The Dutch Disease

Table of Contents

Introduction        2

How does it create market failure        2

Factors which cause the Disease        4

Impact on exchange rates        5

References        6

Introduction

The Dutch Disease, refers to that conundrum which an economy faces when the discovery of a high potential industry leads to an overall decline in productivity as well as economic growth. The reason why this disease has been named so is that because in the 1950s, the Netherlands had discovered large reserves of natural gas, which was leading to an overall boom in the oil and gas sector but was leading to a decrease in productivity and revenue in other sectors (Iacono, 2018). There were many reasons which were put forward as part of this malaise. Many felt that the increasing strength of the currency was one of the main reasons why exports became more expensive imports became cheaper. This led to an overall decline in the economy even though the oil and gas sector was increasingly contributing higher levels to the economy. This then creates a specific situation in which the country is not growing however there are specific industries that are growing much faster than others (Liu & Yang, 2000).

How does it create market failure

The market failure which is mentioned as part of this malaise is caused by the imbalance between the international competitiveness of one sector against another. Market failure in this regard would mean that certain industries within the market has stopped growing which is now causing an overall failure in the market (Corden, 1984). This was experienced by the Netherlands in the 1960s and 1970s when overall economic started to falter. Even though the country was facing increasing contributions from the oil and gas sector, during 1973 and 1979 the unemployment rate of the country had increased from 1% to 5% (Taguchi, 2016). This was extremely worrying for the government as it did not understand why even though oil prices were significant the country was not going. That led the government to understand what were the reasons of the market failure and why is it that even though there are strong industries that are able to put forward the government in a strong position, they were not able to increase the overall growth which would be experiencing the economy.

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Figure 1: Example of market failure

The main reason why this has been seen to be is because of increasing exchange rates.  It is estimated that when there is a large increase in industry it can lead to an increase in the export potential of that product to other countries (Taguchi, 2016). When this production leads to a strengthening of the economy it can lead to an exchange rate which is much more competitive as compared to before. As is understood and economics, whenever the exchange rate rises it leads to exports becoming more expensive and imports becoming cheaper. Even though this reduces the overall import bill of the economy, it does not do much in trying to  increase the overall value of exports which are taking place. In the end, due to the weakness in exports and the strength in the imports, it can lead to a negative cash balance for the economy which is why disintegration takes place (Usui, 1996). All of this happens because the overall forex exchange rate has increased significantly leading to other industries to not being competitive on a global scale. This competitiveness is based on the idea that the foreign currency is leading to higher prices internationally for these businesses which then makes other countries much more meaningful and cheaper when doing business with.

Another reason which has been associated with the cause of market failure is the unnatural increase in money supply which takes place whenever foreign-exchange is converted into the local currency. When this foreign currency is being flooded in the domestic market it can lead to pushing up of prices in the domestic landscape. This is how the real appreciation of the exchange rate takes place which then makes the economy less competitive as well. Even though this can create market failures, many economists are of the opinion that there is nothing wrong with trying to look at competitive and comparative advantage and focusing on only those industries in which the country will have some sort of advantage. However, this does not make it any easier for companies that are looking to establish themselves during periods of high exchange rates, especially those that are export led.

Factors which cause the Disease

The biggest factor which causes this disease has to do with the real exchange rates. Real exchange rates are always the cause of the disease as these exchange rates make the exports of the company much more expensive as compared to other countries around the world (Paldam, 2013). This then may support the booming industry but has an adverse impact on all other industries that are relying on their pricing and the strength or weakness of the exchange rate to determine how many units there able to sell. Given the fact that the exchange rate overall increases in this scenario, it is the main factor which causes the disease leading to an overall decline in the economic health of the country.

Another major factor which has been identified to cause this disease has to do with the rapid increase in foreign-exchange which is being collected due to the industry. This large chunk of foreign-exchange is responsible for increasing the money supply in the long run which also has an impact on the real exchange rates (Liu & Yang, 2000). The central bank that also has to understand how this large reserves of foreign-exchange will impact the monetary policy that is trying to pursue which also has an impact on the inflation led policies which the government might have.