Dutch Disease

An economic phenomenon wherein both the rapid development of one

sector of the economy and the decline of other sectors lead to the
substantial appreciation of the domestic currency

Written by CFI Team

Published November 17, 2019
Updated December 12, 2022

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.