Resource windfalls and public debt: A political economy perspective

Abstract

Can natural resource windfalls increase public debt in democracies? Adopting a political economy perspective, we show that the answer is in the affirmative. Resource windfalls increase both the government’s income and wealth. The former mitigates the need to borrow, whereas the latter encourages further borrowing (as it improves its terms), implying an ambiguous pure effect of resource windfalls on debt. Re-election considerations shorten political time horizons and give rise to political myopia. We show that higher political myopia, induced by more stringent (institutional) re-election restrictions, magnifies the wealth effect, turning positive the effect of resource windfalls on debt. We test the model’s predictions using a panel of U.S. states over the period 1963-2007. Our identification strategy rests on constitutionally-entrenched differences in gubernatorial term limits that provide plausibly exogenous variation in re-election prospects, and geographically-based cross-state differences in natural endowments. Our baseline estimates indicate that a resource windfall of $1 induces an increase of approximately ¢20 in the public debt of states with more stringent re-election restrictions.