W hat makes oil a poisoned chalice?” Why do so many people lead such poor lives while sitting on King Midas’ throne, especially during an oil boom? That is a question millions of Nigerians, Algerians, Indonesians, Iranians, Mexicans and Venezuelans have been asking themselves for decades without getting a convincing explanation.

More often than not, oil booms plague certain oil-rich countries with all sorts of calamities and the calamity of extreme poverty can be the most demoralizing for an oil-rich Third World country’s population.

At the peak of the Arab oil embargo in the mid 1970s, Terry Lynn Karl, an American student of political science, went to Venezuela to do some field research for the dissertation she was writing on the history of OPEC. “Don’t study OPEC,” the late Juan Pablo Pérez Alfonzo, a brilliant Venezuelan lawyer considered to be the “father” of OPEC, told her. “It is boring. Study what oil is doing to us,” he added. As they parted, Pérez Alfonzo presented her with these prophetic words: “Ten years from now. Twenty years from now, you will see. Oil will bring us ruin.”

Karl followed Perez Alfonzo’s advice and eventually wrote what is probably the best book on what oil-booms can do to countries like Venezuela. Truly, The Paradox of Plenty: Oil Booms and Petro-states (University of California Press, 1997) reads like a treatise on the morbid “brain chemistry” of the decision-making elites which rule oil-rich countries such as Venezuela, Nigeria or Indonesia.

What exactly is a petro-state? It could be described as a mining country with weak institutions and a malfunctioning public sector. Its most important feature are laws that grant subsoil rights to the government, from which spring the extraordinary size and duration of the “petro-rent” which is much, much greater than the profits which can be made in the private sector.

An externality occurs when the actions of one person affect those of another. For more on externalities, see “Public Goods and Externalities” by Tyler Cowen in the Concise Encyclopedia of Economics.

Petro-states are structurally different from other countries in the advanced and developing worlds, especially the agricultural or manufacturing exporters, whose products are not thought to be depletable. Large oil revenues imply exchange rates that inevitably encourage imports and hinder exports. To complicate matters, state-owned companies must face the fact that oil is a “capital-intensive” business: the more crude you pump out, the more money you must “reinject” into the same oil well to keep it pumping at the same rate of productiveness. Finally, unlike other economies, petro-states are prone to all kinds of “externalities”; the most unsettling of these is that the petroleum industry is prone to booms and busts.

Global exploitation of petroleum during the 20th century coincided with state building in many Third World countries. This process was closely related to how quickly the major oil companies learned to operate profitably in politically volatile countries, most notably their ability to help shape the “institutions” which were beginning to emerge and the passing of laws that could guarantee property rights.

Some petro-states considered by Karl are senior members of OPEC and some are not. Many of them became fully independent nations only after the swift process of decolonization that followed World War II, such as Indonesia, Nigeria or Algeria. Others are Latin American nations, like Venezuela, Mexico and Ecuador, which are a product of the early 19th century wars of independence from Spanish colonial rule. Karl also studied the economic performance of Iran, a non-Arab Islamic petro-state. Karl found out that most oil-exporting countries “tend to bear a striking resemblance to each other in state capacities and macroeconomic performance, despite differences in types of political regimes, cultures, geostrategic locations, and the like” (emphasis added).

Venezuela is a very illuminating case of the impact of oil-booms in oil exporting countries whose institutions have been shaped by oil-led development. Karl compares Venezuela’s performance during the last two oil booms of the 20th century with that of similarly capital-deficient oil exporting countries like Mexico, Algeria, Indonesia, Nigeria, Iran, Ecuador, Oman or Cameroon. The study left out capital surplus countries such as Saudi Arabia, Kuwait, Libya, Qatar or the United Arab Emirates.

Two “behaviours” can be discerned with amazing regularity in petro-states going through an oil-boom. Their governments first seem to be seized by a sort of schizoid “manic” spell and urgently demand from their citizens special powers to direct the capital accumulation from oil revenues into other productive activities and thus try to catch up to the developed world. “We have plenty of resources so now is the time; everything can be done so everything must bedone!” become watchwords for these governments. It’s no wonder that for Venezuelan politicians of all colors, including Lt. Col. Hugo Chávez, “sowing our petroleum” has been their only “program” for almost 80 years.

As Karl points out in chapter three of her book, “(b)ecause oil revenues poured into the state and not into the private enterprise, each new discovery or price increase enhanced the role of the public sector”. So it is only natural that new agencies and jurisdictions are born. And since it is the state, not the private sector, which has first access to the petro-rent, rent-seeking becomes the name of the game for everyone, including of course the small private sector. Deadly fights over who controls the country’s oil revenues become the only important issue in domestic political life. These “wars” over petro-rents annihilate already weakened institutions, favor the concentration of power, promote the bending of the law, and, last but not least, increase corruption which is already all-pervasive.

While inflation is likely under a system of fixed exchange rates (including various forms of managed float, such as Venezuela’s), note that under a flexible rate system such as in the United States, inflation will not occur unless the Federal Reserve monetizes the increase. Instead, the exchange rate will adjust. For the definitions of fixed for flexible exchange rates, see “Does the Exchange Rate Regime Matter for Inflation and Growth?” [1997, IMF]. For descriptions of the differences between the systems, see “Exchange Rates” by Paul Krugman in the Concise Encyclopedia of Economics.

Furthermore, the very large oil revenues which come into the hands of the state put pressure on exchange rates that foster imports and discourage exports. Inevitably, inflation sets in. The market is soon saturated with imported automobiles, electronic gadgetry, luxurious home appliances and name-brand whisky. The currency becomes overvalued because the oil sector is the core of the economy and extensive reliance on imports undermines local production. To make matters worse, the oil industry employs comparatively few people. In Venezuela, for instance, by 2003 only about 40,000 people out of an economically active population of 11.7 million worked in the oil industry.

A second “behavior” closely associated with the idea of “sowing our petroleum” appears when the benefits of government spending are cancelled out by an overheated economy. Again according to Karl, “(t)he boom not only provokes a grander, oil-led economic model but also simultaneously generates new demands for resources from both the state and the civil society. Policymakers, once torn between their twin preoccupations with diversification and equity, now think they can do both. The military demands modernized weapons and improved living conditions; capitalists seek credit and subsidies; the middle class calls for increased social spending, labor for higher wages, and the unemployed for the creation of jobs. As demands rise, unwieldy and inefficient bureaucracies, suddenly thrust into new roles, find themselves incapable of scaling down expansionist public-sector programs or warding off private-sector requests. Thus they ultimately contribute to growing budget and trade deficit and foreign debt. The boom effect is instantly at work.” (p. 65 )

Petro-states apparently cannot cope with oil booms without running into almost unrepayable debt and without undermining democracy in the end. Such seems to be the curse of the petro-state: “you shall never attain economic diversification and your people will grow poorer and angrier at you with each passing day.” Since the Arab oil embargo in the 1970s, the number of Venezuela’s poor has climbed to almost 65% of a population of 22 million. Today, most Venezuelans agree that it was the harvest of inequality, frustration and political unrest, generated by the oil booms of the mid-1970s and 80s that made possible Lt. Col Chávez’s ascent to power in 1998.

The irony of it all is that, according to a well-respected research group at the Universidad Católica “Andrés Bello” led by Luis Pedro España, an expert on the study of poverty, after seven years of the longest oil-boom in Venezuelan history, with OPEC crude prices reaching unprecedented peaks, there are 2 million more Venezuelans living below the poverty line than in 1998 and, with 117 billion more dollars having passed through the hands of the Venezuelan state, there are almost twice as many government ministries than there were seven years ago.

Despite its radical rhetoric and its denunciations of “neo-liberalism” and “Yankee imperialism” as the enemies of Lt. Col. Chávez’s “revolution,” the Venezuelan petro-state seems unharmed and relatively sound whilst it continues to enjoy the longest oil-boom it has experienced in more than 80 years. But if Karl’s comparative analysis of “the paradox of plenty” is correct, the Venezuelan petro-state’s extravagant squandering of resources, its massive subsidies which only reward inefficiency, the crude inequalities of income and opportunity, and the rampant corruption will mean that “the curse of the petro-state” will prove to be the real enemy of Chávez’s “revolution.”