Richard Alford: The “Dutch Disease” and Once and Future Economic Crises in the US

By Richard Alford, a former New York Fed economist. Since then, he has worked in the financial industry as a trading floor economist and strategist on both the sell side and the buy side.

The term Dutch Disease refers to negative macro-economic effects on a country of a boom in commodity exports or other developments that result in large capital inflows. The negative effects are most apparent when the boom ends and the country is faced with the need to simultaneously adopt counter-cyclical, trade/exchange rate and structural policies if it is to enjoy a return to sustainable full employment. Despite the original example – the Netherlands – the Dutch Disease has generally been associated with difficulties experienced by emerging market economies. However, the term encompasses economic dislocations arising from a variety of external shocks, as well as across economies with differing levels of development. For example, economists and analysts have cited the Dutch Disease as an explanation for the decline in competitiveness in southern Europe that contributed to the Euro crisis. The piece will argue that it is also possible that the Dutch Disease contributed to the recent US recession and that the prospective energy-led US economic recovery could amount to nothing more than another bout of the Dutch Disease.

Definition

The term Dutch Disease was first used in 1977 by The Economist. It linked the exploitation of a large natural gas field discovered in 1959 off the coast of Holland to a subsequent decline in Dutch manufacturing. The narrow definition (from Wikipedia):

..Dutch Disease is the apparent relationship between the increase in exploitation of natural resources and a decline in the manufacturing sector. The mechanism is that an increase in revenues from natural resources (or inflows of foreign aid) will make a given nation’s currency stronger compared to that of other nations (manifest in an exchange rate), resulting in the nation’s other exports becoming more expensive for other countries to buy, making the manufacturing sector less competitive.

Moving beyond the narrow “resource curse” definition (Wikipedia again):

… it can also refer to any development that results in a large inflow of foreign currency, including a sharp surge in natural resource prices, foreign assistance, and foreign direct investment.

There are numerous instances of Dutch Disease-like phenomena. Some of the more frequently cited examples are

• Gold imports to Spain during the 16th century from its possessions in the Americas. This can be viewed as Spain exploiting a natural resource or Spain receiving a large capital inflow—gold was capital/ money
• The Gold rush in mid-19th century Australia
• Petroleum revenue boom in the 1970s (Indonesia)
• North Sea Oil and the Norwegian and UK economies in 1970-1990
• Oil boom in Nigeria and other post-colonial African states in the 1990s
• Oil boom in Azerbaijani in the 2000s
• Mineral commodities boom –Australia in the 2000s and 2010s
• Russian oil and natural gas in the 2000s
• Post-disaster booms following large amounts of relief and recovery assistance such as occurred in some places in Asia following the Asian tsunami in 2004

In the early formulations, there were two transmission mechanisms that linked the external shock to a lagged downward adjustment to economic performance:

1. The “spending effect,” which linked the new resource-based export boom and exchange rate appreciation to reduced competitiveness of the country’s previously existing exports and caused that sector to shrink.
2. The “resource movement effect” (or the direct de-industrialization effect), which linked the boom to the shifting of capital and labor from the declining traditional export sector to the domestic non-traded sector and booming new export sector.

These effects are observable in the instances cited above. However, their appearance does not mean that an export boom is either a necessary or sufficient condition for subsequent adverse adjustments.

Scholars from numerous other disciplines have also been intrigued by the continued incidence of the Dutch Disease. Their interest reflects the periodic crises and the perceived outperformance of relatively resource-poor East Asian economies when compared to the performance of many resource-rich economies in Africa and South America. Their analyses also reflect the belief that the Dutch Disease is a product of the social and political systems as well as narrowly defined economic developments.

Economists have argued that appropriate policy mitigate bouts of the Dutch Disease. The existence of economic policies that can temper or prevent the Dutch Disease coupled with the continued existence of Dutch Disease-like phenomena imply that policymakers and politicians have, in at least some cases, been unwilling or unable to take the appropriate policy steps. Some political scientists have pursued the idea that the booms themselves either prevent appropriate political and policy responses or generate inappropriate political and policy responses. It has also been argued that the boom results in politicians and policymakers becoming myopic and ignoring the medium- and long-run implications of the boom. Others argue that the booms produce winners, sectors, classes and vested interests that pursue policies aimed at entrenching their positions, even at the expense of long-term growth-oriented policies. Yet others have argued that the booms disrupt and weaken existing political structures, thus preventing or limiting appropriate policy responses.

The Dutch Disease in the European Periphery

George Soros and Hans-Werner Sinn exchanged views on German economic policy in a recent Project Syndicate blog posting. It quickly becomes clear that the two found much to disagree about and at times talk past one another. However, there was one area of agreement: the relative decline in the competitiveness of the periphery is a necessary part of any explanation of and cure for the crisis in Euroland. Soros wrote:

The euro crisis has both a political and a financial dimension. And the financial dimension has at least three components: a sovereign debt crisis and a banking crisis, as well as divergences in competitiveness.

He went on to say:

The boost derived from Eurobonds may not be sufficient to ensure recovery; additional fiscal and/or monetary stimulus may be needed. But having such a problem would be a luxury. More troubling, Eurobonds would not eliminate divergences in competitiveness. Individual countries would still need to undertake structural reforms….

Hans-Werner Sinn put the loss of competitiveness front and center:

The ongoing financial crisis is merely a symptom of the monetary union’s underlying malady: its southern members’ loss of competitiveness.

The euro gave these countries access to cheap credit, which was used to finance wage increases that were not underpinned by productivity gains…

Soros says countries that fail to implement the necessary reforms after the introduction of Eurobonds would become permanent pockets of poverty and dependency, much like Italy’s Mezzogiorno region today… (they) will permanently suffer from the so-called “Dutch Disease,” with chronic unemployment and underperformance….

The two also disagreed on the likely adjustment paths that would be followed under various possible permutations of countries abandoning or being forced to abandon the Euro. However, they both agreed that the north-south divergence in competiveness will have to be narrowed if Euroland is to be stable and meet the goals that were expected of it when the Euro was introduced.

Sinn mentioned the Dutch Disease, linking the increased capital flows to the periphery to the erosion of the competitiveness of the periphery. He is not alone in explicitly linking the increased capital inflows and the loss of competitiveness. A recent VoxEU post, “Did the Euro Kill Governance in the Periphery?” by Jesús Fernández-Villaverde, Luis Garicano, and Tano Santos stressed the decline in efforts to promote competitiveness by countries in the periphery once they adopted the Euro:

By the end of the 1990s, under the incentive of Eurozone entry, most peripheral European countries were busy undertaking structural reforms and putting their fiscal houses in order. …the arrival of the euro, and the subsequent interest-rate convergence, loosened a tide of cheap money that reversed the incentives for further reforms. As a result, by the end of the euro’s first decade, the institutions and governance in the Eurozone periphery were in worse shape than they were at the start of the decade.

This conclusion is supported by evidence presented in the research paper, which is abstracted in the VoxEU blog posting. The paper traces the history of and outlines a framework that can explain the mechanisms by which the introduction of the Euro contributed to the pre-crisis boom and the weakening of private and public governance across four countries in the periphery. Like Sinn, Fernández-Villaverde, Garicano, and Santos explicitly linked the Dutch disease to the crisis in Europe: “Also, the “Dutch Disease” suffered most clearly by Ireland and Spain…,” the authors also cite research that identifies links between economic and financial reforms on the one hand and economic conditions on the other:

…It has been long observed in the political economy literature that for growth enhancing reforms to take place, things must get “sufficiently bad”…(the authors cite studies by Sachs and Warner, and Rodrik) . And, as the development literature has emphasized, foreign aid loosens these constraints by allowing those interest groups whose constraints are loosened to oppose reforms for longer…also finds that the mechanism operates when debt grows, rather than aid.

The authors also identify an additional mechanism: the reduced ability and the willingness of economic agents to extract accurate information in a boom or bubble:

When all banks are delivering great profits, all managers look competent; when all countries are delivering the public goods demanded by voters, all governments look efficient (this mechanism applies both to real estate bubbles as in Ireland and Spain, and to sovereign debt bubbles as in Portugal and Greece).

The posts and research cited above do not establish that the crisis in the Euroland periphery can be completely explained as a case of the Dutch Disease. In fact, they reinforce the view that the Dutch Disease may be less of a disease (with a well-defined course and outcome) and more of a syndrome (a set of symptoms with similar courses and outcomes). Nonetheless, it does appear to be a useful perspective from which crises in developed countries can be examined. The analyses suggest cases of the Dutch Disease/Syndrome share a number of factors in common:

1. Significant capital inflows

2. Low interest rates

3. A deterioration of the trade balance and resource shift to the non-tradable sectors

4. Weakening of private and public governance

Has/Will the Dutch Disease Contribute to Economic Problems in the US?

Determining whether or not the four factors listed above were/are present is the first step in assessing the possibility of a Dutch Disease role in the recent recession and the current slow recovery.

1. Was there a capital inflow on a macro-economically important scale? Ben Bernanke has cited the Asian “savings glut” and the resulting capital flows to the US as a driver of the behavior of long-term interest rates, the residential real estate bubble and the financial crash. Assuming that Bernanke is correct, capital inflows were drivers of macro-economically significance.

2. Were interest rates in the US low? The only question is whether or not they were too low for too long.

3. Did the US current account deficit deteriorate in the years prior to the crisis? The US current account deficit increased every year between 2001 and 2006. By 2005, the deficit was in the neighborhood of 6% of GDP, well in to the range of unsustainable. This is consistent with a decline in the competitiveness of the US tradable goods (and services) sector. The boom in residential real estate investment is an example of the “resource movement effect,” aka the “de-industrialization effect. Increased employment in construction grew, offsetting declines in employment in the US manufacture of tradable goods. In addition, there was a sizable reallocation of resources to other non-tradable sectors, e.g., travel, leisure, dining out, and health care. This suggests the Dollar did not depreciate fast enough to offset declines in US competitiveness, even as the trade-weighted Dollar declined. (Note: the decline in manufacturing employment also reflected relative increases in labor productivity.)

4. Was there a weakening of private and public governance? Yes. It is reflected in the increased risk on the balance sheets of financial institutions and households. The decline in the quality of corporate governance and increased risk was reflected in the increased use of leverage and maturity mismatches as well as the decline in loan underwriting standards to the unethical and illegal. The decline in private sector governance was paralleled by a decline in the quality of public sector governance, e.g., neglect of regulatory and supervisory responsibilities and the steps taken to sustain the unsustainable housing price bubble. Furthermore, there was no effort made to restore US competitiveness through changes in trade, exchange rate, tax or other policies and programs.

The US policymakers were also forecasting a continuation of the “Great Moderation” even as the fragilities and unsustainabilities responsible for the Great Recession mounted. This behavior was consistent with the observation that policymakers were myopic and focused on the short term to the complete exclusion of the medium and long terms. The failure of US markets and policymakers to see the fragilities and risks in asset price bubbles and resource misallocation is also consistent with Fernández-Villaverde, Garicano, and Santos’ second mechanism.

Assuming that Bernanke is correct and that the bubble in residential real estate and other asset prices was driven by low long-term interest rates that reflected capital inflows, then a Dutch Disease contribution to the Great Recession cannot be dismissed. The significant difference between typical instances of the Dutch disease and the US from 2001 to 2009 is the reason for the downturn in the US economy. In the typical case, it is a collapse in the capital imports/end of the export boom. In the US case, the ‘transmission mechanism’ broke down. Households became unwilling to continue to borrow and bid up the prices of residential real estate. Speculative demand abated. Excess supply led a decline in prices. The decline in prices led to increased defaults, losses given defaults, reduced residential investment, and the collapse of the balance sheets of financial institutions.

The Dutch Disease perspective may also be relevant for the US today. The origin of the term “Dutch Disease” was an economic dislocation that arose subsequent to a natural gas-based export boom. Today, numerous US pundits and some policymakers are promoting policies to encourage energy-based exports – liquid natural gas and petroleum products. They view the anticipated increase in exports is as a means to stimulate the economy, provide for energy independence and correct the trade deficit.

An energy-led export boom sounds attractive as a stimulus to growth, everything else equal. However, the Dutch Disease or resource curse indicates that everything else cannot be assumed to be equal. An energy-based export large enough to achieve US energy independence – equal to about 50% of the trade deficit or 1.5%-2.0% of GDP – would also set in motion changes in exchange rate movements and resource shifts in the US. The non-energy tradable sectors would presumably contract along with the number of people employed in those sectors. The scale of the US energy sales would produce dramatic changes in the energy markets and the geo-political positions of energy exporters and importers. In addition, it would presumably drive policy changes abroad.
Given that the majority of post-war instances of the Dutch Disease were energy-based export booms, it is reasonable to assume that the US will be putting itself at risk of a bout of the Dutch Disease if it pursues stimulus through an export-led energy boom. It is possible that policies could be put in place to minimize negative effects on the domestic and the non-energy tradable sectors, but they generally involve postponing the repatriation of the proceeds of the energy sales (the establishment of sovereign wealth funds, for example) and investing them abroad. However, the politics and the goal of domestic stimulus suggest that policymakers and politicians would prefer that the proceeds be repatriated and spent immediately. The short-term benefits of the housing price bubble blinded policymakers and politicians to the risks of a collapse in the housing and financial markets. In a similar fashion, the perceived near-term benefits of energy export-led growth could blind decision makers to the medium and long run risks of reducing the size and competitiveness of the non-energy tradables sector. Consequently, an energy-led export boom could wind up being costly even in the absence of adverse environmental side effects.

American policymakers ignored the role of the external sector during the Great Moderation. Domestic economic policy was set as if US prices and output were determined exclusively by domestic factors. Even though the trade deficit grew to nearly 6% of GDP, there was no effort made to address the external imbalance. Today, with the trade deficit is under 4% of GDP, policymakers and others now appear bent on correcting the trade deficit in order to stimulate GDP growth. However, they do not advocate taking steps to enhance the competitiveness of the US tradables sector, e.g., job training, changes in the tax code, currency adjustments changes in trade policies, etc. Instead, they are promoting an energy-led export boom despite medium- to long- term downside economic risks as well as environmental risks.

The discussion of the adoption of public polices to promote energy exports should include evaluations of not only the possible near-term economic benefits and environmental costs, but also the medium- to long-term risks of the US enduring another bout of the Dutch Disease.