The Projected Effects of Dutch Disease

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In 2016, the world witnessed as Venezuela fell into a large-scale economic collapse. For some, this implosion seemingly materialized from nowhere. In revision, its causes could be traced and explained by numerous factors, including economic mismanagement from its government, rigid socialist economic policies, and a fall in oil prices. A combination of the listed factors provoked a phenomenon known as Dutch disease, which plagues the Venezuelan economy in a predicament which continues to strain the country and its citizens.

So what is Dutch disease? First coined by The Economist in 1977, the term was used to describe the effects on the Dutch economy after large deposits of natural gas were discovered in the province of Groningen in 1959. The term is most commonly applied to the discovery of natural resources such as oil and gas, but generally can refer to any situation where a large flow or investment of foreign currency into a country’s economy leads to the rapid appreciation of its currency due to its rising demand. Referring back to Groningen, the discovery increased exports in natural gas, which led to a substantial inflow of foreign currency in exchange for the guilder (the Netherlands’ currency at the time).

At first glance, this phenomenon is seemingly harmless, perhaps even beneficial, to the Dutch economy. In fact, some economists argue that Dutch disease is no disease at all, as it could be said that economies should focus on exporting commodities in which it is most efficient at producing. Furthermore, a stronger guilder makes it cheaper for the Dutch to purchase foreign goods.

However, in lagging sectors such as agriculture or manufacturing (lagging describes a sector with little and/or slow growth), appreciation of a currency makes it more expensive for foreign countries to import goods from these industries, leading in a decrease in global competitiveness. Equivalently, the large inflow of currency from exports increases the money supply domestically (assuming no intervention in monetary policy), which allows for citizens to afford more domestic goods, which inevitably leads to a rise in prices. In other words, the real exchange rate rises, once again making it harder for foreign countries to afford goods from these less dominant industries.

    \[ Real Exchange Rate = E \times \frac{P_D}{P_F} \]

where E stands for exchange rate, P_D is domestic prices, and P_F is foreign prices

So what does this mean for an economy overall? A boom in one industry damages competitiveness for non-related industries globally due to the appreciation in currency, making a country increasingly reliant on a single dominant export. For countries that export an abundant resource (examples include Nigeria and Kuwait, to name a few), issues may arise when reserves dry up, it becomes economically infeasible to export, leading to a decline in revenue. The loss in revenue is difficult to recover alternatively through exports in lagging industries that have been weakened due to a resource boom.

Venezuela’s economy came crashing down when its decade-long reliance on oil exports reared its head after OPEC decided to increase supply and production, which caused global prices to drop significantly. Its citizens, who have lived prosperously through social and welfare programs funded by revenues from their state-owned oil enterprise (the PDVSA), were greatly affected by the decision. As oil made up over 90% of Venezuela’s total exports [1], the drastic drop to approximately USD 30 per barrel at the start of 2016 from around USD 50 a year before (an even more drastic decrease when compared to appx. USD 100 per barrel from the start of 2014) [2] put a strain on revenues and production, cutting welfare for its people, as well as hindering its purchasing power of imports for  essential goods such as food.

Many lessons can be derived from these studies (which vary from case to case). But, the overarching message is the importance of diversifying an economy, and allowing for a fallback should consumers and producers tinker with the stability of markets. Definitely easier said than done.

Sources:

[1] http://www.worldstopexports.com/venezuelas-top-10-exports/
[2] http://www.nasdaq.com/markets/crude-oil.aspx?timeframe=4y
http://www.economist.com/blogs/economist-explains/2014/11/economist-explains-24
https://en.wikipedia.org/wiki/Dutch_disease

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