Dutch Disease

Updated on January 25, 2024
Article byRutan Bhattacharyya
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Dutch Disease?

Dutch disease refers to an economic phenomenon that leads to rapid development in a specific sector while a decline in others, resulting in a significant increase in the domestic currency’s value. A nation must try to avoid this phenomenon to prevent the reduction of exports’ price competitiveness.

Dutch Disease

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Generally, the Dutch disease phenomenon is associated with a new natural resource’s discovery and its unanticipated repercussions on a nation’s economy. Besides negatively impacting exports‘ price competitiveness, it can increase a country’s overall imports. Such factors may lead to increased unemployment over the long term as jobs related to manufacturing or production shift to lower-cost nations.

Key Takeaways

  • Dutch disease refers to the negative impact of the discovery of natural resources on a nation’s economy through the increase in the real exchange rate along with the worsening of the exports’ price competitiveness. 
  • Some effects of this economic phenomenon are income inequality, a rise in real wages, an increase in tax revenue, and a decline in competitiveness. 
  • Countries must expand their national savings, diversify their economy, and make investments to enhance the quality of their production factors to avoid this phenomenon.
  • Unlike Dutch disease, the resource curse is not associated with a new discovery of raw materials or natural resources.

Dutch Disease Explained

Dutch disease refers to negative consequences that may result from a surge in a country’s currency value. It can increase a nation’s imports while reducing the price competitiveness of its exports. As noted above, this phenomenon can severely affect an economy. Hence, countries must utilize different strategies to avoid it.

A few characteristics that are attributable to sectors associated with natural resources can explain the negative effects of this phenomenon on an economy. For instance, mining industries typically require substantial capital investments. However, such industries are not labor-intensive. Hence, foreign nations and multinational companies with the necessary funds often allocate their funds to these ventures.

Foreign investment can lead to a higher demand for a nation’s currency, resulting in an appreciation in its value. The increase in the domestic currency’s value makes the nation’s exports more expensive while the imports become cheaper.

Subsequently, the demand for the products manufactured by domestic manufacturers decreases. Moreover, competition from foreign manufacturers increases. As a result, the economy’s lagging sectors face more troubles.

The Economist magazine coined the term ‘Dutch Disease’ when it conducted an analysis of a crisis that took place in the Netherlands following the discovery of extensive deposits of natural gas in the North Sea. The massive oil exports and newfound oil caused the Dutch guilder’s value to increase sharply, thus making the Dutch exports concerning every non-oil product less competitive in the world market. As a result, Netherlands’ unemployment jumped to 5.1% from 1.1%, and its capital investment dropped.

The Dutch disease phenomenon commonly occurs in nations that heavily depend on natural resources export. It contradicts the comparative advantage model, which involves every nation specializing in a certain industry with a comparative advantage over the other nations.

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Effects

Some effects of the Dutch disease on economics are as follows:

  • Decline In Competitiveness: An economy’s tradable sectors become uncompetitive because of the rise in the exchange rate. The domestic manufacturing industries witness a significant drop in demand owing to the appreciation in the exchange rate. Hence, the economy moves from production to the primary sector.
  • Increase In Real Wages: On account of spending on services and increased wealth, demand for workers in the service sector rises. This causes the real wages in the economy to rise, which leads to another issue for manufacturing companies as they must raise real wages to ensure the retention of workers. This further reduces manufacturing exports’ competitiveness.
  • Income Inequality: In many cases, raw materials’ discovery only benefits a small portion of a nation’s population. While workers may reap the benefits of increased real wages within the service sector, the discovery makes a few billionaires. Hence, a very small percentage of the population account for most of the GDP or gross domestic product.
  • Indirect Deindustrialization: As manufacturing becomes uncompetitive owing to higher wages and a higher exchange rate, output and investment decrease resulting in reduced growth. Such sectors start lagging behind other countries, and catching up can be challenging later.
  • Increase In Tax Revenue: An increased output of gas and oil can significantly increase tax revenue for a government.

When the newly discovered raw materials run out, an economy may experience the following things:

  • Current account deficit
  • Decreasing tax revenue
  • Increase in unemployment
  • Shrunken manufacturing export businesses

Examples

Let us look at a few Dutch disease examples to understand the concept better.

Example #1

In 2021, The exports of components made in Taiwan increased by 26.9% compared to the figure reported a year earlier, as the semiconductor outbound sales jumped 7.1% year-over-year. Moreover, the nation’s video and audio device exports also improved from the previous year’s figures.

While the electronics and semiconductor sector is the economy’s crown jewel, it has led to serious challenges. Among them, a noteworthy one is the significant wage inequity. The wages offered in the electronics and semiconductor space are significantly high compared to the wages offered in other sectors, especially following the pandemic. This has resulted in a significant shortage of skilled workforce in various sectors of the Taiwanese economy.

After opposition lawmakers said that the nation has become overly dependent on some tech firms while non-tech manufacturing industries are declining, Su Jain-rong, the Taiwanese finance minister, said that the country is not impacted by the ‘Dutch disease.’ According to him, the surge in the electronics and semiconductor sector is not impacting other sectors.

Example #2

Suppose in country ABC commodity prices boomed in 2018. Hence, the nation decided to focus mainly on its commodity-based sectors. As a result, the other sectors of the economy were underdeveloped. That said, the commodity prices dropped significantly three years later, and economic growth stagnated. Moreover, the tax revenues of the economy were not on target as it had heavily relied on the commodity sector’s levies.

The next impact was deindustrialization. On a year-to-year basis, the contribution of ABC’s manufacturing sector dropped.

How To Avoid?

Governments may take the following measures to avoid this phenomenon:

#1 – Reduce The Domestic Currency’s Appreciation Rate

This is a feasible strategy that a nation can adopt to avoid the phenomenon’s adverse effects. For instance, a country can reduce its currency appreciation rate by utilizing the earnings generated by exporting its natural resources for investment.

#2 – Expand National Savings

Nations can execute this strategy by executing measures that encourage firms and consumers to decrease the budget deficit of the government (or raise its surplus) or save more.

#3 – Diversify The Economy

This strategy requires a country to adopt a fundamental approach that is unsuitable for all nations. Moreover, the implementation of such a strategy is usually time-consuming. One must note that a nation can fulfill its objective of economic diversification through the subsidization of lagging economic indicators.

#4 – Invest To Increase Production Factors’ Quality

A nation’s government can spend a portion of its revenue to enhance its production factors’ quality. For example, it may invest in research and development, education and training, and infrastructure. Ultimately, using this strategy improves an economy’s production capacity.

Dutch Disease vs Resource Curse

Individuals new to economics can get confused when learning about the resource curse and Dutch disease, as these concepts can appear similar. That said, understanding the key differences between them is essential to develop a clear understanding and steer clear of confusion. So, let us find out how they differ.

Dutch DiseaseResource Curse
Dutch disease in economics refers to a phenomenon that materializes when nations witness uneven growth across the sectors in its economy following the discovery of large oil reserves or any other valuable natural resource. This refers to a paradoxical scenario wherein a nation underperforms from an economic standpoint yet has valuable natural resources.
This phenomenon’s cause is typically associated with discovering a valuable natural resource.It is not associated with a new discovery. Some common causes of resource curse include income elasticity of demand, restricted investment in a nation’s diversified industries, and monopoly ownership. 

Frequently Asked Questions (FAQs)

1. What are the characteristics of Dutch disease?

A key characteristic of this phenomenon is significant development in a particular sector and underdevelopment in other sectors. This leads to a significant appreciation in the value of the domestic currency.

2. What are the factors responsible for Dutch disease?

Factors responsible for Dutch disease include developments that significantly increase foreign currency inflow. The developments may include a significant rise in the prices of natural resources, foreign direct investment, and foreign assistance.

3. How did Norway escape the Dutch disease?

Contrary to other nations rich in petroleum, Norway largely benefited from not having discovered petroleum until it had already developed a wealthy, equitable, and stable economy with a high standard of living. By the time it discovered oil, its public institutions had impressive balances and checks besides democratic accountability.

4. What is the reverse Dutch disease?

One can view the depreciation of a currency’s value owing to a financial crash and a sudden stop of an inflow of capital as the reverse Dutch disease.

This article has been a guide to what is Dutch Disease. Here, we explain its examples, effects, how to avoid it, and differences with the resource curse. You may also find some useful articles here –

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