There is no cure for Dutch Disease

by Alex Paterson. Posted May 19, 2012


Thomas Mulcair, leader of the federal New Democratic Party, says Canada has Dutch Disease. Ontario Premier Dalton McGuinty has implied similarly.

Canadians over 50 are forgiven if they run out and hire an arborist for confusing this ailment with Dutch Elm disease that wiped out so many trees in Canada two generations ago. The economic illness to which Mulcair refers is in fact much more serious than a gardening problem.

Dutch Disease occurs when one part of the economy — in Canada’s case, the oil extraction segment — becomes ridiculously popular on world markets. Cash flows in as foreigners buy up the resource, pumping up the exchange rate. This in turn makes it much harder for other parts of the country’s economy to sell goods and services abroad, as the higher currency makes their products more expensive in world markets.

The term was coined after the Netherlands discovered natural gas, which coincided with an appreciation of the guilder and a decline in the Dutch manufacturing sector. These three phenomena were linked by some analysts, leading The Economist magazine in the late 1970s to label the whole mess “Dutch disease.” The logic was that the natural gas find had increased demand for the guilder such that the exchange rate appreciated significantly, thereby damaging the competitiveness of the export-oriented manufacturing sector.

Mulcair believes Central Canada’s manufacturing sector — which has shed hundreds of thousands of jobs in the past number of years — is suffering the same fate today that the Netherlands faced decades ago. A Canadian dollar equal to the greenback, according to this analysis, is the by-product of the boom in the oilsands and high international demand for this commodity, which is allegedly killing the manufacturing sector’s export competitiveness.

But even if we agree with Mulcair’s analysis — and some economists do — there is almost nothing realistic that governments can do about it, which makes raising this economic bogeyman rather pointless and unnecessarily divisive.

Essentially, there are four ways to cure Dutch Disease.

The first — and most draconian — is to adopt a fixed exchange rate at a level to enhance export competitiveness, say 75 cents to the U.S. dollar. At such a value, Canadian goods-makers could keep selling abroad even in the face of a resource boom.

That policy, however, also throws out any ability of the Bank of Canada to control interest rates. In a fixed-exchange rate world, the sole goal of the central bank’s monetary policy would be to keep the loonie at 75 cents. There is little chance that any Canadian government would give up national economic sovereignty to fix an exchange rate. Moreover, Washington would never accept a Canadian dollar peg that was flagrantly designed to improve Canada’s manufacturing competitiveness at the expense of American companies. We would face all kinds of trade retaliation from the Americans were Canada to go down this road.

The second way to combat Dutch disease is to establish a large sovereign fund that would hold oil revenues offshore, bringing them into Canada gradually to “sterilize” them, which in theory should ease upward pressure on the loonie. Even abstracting from the highly divisive regional politics of creating an offshore fund designed to help Central Canada’s manufacturing industry at the expense of Western Canada’s resource industry, it is hard to see how such an instrument could even work technically in today’s world of massive, hyper-fast financial flows.

A third strategy for alleviating Dutch disease is the development of an activist industrial policy aimed at improving manufacturing productivity. A national industrial policy, however, would take such a long time to have a measurable effect on a manufacturing sector suffering Dutch Disease that the patient would probably be dead before the disease was cured. Worse still, if “industrial policy” turned out to be just a euphemism for protectionist measures, like tariffs or non-tariff barriers, the program would provoke so much trade retaliation that any beneficial effect on the economy would be totally nullified.

The final way to fight off Dutch disease is to impose much higher taxes or royalties on the extraction of the oil, coupled with severe restrictions on foreign ownership of Canadian resource companies and assets, thereby reducing the sector’s value, which would cause the dollar to depreciate. It is a strategy otherwise known as “making Canada poorer,” and would have all of the political appeal that slogan implies.

Canada may or may not have Dutch Disease. The disease itself might not even exist — many Dutch economists don’t believe the Netherlands actually ever had it. But, if we have caught this insidious virus, Canadians need to understand that it is kind of like a bad cold. There is no reasonable cure; you just have to let nature run its course.