Great piece.


How to diagnose your own Dutch disease

By: Brendan Greeley

Imagine that you are the finance minister of a small, developing country that has just discovered an ore belt rich in cobalt, a metal that has more than doubled in price over the last five years. You, a capable technocrat, are familiar with Dutch disease. You know that the sudden discovery of reserves of a high-value commodity can cause sclerosis in other industries, particularly manufacturing, as happened in The Netherlands after the discovery of natural gas in the late 1950s.

Now: imagine you are the Secretary of the Treasury of the United States of America. For "cobalt-rich ore," substitute "dollars," or "dollar-denominated assets," or perhaps just "Treasuries." You still need to worry about Dutch disease. We just never talk about it that way, because the whole framework of booming-commodity-sector analysis is a condescension we reserve for developing countries.
But anyone can get Dutch disease. The US is showing symptoms. And so Alphaville offers a pamphlet. You know, in the interest of public health.

How to check for Dutch disease

Know what you're looking for

There's rich history here of both academic research and practical recommendations. Sachs and Warner (1995) found an inverse correlation between resource abundance and economic growth. Gylfason et al (1999) found an inverse correlation between a country's economic growth and the size of its primary sector. Most models of Dutch disease focus on exchange rates — demand for a country's primary commodity makes its currency relatively more valuable, depressing exports of manufactured goods. But Krugman (1987) suggests that once a country neglects its manufacturing sector, it may have a hard time rebuilding it.

More recent work focuses on institutions and inequality. Mehlum et al (2006) looked at countries that get more than 10 per cent of GDP from resource exports, and showed that Dutch disease is more likely to afflict countries with corruption and weak rule of law. And Robinson et al (2006) suggested that politicians tend to over-extract resources — they discount the future too much — and that a commodity boom raises both the value of being in power for politicians, and the means to influence elections.

Consider your risk factors

The United States certainly has rich vein of a highly valued commodity.

America creates about a quarter of global GDP, but well over half of the currency reserves of the world's central banks is socked away in dollars — $6.6tn of $11.4tn. The dollar is by far the dominant currency for international credit. Dollars are so important as an invoice currency for global trade that shifts in the value of the dollar are an effective predictor for international trade volumes. So many currencies are either explicitly pegged to the dollar, or tied to it through trade, that 50-60 per cent of global GDP swings with the dollar, making it part of a "dollar zone."

The dollar is universally a store of value, a medum of exchange and a unit of account — all the things we consider "money." It is arguably the only currency that is all three of these things. The United States Treasury is not the only place to get dollars. The United States isn't even the only place to get dollars — foreign institutions create dollar-denominated assets, for example — but it is the best place to get dollars.
Here's a chart from a 2017 Bank for International Settlements working paper by Michael Bordo and Robert McCauley. There's a lot of detail in there, but the column on the right shows the growth in US federal and federal-backed debt as an international reserve currency:
The US dropped the dollar's peg to gold in the 1970s, then began borrowing in the 1980s, then discovered that other central banks wanted American debt, because it was a safe asset denominated in dollars and they considered it to be money. Just as The Netherlands struck natural gas, the United States struck dollars. It found a gusher.

The US is not the only producer of dollars. It's possible to create dollar-denominated assets outside the US, for example. In the chart above, there's a difference between what the US reports is owned by foreign central banks, and what the central banks report — that difference is a synthetic dollar called the "eurodollar." 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.

Bordo and McCauley's paper offers the best summary we've read of the current arguments over the dollar. They pick at two questions:

  • What causes the demand for dollars?
  • Is the dollar system sustainable?

These are worthy and interesting questions, and Alphaville can do no better than Bordo and McCauley to address them. We are, however, interested in a different question:

  • Is being the Saudi Arabia of money good for America?

Examine yourself

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 nontradable 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.

It gets more interesting when we look at the more recent research on Dutch disease, around institutions and inequality. The federal government alone controls over the most important dollar-producing lode: Treasuries. Foreign central banks treat US federal debt obligations like money. It's liquid, holds its value, and is denominated in dollars. And when people in capital markets say they're "going to cash," they don't actually buy dollar bills. They buy Treasuries.
So if the US has Dutch disease, from reading Robinson et al (2006) we'd expect for the value from the creation of new federal debt to be distributed as patronage, to a small group of people with access to power. We'd expect the federal government to over-produce debt, without considering long-term value or sustainability of production. And we'd expect the right to produce debt to raise the value of being in power.

This is a fair description of the Tax Cuts and Jobs Act of 2017.

Treasuries aren't the only dollar-denominated safe assets. Real estate is, too. We'd expect an appreciation in real estate prices, and foreign hyperinvestment in exactly the kinds of real estate that best serve as a safe asset — luxury apartments and business towers in large cities. A Park Avenue address is a safe asset, too.

Or we could go back and use the framework of Mehlum et al (2006) to ask about the quality of institutions. After four decades of production of federal debt and dollar-denominated assets (mortgages, say, bundled into tradable securities) what does the country have to show for it? Were the proceeds distributed equally? Did the country invest in education, or shore up retirement plans for a demographic bump? Make investments in infrastructure? If those things didn't happen (they didn't), is the United States among those countries with institutions not fit for the task of handling a commodity boom?

Get help

Norway was a poor country with institutions good enough to handle the discovery of oil, and now it's a rich country fully aware of Dutch disease, and working to avoid the worst of it. Here's one of many case studies, from Holden (2013) at the University of Oslo. And the Norwegians are eager to help, for example through the Oil for Development programme, run by the Norwegian Agency for Development Coordination.

Dutch disease is a well-known, well-studied problem. There are ways to avoid it, although they are not easy.

Consider alternative treatments

One of the clarifying consequences of a discussion around modern monetary theory (if you don't know, just skip this paragraph) is that it looks at federal appropriations as a tool, to be consciously created and deliberately used. Until now, the United States has merrily borrowed and appropriated while idly wondering, sometimes, whether it's all sustainable, avoiding the discussion of what best to do with the windfall. So instead, the country pretends it can't create debt, creates it anyway, and distributes the proceeds terribly. Alphaville welcomes any innovation that would stop the pretending, but is not convinced that US institutions would handle MMT appropriations with any more discretion than they did the proceeds from debt creation.

Seriously though, get help

Call Oslo. It's time.