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In response: the Dutch disease and market forces

Hans Timmer's picture
Also available in: Русский
The following is a response to an earlier blog post by Ulrich Bartsch and Donato De Rosa

Although there exists plenty of analysis of the Dutch disease, the resource curse, and Hotelling’s rule to fill several large libraries, there is nonetheless still ample room for debate about optimal policies in resource-rich countries. What is the optimal pace of extraction? Should they diversify? If so, how should they diversify and when should they diversify? What role should sovereign wealth funds play? Can the destabilizing adjustment process in the wake of an oil price collapse be avoided?
In a recent blog, Ulrich Bartsch and Donato De Rosa revisit the issue of resource revenue management. They cite the Diversified Development report. That report made the important point that any attempt to force diversification in product markets is unlikely to be successful if it is inconsistent with existing comparative advantages and if required underlying assets are not available. A successful diversification strategy should diversify assets (build infrastructure, educate people and improve institutions, in addition to maintaining natural resource wealth). Once the assets have been diversified, diversification in the goods market will follow suit as a result of market forces.
The report offered the surprising conclusion, repeated by Ulrich and Donato, that more of the oil revenues should have been invested at home in roads, schools, and hospitals, instead of in what they call low-yield sovereign wealth funds.
One can read this line of argument as a plea against industrial policy that interferes in goods markets and a plea to use market forces to create an economic structure that is consistent with comparative advantages. Following the argumentation in the report, governments can change these comparative advantages by investing more in domestic assets.
There are many good elements in this analysis, but there is one big problem: The same rigor that is used to analyze the goods markets is not used to analyze the accumulation of assets. While market forces are declared essential in the goods markets, little is said about the role of market forces in the accumulation of assets.
Let’s explore a bit more the relation between market forces, asset accumulation, and comparative advantages.
The first important observation is that relative availability of assets in one country is not the only determinant of comparative advantages.  Comparative advantages and the resulting specialization pattern also depend on global scarcity of resources, reflected in relative prices in world markets. A couple of years ago - when high oil prices reflected global scarcity - oil producers were much less competitive in non-oil sectors than now, when low oil prices reflect global abundance.
In these few years the assets in oil producing countries haven’t changed, but the natural diversification pattern in export markets has changed dramatically. That also means that accumulating more assets not necessarily leads to export diversification. Whether the accumulation of assets makes oil-exporting countries competitive in other sectors very much depends on the oil prices. During the last decade it was extremely difficult to become competitive. Now it is much easier.
Secondly, the more oil-exporting countries spend at home during periods of high oil revenues, the more domestic prices will increase. Between the start of the rise in oil prices in the early 2000s and the peak of the oil prices the real appreciation in oil exporting countries vis-à-vis oil-importing countries was roughly 100%, as we described and explained in the Europe and Central Asia Economic Update.
That means that domestic production became twice as expensive as production abroad. Spending even more domestically could mainly increase domestic prices further, rather than increase production and assets. It might be justified to spend more in certain areas, but the impact on relative prices cannot be ignored.
Because of high domestic prices during periods of high oil prices, it makes economic sense to invest in non-tradable sectors, where not only the costs but also the revenues are high. That explains the huge investments in real estate and domestic services that we have seen in oil-exporting countries. You only have to walk through Baku to see what that means in reality. It makes much less economic sense to invest in tradable sectors where costs are equally high, but prices are not. If, during periods of high oil prices, governments try to invest in assets that would allow diversification in tradable sectors - this would go against market forces and is not that different from standard industrial policy.
Because of high prices and capacity constraints in the domestic economy during periods of high oil prices, it actually should be profitable to invest part of the oil revenues abroad - where costs of production are lower and capacity constraints are less binding. From an investors’ point of view it should also be profitable to divest abroad when oil prices are low and domestic prices are low. These investments would represent a lot more purchasing power when brought back after a collapse of oil revenues. Just think about the value of sovereign wealth funds in domestic currency after the huge depreciations that followed the fall in oil prices. 
Where does this all leave us? What is the lesson to be learned for oil exporting countries from this complicated relationship between relative prices, asset accumulation, and comparative advantages?
I am not ready to follow Ulrich’s and Donato’s assessment that “policy makers clearly realize their failures in the past and bemoan the lack of diversification away from oil.” I think that how much they could have diversified during the period of high oil prices is still an open question.
But one thing is clear: in the current environment of low oil prices there are huge opportunities to diversify. Failure to diversify now will have far-reaching and damaging consequences. It is urgent to facilitate labor mobility and eliminate the constraints to mobility of other resources across sectors. It is vital that new firms in tradable sectors have access to finance, so that they can compete with imports and explore foreign markets. Vested interests are always harmful, but especially harmful in resource-rich countries, which must adjust to much larger shocks than other countries.
I agree very much with the on education and institutions emphasis in the Diversified Development report. Good institutions that ensure a level playing field are important for the necessary mobility. Well-educated people might find it easier to explore new opportunities under changing circumstances.
Probably the most important lesson is that resource rich countries have to be agile, so that they can quickly adjust to new circumstances. More important than the amount of assets is the mobility of assets. So, with that required flexibility in mind, if oil-exporting countries should regret one thing, then it should be that they did not invest more in education and institutions during the oil price boom, instead of all the investments in real estate and other immobile factors. 


Submitted by DICKSON MURIRA on

Very insightful view, though with a contradictory note from popular view but a case to ponder for countries who have recently discovered oil like ours; kenya. Thanks

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