Dutch Disease

What is Dutch Disease?

Dutch disease is a concept that describes an economic phenomenon where the rapid development of one sector of the economy (particularly natural resources) precipitates a decline in other sectors. It is also often characterized by a substantial appreciation of the domestic currency. Dutch disease is a paradoxical situation where good news for one sector of the economy, such as the discovery of natural resources, results in a negative impact on the country’s overall economy.

Breaking Down the Dutch Disease Phenomenon

The Dutch disease term was first introduced in The Economist magazine in 1977 to analyze the economic situation in the Netherlands (hence the name) after the discovery of large natural gas fields in 1959. Although the Dutch economy increased its revenues from the export of natural gas, the significant appreciation of the national currency from the large capital influx into the sector resulted in a higher unemployment rate in the country, as well as a decline in the manufacturing industry.

The phenomenon of Dutch disease commonly occurs in countries whose economies rely heavily on the export of natural resources. The paradox contradicts the concept of comparative advantage. According to the comparative advantage model, each country should specialize in the industry in which it possesses a comparative advantage over other countries.

However, it does not work well with countries that primarily export natural resources. For example, the volatility of commodity prices cannot sustain a country’s economy for long time periods. Also, the overdependence on the export of natural resources leads to the underdevelopment of other sectors of the economy, such as manufacturing and agriculture.

The Workings of Dutch Disease

The negative influence of Dutch disease on the economy can be explained by some features attributable to the sectors that are related to natural resources. For example, mining industries generally require heavy capital investments, but they are not labor-intensive. Therefore, multinational corporations and foreign countries that have capital are often interested in investing in such ventures.

Foreign investment may lead to higher demand for the country’s domestic currency, and it will start appreciating. The appreciation of the domestic currency will make the country’s exports in other industries more expensive while imports will become cheaper.

Subsequently, domestic producers will face lower demand for their products abroad, as well as greater competition from foreign producers. Thus, the lagging sectors of the economy will face further troubles.

How to Avoid Dutch Disease?

The two primary strategies that can help solve Dutch disease are listed below:

1, Deceleration of domestic currency appreciation

The deceleration of currency appreciation is an easier and more viable strategy to prevent the adverse effects of Dutch disease. It can sometimes be achieved by smoothing the spending of revenues earned from the export of natural resources.

One of the most common methods to do so is the creation of a sovereign wealth fund. Many developed and developing countries, including Australia, Canada, Norway, and Russia, manage large sovereign wealth funds.

Sovereign wealth funds aim to stabilize the inflows of capital into the economy to prevent it from overheating and causing significant currency appreciation. Excess revenues can be spent on education or infrastructure that will help to diversify the economy.

2. Diversification of the economy

The diversification of the economy is a strategy that can almost eliminate the negative impact of Dutch disease on the economy. Economic diversification can be achieved by subsidizing lagging sectors of the economy or establishing tariffs to support domestic producers.

More Resources

CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)® certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful:

• Environmental Liability
• Fixed vs. Pegged Exchange Rates
• Negative Externalities
• Public Goods
• See all economics resources