Dutch Disease: Wealth Managed Unwisely

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Dutch Disease: Wealth Managed Unwisely

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Bibliographic details

• Authors: Christine Ebrahimzadeh
• Published: May 10, 2017

Overview

• Article title: Dutch Disease: Wealth Managed Unwisely
• Author: Christine Ebrahimzadeh
• Series: Back to Basics (F&D Magazine)
• Core thesis: Large, sudden increases in a country’s income can produce harmful economic consequences broadly labeled “Dutch disease,” which arise when inflows of foreign currency alter real exchange rates and resource allocation.
• Contextual notes: The term is commonly associated with natural resource discoveries but can arise from any large inflow of foreign currency, including a sharp surge in natural resource prices, foreign assistance, and foreign direct investment.

Diagnosis (mechanics of Dutch disease)

• Foundational reference: Corden, W. Max, and J. Peter Neary, 1982, “Booming Sector and De-Industrialization in a Small Open Economy,” Economic Journal, Vol. 92, (December), No. 368, pp. 825-48.
• Three-sector framework (as in Corden and Neary):
  • The booming export sector (e.g., new natural resource exports).
  • The lagging export sector (traditional traded-goods sector).
  • The nontraded-goods sector (supplies domestic residents; may include retail trade, the service industry, and construction).
• Key mechanisms:
  • Spending effect:
  • Conversion of foreign currency into local currency and domestic spending raises domestic money supply (if exchange rate fixed) or raises the nominal exchange rate (if exchange rate flexible).
  • Both channels cause real exchange rate appreciation, weakening competitiveness of exports and shrinking the traditional export sector.
  • Resource movement effect:
  • Capital and labor shift toward the booming sector and the nontraded-goods sector to meet increased domestic demand, further reducing output in the lagging tradable sector.

Historical and illustrative examples

• 16th century Spain: inflows of American treasures cited as an early episode economists examine in the Dutch disease model.
• Netherlands in the 1960s: discovery of large natural gas deposits in the North Sea led to a stronger Dutch guilder, making non-oil exports more expensive and less competitive.
• 19th century: gold discoveries in Australia in the 1850s referenced as another episode.
• 1970s oil-rich nations: oil-price-driven booms coincided with declines in agricultural and manufacturing sectors.
• Late 1970s Colombia: higher coffee prices after frost destroyed Brazil’s coffee crop triggered a coffee boom at the expense of manufacturing.

How serious is the problem? (debate among economists)

• Position A (not necessarily a problem):
  • If higher inflows are expected to be permanent, the shift from tradable to nontradable sectors can represent the economy’s adaptation to newfound wealth; the term “disease” may be misleading.
• Position B (potentially worrisome):
  • Transition costs: industries shut down and workers must find new jobs; transitions can be economically and politically painful.
  • Long-term growth risks: movement away from manufacturing may reduce “learning by doing,” jeopardizing human capital development and long-term growth potential.
• Policy implication from debate: Regardless of viewpoint, policymakers must help the economy cope with the ramifications.

Policy recommendations (doctor’s orders)

• Policy choices hinge on whether the inflow is temporary or permanent.
• For temporary inflows (expected depletion or transitory terms of trade gains):
  • Consider protecting vulnerable sectors, possibly through foreign exchange intervention.
  • Buildup of official foreign exchange reserves by selling domestic currency in exchange for foreign currency can help keep the foreign exchange value of the domestic currency lower than it would otherwise be, insulating the economy from short-run disturbances.
  • Challenge: ensure reserve buildup does not lead to inflation.
  • Recommendation: manage additional wealth transparently (examples cited: a central bank account or an (oil) trust fund).
• For likely-permanent inflows:
  • Manage structural change to ensure economic stability.
  • Steps may include boosting productivity in the nontraded goods sector (possibly through privatization and restructuring) and investing in worker retraining.
  • Continue to diversify exports to reduce dependence on the booming sector and vulnerability to external shocks (such as a sudden drop in commodity prices).
• Cautionary case: The Netherlands used part of the natural gas windfall to finance a very generous welfare system; when natural gas prices plummeted in the 1970s and income dropped dramatically, the government was not able—for political and social reasons—to reverse the welfare policy.

Article: Dutch Disease: Wealth Managed Unwisely — F&D Magazine; Christine Ebrahimzadeh — https://www.imf.org/en/publications/fandd/issues/series/back-to-basics/dutch-disease