Dutch Disease

A recent BusinessWeek article quoted an Australian bank economist as saying that “there is risk of Dutch disease effect”, in response to the growing exports of coal and iron ore from that country to China, and the incumbent rise in the value of the Australian dollar. We thought it would be a good time to explain the “Dutch disease”.

The phenomenon is based on an analysis of the Netherlands after the discovery of natural gas in the 1960’s. When the output and export of natural resources increases due either to an increase in demand or a new discovery, resources such as capital and labour are required to extract the natural resources. The increase in demand for capital and labour from the new export sector drives up wages, and diverts capital from existing exports and from non-traded goods. The cost of capital may or may not rise depending on the extent of international capital flows, but the return to capital will fall as other input prices rise.

The increased costs in the non-traded sector leads to price increases, while in the existing export sector, output falls. Prices of traded goods are determined in international markets and small countries have little or no effect on those prices. As exports increase, the domestic currency starts to rise in value. The domestic cost of imports falls and puts more pressure on domestic producers. So long as the new exports continue, real income rises.

The ‘disease’ occurs when demand for the new export falls or new supplies in other countries cause a global price decrease. Returns to capital, and the demand for labour, fall in the new export sector. Declining incomes reduce consumer spending in the non-traded sector. While the other export sector still exists, it takes time to shift capital from one industry to another and during this period of adjustment, output and incomes fall and unemployment rises.

The success of the new export sector can ultimately lead to recession. This is what Australia is worried about; though the problem is less severe for a geographically large diversified country such as Australia, than it was for a geographically small specialized country like the Netherlands.