Diagnosing the Dutch Disease
This article is an excerpt from the August 2021 edition of the Finance Gazette Volume III. Click to read the whole edition
Have you ever heard about good news having negative repercussions? Seems weird, doesn't it, a nation stumbling upon new oil reserves might actually deter its economy. In today's article, we explore this paradox of circumstance, called the Dutch Disease.
In the 1960s, news headlines in the Netherlands read “Natural Gas deposits discovered in the North Sea”. After reading this, you would think that this is a positive development and for a brief period of time, it was. The Netherlands experienced a vast increase in its wealth, from a net importer of natural gas, it became a net exporter and the value of the Dutch guilder skyrocketed. However, this is where the problem started. The appreciation of the domestic currency led to the non-oil exports becoming more expensive and thus, they became less competitive. Unemployment rose from 1.1% to 5.1% and the capital investment in the country also reduced. As a result, the economy went into recession. This phenomenon was called ‘The Dutch Disease’ by the Economist in 1977 and is named after its first victim,i.e., Netherlands.
The Dutch disease refers to the negative impact on a country’s economy caused by an increase in the value of the domestic currency. The primary reason for this is the large inflows of foreign income through the discovery of large oil reserves, natural gas, etc. This leads to 2 main economic impacts, namely the price competitiveness of the other sectors of the economy reduces and the imports of the country increase.
The synergy of these two factors has detrimental effects on the economy. As the currency appreciates, manufacturing industries have to deal with a fall in demand due to a higher exchange rate. As a result, the economy will start shifting towards the primary sector and the output, investment and growth of the secondary sector would fall. Thus, these sectors will fail to keep pace with their counterparts in other countries and the nation will start moving towards deindustrialisation leading to loss of jobs.
Some of you might think that even though the manufacturing sector is declining, it is accompanied by the growth of the primary sector. However, you must remember that the growth is being driven by the extraction of natural resources which is predominantly capital intensive and leads to the creation of only a few employment opportunities. Hence, it does not compensate for the loss of value of output and jobs of the secondary sector.
Another side effect of the dutch disease is income inequality. Not everyone in the country owns oil fields and thus only the few who do reap the benefits of the increase in wealth. Moreover, in many developing countries, oil fields are owned by foreign multinationals and this can lead to an outflow of wealth from the country.
Recent research has shown that domestic political instability is another cause of the Dutch Disease. Researchers investigating the foreign greenfield investment (investment in operations built from the ground up in a foreign country) flows to the countries of the Middle East and North Africa from 2003 and 2012 have found that in a politically unstable environment, the investors continue to invest in resource-based projects as long as they have privileged access to resources but the manufacturing and service sectors have to face the wrath of reduced investment brought on by the tumultuous environment. Thus, you see that even without currency appreciation, a country can get diagnosed with the Dutch Disease.
So, the million-dollar question is, is there any way to prevent and cure the Dutch Disease?
Any economist would first prescribe the deceleration of the rate of appreciation of the currency. One of the ways to achieve this is the creation of sovereign wealth funds which help in protecting and stabilizing the economy from the volatility caused by an increase in exports. The country would also be advised to invest in infrastructure and education. In order to cure the disease, the competitiveness of manufacturing industries needs to improve which can be done by investment in public transport, education, research and development, etc. According to the World Bank, the effects of Dutch Disease are much more grave when wealth is concentrated in the hands of few individuals and thus, necessary precautions should be taken by ensuring equitable distribution of income.
If you think about it, an abundance of natural resources is a boon and not a bane. Thus, if utilised wisely they can do wonders for any economy and this is best explained by Miguel de Cervantes Saavedra, the author of Don Quixote de la Mancha: “The gratification of wealth is not found in mere possession or in lavish expenditure, but in its wise application.”
Author: Jayesh Rungta