Economics 101: what is Dutch disease and why hasn’t the GCC contracted it?

Dutch disease is one of many explanations for the occasional economic underperformance of resource-rich countries. Jeff Topping / The National

Resource-rich countries across the world, including in the GCC, are often described as suffering from the "resource curse", whereby a fortuitous endowment of natural resources, such as oil or gold, ends up having an adverse effect on the economy. Among laypeople, this view has been popularised by films such as Blood Diamond, depicting economies destroyed by the conflict that natural resources can spawn.

Much has been written about the resource curse, yet there are many misconceptions about the mechanisms underlying the phenomenon, especially a manifestation commonly referred to as “Dutch disease”, which is one of many explanations for the occasional economic underperformance of resource-rich countries.

The Economist magazine coined the term "Dutch disease" to describe what the Netherlands experienced during the 1970s. Large gas reserves were discovered in 1959, and after the fields were developed, Dutch exports boomed. Normally, policymakers would welcome such a change, but during the period 1970-77, unemployment increased to 5.1 per cent from 1.1 per cent, and private sector investment shrunk, leaving many analysts puzzled as to whether the gas discovery was a blessing or a curse.

To understand Dutch disease, we first need to understand the relationship between the trade balance and the exchange rate. In a country with a flexible exchange rate, when exports exceed imports, known as a current account surplus, then there is a net outflow of the country’s currency, or equivalently, there is a net inflow of foreign currencies.

This cannot go on forever, as the country’s currency would be depleted. Thus, like all competitive markets, the price of the currency will rise to bring net outflows closer to zero, known as currency appreciation: as the value of the currency rises, the price that foreigners pay for exports rises, making them less attractive to foreigners, and the price that domestic people pay for imports falls, making them more attractive, balancing the current account. Conversely, trade deficits create downward pressure on a country’s currency.

Now imagine that a country with a flexible exchange rate and a balanced current account suddenly discovers a huge oilfield and starts exporting large amounts of oil. Initially, this will disrupt the trade balance, as exports will exceed imports; over time, the exchange rate will appreciate and the current account will rebalance. Dutch disease is a two-part problem.

First, all exporting industries will suffer declining demand for their output as the exchange rate rises. Thus, compared to the situation before the arrival of oil, oil exports rise, but at the expense of non-oil exports. This non-oil contraction constitutes the stationary component of Dutch disease, also known as oil “crowding out” non-oil exports.

Second, oil (and other natural resources) tend to be industries with low employment, low levels of technological progress, and low knowledge linkages with other industries, which makes them comparatively unattractive drivers of growth within an economy. In contrast, exporting conventional manufacturing goods is considered desirable, because the sector is labour-intensive (direct job creation). Moreover, the sector regularly witnesses productivity improvements, and R&D conducted in the area can be usefully applied to other sectors, boosting the rest of the economy indirectly.

Thus, shifting the economy away from manufacturing towards oil can result in a decline in job growth and a diminution of broadly beneficial technological progress. These long-term costs constitute the dynamic component of Dutch disease.

Since the Dutch disease mechanism relies upon movements in the value of a country’s currency, the most straightforward countermeasure is to neutralise the exchange rate, for example by operating a fixed exchange rate regime. The Dutch attempted some countervailing currency manipulation once they had assessed that the expensive guilder (the Dutch currency at the time) was stalling the economy, by lowering interest rates, but the plan was ineffective as it encouraged domestic capital to flee the Netherlands in search of higher returns elsewhere.

In countries with a fixed exchange rate – including the GCC countries, which peg their currencies to the US dollar – when a trade surplus emerges due to oil exports, the government and central bank simply accumulate foreign currencies without spending them, often depositing them in foreign assets (such as foreign bonds and shares). Moreover, they may choose to print money to artificially engineer a countervailing downward pressure on the exchange rate.

During the sustained period of high oil prices (2005-14), GCC currencies would definitely have appreciated had they been flexible. As it happens, even in the event of an appreciation, the GCC countries do not have any substantial exporting manufacturing industries that will contract, meaning that Dutch disease is a non-issue in the GCC.

More generally, it should be noted that the concept of a resource curse implicitly refers to economies that would be thriving were it not for the discovery of the natural resources. By virtue of their desert climates, the GCC countries would have a hard time operating anything close to a modern economy were it not for oil. For centuries, the indigenous peoples of the GCC region have toiled in arguably the toughest conditions known to man, a far cry from the temperate conditions and fertile lands of the Netherlands.

Despite their inevitable, climate-induced dependence upon oil, the GCC countries still have a variety of ways of structuring their economies. The emphasis on top-down diversification in all of the GCC economic visions suggests that, left to its own devices, the private sector is not best placed to take advantage of the opportunities offered by natural resources, for reasons that mimic some of the alternative resource curse mechanisms discussed in the literature. We will explore these in the coming three weeks.

Omar Al Ubaydli is programme director for international and geopolitical studies at the Bahrain Center for Strategic, International and Energy Studies, and an affiliated associate professor of economics at George Mason University. He welcomes economics questions from readers via email ([e-mail]) or tweet (@omareconomics).

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