What is Dutch Disease, and How To Cure It

CAW.ca – Facts from the Fringe – No. 240
April 16, 2012.    by Jim Stanford, Canadian Auto Workers

About a decade ago, Canada’s economy began heading in a distinctly different direction. The extraction and export of largely unprocessed natural resources became, not for the first time in our nation’s history, the primary driving force in our economic, political, and even environmental development.

Traditionally, Canadian policy‑makers were preoccupied with escaping our status as a supplier of natural resources and commodities. A series of proactive policy efforts aimed to allow Canada to overcome its role as a “hewer of wood, drawer of water,” and helping us emerge as a full‑fledged, diversified, industrialized economic power in our own right. And in the first decades after World War II, Canada made considerable progress in this regard. By the turn of the century, well over half of our total exports consisted of an increasingly sophisticated portfolio of value‑added products (including automotive, aerospace, and telecommunications equipment); and Canadian firms and tech‑nology were increasingly recognized around the world.

That historic trend was reversed, however, beginning around the turn of the century. Since then, driven by various factors (some global, some national), resource industries have become ascendant once again in setting Canada’s overall economic and policy direction.  Resource industries have grown (led by enormous expansion in the petroleum sector, centred on Alberta’s oil sands), and most of their output is exported in raw or barely processed form. Other export‑oriented sectors of the economy have contracted in both relative and absolute terms. In part, they have been “squeezed out” by the macroeconomic side‑effects of the resource boom. (Some economists call this “Dutch disease,” named after a similar reorientation that occurred in the Netherlands following the discovery and exploi‑tation of that country’s North Sea petroleum resources in the 1960s and 1970s.)

This structural shift is profoundly remaking Canada’s economy, our role in the world, and indeed our very federation. Yet apart from occasional bursts of rhetoric (such as followed the recent public exchange between the Premiers of Alberta and Ontario), it has been the subject of relatively little careful analysis. Moreover, while powerful market forces have certainly contributed to Canada’s increasing resource‑dependence, this remaking of the national economy is by no means inevitable or “natural.” Canadians should think carefully about the costs and benefits of this historic shift in our national economic direction, and make the most of our ability to influence the course of our own economic destiny.

A number of key economic indicators testify to this conclusion that Canada’s economy has been heading in a very different structural direction:

* Natural resource production and export has expanded strongly ‑ especially petroleum, and especially from Alberta’s oil sands.

* Manufacturing output and employment has sharply declined.  Some 600,000 Canadian manufacturing jobs have disappeared since the turn of the century.

* Canada’s currency has appreciated dramatically, rising 60 percent in value against its U.S. counterpart over the last decade.

* Canada’s overall trade balance has deteriorated. The growth of resource exports has been inadequate to offset the decline in other exports (such as manufacturing, tourism, and services).

* The economy has experienced a broad shift from tradable to non‑tradable sectors, so that exports in general constitute a significantly smaller share of total production than a decade ago.[1]  This both reflects, and reinforces, the deterioration in national trade performance.

* The shift to non‑tradable sectors, the loss of high‑productivity manufacturing jobs, and the structural deterioration in our exports have all contributed to the worst decade of productivity growth in Canada’s postwar history.

* Economic and fiscal gaps within Canada have widened considerably. In 2005, Newfoundland’s GDP per capita exceeded the Canadian average for the first time in history ‑ and the next year, Ontario’s fell below the national average, also for the first time in history. Since 2006, then, there have been three “have” provinces: those which produce oil (Alberta, Saskatchewan, and Newfoundland & Labrador).

All other provinces are “have‑not” provinces, and the erosion of national fiscal federalism (due to simultaneous reductions in federal social programs, transfers, and taxes) has meant that those interprovincial gaps are showing up increasingly in major differences in economic and social conditions.

The appreciation of the currency is both a consequence of this resource‑led reorientation of Canada’s economy, and rein‑forces the broad structural trend. International organizations (like the Organization for Economic Cooperation and Development [2]) estimate that the “fair value” of Canada’s currency is about 81 cents U.S. (according to purchasing power parity, or PPP, standards). In the 1990s, Canada’s currency traded for well under this level, making Canadian costs and the prices of Canadian‑made products and services seem highly attractive to international consumers and investors. As currency traders came to associate Canada’s currency with the price of oil (rightly or wrongly), however, this advantage was lost. The dollar began to rise quickly, shooting through its PPP benchmark, and reached par with the U.S. dollar by 2007, where it has fluctuated since. At that level, our currency trades at about 25% more than its PPP fair value ‑ which means that Canadian‑made products and services seem 25% “too expensive” relative to their actual value. This has negatively impacted manufacturing, but also every other non‑resource traded industry (including tourism, and tradable services like transportation and business servic‑es). Indeed, some non‑manufacturing export‑oriented sectors (like tourism) have been harder‑hit by the dollar’s overvaluation than manufacturing. Claims that the effect of overvaluation will disappear over time as companies “adjust” (including by investing in more capital equipment) have not been borne out. Only resource industries have been largely insulated from the impacts of the dollar’s overvaluation. The dollar is the most important channel through which “Dutch disease” symptoms are felt, but it is not the only channel.[3]

Obviously, significant economic opportunities have been generated by the surge in resource extraction and export industries in Canada. The petroleum extraction industry directly employed 54,000 Canadians in 2011 ‑ up 18,000 since 2000. Directly, then, the oil and gas sector’s expansion offset only 3 percent of the net jobs lost in manufacturing in the same period. Indirectly, of course, there are other spin‑off opportunities ‑ concentrated most visibly in oil‑producing regions, but some of which are experienced more broadly across the country. Those opportunities, however, must be measured against the costs and consequences of the resource boom, including its economic, social, and environ‑mental side‑effects. Given the overall deterioration in labour market, productivity, and international trade indicators that has been associated with the resource‑driven restructuring of the national economy since the turn of the century, it is hard to avoid the conclusion that this overall trend has been negative for Canada as a whole.

The challenge facing policy‑makers is to maximize the long‑run, sustainable benefits to Canadians of resource development, and minimize its costs. This means leaning into the winds unleashed by powerful and profitable resource extraction op‑portunities, to ensure that these developments are managed in a manner consistent with Canadians’ long‑run economic, social, and environmental well‑being ‑ rather than simply endorsing the present, largely unmanaged trajectory as somehow optimal (and loudly condemning any critics of that trajectory as “unpatriotic”!). Many policy tools are available to tackle this task of managing the structural changes in Canada’s economy, in order to avoid Dutch disease symptoms, maximize the benefits of resource developments, and minimize their costs.

One especially promising set of policy measures includes proactive efforts to support investment, employment, innovation, and exports in targeted high‑value sectors of the economy. This broad policy envelope is best described as “Sector Development Policy.”[4] The purpose of this paper is to consider the sorts of sector development policies that could be invoked in order to reduce the symptoms of Dutch disease which have become increasingly visible over the past, resource‑led decade.

The general goal of sector development policy is to attain a more desirable sectoral mix in the economy, winning a greater share of output and employment in identified high‑value or “strategic” sectors than would otherwise be the case. Sector development policy has been historically important in Canada, given our ongoing national challenge to escape the “staples trap,” and become more than just a resource‑supplier to other countries. We need more industries that add value to our resources (rather than exporting them in raw form); that generate more high‑income, high‑quality jobs; that embody technology and innovation; and that contribute to greater suc‑cess in world markets.

These policies, and the fiscal tools that could fund them, formed part of the 2012 Alternative Federal Budget (published in March by the Canadian Centre for Policy Alternatives). A stand‑alone paper describing the rationale for sector development policy, and the AFB’s proposals in that area, is available at http://www.policyalternatives.ca/publications/reports/cure-dutch-disease.

JS/kvcope343

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[1] Measured as a share of GDP, total exports of goods and services have declined by about one‑third: from 45 percent in 2000, to under 30 percent ten years later. This is an imperfect measure of export intensity (since exports are a gross measure, and GDP is a value‑added measure, hence exports double‑count the value of imported inputs embodied in them), but it is nevertheless a useful indicator of the broad trend.

[2] “Purchasing power parities for GDP: National Currency Units per U.S. Dollar,” Economics: Key Tables from the OECD, Table 11, January 2012,
< http://www.oecd-ilibrary.org.libaccess.lib.mcmaster.ca/docserver/download/fulltext/190200031x1t004.xls?expires=1331138560&id=id&accname=guest&checksum=F1BF43AD3605C62AF48C80A582B24CC2 >.

[3] Even without a fluctuating currency, a country could experience Dutch disease symptoms resulting from the rapid development of resource exports, through the workings of factor markets, price differentials (especially prices for traded and non‑traded output), and other mechanisms.

[4] In previous times it was called “industrial policy,” but that term implies an undue focus on heavy manufacturing industry, whereas the sorts of policies described here (and the sectors where they can be productively applied) cover a broader range of sectors, including some tradable services industries.

< http://www.caw.ca/en/10869.htm >

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