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When countries experience a sudden large increase in income, the consequences can be harmful

Miguel de Cervantes Saavedra, the celebrated 16th century Spanish author of Don Quixote de la Mancha, once said that “the gratification of wealth is not found in mere possession or in lavish expenditure, but in its wise application.” That was at a time when Spain enjoyed new-found access to a wealth of natural resources, including gold, from the Americas. Could he have recognized, in his own country, symptoms of what later became known as Dutch disease, a term that broadly refers to the harmful consequences of large increases in a country’s income?

In the 1960s, the Netherlands experienced a vast increase in its wealth after discovering large natural gas deposits in the North Sea. Unexpectedly, this ostensibly positive development had serious repercussions on important segments of the country’s economy as the Dutch guilder became stronger, making Dutch non-oil exports more expensive and, therefore, less competitive. This syndrome has been witnessed in many countries across the world, including but not limited to resource-rich commodity exporters. Although Dutch disease is generally associated with a natural resource discovery, it can occur from 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. Economists have used the Dutch disease model to examine such episodes as the flow of American treasures into 16th century Spain and gold discoveries in Australia in the 1850s.

The diagnosis

Why does a dramatic increase in wealth have this paradoxically adverse consequence? The answer is found in a classic paper by Corden and Neary (1982)—which divides an economy experiencing an export boom into three sectors: the booming export sector and the lagging export sector, both of which are traded-goods sectors; and the nontraded-goods sector, which essentially supplies domestic residents. The nontraded goods sector might include retail trade, the service industry, and construction. The authors show that when a country catches Dutch disease, the traditional export sector gets crowded out by the other two sectors.

How does this happen? Let’s take the example of a country that discovers oil. A jump in the country’s oil exports initially raises incomes, as more foreign currency flows in. If the increased foreign exchange were spent entirely on imports, there would be no direct impact on the country’s money supply or demand for domestically produced goods. But suppose the foreign currency is converted into local currency and spent on domestic nontraded goods. What happens next depends on whether the country’s (nominal) exchange rate—that is, the price of the domestic currency in terms of a key foreign currency—is fixed by the central bank or is flexible.

If the exchange rate is fixed, the conversion of the foreign currency into local currency would increase the country’s money supply, and pressure from domestic demand would push up domestic prices. This would amount to an appreciation of the “real” exchange rate—that is, a unit of foreign currency would buy fewer goods and services in the domestic economy than it did before. If the exchange rate is flexible, the increased supply of foreign currency would drive up the value of the domestic currency, which also implies an appreciation in the real exchange rate—in this case through a rise in the nominal exchange rate rather than a rise in domestic prices. In both cases, real exchange rate appreciation weakens the competitiveness of the country’s exports, and causes its traditional export sector to shrink. This entire process is called the spending effect.

At the same time, resources (capital and labor) would shift to the production of domestic goods that are not traded internationally—to meet the increase in domestic demand—and to the booming oil sector. Both of these transfers shrink production in the now lagging traditional export sector. This is known as the resource movement effect.

These effects played out in the oil-rich nations in the 1970s, when oil prices soared and oil exports rose at the expense of the agricultural and manufacturing sectors. Similarly, higher coffee prices in the late 1970s (after frost destroyed Brazil’s coffee crop) triggered a boom in the coffee sector in producers like Colombia at the expense of manufacturing (the lagging tradable sector), as resources were reallocated to the agricultural (nontradable) sector.

How much of a problem?

Is the damper on the lagging internationally traded goods sector really a problem? Some economists say no, if the higher inflows are expected to be permanent. In these cases, they say, Dutch disease may simply represent the economy’s adaptation to its newfound wealth, making the term “disease” a misnomer. The shift in production from the tradable to the nontradable sector is simply a self-correcting mechanism, a way for the economy to adapt to an increase in domestic demand.

But other economists argue that even a permanent change is worrisome. When capital and labor shift from one sector to another, industries are forced to shut down and workers have to find new jobs, and the transition—no matter how brief—is painful, both economically and politically. Economists also worry that a shift in resources away from the manufacturing sector, which generates “learning by doing,” might jeopardize a country’s long-term growth potential by choking off an important source of human capital development. The bottom line is that, regardless of whether these changes are seen as a problem, policymakers must help the economy cope with their ramifications.

Doctor’s orders

What can policymakers do? A lot will hinge on whether the newfound wealth is temporary or permanent. In countries that expect new resource discoveries to be depleted fairly rapidly, aid flows to be temporary, and/or terms of trade gains to be transitory, policymakers may want to protect the vulnerable sectors—possibly through foreign exchange intervention. The sale of domestic currency in exchange for foreign currency—that is, the buildup of official foreign exchange reserves—tends to keep the foreign exchange value of the domestic currency lower than it would otherwise be, helping to insulate the economy from the short-run disturbances of Dutch disease that will soon be reversed. But there remains the challenge of ensuring that the buildup of reserves does not lead to inflation and that the country’s additional wealth is spent wisely and managed transparently through, for example, a central bank account or an (oil) trust fund.

In countries whose newfound wealth is likely to be permanent, policymakers need to manage the inevitable structural changes in the economy to ensure economic stability. They may want to take steps to boost productivity in the nontraded goods sector (possibly through privatization and restructuring) and invest in worker retraining. They may also want to continue to diversify exports to reduce dependence on the booming sector and make them less vulnerable to external shocks, such as a sudden drop in commodity prices. A case in point is the Netherlands, where policymakers assumed that the country’s income from natural gas would last a long time and used part of the windfall to finance a very generous welfare system. But when natural gas prices plummeted in the 1970s, the country’s income dropped dramatically, and the government was not able—for political and social reasons—to turn back the clock on its welfare policy.

Whether exercising prudence in managing new riches or changing the course of the economy to adapt to new circumstances, such wise application of wealth would, undoubtedly, win Mr. de Cervantes’s approval.

Opinions expressed in articles and other materials are those of the authors; they do not necessarily reflect IMF policy.