RE: Origins of 'Dutch Disease'

["Devine, James" <jdevine@xxxxxxx>]

Rob Schaap forwards the following web-page on the "dutch disease." And, I
was right, it wasn't oil but natural gas.

http://www.aims.ca/Publications/gift/remittance.html

here's the text, without graphs:


Looking the Gift Horse in the Mouth:
The Impact of Federal Transfers on Atlantic Canada
by Fred McMahon
AIMS Senior Policy Analyst

[query: what is AIMS?]

- Chapter 2 -
The Remittance Region:
Dutch Disease and the Atlantic Ailment

[T]ransfer payments have in one form or another have never lived up to
expectations in terms of creating a more self-reliant economy. Why this is
so is not clear because of the nature of the data. There is an obvious need
for more research in this area. (Savoie and Winter, 1993, pg. 8)
Beginning in the late 1960s, the Dutch economy was damaged by what should
have been good news -- the discovery of natural gas in the Slochteren
offshore fields. Offshore revenues did not increase the economy's
productivity, but the inflow of these revenues led to an appreciation of the
guilder; 8 the price of domestically produced goods rose relative to the
price of foreign goods, a deviation from purchasing power parity. Dutch
exports were suppressed and imports replaced domestically produced goods;
output and employment fell, particularly in the trade-oriented sectors of
the economy.

This phenomenon came to be known as Dutch disease. Dutch disease can be a
particularly debilitating economic malady because of the crucial role the
trade sector plays in economic growth. A version of Dutch disease can be
traced back to the 14th century when the influx of new world precious metals
had a similar impact on Spain's key cloth and cereal industries, though
their decline was hastened by a number of other counterproductive policy
moves on the part of the monarchy. Britain's North Sea oil discovery had
something of the same consequences for the British economy, although oil and
gas exports represented only a small part of Britain's GDP. Nonetheless,
some of Britain's economic stagnation in the 1970s may, in part, be traced
to the rise of offshore revenues; declines in oil prices may have been
partly responsible for the economy's renewed strength in the 1980s.
"Analysts were puzzled by the combination [in the 1980s] of an apparently
healthy British economy (particularly in the export sector), large capital
outflows, and a pound at record lows against the dollar"" (Yarbrough and
Yarbrough, pg. 632). 9

The inflow of funds due to a petrochemical bonanza is comparable to an
inflow due to net government regional subsidies, or virtually any other type
of inflow where the largest part of the inflow is unrelated to the
productive aspects of the economy. 10 (This is particularly true of
petrochemical money in times of suppressed supply, when price is unrelated
to and far exceeds the cost of production, producing wind-fall revenues for
the producing country which flow into the country both through the profits
of the producers and through tax revenues.)

Winter (1990), while not referring to Dutch disease, showed how a similar
mechanism was at work with regional subsidies. His insight was
straightforward and intuitive. One can visualize, he says, the flow of
regional subsidies into the region as a flow of goods and services. This
goes a long way to explaining the negative impact of regional subsidies. As
Winter says, "You can imagine the impact on a dairy farmer in this region if
Ontario decided to supply us with free milk."

In other words, as noted in the previous chapter, the flow of money into the
region in a pure accounting sense must go to buy goods and services produced
outside the region and this suppresses demand for locally produced goods -
the Atlantic Ailment. In a nation with its own currency, the balance between
financial and product flows works through a currency appreciation, which
makes imports more competitive than many domestically produced products. The
fact that the same balance is required in the face of massive regional
subsidies leads to a strong prediction that increases in regional subsidies
of the magnitude under consideration must be accompanied by an increase in
relative pay rates. The prediction is precisely borne out by the data. Graph
5 shows that Atlantic Canadian relative pay rates moved sharply upwards in
the early 1970s coinciding with the rise in regional subsidies. (Consistent
data for Graph 5 is available only to 1982; see also Graph 7.)

The mechanisms leading to higher relative wages are not difficult to
understand. Courchene (1995, pg. 125) estimates that total federal transfers
equal at least 50 per cent of all wages and salaries for each of the
Atlantic provinces, save Nova Scotia, where the total is in the mid-40 per
cent range. The profusion of government work, government subsidized work and
make-work programs effectively subsidized by unemployment insurance would
force local employers to raise pay rates to compete with these alternatives.
As well, by increasing the regional endowment of wealth, the relative value
of leisure increased.

Mansell and Copithorne (1986) and Vanderkamp (1986) provide an overview of
the literature on the impact of federal programs, particularly UI, on wages
in Atlantic Canada; the DRM Advisory Group study on export oriented firms
(1994, pg. 207) cites "wage rate and other forms of government competition"
as a factor weakening the region's ability to export. (See Chapter 3 for a
brief discussion of wage pressures and the existence of "voluntary"
unemployment implied here.)

Chapter 1 discussed the fact that Atlantic Canadian producers were unable to
pass rising wages on to prices. Squeezed between rising wages and price
resistance, standard economic theory would predict that regional employers
would be forced to reduce employment. This contention is well supported by
the data. The gap between Canadian and Atlantic Canadian unemployment rates
doubled in the early 1970s and the number of hours employed Atlantic
Canadians worked weekly declined relative to the rest of the country. (See
Graphs 5 and 6; consistent data for Graph 6 is available back only to 1966.)
Not all transfer programs are equal in their impact. This research examines
the whole package of regional subsidies, but it is highly likely that the
unemployment insurance program - which is an important component of regional
subsidies and offers extended benefits in Atlantic Canada - is
disproportionately responsible for the labour market impact, though other
regional subsidies certainly played a role. UI subsidized long periods of
unemployment, enabling workers easily to trade off work for leisure; it
supported part-year employment industries; and it allowed workers to
lengthen their search time. There has been excellent research done on the UI
program, in particular its negative impact on regional employment; see in
particular May and Hollet (1995) and May and Gunderson (1996). As Vanderkamp
(1986, p. 100-101) notes:

Suppose that an industry has been hit by an unexpected decline which will
produce a 50 per cent reduction in output and employment unless there is a
dramatic lowering of the wage rate. For the typical worker, a six-month
layoff will still generate 80 per cent of the normal annual income before
tax (with 60 per cent unemployment insurance replacement), and the after-tax
situation is likely to be better. Moreover, the six-month layoff may be
worth something in terms of leisure and related activities. As a result wage
reduction is likely to be unacceptable ....

As regional subsidies were reduced in the 1980s, relative regional pay rates
moved downwards, but only with a lag. (See Graph 7; Statistics Canada data
calculations were changed in 1983 and, rather than artificially trying to
join the differing series, I thought it more accurate to show the series
separately.) Many economists believe pay rates are far stickier downwards
than upwards, and this may help explain the lag.

More troubling, the gap between Atlantic Canada's and Canada's unemployment
rates has not narrowed with the decline in regional subsidies. This may be
because a) the most serious labour market distortions, those created by UI,
have not been subjected to serious reform, at least until the recent
Employment Insurance reform package, though many argue these reforms are far
from adequate, and b) many economists believe that once unemployment rates
are increased - even if by apparently temporary factors - there is a
tendency for unemployment to stick at a higher level for at least a time,
though it is well beyond the scope of this work to review this voluminous
and controversial literature.

The discussion of wage rates in Atlantic Canada leads to another prediction
with even more negative consequences for the region. Put very loosely, the
theory of factor price equalization, as it relates to labour and capital,
states that a poor region with low pay, excess labour, and low capital
intensity will attract additional capital due to the potential savings on
labour costs. Price of labour, wages, is equalized among regions. The
problem for this region is that artificially inflated wages would lead to
the prediction that movement of capital to the region would be discouraged
as wage rates rose. Again, this prediction is supported by the facts. (Graph
8 shows the development of business capital spending over the full period
under consideration; Graph 9 shows capital spending in relation to the wage
and earnings series-consistent data for these labour series is available
only between 1961 and 1982.)

The gap in per capita business investment between Atlantic Canada and Canada
was narrowing in the 1960s, though the graph seems to suggest some cyclical
component. This cyclical component may be partly responsible for the
narrowing in the late 1960s. Nonetheless, after the dramatic rise in
regional subsidies and the region's relative increase in wages, the gap
between regional and national per capita business investment doubled on
average. It's troubling that the gap did not decline in the 1980s but some
of the wage stickiness discussed earlier may be at work, and it is also
possible that the graph does show evidence of a secular decline in the gap
in the late 1980s.

Government investment in Atlantic Canada has been above the national average
for most of the period. (See Graph 10.) However, on a per capita basis the
gap favouring Atlantic Canada in government investment is minute compared to
the gap in business investment. (See Graph 11.) And, while much government
investment doubtless went to worthwhile infrastructure projects, there is
little evidence that government infrastructure grew more dynamically in
Atlantic Canada than in the rest of Canada during this period. The lack of a
twinned commercial highway through the region by itself suggests this. Much
of what was entered as government investment went to overbuilding fishing
industry infrastructure, to the support of declining industries, and to what
would be better described as make-work projects. It is beyond the scope of
this work to investigate in depth what government entered as investment on
its books, but this certainly would make an interesting topic for future
research.

This chapter has outlined how the massive increase in subsidies in the 1970s
might be expected to suppress economic growth through what might loosely be
termed an "appreciation" effect. A number of predictions fall out of this
analysis and they are consistently borne out by the data: relative economic
growth rates, net exports, pay rates, unemployment rates, hours worked and
investment levels all move abruptly and significantly in the direction and
at the time predicted.