Dutch disease

The Dutch disease refers to the problems associated with a rapid increase in the production of raw materials (like oil and gas) causing a decline in other sectors of the economy. When the raw materials run out, the economy can be in a worse position than before.

oil-field
oil field in Azerbaijan by Ken Douglas

– Can the discovery of substantial raw materials be a curse in disguise?

If a country discovers substantial amounts of oil, gas or another natural commodity, it will begin to export these goods causing a substantial increase in GDP; this will improve tax revenues, improve the current account and create employment opportunities. But, often countries who discovered oil have gained much less than you might expect.

Potential effects/problems with discovering oil/gas

1. Appreciation in currency. Due to the discovery of oil and an increase in oil exports, the country will see an appreciation in the exchange rate. This is because higher demand for exports leads to increased demand for Sterling. For example, in the late 1970s, the UK saw a rapid appreciation in Sterling after the discovery of North Sea oil.

2. Decline in competitiveness. The problem of this appreciation in the exchange rate is that other trade-able sectors of the economy will become uncompetitive. Manufacturing industries will see a substantial fall in demand, due to the higher exchange rate. Therefore, the economy will shift from manufacturing towards the primary sector. In the early 1980s, UK manufacturing output fell significantly as a result of the appreciation in the Pound.

3. Growth in luxury imports. Higher output of oil will enable those who benefit to spend on luxury goods and luxury services. These luxury goods tend to be imported meaning that domestic firms gain little benefit.

4. Growth in real wages. Due to the increased wealth and spending on services, there will be higher demand for service sector workers (waiters, hairdressers, chauffeurs e.t.c). This will cause rising real wages in the economy, causing another problem for manufacturing firms as they have to increase real wages to retain workers. This will further decrease the competitiveness of manufacturing exports.

5. Indirect-deindustrialisation. With manufacturing becoming uncompetitive due to higher exchange rate and higher wages, output will fall, and there will be a decline in investment, leading to lower growth. These sectors will begin to lag behind other countries. It can be very difficult to catch up later.

5. Income inequality. Often the discovery of raw materials, such as oil benefits a relatively small percentage of the population. Those who own the oil fields can see huge wealth, but the benefits of oil and gas are often not equally distributed within society. Workers may benefit from rising real wages in the service sector, but the discovery of raw materials often creates a few billionaires, so the increase in GDP is often concentrated in the hands of a small number. In several developing economies, oil fields are developed by foreign multinationals, causing some of the wealth to be taken away from the country.

6. Tax revenue. The high output of oil and gas can lead to substantial tax revenues for the government. The government has the ability to run a budget surplus and spend more on public services, such as infrastructure and education. But, the government will often cut other taxes and come to rely on oil tax revenues.

When the oil runs out

Many countries who produce raw materials may find the high output only lasts for a few years. But, when the oil runs out, the economy has been adversely affected and struggles to catch up where it left off.

  • Manufacturing export industries have shrunk and fallen behind. Because of declining output and investment, it can take many years for the exporting industries to catch up. Therefore, post-oil economies can struggle with lower economic growth.
  • Current account deficit. With oil exports, countries can run a current account surplus, but when oil exports drop their old exporting industries have faded away so they are left with large current account deficits,
  • Falling tax revenue. With oil, governments find it easy to raise tax revenue. But, when oil revenues dry up, they need to raise taxes on income and spending which can lead to lower growth and lower living standards. Ambitious government spending patterns have to be curtailed.
  • Unemployment. With falling GDP, the demand for high-end services will decline, causing unemployment amongst many service sector workers.

Example – of Dutch Disease

The term ‘Dutch disease’ was first coined by the Economist in 1977 to describe the decline in Netherlands manufacturing after the discovery of gas fields in the early 1960s. Many African countries have also struggled to enable rising living standards after the discovery of oil. The UK process of de-industrialisation was sped up by the discovery of North Sea oil and the appreciation of the Pound.

How to Prevent Dutch Disease

  1. Limit the rise in the real exchange rate. For example, China limited its real exchange rate by purchasing US bonds to keep the value of the relatively Yuan lower.
  2. Reduce foreign capital flows. If a country moved from a budget deficit to a budget surplus, it would attract less foreign investment to purchase the government bonds. Lower capital inflows would limit the rise in the exchange rate.
  3. Spend proceeds of oil revenue on infrastructure and education. The government could earmark taxes from oil to be spent on improving the infrastructure of an economy – better public transport, better education, subsidies for investing in technologies with positive externalities. All these can help improve the competitiveness of manufacturing export industries and help them deal with higher wages and higher exchange rate.
  4. Immigration. Many oil-rich economies have encouraged immigration to provide service sector jobs, this keeps real wage growth down.
  5. Sovereign wealth funds. A sovereign wealth fund is a government saving scheme, where income from oil revenues is not spent but saved to give a future income stream. E.g. Government pension fund in Norway.
  6. Greater equality of distribution. This paper at the World Bank states that the ‘Dutch Disease’ effect is worse when wealth is concentrated in the hands of a few billionaires – because there is a marked increase in luxury goods and luxury services. Greater income distribution enables a more diverse economy.
  7. Higher tax on luxury services and luxury imports. This would prevent the economy becoming too skewed towards luxury services which may not be sustainable in the long-term.

Did the UK waste North Sea Oil revenues?

After the discovery of North Sea oil, the UK did little to increase investment or saving. The 1980s saw tax cuts, a falling saving ratio and a long-term relative decline in manufacturing. This contrasts with the Norwegian approach of investment and saving. A good article is here – Did UK waste North Sea Oil Revenues (Mainly Macro)

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3 thoughts on “Dutch disease

  1. But why does a foreign money influx cause our currency to appreciate? If our oil companies earn foreign money and sell it ti out Central bank, our National money supply denominated in our currency base should expand and cause depreciation…I cannot possibly get It, palese help!!

  2. Ben – the currency value is a function of supply and demand. Say Nigeria, for example, sells a bunch of oil for $1 billion … when that $1 bn is converted to the local currency it is a DEMAND for that currency. An increase in demand results in an increase in price (in this case, the price is the exchange rate).

    Your mistake is to think that the increase in oil sales leads to an increase in the money supply. It does not. It leads to an increase in demand for the currency. Those are different things.

    Hope that helps!

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