When countries get too much of a good thing

• Author: Christine Ebrahim-zadeh
• Position: Staff of Finance & Development

Dutch Disease: Too much wealth managed unwisely

Miguel de Cervantes Saavedra, the celebrated sixteenth-century Spanish author of Don Quixote de la Mancha, once said that "the gratification of wealth is not found in mere possession or in lavish expenditure, but in its wise application." This was at a time when Spain enjoyed newfound access to a wealth of natural resources, including gold, from the Americas. Could he have recognized, in his own country, symptoms of what later became known as "Dutch disease," a term that broadly refers to the harmful consequences of large increases in a country's income? Finance & Development explores the issue.

In the 1960s, the Netherlands experienced a vast increase in its wealth after discovering large natural gas deposits in the North Sea. Unexpectedly, this ostensibly positive development had serious repercussions on important segments of the country's economy, as the Dutch guilder became stronger, making Dutch non-oil exports less competitive. This syndrome has come to be known as "Dutch disease." Although the disease is generally associated with a natural resource discovery, it can occur from any development that results in a large inflow of foreign currency, including a sharp surge in natural resource prices, foreign assistance, and foreign direct investment. Economists have used the Dutch disease model to examine such episodes, including the impact of the flow of American treasures into sixteenth-century Spain and gold discoveries in Australia in the 1850s.

The diagnosis is .

Why does a dramatic increase in wealth have this paradoxically adverse consequence? The answer is found in a classic 1982 paper by W.M. Corden and J. Peter Neary. These authors divide an economy experiencing an export boom into three sectors: of these, the booming export sector and the lagging export sector are the two traded goods sectors; the third is the nontraded goods sector, which essentially supplies domestic residents and might include retail trade, services, and construction. They show that when a country catches Dutch disease, the traditional export sector gets crowded out by the other two sectors.

How does this happen? Let's take the example of a country that discovers oil. A jump in the country's oil exports initially raises incomes, as more foreign exchange flows in. If the foreign exchange were spent entirely on imports, it would have no direct impact on...