“Mexico’s Curse”

by

Gabriel Farfán-Mares

External Consultant Public Management and Budgeting Inter-American Development Bank

Washington, D.C.

December 10, 2010 __________________

The Success Story

Mexico has overcome the economic crisis that badly hit the country during 2009. Although still fragile, a sample of three indicators demonstrates Mexico’s recovery. First, from January to October 2010, 850,000 jobs have been created. A simple projection predicts that 2010 will show the creation of more than a million jobs. Second, the consumer confidence index has significantly improved (15.9% in October 2010) and consumption has somewhat recovered.1 Third, Mexico has recently displaced Canada as the number two exporter to the United States (non-oil exports), just after China.2

Although impressive, this is certainly not the first time that Mexico has rebounded following a major economic downturn. Following the 1994-95 crisis, the country began growing at higher rates than before the crisis and by 1997, several indicators denoted a swift recovery. While the nature and depth of both crises are different, the data demonstrate that Mexico’s trade liberalization and proximity to the United States work as engines that have the power to pull the country out of economic predicaments. Unfortunately, this is only one side of the coin.

1 See De la Rosa, Gustavo. 2010. "Crece confianza del consumidor 15.9%." in Reforma. Mexico City. 2 Quintana, Enrique. Ibid."Tres buenas noticias."

Perspectives on the Americas A Series of Opinion Pieces by Leading Commentators on the Region

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The Other Side of the Coin: The Rentier State 3

Mexico has succeeded in de-petrolizing its export sector and national economy. Nevertheless, an oil-supported fiscal policy has remained constant for almost four decades. The public sector has managed to maintain its dependence on oil, whose contribution has ranged between 30 and 45% of the government’s total revenue between 1977 and 2010 (average 33%). On the other hand, from an economic standpoint, Mexico has nothing in common with richly-endowed oil countries. Its economy and external sector are more diversified in manufactures and services, although they remain highly focused on the U.S. market. Mexico has a very big private sector, which has expanded its investments regionally and globally. The private sector consists of over 5 million firms (from individual entrepreneurs to medium- and large-size firms), more than 2 million employers and a work force of 50 million (out of a total population of 107 million).4

Because hydrocarbon-rich countries are often labeled as politically backward, it is also important to acknowledge that Mexico is an electoral democracy, particularly since its once-dominant party, the Partido Revolucionario Institucional (PRI) lost its majority in the Chamber of Deputies 1997 and subsequently, the presidency in 2000. Nevertheless, the country is still muddling through to become a real democratic and liberal society. Political representation is effectively hindered by the presence of strong, centralized and nationally-based political parties that receive large amounts of public funds to build clientelist networks around elections, turning Mexico in one of the most expensive democracies in the world.5

These strong clientelist networks are reinforced by government patronage and welfare policies that focus on the distribution of public-sector jobs to the winning coalition on a non-merit basis–a true spoils system which results in a politically-biased allocation of transfers and subsidies to the population.

Therefore, although Mexico cannot be compared to its Middle East and African oil rentier counterparts, it is an oil-rentier state that, from a comparative standpoint, suffers from some of the maladies associated with the oil curse.

3 The rentier state concept was coined by Hussein Mahdavy to explain the institutional transformation of Iran in the context of its oil bonanza in the 1950s and has been used since then to assess the impact of oil in the structure and behaviour of states. See Mahdavy, Hossein. 1970. "The Patterns and Problems of Economic Development in Rentier States: the Case of Iran." Pp. 428-467 in Studies in the Economic History of the Middle East: From the rise of Islam to the Present Day, edited by M. A. Cook. London, New York: Oxford University Press. Remarkably, this concept has never been used to address the Mexican state’s political economy. 4 Data from the Instituto Nacional de Estadística y Geografía and Consejo Nacional de Población. 5 International Foundation for Electoral Systems. 2009. "Aplicación de la Reforma Electoral de 2007/2008 en México desde una perspectiva internacional comparada." International Foundation for Electoral Systems, Mexico City.

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The Commodity Curse

For countries that are rich in hydrocarbons, oil is “the only game in town.” This fact has inspired social scientists, analysts and policymakers around the world for many decades to argue that a country is negatively affected by commodities (the so-called “commodity curse”). Allegedly, oil tends to produce an array of negative phenomena: meager economic growth, violence, civil war, separatist movements, poverty and authoritarianism. Yet, comparative studies have failed to provide conclusive evidence of the alleged “commodity curse.” They have only produced deceptive or inconclusive findings, with many analysts concluding that oil is neither a curse nor a blessing.6

As a recent and comprehensive World Bank study on the overall impact of natural resources in Latin America argues, commodities, and particularly oil, have been positive for economic growth during the commodity boom and, in the long-run, have been supportive of democracy.7 The study concludes that “the preponderance of the evidence indicates that resource wealth, on average, neither undermines nor disproportionately promotes economic growth. Nor, it seems, is there any ‘political curse’ (that natural resource abundance weakens democratic institutions and fuels large-scale conflict), at least not in LAC [Latin America and the Caribbean]”.8

After praising the same study, Stephen Haber, a researcher from Stanford University, contests the resource curse thesis by addressing the importance of building “what if,” or counterfactual, reasoning. If resource rich countries had not had those resources, would they be better off today? He concludes that this is highly unlikely. While no one can empirically contest that oil has been, and can be, a short-term blessing, no one has explored indirect, non-statistical and non-purely-economic, long-term perspectives on the issue. In the long run, it can certainly be argued that commodities help to build the state. Yet, to endorse, as Haber does, “the report on commodities in Latin America by the World Bank team [as] an important step in moving toward policies that will encourage sustainable development,”9

is, to say the least, a dangerous conclusion. Commodities, and among them oil, might be positive for countries in the short run. However, to argue that they can provide sustainability to a developmental model in the region, and particularly in Mexico, is a serious policy mistake.

6 Rosser, Andrew. 2006. "The Political Economy of the Resource Curse: A Literature Survey." Institute of Development Studies, University of Sussex, Brighton. 7 Sinnott, Emily, John Nash, and Augusto De la Torre. 2010. Natural Resources in Latin America: Beyond Booms and Busts? Washington, D.C.: IBRD / The World Bank. 8 Ibid., p. 57 9 Inter-American Dialogue. 2010. "Are Latin America's Resources a Blessing or a Curse?" Inter-American Dialogue,, Washington, D.C., p. 4.

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The same World Bank report, based on a paper published by the International Monetary Fund (IMF),10

finds only one direct and statistically-robust effect that can be attributed to natural resources, and particularly, to crude oil: the state’s tax effort. Oil rents are a government’s regular source of revenue and a direct threat to an effective tax effort. Each time a country is able to increase oil production, or to benefit from a higher oil price, there is an “automatic” relaxation of the government’s tax effort.

This is very relevant to Mexico, which, over the past 200 years, has not been able to consistently sustain a taxation rate of more than 10% as a proportion of its GDP. As a recent report of the Economic Commission on Latin America and the Caribbean (ECLAC) on taxation capacity has noted,11

Mexico ranks even lower than Haiti in its taxation effort. One thing is clear: oil revenues undermine Mexico’s taxation effort.

Taxes are not only a fiscal or financial indicator, but also reflect the quality of the public sector, as fiscal sociology has emphasized.12

As long as the government depends on the contribution of individuals and firms to finance its activities, public servants and citizens have positive incentives to enforce a productive and legal use of resources, as well as government control and oversight, thereby increasing accountability. Taxes also help citizens understand how and to what extent the state is connected to the market and to what degree it can positively help spur economic growth. If a state does not depend on taxes, it tends to behave independently from economic activity in the country, since it does not depend entirely on it, but instead, on oil production and its international price. Under such conditions, the state’s decisions can be highly erratic, putting politics and short-term interests before the country’s development.

Mexico’s Policy Curse

Oil not only undermines taxation capabilities and efforts, but, as a recent 10-year research project demonstrates,13

10 Bornhorst, Fabian, Sanjeev Gupta, and John Thornton. 2008. "Natural Resource Endowments, Governance, and the Domestic Revenue Effort: Evidence from a Panel of Countries." International Monetary Fund, Washington, D.C.

it gravely damages the sustainability and quality of public policies. When oil rents are treated as regular income, both the number and cost of public employees soars. Perhaps more important, the unrestrained, discretionary use of public expenditures provides perverse incentives that impede the construction of a merit-based bureaucracy. Instead, it encourages extensive clientelist networks in federal, state and local welfare policies that tend to benefit current expenditures at the expense of net fixed capital investment. Furthermore, in terms of both administration and policy decisions, oil deeply transforms the state apparatus: the government’s need to control rents triggers an extreme centralization of public finances, as well as micro-management of the national budget. These developments undermine the efforts of

11 Comisión Económica para América Latina. 2010. La hora de la igualdad. Brechas por cerrar, caminos por abrir. Brasilia: Comisión Económica para América Latina. 12 Wagner, Richard E. 2007. Fiscal sociology and the theory of public finance: an exploratory essay. Cheltenham, United Kingdom: Edward Elgar. 13 Farfán-Mares, Gabriel. 2010. "Non-Embedded Autonomy: The Political Economy of Mexico's Rentier State (1918-2010)." Doctorate Thesis, Government, London School of Economics and Political Science, London.

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agencies and policymakers to do strategic planning at the sectoral level involving, for example, health, education and transport. The substitution of oil rents for taxes freezes any attempt to implement new public management and results-based agendas.

Institutions Do Matter

As the recent history of Latin America confirms, commodities, and oil revenues in particular, can support economic growth, democracy, social stability and political consensus, but they also can produce a policy curse within the state apparatus that creates and enforces negative incentives within and outside of the government. Public institutions often underestimate, if not totally discard, the principles of scarcity and productivity in their decision-making. When resources are inexpensive and easy to get, there is a generalized phenomenon of overspending by politicians, bureaucrats and even worse, by society at large. Thad Dunning has argued that commodity bonanzas bring more benefits than costs because they reduce the redistributive costs of democracy and tax reform.14

Yet, once politicians, the public sector and society accept the idea of “manna from heaven,” or unearned affluence, they change and become oriented toward distributing the new-found wealth rather than producing wealth. As Mexico sadly demonstrates, the oil bonanza has helped the public sector grow at a considerably faster pace than the private sector and keeps detaching itself from the true needs of the economy and people. No matter how much oil revenue is available to bureaucrats and politicians, the state will be unable to use those resources productively. As a result, the country remains underdeveloped.

What’s Next?

Mexico remains stuck in the oil trap. Unfortunately, however, Mexican leaders, policymakers and society in general are not aware of the dangers inherent in the use of oil to finance government operations, state policies or political processes. Most of the recent reforms addressing Mexico’s energy sector are focused almost exclusively on increasing production and export levels. They do not consider oil’s role from a political economy or long-term public policy perspective. Mexico faces the potential of becoming a net oil importer in the coming years. This means that the oil-based rentier Mexican state will be short-lived. The loss of oil revenues could prove a blessing in disguise if Mexico is able to take advantage of this development to transition to a more productive, efficient and modern economy that will be more responsive to, and make better use of, its citizens’ talents and capabilities. 14 Dunning, Thad. 2008. Crude Democracy: Natural Resource Wealth and Political Regimes, Edited by M. Levi. New York: Cambridge University Press.

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Gabriel Farfán-Mares is an external consultant for the Inter-American Development Bank in Washington, D.C. Prior to this, he was a consultant at the Center for Economic Research and Teaching (CIDE) in Mexico City. From 2006-2008, he was director for budget analysis and team leader on transparency for public management and budgetary reform at the Ministry of Finance in Mexico City’s government. Dr. Farfán-Mares has twice been an advisor in Mexico’s Ministry of Foreign Affairs, and has been a professor at universities in Mexico City, Monterrey and San Luis Potosí.

The “Perspectives on the Americas” series is assisted financially by the Bureau of Educational and Cultural Affairs of the United States Department of State.

All statements of fact or expression of opinion contained in this publication are the responsibility of the author.