Beware The Dutch Disease
“This isn’t a medical blog!”, I hear you
proclaim. Indeed, it isn’t, but the Dutch Disease isn’t a medical issue either.
Granted, there is much debate among Economists as to whether the Dutch Disease
is even a disease, a topic that I shall address in a future post. Coined by The
Economist in 1977 to explain the decline in the manufacturing sector in the
Netherlands due to the discovery of natural gas reserves in 1959, the Disease
describes the relationship between the abundance of a primary commodity and the
corresponding decline in other sectors in the economy. So what is this Disease?
How do countries catch it? Can we prevent it?
A Bank of America Merrill Lynch report put
forward the case that Canada caught the deadly Disease a couple of years ago;
an oil and gas boom resulted in the Canadian dollar appreciating, having a
detrimental impact on other tradable goods. Moreover, it has been argued that
recently Russia suffered from the Disease, having benefited tremendously from prosperous
oil and natural gas reserves. However, it is important to note that the rouble
is not undervalued; the rouble is weaker than expected because, after the
turmoil of the past few years, “there has been a ‘flight’ of money to ‘safe’
assets and currencies”(1).
Causes and symptoms
To explain the impact of the Disease we shall
take a fictional country, Econoland. Let’s imagine that Econoland discovers a
vast reserve of diamonds. The ensuing resource boom would result in an increase
in the demand for labour in the mining industry. This would reallocate labour
and resources from the manufacturing sector towards this primary industry. This
is the ‘resource-movement effect’ and results in direct deindustrialisation. It
is important to note, however, that this reallocation of resources may not be
very significant, especially if the resource boom is centred on an industry
which is not labour intensive, such as the extraction of hydrocarbons.
A ‘spending effect’ would also manifest
itself. Additional revenue from the resource boom would result in workers
employed in the mining industry spending their wages in the ‘non-tradable
sector’, namely products and services. In turn, this would increase the demand
for labour in the tertiary sector, diverting labour from the manufacturing sector.
It would also result in the manufacturing sector being forced to increase wages
or face being ousted from the market due to a lack of human resources. However,
increasing wages would in turn decrease the competitiveness of the
manufacturing sector, as the industry would face greater production costs. Furthermore,
due to the resource boom, foreigners would increase their demand for
Econoland’s currency, in order to purchase the increased supply diamonds from
Econoland, resulting in the currency’s appreciation. However, this would ultimately
result in exports becoming relatively more expensive and so decreasing the
competitiveness of Econoland’s manufacturing industry in the world market. These
combined effects, which decrease the competitiveness of the manufacturing
industry, would decrease the quantity demanded of manufactured items, both
domestically and internationally, resulting in a decrease in revenues and a
decline in the size of the sector. This is indirect deindustrialisation.
Now, although there may be hostile feelings
towards the loss of the manufacturing sector, due to a loss of jobs, this is
not necessarily a negative symptom of the Disease, at least initially. The commodity boom
would have resulted in a more optimal allocation of resources in the economy, directing
resources away from the waning manufacturing sector to the booming mining
industry, where the country’s comparative advantage lies. The problem arises,
as is always the case, after the party ends and the fun stops. When the primary
resource is depleted, the currency would depreciate, as there would be a rapid
decline in demand for the currency. This wouldn’t be a problem if Econoland
could increase exports. However, Dutch Disease would mean that Econoland would
not have a manufacturing sector to fall back on; it would have decayed due to a
decrease in competitiveness. Unemployment
would also rapidly increase, directly due to the depletion of the mining
sector, and indirectly through a negative multiplier effect through the economy
that would decrease the demand for services.
Prevention
So, how would we mitigate these effects whilst
still ensuring the optimum allocation of resources at any given time?
Prevention, as they say, is the best cure. In this case, we would need to
prevent the appreciation of the real exchange rate.
One solution is to sterilise the boom
revenues by saving some of the revenues abroad in a sovereign wealth fund. This
would reduce the spending effect, thus reducing the effect of inflation and
shift in jobs to the service sector. Another solution is to encourage saving in
the economy, in order to reduce large capital inflows. The government could aim
to run a budget surplus, thus attracting less foreign investment in the form of
government bond purchases. There quantity demanded of the currency would not be as great and so the currency would not appreciate to as high levels. China mitigated the
appreciation of the Yuan by purchasing US bonds.
Moreover, the government could also aim to
increase the competitiveness of the manufacturing sector, reducing the negative
effects when the primary resource depletes. For example, the government could invest
the increased tax revenue from the primary industry in education, thus
increasing human capital, and in infrastructure developments, helping to reduce
transport costs for manufacturing firms. This would reduce costs for the
manufacturing sector, ensuring that the final product’s price does not increase
too rapidly. This would help manufacturers to maintain similar levels of
revenue, reducing the incentive to leave the industry and initiating the
decline of the sector.
A more active government approach would be to
increase subsidies or tariffs to protect the manufacturing sector against
international competition. However, this could increase the negative symptoms
of the Disease. By imposing tariffs on imported manufactured goods, the country’s
demand for foreign currency would decrease, thus resulting in a further
appreciation of the exchange rate.
Phew! I’m sure you’re glad to hear you don’t
have the Dutch Disease!
