Are windfalls a curse?

Abstract

A puzzling feature of temporary terms of trade booms is that some countries have responded to such windfalls by running current account deficits. Furthermore, those countries that ran current account deficits failed to attain greater post-boom growth rates, indicating the deficits were consumed or invested in low quality projects. The point we make is that the structure of the fiscal process is critical in determining outcomes. If fiscal control is unitary, then the consumption-smoothing effect is operative, and representative-agent models of the current account have predictive power. However, if control is divided among several fiscal claimants, a voracity effect appears which counteracts the consumption smoothing effect, leading to a deterioration of the current account in response to a positive temporary shock. We model the interaction among fiscal claimants as a dynamic game and show that in equilibrium aggregate appropriation increases more than the windfall itself. This results in a deterioration of the current account. We also show that all the windfall is dissipated, with the country experiencing no increase in welfare. © 1998 Elsevier Science B.V.