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By Andrew Holland on Jun 7, 2012 with 1 response

Will Dutch Disease Follow-on the American Energy Boom?

Stronger Currency

An ongoing discussion among some of us analysts at Consumer Energy Report has been about whether having natural resources like oil or coal is actually beneficial to a country (see Are Countries With Vast Oil Resources Blessed or Cursed?, Oil Dependence — Tom Friedman’s False Narrative, and Oil — Easy to Produce, But Not Easy to Buy).

The argument which I’ve made is that a boom in natural resources production can cover up some short-sighted economic policies; in effect, the earnings from producing oil mean that countries do not have to invest in their education or produce their own manufactured goods. The other side of the argument is that it can only be a good thing for new resources to be found.

Leaving aside the question of whether natural resource wealth undermines institutions or causes corruption (and there is good evidence of a resource curse among developing countries) there is one thing that increased production of oil does, once it gets to be a big enough sector of the economy: it pushes up the value of that country’s currency.

All else equal (as economists always have to say), new production of natural resources strengthens the domestic currency. That’s because those resources are either exported or are used to replace imports.

Dutch Disease Phenomenon

Now – I should mention that I like a strong dollar, personally: it means I can afford to travel abroad more, and buy more when I get there. It also means that French wine (for example) becomes cheaper relative to Californian wine. I like French wine, and would welcome being able to buy more. However, that shows the problem with having a strong currency — it undermines domestic manufacturing and production (of Californian wine, in this example) by driving up prices of American-made goods and services.

This phenomenon is called “Dutch Disease.” Coined by The Economist in 1977 to describe how finding natural gas in the North Sea in 1959 affected the Netherlands’ economy over the ensuing decades. The symptoms of the ‘disease’ are when commodity exports push up the value of a nation’s currency, making other parts of the economy less competitive. This leads to a current-account deficit, which makes the economy even more dependent upon the commodity. The disease is especially pernicious for commodities like oil, coal, and natural gas because these industries are very capital-intensive, and actually do not generate that many jobs.

There are two major industrialized countries that have undergone commodities booms over the past decade: Canada and Australia. They are both showing signs of suffering from Dutch Disease, with the Canadian dollar increasing in value vs. the American dollar (Canada’s #1 trading partner by far) by over 50% in the last ten years, and the Australian dollar increased in value compared to world currency rates by almost 70% in the past decade.

Exports vs. Domestic Manufacturing

Canada’s boom, related to the exploitation and exports of Alberta’s Oil Sands, has brought boom times to the resource-rich areas of Western Canada. However, an article in the Global Post highlights how the boom is dividing Canada: Western politicians are pushing for more oil-centered exports, while politicians in Ontario and Quebec, Canada’s traditional manufacturing heartland, are saying that increased oil exports have undercut their ability to manufacture. The article says:

The debate was reignited last month by Tom Mulcair, leader of the federal New Democratic Party, the main opposition to the ruling Conservative government. The high dollar, he said, has “hollowed out the manufacturing sector” and cost a half-million jobs.

Australia too, is having problems with its currency. Steve LeVine writes in EnergyWire that “A Cautionary Tale for U.S. Energy Policy Unfolds in the Land Down Under” (paywalled). While Australia’s boom is not related to oil, it is exports of coal and iron ore – much of it exported to fuel China’s dramatic economic expansion – as well as becoming an important new exporter of Liquefied Natural Gas (LNG). Levine writes:

Australia’s dollar has surged 69 percent in value in the past decade, cutting into tourism and eroding the competitiveness of its manufactured products. Its manufacturing base has shrunk by almost 100,000 jobs over the past four years, according to government figures.

Conclusion: U.S. Should Keep An Eye Open

There are lessons here for the U.S. economy.  The first is that it is easier to prevent Dutch Disease than it is to treat it. Countries that have been successful in preventing Dutch Disease include Norway, Singapore, and (to a lesser extent) Russia.

As these countries saw that they were about to experience a boom in commodities exports, they set up sovereign wealth funds that would pull in capital inflows. These funds then pay out over a longer time period, allowing the countries to avoid the boom-bust cycle. Such a fund in the U.S. would take a portion of export revenue, whether from natural gas, petroleum products, or other commodity, and sequester it from circulation. Needless to say, this would be a very politically difficult measure in our low-tax, small government political culture.

Another strategy for avoiding the disease is to increase national savings across the economy — and the best way for government to do that is to run a budget surplus. Looking to our deficit projections, I would say that a surplus looks very unlikely, but increased revenue from commodity production — whether taxes or royalties — can (and should) be used to pay down America’s long term deficits.

Fortunately, the U.S. economy is big and diverse; we are unlikely to become completely dependent upon commodities exports.  And, fortunately for me, an appreciating dollar would be good for me: allowing me to drink more French wine and travel more frequently. Whether it is a good thing for a slowly recovering U.S. economy and manufacturing sector is another question. As the U.S. prepares export terminals for natural gas and continues to enjoy its boom in energy production, is there anything else that the government should do to alleviate or avoid a currency appreciation that harms manufacturing?

  1. By Optimist on June 13, 2012 at 6:11 pm

    For some reason the Canadians insist on exporting the raw product (crude) when they could be setting up entire industies around the tar sands.

    Americans, for some reason, are less likely to make that mistake. See reports on all the industries (and associated jobs) that cheap fracking gas is spouting in the Gulf states.

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