The Dutch disease and the distribution of resource revenues

The decline in a country’s manufacturing sector after new resources (e.g. oil, gas) are found is referred to as the Dutch disease. The classical manifestation of the Dutch disease is due to an appreciation of the exchange rate. In other words, the resource-rich country exports a lot of natural resources, which makes its currency appreciate in value. This will then render (manufacturing) exports less competitive, and hence the subsequent slump in the manufacturing sector.

While this may be the original definition, the Dutch disease is actually more complicated. Certain countries feel it more severely than others, and in many cases it occurs even when exchange rates do not enter the picture at all.

This post is about a working paper by Chisik, Onder and Battaile (2014), which attempts to investigate what other factors might play a role in the emergence of the Dutch disease.

The paper addresses several issues regarding the Dutch disease:

  1. Only a low fraction of the population is generally employed in resource extraction. This is important because it means that a large movement of workers from the manufacturing to the natural resource sector cannot explain a drop in manufacturing productivity.
  2. Places without a national currency can also develop the Dutch disease. See e.g. this post on Appalachia and coal.
  3. The Dutch disease doesn’t occur in every country/region with resource wealth. Places like Australia, Botswana or Canada for instance have fared quite well.

The authors develop a model that tries to incorporate these issues. The model economy is comprised of three sectors: a manufacturing, a resource, and a services sector. The former two are tradable goods, the latter is not. The model then compares two countries with equal resource endowment to see how the Dutch disease might arise in one but not the other.

First, it is shown that the Dutch disease can indeed arise without a reallocation of labor from manufacturing to resource extraction (point 1 above). The way this is achieved in the model is that it is assumed that the resource sector does not need any labor (resources are treated as endowments that can be directly sold without any labor input). The fact that the Dutch disease can arise in such a model shows that labor movement away from manufacturing is not necessary for manufacturing output to decline.

The reason this occurs is that a higher oil endowment raises export revenues and thus decreases the need for manufacturing to generate export revenues. So labor moves to the (non-tradable) services sector.

Secondly and more interestingly, the authors show that if the countries are initially identical in all respects except the distribution of natural resource revenues, then the country with the more unequal distribution will suffer more from the Dutch disease. In other words, if resource revenues accrue to a small elite as opposed to a larger share of the population, then the Dutch disease will be more severe.

The mechanism via which this works is luxury services. Namely, if resource revenues are held by a select few, these people will be quite rich and will increase their consumption of luxury services. This will incentivize the country to reallocate labor from manufacturing to services. And you get the Dutch disease.

There are of course some assumptions in the background. In a situation with completely equal resource distribution, everyone purchases some services. In a situation with unequal distribution, the rich (those with the resource) still purchase services, but the poor (those with no resource) do not anymore. Thus moving from an equal to an unequal distribution reduces the number of people purchasing services. But the model is set up in such a way that the rich spend so much more on services that overall spending on services increases.

This is done by basically splitting services into a non-luxury and a luxury component. And once a person has no resource (i.e. they’re poor) they don’t consume any of the luxury component (by assumption). Obviously, someone else (a rich person) will have the resource that the poor person doesn’t have anymore. So that person could increase their luxury consumption by the same amount that the poor person decreased theirs. And so the two effects would cancel out.

The reason why this doesn’t happen (if I understand correctly) is that the non-luxury component of services is assumed to be a sort of guaranteed/mandatory consumption. So the poor person must consume that minimum level of services. Consequently, they may not be able to reduce their services consumption by as much as the rich person is able to increase theirs. Technically speaking, preferences are non-homothetic in the model.

In any case, this delivers the result mentioned above: that a more unequal distribution of resource revenues increases the severity of the Dutch disease by diverting labor from manufacturing to (luxury) services.

A sort of obvious side note is that the less of the natural resource a country has, the less of a problem an unequal distribution of resource revenues is. In other words, if resources do not constitute a large part of your economy, then even if you have a handful of very rich people, they won’t be able to have such a huge effect on your economy so as to induce a (significant) movement of labor from the manufacturing to the (luxury) services sector.

This completes the description of the main points of this theory. So what are the implications? It seems that somehow enforcing a more equal distribution of resource revenues can help resource-rich countries. This can be done for instance via redistributing revenues or (according to the authors) taxing luxury services (as opposed to manufacturing imports).

I think it’s a rather unsurprising conclusion that ensuring a more equal distribution of resource revenues (especially in countries that heavily depend on natural resources) is beneficial. What’s new and interesting is that such redistribution may help the country avert the Dutch disease (or at least alleviate its symptoms).

Indeed for instance, the most successful African resource-extracting country, Botswana, has a very extensive welfare system that seems to ensure that diamond revenues are more equally distributed among the population.

My major concern regarding this research is whether the movement of spending (and labor) from manufacturing to luxury services is empirically significant enough to induce the Dutch disease. In my opinion, it’s hard to imagine that this is the case in developed, well-diversified economies such Australia, Canada or the US on a country-level. But it’s easy to believe that it may be the case on a regional level (Appalachia, North Dakota, etc.) or in various developing African countries.

So yes, in certain cases, this theory might provide a good explanation for the existence or lack of the Dutch disease in a given economy. Hopefully, empirical work will follow to test these claims.

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