The Misery of the “Dutch Disease and Deindustrialization” Argument

High commodity prices, abundance of liquidity, and sustained growth in Asia: all factors of good luck in the current foreign environment of Latin America, right? Not quite, according to frequent references to “deindustrialization” and “resource curse” afflicting the region as features of the international labor division that has been consolidating along the current world economic cycle.

This pessimistic view has two components. One relates to the structural downward move of the price of labor-intensive goods and services relative to natural resource-based ones and the associated geographical dislocation of manufacturing activities toward Asia (either in relative or absolute terms), combined with increased natural resource-linked activities in Latin America. On the same direction, a second strand of “bad luck” arguments alludes to a kind of “Dutch disease” contracted by Latin American economies in the current cycle. The substantial increase of value of exports of natural resources, in conjunction with the liquidity glut abroad and huge capital inflows would be generating insurmountable pressures toward overvalued local currencies, and a corresponding second round of deleterious effects upon domestic labor-intensive production.

Those who characterize this double trend as intrinsically negative express a view that the specialization in natural resource-based production is necessarily harmful to development in the long run. In our view, both lines of arguments often convey an ungrounded prejudice in terms of sector analysis, potentially leading to a mistaken policy agenda if taken for face value in the usually superficial manner with which they are formulated.

Let us recall the concept of “Dutch Disease”. The term appeared for the first time in an article in the November 26, 1977 issue of the The Economist magazine. It referred to Holland’s discovery of natural gas in the North Sea in the 1960s, and how the real appreciation of the Royal Dutch as a consequence of increased exports contributed to a decline in the local manufacturing production. Since then, the expression has been used whenever one sees harmful consequences of discoveries – or sudden upward revaluations – of exported natural resources in developed and developing countries alike.

The theoretical argument about the ultimate effects of such discoveries or permanent revaluations of domestic natural resources on the local GDP composition and labor allocation – after full adjustment in both goods and labor markets – is clear-cut. Independently of whether nominal exchange rates are fixed or flexible, as well as of whether or not domestic aggregate demand is continuously fine-tuned to keep the local price index stable, any substantial and prolonged surge in export revenues of a limited set of goods tends to rob labor and capital from other tradable sectors. See Deindustrialization and the Dutch Disease regarding the different channels by which the Dutch Disease may inflict the competitiveness of other existing activities in the economy.

In order for such a blessing by nature to be ironically treated as a “disease” in Latin America, amplified by the huge extension of low-cost labor-intensive production in Asia, one has of course to state why it entails negative effects for the region’s income growth, levels or quality of employment, etc. despite improved terms of trade. And at this juncture of History and knowledge one has to go much beyond the outdated generic contraposition of “primary products” versus “manufacturing”, as it was the case at the time of the old-fashioned Prebish-flavored controversies. Furthermore, let me take as reasonably evident that in the long run the system of prices and the corresponding adjustments prevail upon “structural rigidities” in factor and product markets. It does not suffice simply to proclaim that natural resource-based patterns of specialization are intrinsically inferior to manufacturing-based ones!

This falls far short from saying that “patterns of specialization do not matter”, as traditional trade theory has predominantly led us to think. We suggest here two recent papers that take stock of theoretical arguments and empirical evidence favorable to two key propositions that contrast with what most conventional trade models convey: firstly, different patterns of specialization do affect future growth of individual economies (Hausmann, Hwang and Rodrik), and secondly, such patterns are “sticky” and tend to exhibit path-dependence and differing degrees of scope for evolution, diversification, and technological change (Hausmann and Klinger).

Nevertheless, one should not incur in a mistaken full-of-prejudice association between natural resource-based products and low requirements in terms of technology and skilled labor. Take for instance the case of agro-energy (biofuels) or soybeans in Brazil, where the bioengineering of seeds and the diffusion of computer-aided weather and soil analysis have been at the core of astounding high rates of productivity increases. Besides those backward linkages and in-house technological requirements, that progress generated favorable inducements forward (as e.g. new flexible sugar-ethanol mills close to crop sites and new flex-fuel ethanol-user vehicles). 

Think also of Brazilian savannahs (“cerrados”), which have become fertile areas as a result of agricultural research, whereas they were considered as desert-like zones not long ago. The fact is that the “discovery” and incorporation of “cerrados” as natural resources has been made feasible by both the dynamism of agricultural markets abroad and technological change, and it has crowded-in capital accumulation, rather than stolen factors of production from more prosperous activities. One should also keep in mind the indirect positive effects that such a “discovery” brought to other activities, by e.g. helping decrease levels of the country risk premium.

Nor it is appropriate to identify the mere presence of manufacturing activities with automatic progress, even when these activities include unskilled labor-intensive segments of production chains in industries classified as “high-tech”. If human and physical capital accumulation, as well as local mastery of technology, does not evolve accordingly, a country may get stuck in producing low technology, low skilled-labor manufacturing activities.       

The bottom-line is straightforward: instead of playing with protectionist measures to halt what is taken as “Dutch disease” and mischievous deindustrialization forces, Latin American economies might better focus on mitigating the real diseases, i.e. low levels and quality of education, insufficient capillarity of science and technology in the production system, dead-weight inefficiencies and lower private willingness to invest derived from institutional failures in the business environment, lack of fiscal space for public investments in infrastructure and other structural malaises.

7 Responses to "The Misery of the “Dutch Disease and Deindustrialization” Argument"

  1. Nouriel   July 23, 2007 at 4:33 pm

    Otaviano, a very interesting piece that refutes ongoing concerns about Dutch Disease and excessively overvalued currencies.  But here two questions, the first of which i already asked Mark Turner in his recent blog on Peru:  1. It looks like – as you also suggest – that the new comparative advantage of Latin American economies is in resources: they can grow fast if they invest in such resources as commodity prices are now so high and expected to remain high. But such resorce intensive sectors are often capital intensive (mines, energy, etc.). Thus high growth from resources may not trickle down to the masses; thus inequality of income and wealth may persist in spite of high growth and lead to social unrest unless fiscal policy has some redistributive role. Is this argument correct or not?  2. If we take your argument literally Brazil, Colombia and other Latam economies should not prevent the nominal and real appreciation that is accompanying the recent high commodity prices, increases in terms of trade and capital inflows. So any forex intervention to slow down such appreciation should be avoided as there is no Dutch Disease to worry about. Do you agree? Should they all stop intervening and allowing the resulting exchange rate appreciation? At which point – if any – that would hurt manufacturing exports? Or there is not issue at all with that?

  2. JohnH   July 23, 2007 at 7:51 pm

    As you say, “Latin American economies might better focus on mitigating the real diseases,” which you enumerate.  Why not also fully exploit a nation’s comparative advantage by encouraging the advantaged industry to vertically and horizontally integrate into related activities? One of the reasons Norway is regarded as a model petro state is that it insisted that multinationals transfer technology to it. And then Norway went beyond being a supplier of oil to having a world class company, Statoil, that competes in exploration and development and in many other areas. One of the problems with Latin America’s resource industries, starting with the Spanish and Portuguese colonization, is that much of the value added from resource industries was realized outside Latin America. Keeping it at home creates businesses, generates high value employment, and establishes a solid tax base. But it probably won’t win friends in Washington.

  3. Mark Turner   July 24, 2007 at 1:30 pm

    Correct me if I’m wrong fellowbloggerOtaviano, but the best way to avoid dutch disease is to move to a second phase of growth via capital investment in value-added products (eg Argentina builds itself a shoe factory or two and stops selling leather to Brazil who then sells shoes to Argentina….a hundred other examples available). In this way GDP growth is maintained when the growth spurt in the (dare i say the word) primary industry reaches maturity.  Thus your argument at the bottom of the note (paragraph beginning “the bottom line..”) is a slight self-contradiction, is it not? Your proposals are the same things that avoid dutch disease from spreading in the first place!  I expect (and probably deserve) a thwack on the head due for my insolence.

  4. Otaviano Canuto   July 24, 2007 at 9:17 pm

    Nouriel  1. I think your argument about the likely income-distribution implications of a capital-intensive pattern of growth in poor countries is correct. But notice that this is more the case with mineral resources than with agro-industry: modern and competitive agriculture is nowadays one component of a cluster of activities that range from manufacturing to high-tech services. It all depends on whether the exploitation of resources occurs as part of a whole value chain (including backward and forward linkages) or as a stand-alone activity (without the vertical and horizontal integration – referred by JohnH in his comments – that was a key element of the Nordic countries’ successful natural resource-led industrialization). As far as income and wealth inequality is concerned, and the associated risks of social unrest: the redistributive role of fiscal policy will have to stay with us in Latin America for at least a generation, with or without higher growth, until hopefully a generational change in the level of education of the masses takes place. The social legacy of the region’s past will remain a burden for many years…  2. The best thing to do while the current long upward phase of the commodity-price cycle does not turn down is to pile up reserves (up to a threshold, at least) and, if possible, reduce domestic real interest rates. In the meantime (before there occurs the expected reversal of hot money inflows), cold blood… and speed up reforms that can mitigate the Asian impact on manufacturing! Ad hoc economic measures have a long sad history in the region and we should avoid them as much as possible.  JohnH  You are right wihen you argue that what makes a difference in the case of natural resources is the extent of local vertical and horizontal integration. But rather than emphasizing the nationality of ownership of resources, I would highlight local investments in education, physical and social infrastructure, applied research, institutional improvement enhancing local financial markets and investment funding etc. Local private owners or even state-owned companies are no guarantee of a trickle-down…  Fellow blogger Mark  I have to acknowledge “Touche'” when you say that if the reforms mentioned in the last paragraph were in place, there wouldn’t be a Dutch disease to start with. Maybe I should rephrase my argument in the following: the Asian challenge is just making the absence of those reforms an even more lethal feature…

  5. Mark Turner   July 24, 2007 at 9:44 pm

    “….the redistributive role of fiscal policy will have to stay with us in Latin America for at least a generation, with or without higher growth, until hopefully a generational change in the level of education of the masses takes place. The social legacy of the region’s past will remain a burden for many years….”  A standing ovation. Beautifully put. I doff my cap.

  6. JohnH   July 25, 2007 at 10:28 am

    “I would highlight local investments in education.” I agree. And the best education is technology transfer, so that local people perform the high value tasks often outsourced to places like Houston and New York. Once people have leading edge skills and technology, they are in a position to start creating businesses in areas related to the country’s comparative advantage.   Simply having an educated workforce in no way means that foreign resource companies will choose to perform the highest value added functions locally or that they will chose locals to fill those jobs. Nor does it mean that locals will ever be able to develop the highly specialized skills needed to create businesses in related areas that fully exploit a nation’s competitive advantage.

  7. Shigeo Shiki   May 22, 2013 at 7:38 am

    Otaviano, you´re right about "Dutch disease" and deindustrialization in Brazil, but your arguments weaken when you point the bottom-line as Turner comments: we do have to integrate horizontally and vertically our resource-based and manufacturing industries with policy measures you indicate, which I fully support.