Developing indicators to diagnose Dutch Disease

Diplomarbeit von Lorenz Meyenburg

Introduction:

The term Dutch Disease (abbreviated to DD throughout the paper), introduced in 1977, refers to the adverse effects on Dutch manufacturing of the natural gas discoveries of the 1960s. The crucial sub-period from 1974 to 1979 after the oil price shock in 1973 / 1974 was then marked by a consumption driven booming government sector in the context of a European stagnation, and though this process in itself did not bear a disease character, the strong real appreciation due to an overvaluation of the Dutch Guilder and an inflexible labour market were at least the clearest possible signs of a disease. It is actually doubted that the DD is Dutch, but the existence of the DD as a general phenomenon is widely accepted in the literature.

The fascination of the DD arises from its paradoxical nature that something intuitively good develops a dark side.

There is a good side of every boom, its initial impact is beneficial and amounts to Pareto-improvement for the economy as a whole. This implies a rise in real living standards due to higher levels of public and private consumption and higher levels of investment (and savings). Windfalls, the linked fiscal revenues, and easier domestic and foreign borrowing can finance core public goods. Especially regarding developing countries, windfalls principally allow breaking out of the poverty trap: poverty – lack of public finance – lack of public goods – lack of private investment – poverty.

Approaching the dark side, a favourable shock like a discovery of oil is a mixed blessing to developing countries, and research does not show a clear outperformance of the oil nations as a whole. The DD can be formulated as a provoking dilemma: ‘Enjoy boom revenues to boost economic development while those revenues in fact turn out to be responsible for the economic stagnation through the deterioration of the tradeable sectors.” The provoking nature of the DD runs the risk of being misused in the media in the longing for exciting economical statements, and a healthy mistrust should always accompany an alleged DD even in the literature, as the real problem can lie somewhere else in the dynamic economy. For example, in many countries, the downward trend in the share of manufacturing in national output is dominated by other reasons than a favourable shock. In general, policy choices can exacerbate or mitigate the DD, so that there is a direct connection, but the majority of influences rather works independently from the DD and is, if at all, indirectly linked with it.

A disease typically calls for a cure. Political issues of the DD cover the distribution of the gains, transitional assistance to declining sectors and the appropriate response to various market failures which may impede the smooth adjustment of the economy to its new equilibrium. This paper searches mainly for the pure disease character but does not exclude the curing counterparts or exacerbating distortions that support a more realistic view on the disease’s extent.

The concluding course of investigation is as follows.

Beginning with the structuring of its theoretical background, the DD is then split into a real type of the DD, with a focus on structural changes in a rather static framework, and a monetary type of the DD that focuses on monetary adjustment problems associated with a boom or something similar that stresses more the problems of the adjustment phase and is thus rather dynamic.

The subsequent section’s pure dynamics of the DD presents the central idea of the DD and integrates both the real and monetary type, though stressing the real type of the DD as its core.

The main extensions and distortions of models and results are explained where adequate in these three main sections, and the remaining distortions that are only indirectly connected with the DD will be explained in a separate section.

The theoretical analysis is ended with the main definitory conclusions that form the DD hypothesis which is not a definition in the classic sense but a conglomerate of definitions. A short definition of the DD would probably miss the point, and this is the reason why it is not forestalled in this section. These theoretical conclusions shall also substitute a conclusion at the end of the paper.

The comprehensive theoretical analysis is complemented by the measurement methods in the literature and eventually followed by the empirical research as a practical implementation of the theoretical part. The research objective will not be to prove the existence of the DD which would require thorough qualitative country studies. The objective is to develop a quantitative method of diagnosing the DD in a way of determining its intensity with simple descriptive statistics, and this on a world-wide scale. The DD candidates with comparatively high intensities of the main indicators in neighboured years can finally be expected to have it. The research approach is thus focused on electing the potential DD candidates on an aggregate level and on setting the possible DD cases in relation to each other, allowing for a final indexation of the DD intensity and two world-wide overviews. A sample of this overview is tested on its accordance with the results from the literature. And though there are still weak points left and discussed, the question of how to diagnose the DD is solved to the main extent. Lastly, there is some information about the probable main disease cases in percent of total cases.

Table of Contents:

Text Sample:

Chapter 7.1, Measuring the relative prices:

The real exchange rate – as opposed to the real effective exchange rate that will be explained directly afterwards – was prevailing in the theoretical models above. As was said before, it is the key equilibrating variable in the adjustment process after a favourable shock. The next two sections explain the possible empirical measuring methods.

Empirical complications of the real exchange rate:

There are three main complications in empirically using the real exchange rate, first the variability of its definition, second the determination of prices, and third the problem of determining tradability, and these complications occur even without distortions from policies and economical development.

Variability of real exchange rate definitions. There are different real exchange rate indices just as there are different price indices. Until now, the real exchange rate was referred to as the ratio between non-traded goods and services on the one hand and internationally traded goods on the other. But it is not as plain to actually define the real exchange rate. It acts as a summary indicator of the outcome of macroeconomic adjustments that occur following an increase in capital inflow. Generally, an external equilibrium is reached when any account imbalance is compensated for by a sustainable flow of international capital, and this sustainability depends on the stock of foreign assets and liabilities of the economy, so that changes to the net foreign asset position of the country will lead to changes in the real equilibrium exchange rate position of the country.

Conventionally, an empirical real exchange rate model covers a set of policy variables (government expenditure, excess money growth), capital inflows (indirect money growth) and openness to trade – more of the latter likely leads to a real depreciation, more of the former two leads to a real depreciation.

The appreciating impact of higher government expenditure is analysed in section 3.3. Both induced money supply growth due to fiscal policies and indirect money growth due to higher capital inflows increase the price of non-traded goods, leading to a real appreciation.

Openness is measured by trade restrictions which raise the import price and thus lead to a real depreciation (income effect), but domestic consumers will also switch demand to non-tradeables which raises the real exchange rate again (substitution effect). The income effect is less likely to dominate, so in the end a higher openness leads to lower import prices and is thus likely to imply real depreciation. It is clear that free policy choices like openness to trade are not directly linked to the DD, so any change of it after a favourable shock can distort the diagnosis.

As a consequence, comparability among single-country studies is often bad due to different definitions of the real exchange rate and different capital inflow variables.

Determination of prices. When measuring the prices, there may be differences between the prices for the public and the private market. Especially with regard to services with its large weight in the Non-traded Sector, many of the most easily measurable service prices are those of public utilities controlled by the government which do not mirror the market pressures.

Determination of tradability. As the second main complication, the determination of the real exchange rate is further complicated by the continuous rather than discrete nature of tradability.

Four distorting issues concerning tradability should be considered. First, a good that cannot be transported is only likely to be non-tradeable, since it might be tradeable as a financial asset in the international markets. Furthermore, there are also intermediate stages of transportability. A transport cost model and a similar model for the market functionality can provide a graduation between tradeable and nontradeable sectors in these cases. Second, if products are subject to binding quantitative restrictions, so that their domestic prices are not determined by world market prices, but rather by domestic demand and supply conditions, they should be treated as non-tradeables even though they are potentially tradeable. It is actually not the question whether a commodity is tradeable or not, but whether it is at least in part effectively traded or not. And third, locally produced manufactures are often close but not perfect substitutes for imports; they might be thought of as containing both a tradeable and a non-tradeable element so that they could, on balance, be beneficiaries from the spending effect.

Empirical advantage of the real effective exchange rate:

For empirical research, the real effective exchange rate (or purchasing-power-parity-adjusted effective exchange rate) is more adequate than the real exchange rate.

The real effective exchange rate is an index of domestic prices (for tradeables and non-tradeables) set relative to the prices of major trading partners converted at market exchange rates, Pdomestic /(ePmajor partners). It solves the real exchange rate’s problem of the continuous nature of tradability and is more independent of country-specific market policies.

Normally, both concepts of real exchange rates go into the same direction. If the price of traded goods Pt is set by the level of foreign prices and a fixed tariff (so that Pt = eP[1+t]), real exchange rate appreciation will imply real effective exchange appreciation. In some cases, though, it is possible, that the real exchange rate (defined as the price of non-traded goods relative to traded goods) appreciates, while trade liberalisation can cause the real effective exchange rate (defined as the level of domestic prices relative to foreign prices) to depreciate.

As an example, if tariffs or quotas that protect traded sectors are eliminated in response to rising oil revenues, and the nominal exchange rate is fixed, it is possible for the domestic price level to fall (that is, the real effective exchange rate depreciates) even though the relative price of non-tradeables to tradeables rises.

There is a basic systematization of effective relative prices which can be measured either by the external or by the internal relative price: the method of the external relative price covers the real effective exchange rate using either the official or the parallel rate, while the internal relative price is associated either with the GDP-deflator or the consumer price index.

Combinations are possible. One measuring method is for example the trade-weighted real exchange rate that sets the domestic consumer price level in relation to the geometrically trade-weigthed price indices of the major trading partners converted at average exchange rates, indicating a loss of competitiveness.

Reasons for diverging trends between external and internal relative price indicators could be the behaviour of food prices in the aftermath of an oil price shock. The expansion in the size of government draws labour away from the rural towards the urban areas, and the decline in agricultural production raises food prices. The government could additionally spend its windfalls on investments into manufacturing, so that by the same time the agricultural traded sector declines even more due to the induced labour movement. This is rather a problem of policy decisions or more generally a problem of the higher public expenditure quota after windfalls, and it distorts the sectoral shifts but on an aggregate level of combined non-booming Traded Sectors it cannot reverse the sectoral DD symptoms.