Dutch disease

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Dutch disease: a simple, short explanation

What is it?
Dutch disease is the idea that a big boost in one part of an economy—usually from natural resources like oil or gas—can make other parts, such as manufacturing or farming, weaker. A resource boom brings lots of money into the country, but it can also cause the currency to become stronger and make non-resource industries less competitive.

How does it happen? The two main effects
1) Resource movement effect (direct deindustrialization)
- A booming resource sector creates more demand for workers.
- Labor shifts from other industries (like manufacturing or agriculture) to the booming sector.
- In some cases this shift is small, but it can still lower output in the lagging sectors.

2) Spending effect (indirect deindustrialization)
- Resource booms raise national income, boosting demand for services (non-tradables).
- This pulls more labor into the non-tradable sector (like construction, health, and other services).
- Prices rise in these non-tradable goods and services, while tradable sectors (which compete abroad) can’t raise prices as easily. This makes the country’s real exchange rate stronger.
- A stronger currency makes exports more expensive for other countries and imports cheaper, hurting manufacturing and farming that compete with foreign producers.

The classic model
Economists W. Max Corden and J. Peter Neary described Dutch disease with three parts: a booming tradable sector (often natural resources), a lagging tradable sector (manufacturing or agriculture), and a non-tradable sector (services). A resource boom increases demand for labor and raises income, which can shift resources toward the booming sector and toward non-tradables. The result is an appreciated real exchange rate and weaker competition for the lagging tradable sector.

What are the effects?
- The non-resource sectors (especially manufacturing) may shrink or grow more slowly.
- The economy can become more dependent on a single resource, making it vulnerable to price swings.
- Jobs may shift toward the resource and service sectors, reducing employment in traditional export industries.
- Over time, slower growth in the lagging sectors can limit overall economic diversification and tinkering with technology and innovation.

How can countries minimize the risk?
There are three broad approaches:
1) Slow the currency’s rise from the boom
- Save some of the extra revenue abroad in a sovereign wealth fund or similar mechanism.
- Spend the windfall gradually rather than all at once to avoid overheating the economy.

2) Improve the lagging sectors’ competitiveness
- Invest in education, infrastructure, and technology to boost manufacturing or agriculture.
- Support the lagging sectors with targeted policies that don’t overheat the whole economy.

3) Stabilize government finances and encourage saving
- Use budget surpluses to reduce the need for foreign borrowing.
- Encourage saving and reduce inflation, which helps keep real exchange rates more stable.

Other notes
- Protectionism (tariffs or subsidies) to protect lagging sectors can backfire by attracting more imports and raising the currency’s strength, potentially worsening the problem.
- The effect is not inevitable; well-planned policy can reduce the harm and help the economy diversify.

Diagnosis: can you tell if Dutch disease is happening?
It’s often hard to prove. A rising real exchange rate can be caused by many factors, not just a resource boom (like productivity gains or capital inflows). However, when a large oil or gas discovery or other resource boom is followed by a noticeable strengthening of the currency and a shrinking non-resource sector, Dutch disease is a plausible explanation.

Examples
- Groningen gas field boosted the Dutch economy in the mid-20th century but raised questions about long-term impacts on other industries.
- North Sea oil booms in the UK and Norway during the 1970s–1990s are classic cases studied by economists.
- Other resource booms around the world (gold rushes, oil in Kuwait, oil and minerals in various countries) have been linked to Dutch disease in analyses.

Bottom line
Dutch disease shows how a big windfall from resources can unintentionally hurt other parts of the economy. By carefully managing revenues, investing in diverse industries, and stabilizing finances, governments can reduce these risks and support broader, longer-term growth.