What is Dutch Disease?

What is Dutch Disease?

Dutch disease is an economic term for the negative consequences that can arise from a spike in the value of a nation’s currency. It is primarily associated with the new discovery or exploitation of a valuable natural resource and the unexpected repercussions that such a discovery can have on the overall economy of a nation.

Dutch disease is a shorthand way of describing the paradox which occurs when good news, such as the discovery of large oil reserves, harms a country’s broader economy.

It may begin with a large influx of foreign cash to exploit a newfound resource.

The Workings of Dutch Disease

The negative influence of Dutch disease on the economy can be explained by some features attributable to the sectors that are related to natural resources. For example, mining industries generally require heavy capital investments, but they are not labor-intensive. Therefore, multinational corporations and foreign countries that have capital are often interested in investing in such ventures.

Foreign investment may lead to higher demand for the country’s domestic currency, and it will start appreciating. The appreciation of the domestic currency will make the country’s exports in other industries more expensive while imports will become cheaper.

Subsequently, domestic producers will face lower demand for their products abroad, as well as greater competition from foreign producers. Thus, the lagging sectors of the economy will face further troubles.

Origin of the Term Dutch Disease

The term Dutch disease was coined by The Economist magazine in 1977 when the publication analyzed a crisis that occurred in The Netherlands after the discovery of vast natural gas deposits in the North Sea in 1959. The newfound wealth and massive exports of oil caused the value of the Dutch guilder to rise sharply, making Dutch exports of all non-oil products less competitive on the world market. Unemployment rose from 1.1% to 5.1%, and capital investment in the country dropped.

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Dutch disease became widely used in economic circles as a shorthand way of describing the paradoxical situation in which seemingly good news, such as the discovery of large oil reserves, negatively impacts a country’s broader economy.

How to Avoid Dutch Disease?

The two primary strategies that can help solve Dutch disease are listed below:

1, Deceleration of domestic currency appreciation

The deceleration of currency appreciation is an easier and more viable strategy to prevent the adverse effects of Dutch disease. It can sometimes be achieved by smoothing the spending of revenues earned from the export of natural resources.

One of the most common methods to do so is the creation of a sovereign wealth fund. Many developed and developing countries, including Australia, Canada, Norway, and Russia, manage large sovereign wealth funds.

Sovereign wealth funds aim to stabilize the inflows of capital into the economy to prevent it from overheating and causing significant currency appreciation. Excess revenues can be spent on education or infrastructure that will help to diversify the economy.

2. Diversification of the economy

The diversification of the economy is a strategy that can almost eliminate the negative impact of Dutch disease on the economy. Economic diversification can be achieved by subsidizing lagging sectors of the economy or establishing tariffs to support domestic producers.

Examples of Dutch Disease

In the 1970s, Dutch Disease hit Great Britain when the price of oil quadrupled, making it economically viable to drill for North Sea Oil off the coast of Scotland. By the late 1970s, Britain had become a net exporter of oil, though it had previously been a net importer. Although the value of the pound skyrocketed, the country fell into recession as British workers demanded higher wages and Britain’s other exports became uncompetitive.

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In 2014, economists in Canada reported that the influx of foreign capital related to exploitation of the country’s oil sands may have led to an overvalued currency and a decreased competitiveness in the manufacturing sector. Simultaneously, the Russian ruble greatly appreciated for similar reasons.

 In 2016, the price of oil dropped significantly, and both the Canadian dollar and the ruble returned to lower levels, easing the concerns of Dutch disease in both countries.