Dutch disease
Encyclopedia
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".
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.
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. 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. 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.
, 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. 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 will not invest if they are not sure what the future economic conditions will be.
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 fund
s 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).
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 tax
es. 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 tariff
s. 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.
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 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.
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. They also show that it is the volatility in commodity prices, rather than abundance per se, that drives the resource curse
paradox.
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...
, the Dutch disease is a concept that purportedly explains the apparent relationship between the increase in exploitation of natural resources
Natural Resources
Natural Resources is a soul album released by Motown girl group Martha Reeves and the Vandellas in 1970 on the Gordy label. The album is significant for the Vietnam War ballad "I Should Be Proud" and the slow jam, "Love Guess Who"...
and a decline in the manufacturing sector
Secondary sector of industry
The secondary sector of the economy or industrial sector includes those economic sectors that create a finished, tangible product: production and construction.-Function:...
. 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
Exchange rate
In finance, an exchange rate between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency...
), 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
Currency
In economics, currency refers to a generally accepted medium of exchange. These are usually the coins and banknotes of a particular government, which comprise the physical aspects of a nation's money supply...
, including a sharp surge in natural resource prices, foreign assistance, and foreign direct investment".
The term was coined in 1977 by The Economist
The Economist
The Economist is an English-language weekly news and international affairs publication owned by The Economist Newspaper Ltd. and edited in offices in the City of Westminster, London, England. Continuous publication began under founder James Wilson in September 1843...
to describe the decline of the manufacturing sector in the Netherlands
Netherlands
The Netherlands is a constituent country of the Kingdom of the Netherlands, located mainly in North-West Europe and with several islands in the Caribbean. Mainland Netherlands borders the North Sea to the north and west, Belgium to the south, and Germany to the east, and shares maritime borders...
after the discovery of a large natural gas
Natural gas
Natural gas is a naturally occurring gas mixture consisting primarily of methane, typically with 0–20% higher hydrocarbons . It is found associated with other hydrocarbon fuel, in coal beds, as methane clathrates, and is an important fuel source and a major feedstock for fertilizers.Most natural...
field in 1959.
The “Core Model”
The classic economic modelModel (economics)
In economics, a model is a theoretical construct that represents economic processes by a set of variables and a set of logical and/or quantitative relationships between them. The economic model is a simplified framework designed to illustrate complex processes, often but not always using...
describing Dutch Disease was developed by the economists W. Max Corden
W. Max Corden
Warner Max Corden is an Australian economist. He is mostly known for his work on the theory of trade protection, including the development of the dutch disease model of international trade. He has also been active in the fields of international monetary systems, macroeconomic policies of...
and J. Peter Neary
J. Peter Neary
J. Peter Neary FBA is an economist specialising in international trade. He is Professor of Economics at Oxford University, and a Professorial Fellow of Merton College, Oxford as well as Associate Member of Nuffield College, Oxford. He was previously Professor of Political Economy at University...
in 1982. In the model, there is the non-traded good sector (this includes services) and two traded
Tradable
Tradability is the property of a good or service that can be sold in another location distant from where it was produced. A good that is not tradable is called non-tradable. Different goods have differing levels of tradability: the higher the cost of transportation and the shorter the shelf life,...
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
Manufacturing
Manufacturing is the use of machines, tools and labor to produce goods for use or sale. The term may refer to a range of human activity, from handicraft to high tech, but is most commonly applied to industrial production, in which raw materials are transformed into finished goods on a large scale...
, but can also refer to agriculture
Agriculture
Agriculture is the cultivation of animals, plants, fungi and other life forms for food, fiber, and other products used to sustain life. Agriculture was the key implement in the rise of sedentary human civilization, whereby farming of domesticated species created food surpluses that nurtured the...
.
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
Hydrocarbon
In organic chemistry, a hydrocarbon is an organic compound consisting entirely of hydrogen and carbon. Hydrocarbons from which one hydrogen atom has been removed are functional groups, called hydrocarbyls....
and mineral
Mineral
A mineral is a naturally occurring solid chemical substance formed through biogeochemical processes, having characteristic chemical composition, highly ordered atomic structure, and specific physical properties. By comparison, a rock is an aggregate of minerals and/or mineraloids and does not...
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-deindustrialization. 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.
Effects
In simple trade models, a country ought to specialise in industries in which it has a comparative advantageComparative advantage
In economics, the law of comparative advantage says that two countries will both gain from trade if, in the absence of trade, they have different relative costs for producing the same goods...
, 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
History of technology
The history of technology is the history of the invention of tools and techniques, and is similar in many ways to the history of humanity. Background knowledge has enabled people to create new things, and conversely, many scientific endeavors have become possible through technologies which assist...
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 will not invest if they are not sure what the future economic conditions will be.
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
Developing country
A developing country, also known as a less-developed country, is a nation with a low level of material well-being. Since no single definition of the term developing country is recognized internationally, the levels of development may vary widely within so-called 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 fund
Sovereign wealth fund
A sovereign wealth fund is a state-owned investment fund composed of financial assets such as stocks, bonds, property, precious metals or other financial instruments. Sovereign wealth funds invest globally. Some of them have grabbed attention making bad investments in several Wall Street financial...
s include the Government Pension Fund in Norway, the Stabilization Fund of the Russian Federation
Stabilization Fund of the Russian Federation
The Stabilization fund of the Russian Federation wasestablished by resolution of the Government of Russia on January 1, 2004, as a part of the federal budget to balance the...
, the State Oil Fund of Azerbaijan
State Oil Fund of Azerbaijan
The State Oil Fund of Azerbaijan is the state-owned fund managing financial assets generated by oil and natural exploration and development in Azerbaijan. It's located on Neftchiler Avenue in Baku.-Overview:...
, and the Future Generations Fund of the State of Kuwait
Kuwait
The State of Kuwait is a sovereign Arab state situated in the north-east of the Arabian Peninsula in Western Asia. It is bordered by Saudi Arabia to the south at Khafji, and Iraq to the north at Basra. It lies on the north-western shore of the Persian Gulf. The name Kuwait is derived from the...
established in 1976. Recent talks led by the United Nations Development Programme
United Nations Development Programme
The United Nations Development Programme is the United Nations' global development network. It advocates for change and connects countries to knowledge, experience and resources to help people build a better life. UNDP operates in 177 countries, working with nations on their own solutions to...
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
Resource curse
The resource curse refers to the paradox that countries and regions with an abundance of natural resources, specifically point-source non-renewable resources like minerals and fuels, tend to have less economic growth and worse development outcomes than countries with fewer natural resources...
(Paradox of plenty).
Another strategy for avoiding real exchange rate appreciation is to increase saving
Saving (money)
Saving is income not spent, or deferred consumption. Methods of saving include putting money aside in a bank or pension plan. Saving also includes reducing expenditures, such as recurring costs...
in the economy in order to reduce large capital
Capital (economics)
In economics, capital, capital goods, or real capital refers to already-produced durable goods used in production of goods or services. The capital goods are not significantly consumed, though they may depreciate in the production process...
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
Income tax
An income tax is a tax levied on the income of individuals or businesses . Various income tax systems exist, with varying degrees of tax incidence. Income taxation can be progressive, proportional, or regressive. When the tax is levied on the income of companies, it is often called a corporate...
and profit tax
Tax
To tax is to impose a financial charge or other levy upon a taxpayer by a state or the functional equivalent of a state such that failure to pay is punishable by law. Taxes are also imposed by many subnational entities...
es. By increasing saving, a country can reduce the need for loans to finance government deficits and foreign direct investment
Foreign direct investment
Foreign direct investment or foreign investment refers to the net inflows of investment to acquire a lasting management interest in an enterprise operating in an economy other than that of the investor.. It is the sum of equity capital,other long-term capital, and short-term capital as shown in...
.
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
Protectionism
Protectionism is the economic policy of restraining trade between states through methods such as tariffs on imported goods, restrictive quotas, and a variety of other government regulations designed to allow "fair competition" between imports and goods and services produced domestically.This...
, that is, increase subsidies
Subsidy
A subsidy is an assistance paid to a business or economic sector. Most subsidies are made by the government to producers or distributors in an industry to prevent the decline of that industry or an increase in the prices of its products or simply to encourage it to hire more labor A subsidy (also...
or tariff
Tariff
A tariff may be either tax on imports or exports , or a list or schedule of prices for such things as rail service, bus routes, and electrical usage ....
s. 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.
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 effectBalassa-Samuelson effect
The Balassa–Samuelson effect, also known as Harrod–Balassa–Samuelson effect , the Ricardo–Viner–Harrod–Balassa–Samuelson–Penn–Bhagwati effect , productivity biased purchasing power parity and the rule of five eights is either of two related things:#The observation that consumer price levels...
occurs when productivity-increases affect the real exchange rate. Also important are changes in the terms of trade
Terms of trade
In international economics and international trade, terms of trade or TOT is /. In layman's terms it means what quantity of imports can be purchased through the sale of a fixed quantity of exports...
and large capital inflows. 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.
Examples
- Australian gold rush in the 19th century, first documented by Cairns in 1859
- Australian mineral commodities in the 2000s
- Australian mineral boom in 2011
- Signs of emerging Dutch disease in ChileChileChile ,officially the Republic of Chile , is a country in South America occupying a long, narrow coastal strip between the Andes mountains to the east and the Pacific Ocean to the west. It borders Peru to the north, Bolivia to the northeast, Argentina to the east, and the Drake Passage in the far...
in the late 2000s, due to the boom in mineral commodity prices - AzerbaijanAzerbaijanAzerbaijan , officially the Republic of Azerbaijan is the largest country in the Caucasus region of Eurasia. Located at the crossroads of Western Asia and Eastern Europe, it is bounded by the Caspian Sea to the east, Russia to the north, Georgia to the northwest, Armenia to the west, and Iran to...
i oil in the 2000s - CanadaCanadaCanada is a North American country consisting of ten provinces and three territories. Located in the northern part of the continent, it extends from the Atlantic Ocean in the east to the Pacific Ocean in the west, and northward into the Arctic Ocean...
's rising dollar hurting the manufacturing sector in the 2000s due to foreign investment in oil, particularly the Athabasca oil sandsAthabasca Oil SandsThe Athabasca oil sands are large deposits of bitumen, or extremely heavy crude oil, located in northeastern Alberta, Canada - roughly centred on the boomtown of Fort McMurray...
. - Greatly increased export revenues for IndonesiaIndonesiaIndonesia , officially the Republic of Indonesia , is a country in Southeast Asia and Oceania. Indonesia is an archipelago comprising approximately 13,000 islands. It has 33 provinces with over 238 million people, and is the world's fourth most populous country. Indonesia is a republic, with an...
after the oil booms in 1974 and 1979 - New ZealandNew ZealandNew Zealand is an island country in the south-western Pacific Ocean comprising two main landmasses and numerous smaller islands. The country is situated some east of Australia across the Tasman Sea, and roughly south of the Pacific island nations of New Caledonia, Fiji, and Tonga...
dairy industry boom in the 2000s - NigeriaNigeriaNigeria , officially the Federal Republic of Nigeria, is a federal constitutional republic comprising 36 states and its Federal Capital Territory, Abuja. The country is located in West Africa and shares land borders with the Republic of Benin in the west, Chad and Cameroon in the east, and Niger in...
and other post-colonial African states in the 1990s - The PhilippinesPhilippinesThe Philippines , officially known as the Republic of the Philippines , is a country in Southeast Asia in the western Pacific Ocean. To its north across the Luzon Strait lies Taiwan. West across the South China Sea sits Vietnam...
' strong foreign exchange marketForeign exchange marketThe foreign exchange market is a global, worldwide decentralized financial market for trading currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends...
inflows in the 2000s leading to appreciation of currency and loss of competitiveness - RussiaRussiaRussia or , officially known as both Russia and the Russian Federation , is a country in northern Eurasia. It is a federal semi-presidential republic, comprising 83 federal subjects...
n oil and natural gas in the 2000s - Gold and other wealth imported to SpainSpainSpain , officially the Kingdom of Spain languages]] under the European Charter for Regional or Minority Languages. In each of these, Spain's official name is as follows:;;;;;;), is a country and member state of the European Union located in southwestern Europe on the Iberian Peninsula...
during the 16th century from the Americas
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. They also show that it is the volatility in commodity prices, rather than abundance per se, that drives the resource curse
Resource curse
The resource curse refers to the paradox that countries and regions with an abundance of natural resources, specifically point-source non-renewable resources like minerals and fuels, tend to have less economic growth and worse development outcomes than countries with fewer natural resources...
paradox.