Dutch Disease

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Dutch Disease

The “Dutch Disease” or resource trap is the deterioration of the manufacturing sector of a country due to high increases of exports of resources such as oil and other minerals. This pattern is experienced when a country’s income greatly increases due to the export of natural resources detrimentally affecting the manufacturing sector. In most cases, it arises due to the discovery of natural resources for example natural gas. However, it can also be caused by any large rise in foreign currency, foreign aid, foreign direct investments, as well as a significant increase in the natural resources price. When the natural resource is exported, the currency value rises and consequently the other goods become less attractive and their demand decreases.

What are the major effects of the Dutch Disease around the world? This paper discusses the contributory factors that have led to the phenomenon in various regions and countries in the world. It highlights the impact of the model, how it affects the economy, various types of goods, and methods that can be used or have already been utilized to counter or mitigate the effects of the “Dutch Disease”. Moreover, I have evaluated which type of countries may fall into this situation and how the pattern might affect the development of the economy. The paper focuses on the findings of Ernest Aryeetey (2011) in his book, The Oxford Companion to the economies of Africa. Aryeetey evaluates the conditions of the economies of various countries in Africa trying to answer the question, “Is Africa caught in a ‘Resource Trap?’ He analyzes the constraints facing development, and the contribution of the “Dutch Disease” in the poor countries. Peter Hess, (2013) in his book also reviews his model of the “Natural Resources Curse”. He highlights a different outlook where the political elite, the wealthy, and their cronies, gain exclusive licenses to export the discovered resources in a bid to capture power and more wealth. The effects of the ‘Resource Trap’ escalate and become legal issues and lead to civil wars and armed conflicts.

Sources

Aryeetey, Ernest. The Oxford Companion to the Economics of Africa. Oxford [u.a.: Oxford Univ. Press, 2011. Print.

Hess, Peter. Economic Growth and Sustainable Development. Routledge. 2013. Print.

Introduction.

The Resource Trap or as it is also known, the “Dutch Disease” is a relationship where a country’s economic development in natural resources increases, while the manufacturing sector declines. It normally arises where a significant increase in income realized from natural resources, or foreign aid, makes a countries currency stronger. This causes the nations other exports to be quite expensive for other countries and its imports cheaper therefore reducing competition in the manufacturing sector. Often, it is affiliated to the discovery of natural resources but it can imply the development that arises due to a large influx of foreign exchange, a sudden extraordinary increase in the overall price that the global market is willing to pay for a natural resource, or foreign direct investment.

The Natural Resource Trap can result in reduced economic growth but can also be utilized to work in favor of the country with the resource abundance. However, in most scenarios, revenues earned from the natural resources do not trickle down to the citizens of a country. Moreover, when a natural resource is discovered or becomes extremely profitable, there is an influx of investment into one segment of the economy. This attracts all attention, skill, and capital from the other sectors making them less developed than the trending sector. The demand, business development, and infrastructure of the natural resources sector, inevitably becomes more superior to all other sectors (Hess, 2013). As more of the resource is exploited, the other sectors deteriorate and their costs increase partly due to the inequitably shared high influx of foreign currency into the country.

Economic model

The model developed by Corden and Neary, contains a non-tradable sector for instance services, and two tradable sectors, which include the booming industry and the non-booming industry. The performing sector comprises of exploitation of the natural resource, and the non-booming or lagging industry is manufacturing or in some instances, agriculture. The boom may affect the economy in either of two ways. The resource movement, where the labor demand increases in the booming sector thus moving production from the non-booming trade sector. This movement of labor from the lagging industry is a process known as direct-deindustrialization. The second probable impact is called the spending effect, which happens due to the increased revenue realized from the boom. This effect leads to the movement of workers away from the non-performing industry to satisfy the labor requirement in the non-tradable industries through the process known as indirect-deindustrialization. The higher demand for the non-tradable services causes their prices to increase. On the other hand, tradable good’s prices are set internationally hence cannot change (Corden & Neary p. 824).

Though the country enjoys important economic improvements in the short run from the sudden increase in revenue from the exported raw materials, in the long run it has to maintain the technical, cultural, and intellectual enhancement which can only be provided by a strong manufacturing industry (Corden & Neary p. 824). Using conventional trade models, countries ought to specialize in industries with a comparative advantage. In other words, a country with abundant natural resources should specialize in extracting the natural resources. However, practically a massive shift away from the manufacturing sector can harm the economy. For instance, when or if the resources deplete, or drastically fall in prices, the manufacturing industry will not recover fast enough or easily. This can be attributed to the fact that manufacturing is built on “learning from gaining experience” process as spending a long time idle, can result in a comparative disadvantage. Consequently, when the country can no longer depend on the natural resources, the manufacturing sector is still unable to compete effectively internationally and cannot take over from the resource and lead the economy. In the long run, the Dutch Disease can have an impact of damaging the country’s manufacturing sector which is difficult to restore.

The term “Dutch Disease” came from the catastrophe in Netherlands in the 1960s. The Dutch currency appreciated and there was a boom in gas export causing inflation, which resulted in the fall of the lucrativeness of the manufacturing sector as well as the services industry. The Dutch exports in the 1960s reduced drastically relative to GDP. After sometime, the larger gas exports dominated over the other manufacturing exports and reduced noticeably the Dutch exports relative to GDP. More workers shifted to the gas industry making the other industries non-competitive and less profitable than the gas industry. In effect, the country had more imports and less exports as the companies goods became less desirable as the gas exploits. However, the problem was not for a long time. From the late 1960s, exports of the country’s goods and services have gradually increased from about 40 percent of the GDP to almost 55 percent which is a high ratio for the country with only 16 million people.

A country in the resource trap, therefore should trade off the short run benefits of the abundant natural resource against suffering the implications of a permanently lagging economy. This concept can be seen in the illustration below.

 

The level of the benefits and losses in terms of present value can be depicted by curve G2 against G1. They are influenced by factors such as price shocks and other economy affecting changes such as domestic policies. For a particular size of A and B, the NPV, Net Present Value is affected by the discount rate (Corden & Neary p. 827). As the rate becomes bigger, so does the relevance of the augmented oil gains or in other words, A becomes bigger.

Moreover, the Dutch Effect reduces investments. The high volatility in natural resources price and consequently the real exchange rate may discourage investment, as firms will be reluctant to invest if they are unaware of probable upcoming economic conditions. However, in some instances, natural resources can be used for productive activities, where the losses incurred in competitiveness, are compensated for by development in other sectors. For example, direct investments in agriculture where most of the population might be employed may result in productivity improvement in the sector leading to reduction of poverty levels. Similarly, using the revenues earned from the natural resource to increase spending on education and health can improve the labor productivity of the urban and rural population resulting in short and long-term growth.

Negative effects of the Resource trap

In economies that are not complimented by income from abundant resources, governments mainly earn revenue by taxing citizens who consequently demand a responsive and efficient government. This deal creates a relationship between the ruling class and the citizens. On the other hand, countries rich in natural resources do not need to tax their citizens as they have a fixed source of income from the natural resource. Since the citizens are minimally taxed, they are not motivated to keep a watchful eye on the expenditure of the government. Moreover, the political elite recognize that an effective and watchful civil service may be a threat to their enjoyed benefits therefore take measures to impede the civil society.

Oil rich countries tend to be the targets of international conflicts or are the instigators of the feuds. For example, the invasion of Iraq on Kuwait and Iran, Libya’s continuous incursions into neighboring Chad, the long existing suspicion of Iran on Western countries, and the relationship between U.S.A and oil rich countries like Iraq and Iran.

The distribution of wealth in countries rich in resources may not be even. Regions or people with a resource or certain industry may become wealthier or better off than others who do not have (Hess, 2013 p. 98). Consequently, internal conflicts become prevalent in countries with natural resources. Often regions start to gain animosity and fight for control benefits from the resources, and acquire separatist disputes. This is not only seen in the societies where different groups of people fight for a large share of the resource but also between the government ministries and departments for budgetary allocations access. Among the public, secessionists’ conflicts arise in the regions with the resource while in the administration it can lead to poor functions of the government. Consequently, the poor resource management can result in lower government and economic performance increasing the susceptibility of the country to conflict. Moreover, the control and exploitation of the natural resource as well as the allocation of revenue earned from its export serves as a source of conflict among the public and the government. In other cases, access to the revenues from the resource can extend the conflict. According to an academic study, a country that has primary commodity exports that contributes highly to the Gross Domestic Product (GDP), has a higher risk of conflict than a country whose exports contribute a lower percent of the GDP. The study went on to draw to the conclusion, that countries that had high percentages of natural resource exports had a slower growth rate than those who had fewer resources.

Natural resource abundance may demotivate the private sector and public sector from saving and investing thus limiting economic growth. When the output share, of the resources rises, demand for capital decreases while reducing the demand for capital. Consequently, the real interest rates decrease and the rate of growth reduces. If mature institutions efficiently use their resources, including natural resources, and poor institutions do not, then the natural resource richness can limit the progress of financial institutions and thus hinder saving, economic growth and investment through the banks and financial institutions (Paul, 2007 p. 124).

In countries with abundant resources, it is easier to keep authority by allocating resources to some favored constituents than having growth oriented policies and a level playing field. Large inflows of money from the natural resource fuel the political corruption. The government may feel it has a lesser need to develop the institutional infrastructure to control and tax an economy separate from the resource sector. This results in the economy remaining underdeveloped from the overdependence of the resource sector. Moreover, tax havens offer corrupt politicians numerous opportunities to hide wealth acquired from the natural resource. Often money that should go to the country’s poor people ends up with the political elite and wealthy people or it is spent on big projects that are just for show instead of it being properly invested.

The creation of wealth significantly influences entrepreneurship. Without enough capital entrepreneurial activity is quite limited. An industry’s growth is limited by the amount of resources that are available, that are in use, the rate they are capable of being used at, and the reserves available. It cannot be easily expanded from adding resources into it. Various economic forces such as supply, demand, infrastructure, technology in use among others will influence the magnitude of operations in the industry. In countries with one performing industry where much wealth can be generated, starting entrepreneurial ventures in other industries is not as lucrative as joining the rich industry. Subsequently, other industries growth and profitability are constrained (Paul, 2007 p. 125). No matter the number of players, the share of the wealth is fixed instead of gaining profits from the growing economy. This limits the growth rate of the country and it may be detrimental in the end. Where, when or if the resources are depleted, or the prices reduce drastically, the manufacturing industry will not be able to recover fast enough or as easily as they moved away. In total, the availability of excess capital from the natural resource, can lead to lower quality of social, physical and human capital thus be a block to fast economic growth. In effect, the abundance of the resource surprisingly leads to slow growth of the economy due to deindustrialization.

The phenomenon of the Dutch disease has occurred in various countries over the years. For example,

• The gold rush in the 19^th century in Australia
• The oil boom in the 1990s in Nigeria and other independent African states
• Caracas, one of the most expensive cities according to the official exchange rate, has a currency that is highly overvalued, though the black market exchange rate has valued it quite high. This is related to the fact that it is a major exporter of oil.
• Azerbaijan in 2000s when it experienced the oil boom.
• Indonesia had a great change in export revenues following the oil boom in 1974 and 1979.

However, the problem is not caused by the existence of an abundant natural resource but by the mismanagement of the revenues earned and the potential dangers likely to arise. It is not always that availability of a natural resource prevents the creation or maintenance of a dynamic economy or their discovery lead to the dampening of the already developed economy.

As seen in Norway, the second largest oil exporter in the world, there can be no symptoms of the Dutch disease where there is the availability of natural resources. On the contrary, Norway has had a constant ratio of exports to the GDP, even prior to the discovery of oil. This shows that the oil exports have not exceeded crowding out other exports that are not affiliated to oil. Regardless of the loud cries from some parties calling for more revenue from the oil to address local social needs instead of its present use of investments in foreign securities, Norway’s economy does not display rent-seeking behavior that may be socially detrimental (Larsen, 2004 p. 104). Moreover, there are no signs of inadequate investment or non-commitment to education or a false sense of security. Subsequently the country has been growing at a relatively constant rate.

Investing especially abroad as seen in Norway’s case is a viable remedy for the Dutch Disease. This is beneficial to the country in the long term rather than spending the wealth excessively to develop the resources industry or engage in corrupt activities that will harm the economy. Transparency and accountability are also valuable methods that can be used to control the exploitation, revenue earning, and allocation from the natural resources industry. This is useful in avoiding conflicts and fraudulent behaviors that may arise from the wealthy resource.

Resource trap is a phenomenon that has affected the economy and currency values of several countries. The manufacturing industry has been negatively affected leading to other non-oil related products losing market share, employees as well as more funds and resources important for growth.

 

 

 

 

 

 

 

 

 

 

Works cited

Aryeetey, Ernest. The Oxford Companion to the Economics of Africa. Oxford [u.a.: Oxford Univ. Press, 2011. Print.

Hess, Peter. Economic Growth and Sustainable Development. Routledge. 2013. Print.

Acosta Pablo A, Lartey Emmanuel K.K, & Mandelman Frederico S. Remittances and the Dutch Disease. Federal Reserve Bank of Atlanta. 2007. Working paper.

1. Max Corden and J. Peter Neary. “Booming Sector and De-industrialization in a Small Open Economy.”

The Economic Journal, Vol. 92, No. 368, pp. 825-848, 1982.

Paul Krugman, The narrow moving band, the Dutch disease, and the competitive consequences of Mrs. Thatcher: Notes on trade in the presence of dynamic scale economies, Journal of Development Economics, Volume 27, Issues 1–2, 1987.

Larsen, Erling Røed. “Escaping the resource curse and the Dutch Disease? When and why Norway caught up with and forged ahead of its neighbors.” (2004).

Collier, Paul. “The bottom billion.” Economic Review-Deddington- 25.1 (2007): 17.