Dutch disease is an economic condition that, in its broadest sense, refers to negative consequences arising from large increase in a countries income. Dutch disease is primarily associated with a natural resource discovery, but it can result from any large increase in foreign currency, including foreign direct investment, foreign aid or a substantial increase in natural resource prices. This condition arises when foreign currency inflows cause an increase in the affected country's currency.
This has two main effects for the country with Dutch disease:
1. A decrease in the price competitiveness, and thus the exports, of its manufactured goods
2. An increase in imports In the long run, both these factors can contribute to manufacturing jobs being moved to lower-cost countries. The end result is that non-resource industries are hurt by the increase in wealth generated by the resource-based industries.
The term was coined in 1977 by The Economist to describe the decline of the manufacturing sector in the Netherlands after the discovery of natural gas in the 1960s.
The classic economic model describing Dutch Disease was developed by the economists W. Max Corden and J. Peter Neary in 1982. In the model, there is the non-traded good sector (this includes services) and two traded good sectors: the booming sector, and the lagging sector, also called the non-booming tradable sector. The booming sector is usually the extraction of oil or natural gas, but can also be the mining of gold, copper, diamonds or bauxite, or the production of crops, such as coffee or cocoa. The lagging sector generally refers to manufacturing, but can also refer to agriculture.
A resource boom will affect this economy in two ways. In the resource movement effect, the resource boom will increase the demand for labor, which will cause production to shift toward the booming sector, away from the lagging sector. This shift in labor from the lagging sector to the booming sector is called direct-deindustrialisation. However, this effect can be negligible, since the hydrocarbon and mineral sectors generally employ few people. The spending effect occurs as a result of the extra revenue brought in by the resource boom. It increases the demand for labor in the non-tradable, shifting labor away from the lagging sector.
This shift from the lagging sector to the non-tradable sector is called indirect-deindustrialisation. As a result of the increased demand for non-traded goods, the price of these goods will increase. However, prices in the traded good sector are set internationally, so they cannot change. This is an increase of the real exchange rate.
Effects of Dutch Disease
In simple trade models, a country ought to specialize in industries that it has a comparative advantage in, so theoretically, a country rich in natural resources would be better off specializing in the extraction of natural resources. In reality, however, the shift away from manufacturing can be detrimental.
If the natural resources begin to run out or if there is a downturn in prices, competitive manufacturing industries do not return as quickly or as easily as they left. This is because technological growth is smaller in the booming sector and the non-tradable sector than the non-booming tradable sector. Since there has been less technological growth in the economy relative to other countries, its comparative advantage in non-booming tradable goods will have shrunk, thus leading firms not to invest in the tradable sector. Also, volatility in the price of natural resources, and thus the real exchange rate may prevent more investment from firms, since firms will not invest if they are not sure what the future economic conditions will be.
There are also many other harmful effects often associated with Dutch disease, such as corruption and protectionist policies for affected lagging sector industries. However, these effects can most accurately be described as part of the broader resource curse.
There are also many other harmful effects often associated with Dutch disease, such as corruption and protectionist policies for affected lagging sector industries. However, these effects can most accurately be described as part of the broader resource curse.
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