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Finance & Development March 2003 49

~TO BASICS
(.)
c(
r:a
Dutch Disease
Too much wealth managed unwisely
Christine Ebrahim-zadeh
M
IGUEL DE CERVANTES SAAVEDRA,
the celebrated sixteenth -centur y Spanish
autho r of Don Quixote de la Mancha,
once sa id that "the gratification of wea lth
is not found in mere possession o r in lavish expenditure,
but in its wise applicati on." This was at a time when Spain
enjoyed newfound access to a wealt h of natural resources,
including gold, fro m the Americas. Could he have recog-
nized, in his own co untry, sympto ms of what later
beca me known as "Dutch disease," a te rm that broadl y
refers to the harmful consequences of large in creases in a
co untry's inco me? Finance & Development expl o res th e
ISS Ue .
In the 1960s, the Netherlands experienced a vast
increase in its wea lth after discovering large natural gas
deposits in the No rth Sea. Unexpectedly, this ostensibly
positive develo pment had serio us repercussio ns o n
impo rtant segm ents of the co untry's econo my, as the
D utch guilder beca me stronger, m akin g Dutch no n-o il
expo rts less competitive. This syndro me has co me to be
kn own as "Dutch disease." Altho ugh the disease is gener-
ally associated with a natural reso urce discovery, it ca n
occur fro m any developm ent that resu lts in a la rge inflow
o f fo reign currency, including a sha rp surge in natura l
resource prices, fo reign assistance, a nd fore ign direct
investm ent. Econo mi sts have used th e Dutch disease
model to examine such episodes, in cludin g the impac t of
th e fl ow of Am eri ca n treasures into sixteenth-ce ntur y
Spain and gold discoveries in Australia in the 1850s.
The diagnosis is ...
Why does a dram atic increase in wea lth have this para-
dox ically adverse co nsequence? The answer is fo und in a
cl ass ic 1982 paper by W. M. Corden and J. Peter Neary.
Th ese authors divide an eco no my exper iencing an
expo rt boom into three secto rs: o f these, the boo ming
expo rt sector and th e laggin g export sector are the two
traded good s secto rs; the third is th e no ntraded goods
secto r, which essentially suppli es do mestic residents and
might includ e retail trade, se rvices, and construction.
Th ey show that wh en a country catches Dutch disease,
50 Finance & Development March 2003
th e traditional expo rt sector gets crowded o ut by the
oth er two sectors.
H ow does this happen? Let's take th e exa mpl e of a
co untr y that discovers oil. A jump in the country's o il
expo rts initially raises incom es, as more fo reign
exchange flows in . If th e fo reign exchange we re spent
entirely o n impo rts, it wo uld have no direct im pact on
th e co untr y's money supply or dem and fo r do m esti cally
produced goods. But suppose the fo reign currency is
co nverted into local currency and spent on do mesti c
no nt ra ded goods. What happens next depends o n
wheth er the co untr y's (nominal ) exchange rate-that is,
the pri ce of the domesti c currency in terms of a key for-
eign currency- is fi xed by the central bank or is flexible.
If the exchange rate is fixed, the conversion of the fo r-
eign currency into local currency wo uld increase the
co untry's money supply, and pressure from do mestic
dem and would push up dom estic pri ces. This wo uld
am o unt to an appreciation of the "rea l" exchange ra te-
that is, a unit of fo reign curren cy now buys fewer "real"
goods and services in th e dom estic eco nomy than it did
befo re. If the exch ange rate is fl exible, th e in creased sup-
pl y o f fo reign currency wou ld dri ve up the value of th e
domestic currency, whi ch also imp lies an appreciation in
the rea l exchange ra te, in this case through a rise in th e
no minal exchan ge rate rather than in dom estic pri ces. In
both cases, real exchange rate appreciation wea kens the
co mpetitiveness of the country's expo rts and , hence,
ca uses its traditional export secto r to shrink. This entire
process is called the "spending effect."
At th e same tim e, resources (capital and labo r) wo uld
shi ft into the produ ctio n of domesti c nontraded goods
to meet the increase in domesti c demand and into the
booming oil secto r. Both of these tran sfers would shrin k
produ ction in the now lagging traditio nal expo rt secto r.
This is known as the "resource movement effect."
These effects played o ut in th e oil-ri ch nati o ns in th e
1970s, when oil prices soared and o il exports rose at th e
expense of the agri cul tural and ma nufacturing secto rs.
Similarly, higher coffee pri ces in th e late 1970s (after
frost destroyed Brazil's coffee crops) triggered a boo m in

coffee sectors in producers like Colombia at the expense of
the traditional export sector as spending and resources
were reallocated to the nontraded goods sector (see chart).
. . . bleak?
Is the damper on the lagging 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 mis-
Trouble brewing in Colombia?
BACK-I
0
nomer. The shift in production from the tradable to the
non tradable 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. This transition-no matter
how brief-is painful, both economically and politically.
Economists also worry that a shift in resources away from
manufacturing sectors that generate "learning by doing"
might jeopardize a country's long-term growth potential by
choking off an important source of human capital develop-
ment. 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
50•
1967 69 71 73 75 77 79 81 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 terms of trade gains
to be transitory, policymakers may want to protect the vul-
nerable sectors-possibly through foreign exchange inter-
vention. 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
... and led to a boom in the coffee sector,
value of the domestic currency lower than it would other-
wise 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
-2 0 2 4 6 8 10 12 14 16 18 20
the buildup of reserves does not lead to inflation and that
faster growth in the nontradable goods sector, the country's additional wealth is spent wisely and man-
Construction and public works
aged transparently through, for example, a central bank
Residential rent
account or a trust fund.
Government services
In countries whose newfound wealth is likely to be per-
I manent, policymakers need to manage the inevitable struc-
-2 0 2 4 6 8 10 12 14 16 18 20 tural changes in the economy so as to ensure economic
and slower growth in the traditional traded goods sector. stability. They may want to take steps to boost productivity
in the nontraded goods sector (possibly through privatiza-
Textiles. clothing, and leather
tion and restructuring) and invest in worker retraining.
Paper and printing
They may also want to continue to diversify exports to
Refined petroleum products
reduce dependency on the booming sector and make them

1
555i~~;;;~-::Chemicals Manufacturesand
of metals
rubber
Transport materials
less vulnerable to external shocks, such as a sudden drop in
commodity prices.
Whether exercising prudence in managing new riches or
Machine? and equipment changing the course of the economy to adapt to new cir-
-2 0 4 6 8 10 12 14 16 18 20 cumstances, such wise application of wealth would,
(percent)
undoubtedly, have won Cervantes's approval. •
• Average annual growth (1970-75)
• Average annual growth (1976-81)

Source: Linda Kamas, 1986, "Dutch Disease Economics and the Colombian Export
Boom ,' World Development, Vol. 14 (September), pp. 1177-98. Christine Ebrahim-zadeh is on the staff of Finance &
Development.

Finance Development
& March 2003 51