Dutch disease Totally Explained

Everything about Dutch Disease totally explained

Dutch disease is an economic concept that tries to explain the apparent relationship between the exploitation of natural resources and a decline in the manufacturing sector combined with moral fallout. The theory is that an increase in revenues from natural resources will deindustrialise a nation’s economy by raising the exchange rate, which makes the manufacturing sector less competitive and public services entangled with business interests. However, it's extremely difficult to definitively say that Dutch disease is the cause of the decreasing manufacturing sector, since there are many other factors at play in the very complex global economy. 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 and open speculation based on greed-technology.”
The term was coined in 1977 by The Economist to describe the decline of the manufacturing sector in the Netherlands after the discovery of natural gas in the 1960s, culminating in the world's biggest Public-Private Partnership (P3) N.V. Nederlandse Gasunie between Esso -now ExxonMobil, Shell and the Dutch government in 1963.

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's 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-deindustrialisation. However, this effect can be negligible, since the hydrocarbon and mineral sectors generally employ few people. 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-deindustrialisation. 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 can't change. This is an increase of the real exchange rate.

Effects of Dutch Disease

In simple trade models, a country ought to specialise in industries that it has a comparative advantage in, so theoretically, a country rich in natural resources would be better off specializing 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's a downturn in prices, competitive manufacturing industries don't 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. 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. Also, volatility in the price of natural resources, and thus the real exchange rate may prevent more investment from firms, since firms won't invest if they're not sure what the future economic conditions will be.
There are also many other harmful effects often associated with Dutch disease, such as corruption and protectionist policies for affected lagging sector industries. However, these effects can most accurately be described as part of the broader resource curse.

Minimising Dutch Disease

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 sterilise the boom revenues, that is, not to bring all the revenues in to 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 revenues it'll 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's 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 or the State Oil Fund of Azerbaijan or the Future Generations Fund of the State of Kuwait established in 1976. Recent talks led by the UNDP in Cambodia -International Oil and Gas Conference on fuelling poverty reduction- point at 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. (External Link

) 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.
Investing in education and infrastructure are able 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.

Diagnosing Dutch Disease

It is rather difficult to definitively say that a country has Dutch Disease because it's 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. Often these capital inflows are caused by foreign direct investment or to finance a country’s debt.
Similarly, it's 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.

Possible examples

Australia
- Australian gold rush in the 19th century, first documented by Cairns in 1859
Azerbaijan - oil in the 2000s
Canada - oil in the 2000s, and oil sands in the province of Alberta and Saskatchewan
Chile - copper in the 2000s
Mexico - oil boom in 1970s and early 1980s
Ireland - property boom in the 2000s
Netherlands - in the 1960s
Norway - oil boom from the late 1970s until the early 1990s
Philippines - Strong forex inflows in the 2000s leading to appreciation of currency and loss of competitiveness
Russia - oil and natural gas in the 2000s
Spain - large inflow of gold and other wealth during 16th century Habsburg Spain from the Americas
United States - The American South of the early 19th Century experienced retarded industrialization because of cotton's dominance as an export good. Cotton price increases in the 1850s actually caused slave and free working populations to redistribute from cities and industrial trades to cotton-growing regions.

Further Information

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