This week’s column addresses the Permanent Income Hypothesis (PIH) fiscal rule as applied to Natural Resources Funds (NRFs). I have listed this topic at eighth on my top-10 list of development challenges, which spending Guyana’s Government Take from its coming petroleum sector will have to navigate. Thus far, this eighth topic has led to a rather extended discussion. This is basically due to the fact that the Green Paper on Guyana’s NRF, proposed for 2019, incorporates the fiscal rules that will apply to the compulsory externally-held assets of Guyana’s NRF. Because the Fund embraces elements of the PIH fiscal rule, I begin by responding, in the next section, to the question: what is the PIH rule?
Permanent Income Hypothesis
The PIH rule is generally acknowledged as one of the most widely adopted fiscal rules employed in natural resources revenue management. This is especially true for petroleum, because of its exceptional price volatility. When applied to Guyana, this rule basically sets a limit to the spending of Government Take in any given year. That limit is the “interest accrued” from total natural resources wealth (including petroleum wealth); both extracted and non-extracted resources. This rule, in effect, converts revenue from Guyana’s natural resources wealth (including petroleum wealth) into a permanent income that can be maintained indefinitely.
More formally, economic theory posits that: a country with natural resources revenue finds “its inter-temporal budget constraint is satisfied, when its yearly spending (that is, the non-natural resources primary deficit) is limited to the perpetuity that can be supported by the present value of the natural resources wealth.” One may say, therefore, that definitively this “fixes the highest level of smoothed spending over time that maximizes Guyana’s welfare”.
Based on this formulation, it has been argued that “the PIH is the relevant base to set a spending target that can be followed in natural resources based countries, in order to guarantee: 1) long term availability of resources and, simultaneously 2) avoid sharp cuts in public spending in the post natural resources availability period” (Omgba & Djioloch, 2010, Journal of Economic Literature, September, 2010).
However, I readily admit, this view has been strongly challenged by a number of economists. They argue along the following lines: developing countries, with scarce capital like Guyana, (my emphasis), might do better, by prioritizing domestic investments in the early stages of their development; compared to the adoption of the PIH approach.” The Economic Policy Research Centre (EPRC) has noted in reference to Uganda that PIH policy “fails to address concerns about current poor living conditions and investment needs in capital-scarce low-income economies” (EPRC, 2015, Page 7).
Research reveals that there are two distinct tributaries of theory and analysis, which flow into the PIH hypothesis, as a fiscal rule. One of these is based on the seminal work of Hotelling (1931). This work is on the economically efficient management of exhaustible natural resources intergenerationally, along an “optimal extraction path,” And, the other tributary flows from the equally seminal work of Milton Friedman (1957) concerning how “economic agents distribute consumption over their lifetime.” The latter means how the consumption of economic agents is determined not only by current income, but also future expected income or indeed the level of permanent income!
Modified PIH Extension
The EPRC (2015) study, which I have cited above, refers to two modifications to the traditional PIH approach. These are: 1) a “modified” PIH approach; and 2) a fiscal sustainability framework (FSF). This latter is typified in the one proposed in Guyana’s NRF Green Paper.
More specifically, the modified PIH “allows for an initial scaling up of spending, alternatively known as frontloading the spending of Government Take.” This is regularly combined with external savings in a Sovereign Wealth Fund. How-ever, this approach continues to insist: “Fiscal policy remains anchored in the long-term sustainable use of natural resources revenue. Therefore, while spending Government Take is front-loaded, spending it is lowered in further out years.”
Green Paper’s FSF
Alternately, the FSF approach seeks to stabilise revenues over the very long-term. It thus allows for front-loading the spending of Government Take, in order to stabilise public spending at a higher level in later years. This is because (as the Green Paper indeed asserts) of existing infrastructure and human capital gaps in capital-scarce Guyana. The modified PIH has been likened to the “Big Push” development strategy. And the FSH is likened to the “investing to invest” development strategy. This latter development strategy recognises the point that I made last week, which is, future generations are going to be richer than the present, if there are positive real per person GDP increases generationally.
Critique of PIH
It is also widely recognized among several economists that, as a fiscal rule, the PIH is strongly conservative in regard to the spending of Government Take. It definitely seeks to restrain Government spending to the equivalent of interest accrued on the net present value of Guyana’s natural resources wealth; over the lifespan of these natural resources. This focus reduces to a second order priority concerns about current living conditions and investment needs in a capital-scarce economy, like Guyana.
Important international institutions, like UNCTAD and even the International Monetary Fund (although an early proponent of the PIH) have been urging the re-evaluation of the PIH fiscal rule (UNCTAD, 2011 and IMF, 2012). There is growing acknowledgement that productive government spending can do much better for growth, development, and employment (as a fiscal path) in credit-constrained and severely capital scarce environments.
I urge readers to keep always to the forefront of their considerations that, natural resources are finite and eventually exhaustible. The compelling logic of this circumstance is that this will irresistibly produce progressively binding constraints on natural resources. Almost certainly revenues and profits from their sale will eventually peak and then dwindle. They, however, dwindle because resources are depleted. The consequence is profits fall and unit costs rise. Unit costs rise, because resources accessibility and/or quality are reduced over time.
Next week, I turn to evaluate the penultimate (ninth) topic on my list of top-10 challenges which spending Guyana’s Government Take will have to navigate. That is, managing expectations. Although seemingly, not too technical (difficult!) a task, this has frequently proven, in practice, to be one of the most intractable in the top-10 development challenges.
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