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Government should use resource wealth as an opportunity to secure effective public expenditure and to increase the efficiency of public spending.
The opportunities for sustained growth that are created by a large increase in public expenditure, such as is made feasible by new resource revenues, requires effective allocation and control of spending and careful attention to the macro-economic impacts on other sectors of the economy.
The first problem is the quality of public spending. If public spending has been properly prioritized, extra spending will be less valuable than existing spending. Deterioration in the quality of spending may also occur as a result of political economy pressures: once lobby groups know that public spending will increase, they will increase their efforts to capture it for their own advantage, a process known as ‘rent-seeking’. If the quality of extra public spending is low then the resource revenues cannot be transformed into substantially higher living standards.
The solution to the problem of low-quality public spending is to recognize that a substantial increase in public spending is also an opportunity for innovation in spending systems. It may be politically easier to introduce improved but tougher management for new spending than to reform existing spending.
Innovations in public spending systems are needed for two distinct objectives: integrity and efficiency. As in our discussion of integrity and efficiency in resource extraction, competition is an effective instrument in achieving both. The institutional equivalent of an auction for the sale of extraction rights is to require competitive tendering for all public procurement. In addition to competitive tendering there are some systems which are primarily for integrity. The decisions to approve expenditures should be made transparent through published budgets; once expenditures have been incurred they should be subject to the scrutiny of independent audit. Other systems are primarily for efficiency. Prior to approval, the costs of major expenditures should be compared to their likely benefits (cost-benefit analysis), and as noted in Precept 8, the investment program must take account of the absorptive capacity of the country. After completion such expenditures should be evaluated, the results being used both for accountability and for learning.
As part of the reform of public spending special attention also needs to be given to the absorptive capacity of the country, that is its ability to actually realize and carry out public investments. Limitations of human or physical capital may limit the efficiency of investment, and it is necessary to think through the sequence of investment in order to reduce these constraints so that further investment can be efficiently managed so as to realize the intended objective.
The second problem is that a large increase in spending financed from resource export earnings has macroeconomic repercussions which can damage sectors which indirectly are in competition with resource exports. Firms that produce other types of exports can be hurt by changes in exchange rates that make their exports less competitive, and firms which produce tradable goods for the domestic market, such as manufactures, can be hurt because labor and other costs may be bid up by demands from the resource sector. These effects are known as ‘Dutch disease’.
The solution to the problem of Dutch disease is in part to offset the damage done to producers of other exports and import-substitutes by lowering their costs. The way to do this on a sustainable basis is not through subsidies but through targeting infrastructure spending towards their particular needs, such as power, water, roads and ports. Additionally, the problem of Dutch disease can be reduced by smoothing peaks and troughs of commodity price fluctuations, as discussed in Precept 8. However, even with such smoothing the economy will need to adjust to periodic external shocks and this has implications for the design of economic policies that superficially might appear unrelated to resource extraction. A key policy that appears to improve the ability of resource-rich economies to weather shocks is labor market flexibility. This implies that policies for social protection might need to be distinctive in such economies, with greater focus on direct help to households and assisted job mobility rather than through the protection of existing jobs.
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