Recent years have seen a great deal of attention devoted to the allegedly harmful consequences of natural resource discoveries in developed and developing countries alike. Whether it is natural gas in the Netherlands, oil in the UK, Norway or Mexico, or minerals in Australia, such discoveries have been accused of causing structural problems almost as severe as the absence of indigenous resources has undoubtedly caused in less fortunate countries. These problems have even been given a name - the 'Dutch Disease' - which prompted The Economist to comment that 'to refer to a vast, valuable energy resource as the source of a disease is surely rather ungrateful'. This article gives an overview of some of the issues raised by academic research on this topic, especially that by CEPR Research Fellows.

Ultimately concern with natural resource discoveries arises from their effect on the competitiveness of existing activities in the economy. Established enterprises producing largely for the home market can pass on cost increases to their customers. In any case they are likely to enjoy an increased demand for their products as the income from the resource discovery is spent. Hence, the brunt of adjustment must be borne by the 'exposed' sectors of the economy: exporting firms and those subject to effective import competition. Since in many countries these sectors are largely synonymous with manufacturing industry, the essence of the Dutch Disease may be summarized as the tendency of natural resource discoveries to give rise to 'deindustrialization'. It is possible to identify at least three distinct channels by which this may come about.

The first channel has already been mentioned: to the extent that the extra income arising from the discovery accrues to domestic residents, they may be expected to increase their spending. The exposed manufacturing sector cannot use this extra spending as an opportunity to raise its prices, since it must contend with actual or potential foreign competition. By contrast, the extra demand for non-traded goods and services will tend to bid up their price. The result is a rise in the relative price of non- traded to traded goods or, as it is sometimes called, a 'real appreciation', which reduces the relative profitability of manufacturing industry. This tendency is likely to be exacerbated to the extent that a large proportion of the extra income accrues to the government in the form of tax revenue, since governments typically have a relatively higher marginal propensity to consume domestic goods. (It has been alleged that increased State spending in the Netherlands was the main source of the Dutch Disease on its home ground.)


A second and distinct source of pressure on manufacturing industry is the effect of the discovery on domestic factor markets. To some extent, manufacturing may compete directly with the resource sectors, although this effect is likely to be localized and confined to a few factors of production such as specialized labour skills. More serious is the fact that the exploitation of natural resources will itself place heavy demands on domestic goods and services. This places further pressure on their relative price, and so contributes to reducing the relative profitability of manufacturing.

Finally, the two channels mentioned so far apply when goods and factor markets are perfectly competitive. If, in addition, there are rigidities in the labour market or in domestic goods markets which prevent rapid price adjustment, a third source of pressure on the manufacturing sector may arise. It might be thought that this is unlikely to be a serious problem since the resource discovery places upward pressure on domestic prices. However, the key requirement for this to be the case is that domestic monetary policy be sufficiently expansionary to accommodate the extra spending induced by the discovery. If this accommodation is not forthcoming and if the country is pursuing a floating exchange rate policy, the resource discovery may induce a currency appreciation sufficiently great to put downward pressure on domestic prices and wages. If these are not flexible, the consequence is unemployment and a further squeezing of profit margins in the exposed sectors of the economy. In this scenario, a resource discovery can actually induce (at least temporarily) a recession.

So much for what may happen as a result of a natural resource discovery. The obvious question to ask is whether any or all of these consequences should be the concern of governments and, if so, what the appropriate policy response should be. At the outset, it is important not to be misled by the term 'disease'. Except for transitional unemployment, all the phenomena mentioned so far are simply manifestations of structural change, normal in a dynamic economy and essential if the fruits of progress are to be enjoyed. Admittedly, the scale and pace of adjustment following a natural resource discovery may exceed that likely to follow other sources of structural change (such as technological advances). Moreover, it is often claimed (for example in the UK) that the finite nature of natural resources poses special problems of adjustment.

None of these issues should produce special difficulties, however if the economy is able to adjust smoothly and reversibly to the resource discovery. One likely source of rigidity is sluggish adjustment in domestic labour or goods markets, which has already been mentioned. Another, which underlies fears of 'what to do when the oil runs out', is the presence of 'learning-by-doing' in manufacturing. To the extent that this is important and irreversible, industry cannot simply be reactivated once resource depletion becomes imminent. Yet another possible justification for intervention is the absence of perfect capital markets, which prevents firms and consumers from bringing forward to the present the extra spending and investment justified by a natural resource discovery.

All of these departures from the idealized competitive world may justify specific interventions by governments, but only the second provides a firm basis on efficiency grounds for subsidizing manufacturing industry. Temporary assistance may be justified as a way of slowing the necessary pace of adjustment, but it should be kept in mind that this is being done at the expense of gains to the economy as a whole. Finally, one should also note one other form of intervention much favoured by countries which benefit from natural resource discoveries, namely, the development of 'downstream' activities, such as smelting or oil-refining. Although these are often thought to be justified by the availability of indigenous resources, this only affects the cost-benefit calculations to the extent that domestic resources may be used without incurring transport costs. Since this aspect is unlikely to be of major quantitative importance in most cases, the lesson appears to be that downstream activities which were not justified before a resource discovery are unlikely to be socially profitable afterwards.

A great deal of theoretical research has concentrated in recent years on elucidating the positive and normative aspects of natural resource discoveries which have been discussed above. However, much empirical work remains to be done in order to establish the relative importance of the different issues which have been raised. As always, the difficulty with such work lies in the need to disentangle the effects of a resource discovery from those of other contemporaneous events. In the UK, for example, the exploitation of North Sea oil coincided with contractionary monetary policy; most commentators agree that the latter had a more important influence than the former on the appreciation of sterling in the late 1970s and early 1980s. Despite these difficulties, it is essential that more empirical work be carried out in this area. This is the objective of the 'Natural Resources and the Macroeconomy' project, currently underway at CEPR. This will bring together, within a common theoretical framework, both international comparisons and case studies of the experience of individual countries following natural resource discoveries. This type of cross-country perspective, in combination with the theoretical work which has been outlined above, should serve to further our knowledge of both the causes and of cures for the Dutch Disease.

J Peter Neary


This is the first in a series of articles describing research relevant to economic policy undertaken by CEPR Research Fellows. Peter Neary is Professor of Political Economy at University College Dublin and Director of the research programme in International Trade at the Centre for Economic Policy Research. Other CEPR Research Fellows working in this area include Sweder van Wijnbergen, Tony Venables, David Newbery and David Pearce. Further information concerning the research discussed in this article may be obtained by contacting Professor Neary at CEPR.