Dutch disease

This article is about the economic phenomenon. For the disease affecting elm trees, see Dutch elm disease.

In economics, the Dutch disease is a concept that purportedly explains the apparent relationship between the increase in exploitation of natural resources and a decline in the manufacturing sector. The claimed mechanism is that an increase in revenues from natural resources (or inflows of foreign aid) will make a given nation's currency stronger compared to that of other nations (manifest in an exchange rate), resulting in the nation's other exports becoming more expensive for other countries to buy, making the manufacturing sector less competitive. While it most often refers to natural resource discovery, it can also refer to "any development that results in a large inflow of foreign currency, including a sharp surge in natural resource prices, foreign assistance, and foreign direct investment".^[1]

The term was coined in 1977 by The Economist to describe the decline of the manufacturing sector in the Netherlands after the discovery of a large natural gas field in 1959.^[2]

The “Core Model”

The classic economic model describing Dutch Disease was developed by the economists W. Max Corden and J. Peter Neary in 1982. In the model, there is the non-traded good sector (this includes services) and two traded good sectors: the booming sector, and the lagging sector, also called the non-booming tradable sector. The booming sector is usually the extraction of oil or natural gas, but can also be the mining of gold, copper, diamonds or bauxite, or the production of crops, such as coffee or cocoa. The lagging sector generally refers to manufacturing, but can also refer to agriculture.

A resource boom will affect this economy in two ways. In the "resource movement effect", the resource boom will increase the demand for labor, which will cause production to shift toward the booming sector, away from the lagging sector. This shift in labor from the lagging sector to the booming sector is called direct-deindustrialization. However, this effect can be negligible, since the hydrocarbon and mineral sectors generally employ few people.^[3] The "spending effect" occurs as a result of the extra revenue brought in by the resource boom. It increases the demand for labor in the non-tradable, shifting labor away from the lagging sector. This shift from the lagging sector to the non-tradable sector is called indirect-deindustrialization.^[3] As a result of the increased demand for non-traded goods, the price of these goods will increase. However, prices in the traded good sector are set internationally, so they cannot change. This is an increase of the real exchange rate.^[4]

Effects

In simple trade models, a country ought to specialise in industries in which it has a comparative advantage, so theoretically a country rich in natural resources would be better off specialising in the extraction of natural resources. In reality, however, the shift away from manufacturing can be detrimental.

If the natural resources begin to run out or if there is a downturn in prices, competitive manufacturing industries do not return as quickly or as easily as they left. This is because technological growth is smaller in the booming sector and the non-tradable sector than the non-booming tradable sector.^[5] Since there has been less technological growth in the economy relative to other countries, its comparative advantage in non-booming tradable goods will have shrunk, thus leading firms not to invest in the tradables sector.^[6] Also, volatility in the price of natural resources, and thus the real exchange rate, may prevent more investment from firms, since firms will not invest if they are not sure what the future economic conditions will be.^[7]

Minimization

There are two basic ways to reduce the threat of Dutch disease: by slowing the appreciation of the real exchange rate and by boosting the competitiveness of the manufacturing sector.

One approach is to sterilize the boom revenues, that is, not to bring all the revenues into the country all at once, and to save some of the revenues abroad in special funds and bring them in slowly. Sterilisation will reduce the spending effect. Another benefit of letting the revenues into the country slowly is that it can give a country a stable revenue stream, rather than not knowing how much revenue it will have from year to year. Also, by saving the boom revenues, a country is saving some of the revenues for future generations. Especially in developing countries, this can be politically difficult as there is often pressure to spend the boom revenues immediately to alleviate poverty, but this ignores broader macroeconomic implications. Examples of these sovereign wealth funds include the Government Pension Fund in Norway, the Stabilization Fund of the Russian Federation, the State Oil Fund of Azerbaijan, and the Future Generations Fund of the State of Kuwait established in 1976. Recent talks led by the United Nations Development Programme in Cambodia – International Oil and Gas Conference on fueling poverty reduction – point out the need for better education of state officials and energy cadres linked to a possible Sudden Wealth Fund to avoid the Resource curse (Paradox of plenty).^{[citation needed]} Another strategy for avoiding real exchange rate appreciation is to increase saving in the economy in order to reduce large capital inflows which are able to cause an appreciation of the real exchange rate. This can be done if the country runs a budget surplus. A country can encourage individuals and firms to save more by reducing income and profit taxes. By increasing saving, a country can reduce the need for loans to finance government deficits and foreign direct investment.

Investments in education and infrastructure have the ability to increase the competitiveness of the manufacturing sector. An alternative is that a government can resort to protectionism, that is, increase subsidies or tariffs. However, this could be a dangerous strategy and could worsen the effects of Dutch Disease, as large inflows of foreign capital are usually provided by the export sector and bought up by the import sector. Imposing tariffs on imported goods will artificially reduce that sector’s demand for foreign currency, leading to further appreciation of the real exchange rate.^[8]

Diagnosis

It is rather difficult to definitively say that a country has Dutch Disease because it is difficult to prove the relationship between an increase in natural resource revenues, the real-exchange rate, and a decline in the lagging sector. There are a number of different things that could be causing this appreciation of the real exchange rate. The Balassa-Samuelson effect occurs when productivity-increases affect the real exchange rate. Also important are changes in the terms of trade and large capital inflows.^[9] Often these capital inflows are caused by foreign direct investment or to finance a country’s debt.

Similarly, it is difficult to show what is causing a decrease in the lagging sector. A case in point is the Netherlands. Though this effect is named after the Netherlands, economists have argued that the decline in the Dutch manufacturing industry was actually caused by unsustainable spending on social services.^[10]

Examples

• Australian gold rush in the 19th century, first documented by Cairns in 1859^[10]
• Australian mineral commodities in the 2000s^[11]
• Australian mineral boom in 2011^[12]
• Signs of emerging Dutch disease in Chile in the late 2000s, due to the boom in mineral commodity prices ^[13]
• Azerbaijani oil in the 2000s^[14]
• Canada's rising dollar hurting the manufacturing sector in the 2000s due to foreign investment in oil, particularly the Athabasca oil sands.^[15][16]
• Greatly increased export revenues for Indonesia after the oil booms in 1974 and 1979^[17]
• Irish Property Bubble in the 2000s^[18]
• New Zealand dairy industry boom in the 2000s ^[19]
• Nigeria and other post-colonial African states in the 1990s^[20]
• The Philippines' strong foreign exchange market inflows in the 2000s leading to appreciation of currency and loss of competitiveness^[21]
• Russian oil and natural gas in the 2000s^[22][23]
• Gold and other wealth imported to Spain during the 16th century from the Americas^[10]

Using data on 118 countries over the period 1970-2007, a study by economists at the University of Cambridge provides evidence against the Dutch disease operating in primary commodity abundant countries.^[24] They also show that it is the volatility in commodity prices, rather than abundance per se, that drives the resource curse paradox.

See also

• Resource curse

References

1. ^ Ebrahim-zadeh, Christine (March 2003, Volume 40, Number 1). "Back to Basics – Dutch Disease: Too much wealth managed unwisely". Finance and Development, A quarterly magazine of the IMF. IMF. Archived from the original on 2008-06-17. http://www.webcitation.org/5YeSchvbI. Retrieved 2008-06-17. "This syndrome has come to be known as "Dutch disease." Although the disease is generally associated with a natural resource discovery, it can occur from any development that results in a large inflow of foreign currency, including a sharp surge in natural resource prices, foreign assistance, and foreign direct investment. Economists have used the Dutch disease model to examine such episodes, including the impact of the flow of American treasures into sixteenth-century Spain and gold discoveries in Australia in the 1850s." 
2. ^ “The Dutch Disease” (November 26, 1977). The Economist, pp. 82-83.
3. ^ ^{a b} Corden WM (1984). "Boom Sector and Dutch Disease Economics: Survey and Consolidation". Oxford Economic Papers 36: 362. 
4. ^ Corden WM, Neary JP (1982). "Booming Sector and De-industrialisation in a Small Open Economy". The Economic Journal 92 (December): 825–848. doi:10.2307/2232670. 
5. ^ Van Wijnbergen, Sweder (1984). “The ‘Dutch Disease’: A Disease After All?” The Economic Journal 94 373:41. doi:10.2307/2232214
6. ^ Krugman, Paul (1987). “The Narrow Moving Band, the Dutch Disease, and the Competitive Consequences of Mrs. Thatcher.” Journal of Development Economics 27 1-2:50. doi:10.1016/0304-3878(87)90005-8
7. ^ Gylfason, T., Herbertsson, T.T., Zoega, G. (1999). A mixed blessing. Macroeconomics Dynamics. 3 June:212.
8. ^ Collier, Paul (2007). “The Bottom Billion.” Oxford University Press, pp. 162
9. ^ De Gregario, José, Wolf, Wolger C. (1994). Terms of trade, productivity, and the real exchange rate. NBER Working Paper 4807. Cambridge, MA.
10. ^ ^{a b c} Corden (1984), 359
11. ^ Paul Cleary (2007-11-11). "Mining boom could bust us". The Age. http://www.theage.com.au/news/business/mining-boom-could-bust-us/2007/11/10/1194329562546.html. 
12. ^ Peter Ker and Ben Schniders (2011-09-06). "Labor woeful on economic reform, Says Argus". http://www.smh.com.au/national/labor-woeful-on-economic-reform-says-argus-20110905-1jucc.html. 
13. ^ http://www.economia.puc.cl/docs/luders_27_01_10.pdf
14. ^ "Boom and gloom". The Economist. 2007-03-08. http://www.economist.com/displayStory.cfm?story_id=8819945&fsrc=RSS. 
15. ^ Lee Greenberg (2011-07-20). "Growing Equalization Payments to Ontario Threaten Country". National Post. http://news.nationalpost.com/2011/07/20/growing-equalization-payments-to-ontario-threaten-country-expert/. 
16. ^ Michel Beine, Charles S. Bos, Serge Coulombe (2009-01). "Does the Canadian economy suffer from Dutch Disease?". http://www.economie.uqam.ca/pages/docs/Beine_Michel.pdf. 
17. ^ Peter McCawley, 'Indonesia's New Balance of Payments Problem: a Surplus to get rid of', Ekonomi dan Keuangan Indonesia, 28(1), March 1980, pp. 39-58.
18. ^ "The Irish Economy and the Inconvenient Truth" http://www.finfacts.com/irelandbusinessnews/publish/article_10009014.shtml
19. ^ Moore, Mike (28 April 2008). "Mike Moore: Nothing more vital than world's food". The New Zealand Herald. http://www.nzherald.co.nz/feature/story.cfm?c_id=1501825&objectid=10506515. Retrieved 29 September 2011. 
20. ^ "Our Continent, Our Future", Mkandawire, T. and C. Soludo. "In most recent attempts to explain Africa's performance with growth and investment regressions, studies find that inaccessible location, poor port facilities, and the 'Dutch Disease' syndrome, caused by large natural-resource endowments, constitute serious impediments to investment and growth".
21. ^ "Strong forex inflows now hurting economy, GMANews.TV.
22. ^ "Dutch Disease Hits Russia", Latsis, O. (2005). Moscow News, June 8–14.
23. ^ Mining accounts for most of the economic growth
24. ^ Cavalcanti, Tiago; Mohaddes, Kamiar & Raissi, Mehdi (2011). "Commodity Price Volatility and the Sources of Growth". Cambridge Working Papers in Economics. http://www.econ.cam.ac.uk/postgrad/km418/RMC.pdf. 

Further reading

• Buiter, Willem H.; Purvis, Douglas D. (1983). "Oil, Disinflation, and Export Competitiveness: A Model of the 'Dutch Disease'". In Bhandari, Jagdeep S.; Putnam, Bluford H.. Economic Interdependence and Flexible Exchange Rates. Cambridge: MIT Press. pp. 221–247. ISBN 0262021773. 

External links

• Norway’s Government Pension Fund
• State Oil Fund of the Azerbaijan Republic