002), Flam and Nordström (2006), Berger and Nitsch (2005), De Nardis and Vicarelli (2003, 2008), and Chintrakarn (2008). The general finding was that bilateral trade among euro members had indeed increased significantly, but that the effect was far less than the one that had earlier been estimated by Rose and others on the larger data set of smaller countries. Overall, the central tendency of these estimates seems to be a trade effect in the first few years on the order of 10-15%. None came anywhere near the tripling estimates of Rose (2000), or the doubling estimates (in a time series context) of Glick and Rose (2002).

There are three leading explanations for the discrepancy between the estimates of the euro’s effects (10-15% increase in trade among members) and those from historical estimates (doubling or tripling). (more…)