Dollar Dis-ease

When it rains, it pours

“Dutch disease” is one of the several phenomena in economics that confirm the idea that one can, indeed, have “too much of a good thing.” When most people think about the economy, they are usually interested in the challenge of managing scarcity. How to grow and produce more wealth so that people’s lifestyles can be improved.

Generating economic growth is no trivial task. It requires coordinating activity across huge scales, making sure resources find their way to where they are most useful. But it’s easy to forget that managing excess is just as important as managing scarcity, and sometimes it can be even trickier if you want growth that is sustainable.

Every once in a while, a society might get lucky and find a huge reserve of a valuable natural resource on their land. It could be in the form of oil, natural gas, or some other such commodity. Dutch disease describes what happens when that excess is not managed well (we recently covered a different kind of “disease of excess” — runaway productivity growth — in our profile of economist Bruce Greenwald).

The phenomenon gets its name from observations of the Dutch economy immediately after the discovery of huge natural gas fields in the mid-1950s. What should have been a boon for the economy somehow marked the beginning of a steep decline in the country’s manufacturing base.

In 2019, Financial Times contributor, Brendan Greeley, published a piece where he claimed that the U.S. actually suffered from a unique form of Dutch Disease. The commodity that distorted America’s economic picture wasn’t a natural resource, but rather the U.S. dollar.*

To understand Greeley’s hypothesis, we need to first understand the mechanics of the disease…

How Dutch Disease works

When a society discovers a huge reservoir of a valuable commodity in their territory, the economy can be divided into three sections — 1) “lucky” tradable sector, 2) “unlucky” tradable sector, and 3) the non-tradable sector.

The “lucky” tradable sector is comprised of all the various businesses and institutions that are directly connected with the production, refinement, and selling of the newly discovered commodity. It is considered “tradable” because the commodity can be exported to other societies that have a demand for it.

The non-tradable sector is comprised of all the various goods and services that are generally not conducive to export, like education, healthcare, hospitality, etc. And the “unlucky” tradable sector is comprised of the various businesses and institutions that can export their goods but don’t deal directly in the newly discovered commodity.

It is unlucky because it is no longer favored as a destination for financial or human capital which will be diverted to the lucky sector. It is just easier to make profits when you are dealing in a commodity that is globally scarce, but where you have an abundance; and capital will always flow to the least risky returns.

As the new commodity sector gets built out from the influx of capital and labor, it will begin selling its product internationally. This will cause a spike in demand for the country’s currency, causing appreciation in the value of the currency.

For those in the lucky tradable sector, this is an amazing windfall. They are in an expanding and profitable business and the value of the currency they are earning is growing on the international stage. They become increasingly rich.

The non-tradable sector also benefits as the people in the lucky sector start paying more for their services. The non-tradable sector slowly starts to shift its business models to cater to this new, affluent clientele.

The unlucky sector, however, is not so…lucky. This explainer on Dutch Disease from the IMF, which uses oil as the newly discovered commodity, explains it succinctly.

“[R]esources (capital and labor) would shift to the production of domestic goods that are not traded internationally — to meet the increase in domestic demand — and to the booming oil sector. Both of these transfers shrink production in the now lagging traditional export sector. This is known as the resource movement effect.”

The shift in resources towards the lucky sector and the appreciation of the currency are the immediate symptoms of Dutch Disease. These go on to produce disastrous effects for the unlucky sector if the situation is mismanaged.

Just as the lucky tradable sector benefits three times over — from the easily expanding sales through exports, growth in the exchange rate value of the domestic currency, and influx of capital and labor into the sector — the unlucky tradable sector loses twice over — from the loss of capital and labor and non-competitiveness of its exports due to the increased exchange rate. While the value of the currency they do earn is higher, they struggle to sell their inventory.

This process is self-reinforcing. As more people see the relative lucrativeness of the lucky sector, more capital and labor will flow in that direction. The unlucky sector loses talent and resources over time and continues to lose market share for its goods in international markets.

The sudden success of the lucky sector effectively caps the growth potential of the unlucky sector.

Inequality between those engaged in the lucky sector and those in the unlucky sector expands. Inflation in domestic services — the non-tradable sector — starts to grow. While those who became rich from the natural resource discovery can afford these services, those who are locked into the unlucky sector find it increasingly difficult to secure the same level of healthcare, education, and financial services as others. The non-tradable sector begins to shift towards catering to those in the lucky sector because that seems to be where the money is.

It’s clear that the above sequence of events does not reflect an economic process that most people would call “healthy.” Yet, the behavior that is described is perfectly rational from the perspective of the individuals making the decisions. It makes financial sense for capital to flow into the lucky sector to capture the newly discovered wealth. It makes financial sense for individuals to shift their careers to this sector as they see the opportunity for greater salaries and career advancement. It makes financial sense for those engaged in the non-tradable sector to shift their businesses towards catering to the burgeoning lucky sector and to raise their prices when they see a customer base that can afford it.

But these natural market forces lead to social chaos down the line. Unfortunately, it is often unrealistic to expect people to make personal sacrifices in the short term to preserve broader social harmony over the long term. So it falls on policy makers to craft industrial policies that manage these excesses of wealth. And this, too, is by no means easy.

The ‘exorbitantly privileged’ sector

In his FT post, Brendan Greeley makes the claim that the dollar is the “natural resource” which America has in abundance and we are suffering from a unique form of Dutch Disease as a result.

“So let’s go back to the original research on Dutch disease. We have a basic model of an economy where the export of a single commodity raises the exchange rate, discouraging the export of manufactured goods. If the commodity is the dollar, then demand for the dollar raises the value of the dollar itself — this isn’t too hard to wrap our heads around, and since 1980 the dollar has appreciated, even as the US has declined as a share of global GDP. We’d expect to see inflation in non-tradable services, like medical care and college tuition, but not in tradable goods, like t-shirts and TV sets. And we’d expect a decline in the value added to GDP from manufacturing. None of these are dispositive, and Alphaville is sadly not an econometrician. But they have all happened.”

Of course, the U.S. government has a natural advantage in the production of dollars. As Greeley notes:

“The US is not the only producer of dollars. It’s possible to create dollar-denominated assets outside the US…But America is the dominant producer of dollars. In oil, they’d call it the “swing producer.” Basically, around 1980 the United States discovered that it was the Saudi Arabia of money.”

Interestingly, Greeley notes that America stumbled onto this realization almost by accident in the 1980s. After the US dropped the dollar’s peg to gold in the 1970s, it quickly realized that central banks and other institutions around the world still had a strong desire to hold dollar-denominated debt, even though the dollar was no longer tied to the precious metal. This cleared the runway for deficit expansion and dollar dominance. What French president Charles De Gaulle had once called America’s “exorbitant privilege” continued to assert itself.

Greeley then runs through a checklist of Dutch Disease “symptoms” to see if they can explain the condition of the U.S. economy. He finds several concerning signs, both in the economic data and in the behavior of political institutions, that match with many academic findings around the effects of Dutch Disease.

In Part 2 (coming soon…), we will also run through a checklist with a focus on the economic symptoms we’ve discussed above and see if a cursory survey of the data corroborates Greeley’s diagnosis. We’ll also look at some contemporary discussions surrounding the dollar’s role in the global economy, which have flared up recently due to the difficulties in the U.S. banking sector and major shifts in geopolitics.

*Obviously, a currency isn’t exactly like a natural commodity. Natural commodities are made scarce by natural laws whereas the supply of a currency is determined by the decisions of governments and financial institutions. It is possible that the Dutch Disease model could fail in perfectly explaining the U.S. economy because of these subtle differences between a currency and a natural resource. The goal of Part 1 was to introduce Greeley’s hypothesis, lay out the general Dutch Disease framework, and suggest how it might explain parts of the U.S. economy. We’ll try to interrogate the metaphor a little more closely in Part 2.

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