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What’s is: Dutch Disease is a term that describes an economic phenomenon when the exploitation of natural resources triggers weakness in other sectors, especially manufacturing. An increase in income from the exploitation of natural resources will result in an appreciation of the exchange rate, making domestic products, mainly from manufacturing sectors, less competitive in the international market.
The History of Dutch Disease
This term first appeared in The Economist magazine in 1977. The magazine analyzed the Netherlands’ economic situation after discovering a large natural gas field in 1959.
At that time, the Dutch economy increased its income from natural gas exports. This resulted in a significant appreciation of its currency due to a massive influx of capital into this sector.
However, due to the focus on natural gas, other sectors are less developed. Ultimately, the country’s unemployment rate is higher, and the manufacturing industry declines.
Dutch Disease explained
Dutch Disease is generally associated with countries whose economies are heavily dependent on exports of natural resources. For example, Indonesia.
This phenomenon is a paradox of the concept of comparative advantage. In the comparative advantage model, each country must specialize in an industry with a comparative advantage over other countries.
However, such advantages do not work well with resource-exporting countries. These countries try to exploit natural resources when global commodity prices increase. They ignore the development of other economic sectors.
Commodity prices cannot sustain a country’s economy in the long run. They can fall immediately when demand in global markets weakens, for example, during a recession.
The sudden explosion in the exploitation of natural resources increases the demand for labor in this sector. The workforce usually comes from industries such as manufacturing.
Then commodity prices fall, and they become unemployed because firms are cutting jobs. They may also not be able to move to other jobs due to inadequate skills flexibly, and hence, they may be unemployed for longer.
The economy then experienced a sharp fall in income, which could not be compensated for by rapid growth in an already weakening manufacturing sector. The effects may be long-lasting or possibly brief, depending on the severity.
Dutch Disease examples
Mexico’s oil boom in the 1970s and early 1980s exemplifies Dutch Disease. The country experienced a surge in oil revenue, but this also led to an appreciation of its currency. This, in turn, hurt the competitiveness of Mexico’s manufacturing sector.
Indonesia provides another real-world example. Following the 2008-2009 financial crisis, a boom in commodity prices led Indonesia to prioritize commodity-based industries. Unfortunately, this focus neglected the development of downstream commodity industries. When commodity prices plunged in 2015, Indonesia’s economic growth stalled at 5%. Additionally, the country’s tax revenue suffered as it had become overly reliant on levies from the commodity sector.
This case highlights the potential dangers of Dutch Disease. While a surge in commodity exports can initially boost economic growth, it can also create vulnerabilities. A focus on resource extraction can lead to a neglect of other industries, such as manufacturing. Additionally, economies become more susceptible to fluctuations in global commodity prices.
Combating Dutch Disease
There are various options for dealing with the Dutch Disease phenomenon. Four of them are:
- Slowing down the rate of appreciation of the domestic currency
- Economic diversification
- Growing national savings
- Investments in quality production factors
Slows down the rate of exchange rate appreciation
Slowing currency appreciation is a more accessible and feasible strategy to prevent the adverse effects of the Dutch Disease phenomenon. For example, this step could be achieved using the income generated from the export of natural resources for investment.
One common method of doing this is creating a sovereign wealth fund (SWF). The SWF sterilizes large investments in the booming sector by keeping a portion of this new revenue abroad. Furthermore, countries can decide to slowly repatriate these savings for various purposes, such as infrastructure development.
As it aims to stabilize capital inflows and prevent a significant appreciation of the currency, SWF usually invests overseas in a non-domestic currency. For example, Norway transferred a portion of the revenue flowing from oil sales to assets denominated in foreign currency.
There are many examples of SWFs. Among them are the Australian Government Future Fund, the Government Pension Fund in Norway, the Iranian National Development Fund, the Stabilization Fund of the Russian Federation, the State Oil Fund of Azerbaijan, and the Alberta Heritage Savings Trust Fund of Alberta in Canada. You can view the SWF ranking on the Sovereign Wealth Fund Institute homepage.
Diversify the economy
Economic diversification is a crucial strategy for combating Dutch Disease. It involves fostering a broader range of industries within a nation’s economy, reducing its reliance on resource extraction. This approach is essential because a sudden drop in commodity prices can cripple an economy overly dependent on a single sector.
However, implementing economic diversification is a complex undertaking. It requires a long-term commitment from policymakers and may not be a quick fix. Additionally, not all countries have the resources or infrastructure to diversify their economies effectively.
Here are some methods governments can employ to diversify their economies:
- Subsidize lagging sectors: Governments can incentivize growth and development by providing financial assistance to struggling industries outside the resource sector. This can create new jobs, boost innovation, and make the overall economy more resilient.
- Targeted tariffs: Strategic import tariffs can temporarily shield domestic producers, particularly those in non-commodity sectors, from intense foreign competition. This allows them time to develop and become more competitive in the global marketplace. However, it’s important to avoid excessive protectionism, which can stifle innovation and harm consumers.
Growing national savings
Another strategy to mitigate Dutch Disease is to increase national savings. This involves encouraging both consumers and businesses to save a larger portion of their income. The government can achieve this through various policies, such as tax breaks on savings accounts or increased interest rates on government bonds.
A higher national savings rate translates to a larger pool of domestic capital available for investment. This reduces a nation’s dependence on foreign investment to fund economic growth. With more loanable funds available, domestic businesses can access capital to expand and innovate, ultimately strengthening the overall economy.
Investments in the quality of production factors
The government can also invest part of the revenue to increase the quantity or improve the quality of production factors. For example, through:
- Education and training
- Research and development
- Infrastructure
This ultimately increases the productive capacity of the economy. Education and training, for example, increase productivity through improved skills. It also increases labor mobility.
Infrastructure such as roads and railways is also essential to reduce logistics costs. It was ultimately the manufacturing industry to remain competitive in the international market.
