Dutch disease

In economics, the Dutch disease is a concept that explains the apparent relationship between the increase in exploitation of natural resources and a decline in the manufacturing sector. The 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 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]

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.

Other models and theories suggest that this could be detrimental. For instance, when the natural resources begin to run out or if there is a downturn in prices and competitive manufacturing industries cannot 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]

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, Alberta Heritage Savings Trust Fund of Alberta, Canada, 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]

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]

• 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 hampered its manufacturing sector beginning in the 2000s and continues today due to foreign demand for natural resources, with the Athabasca oil sands becoming increasingly dominant.^[15][16]
• Indonesia's greatly increased export revenues after the oil booms in 1974 and 1979^[17]
• New Zealand dairy industry boom in the 2000s^[18]
• Nigeria and other post-colonial African states in the 1990s^[19]
• The Philippines' strong foreign exchange market inflows in the 2000s leading to appreciation of currency and loss of competitiveness^[20]
• Russian oil and natural gas in the 2000s^[21][22]
• Gold and other wealth imported to Spain during the 16th century from the Americas^[10]
• The effect of North Sea Oil on manufacturing sectors in Norway and the UK in 1970-1990.^[23]
• Post-disaster booms accompanied by inflation following the provision of large amounts of relief and recovery assistance such as occurred in some places in Asia following the Asian tsunami in 2004^[24]
• Australia

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.^[25] They also show that it is the volatility in commodity prices, rather than abundance per se, that drives the resource curse paradox.

• Resource curse

• 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. (eds.). Economic Interdependence and Flexible Exchange Rates. Cambridge: MIT Press. pp. 221–247. ISBN 0-262-02177-3.

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