The Arab Gulf countries’ plentiful oil confers many benefits upon their citizens, but the Opec meeting on May 25 reminds us of one of the key downsides: long-term budgetary planning is fiendishly difficult when your finances are at the mercy of the “black gold”. Why is that the case?
When governments draft budgets, they do so with an eye on four major goals: robust economic growth; low unemployment; low inflation; and sustainable government finances, by balancing the budget and keeping public debt low. Successful budgeting typically combines prudent investment in strategically important areas, with a lean and efficient civil service that allows the private sector to be the economy’s key driver.
Citizens also hate volatility in things such as unemployment and inflation, resulting in the added short-term goal of maintaining stability in the economy. This is typically achieved by relaxing the constraint that the government balance its books; instead, economic policies are usually deployed counter-cyclically to try to dampen the business cycle, by loosening the government’s purse strings during recessions, and tightening them during booms.
In conventional economies, the business cycle is typically mean-reverting, meaning that when the economy is growing faster than average, it will predictably and organically slow down, and vice versa. This is because a key driver of modern business cycles is temporary misallocations of resources, such as financial bubbles, rather than changes in the fundamental structure of the economy. The business cycle’s mean-reversion underlies the proposed effectiveness of counter-cyclical fiscal policy: recessions tend to be followed by booms, and so you can afford a short-term deficit because there will be an opportunity to run a surplus in the not-too-distant future.
In the GCC, oil changes the rules of the game, because oil income is not mean-reverting – it does not oscillate around a predictable average. Instead, oil prices (and hence oil income) are an approximate random walk, meaning they meander in an effectively arbitrary fashion. Most notably, unlike unemployment in the United States, when oil prices are above their recent average level, that does not make them more likely to fall back to that average, and vice versa. Stock prices exhibit similar properties, and that is why accurately predicting oil or share crashes is basically impossible.
Consequently, the GCC business cycle is not mean-reverting, rendering counter-cyclical fiscal policy inherently unsustainable: when oil prices fall and the economy contracts, should the government run a budget deficit to cushion the impact? There is no statistical basis for expecting a subsequent boom in oil prices that will balance the books. GCC citizens who clamour for their governments to give the economy a fiscal boost when oil prices fall are asking their governments to undertake a much greater risk than US citizens asking for a stimulus during a conventional recession.
Oil reliance also makes long-term planning more arduous, for the same reason. Whereas economic growth in traditional economies is driven by broad-based technological progress, which tends to be mean-reverting, economic growth in oil economies is driven by oil prices and production, neither of which is mean-reverting. As a result, GCC policymakers strategising for the long-term face much higher degrees of uncertainty than their American counterparts.
In the case of a small, oil-dependent country, futures contracts can be used to lock in oil prices, while large sovereign wealth funds can smooth the returns from oil income. However, neither strategy addresses the economy’s inherent instability, because of the continuing dependence upon an asset that does not exhibit mean-reversion.
It has taken a while for this point to sink in because good quality macroeconomic data has only been available for about 50 years (even less for non-western economies), and much of the relevant economic and econometric theory is even younger. The 2014 oil price crash has reaffirmed this point to GCC policymakers, who have correctly surmised that the only solution is genuine diversification.We welcome economics questions from our readers through email at omar@omar.ec, or twitter via @omareconomics
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