Commentary: ‘Dutch Disease’ diagnosis oversimplistic and wrong

The following is an edited excerpt of a speech on the so-called “Dutch Disease,” made by Mark Carney, governor of the Bank of Canada, at the Spruce Meadows Round Table in Calgary on Sept. 7, 2012. For the full speech, including charts and footnotes, visit: bankofcanada.ca/2012/09/speeches/dutch-disease/

Some regard Canada’s wealth of natural resources as a blessing. Others see it as a curse.

The latter look at the global commodity boom and make the grim diagnosis for Canada called the “Dutch Disease.” (The term was first coined by The Economist in 1977 to describe the poor performance of the Dutch economy after a major natural gas discovery.) They dismiss the enormous benefits — including higher incomes and greater economic security — that our bountiful natural resources can provide.

Their argument goes as follows: record-high commodity prices have led to an appreciation of Canada’s exchange rate, which, in turn, is crowding out trade-sensitive sectors, particularly manufacturing. The disease is the notion that an ephemeral boom in one sector causes permanent losses in others, in a dynamic that is net harmful for the Canadian economy.

While the tidiness of the argument is appealing, and making commodities the scapegoat is tempting, the diagnosis is overly simplistic and, in the end, wrong. Canada’s economy is much more diverse and much better integrated than the Dutch Disease caricature. Numerous factors influence our currency and, most fundamentally, higher commodity prices are unambiguously good for Canada.

That is not to trivialize the difficult structural adjustments that higher commodity prices can bring. Nor is it to suggest a purely laissez-faire response. Policy can help minimize adjustment costs and maximize the benefits that arise from commodity booms, but like any treatment, it is more likely to be successful if the original diagnosis is correct.

Deceleration

The global economy is experiencing a broad-based deceleration from an already modest pace.

Given the strains on global growth, commodity prices have fallen 13% since their peak in April of last year, and can be expected to remain volatile. Nonetheless, prices are still about 25% above their longer-term averages in real terms.

In fact, real prices for energy and metals have been well above their long-term averages for more than seven years, and real food prices are at their highest level in 35 years.

Throughout the current decade-long boom, the scale of price increases has been higher, and the range of affected commodities broader, than in previous upturns. Since 2002, prices for metals and grains have more than doubled, while crude oil prices almost quadrupled.

The question is whether such strength will persist.

The bank’s view is that a large, sustained increase in demand is the primary driver of elevated prices. The breadth and durability of the commodity rally underscore this conclusion.

Rapid urbanization underpins this growth. Since 1990, the number of people living in cities in China and India has risen by 500 million, the equivalent of housing the entire population of Canada every 18 months. Despite the sharp, cyclical slowdowns in China and India, this secular process can be expected to continue for decades.

So, even though history teaches that all booms are finite, with convergence to Western levels of consumption still a long way off, the demand for commodities can be expected to remain robust and prices elevated.

In Canada, the impact of rising commodity prices has been reinforced by strong growth in the supply of some commodities. Oil is now our most important commodity by value, with its share rising over the past 15 years from 18% to 46% of total Canadian commodity production.

Coinciding with this period of elevated commodity prices, the share of the manufacturing sector in Canadian gross domestic product (GDP) has declined since the turn of the century from 18% to around 11%.

For the promoters of Dutch Disease, this is the “aha” fact, with the coincidental relationship described as causal. With a broader view, however, it is evident that the decline in manufacturing is only partially in response to the rising exchange rate and, in fact, is part of a broad, secular trend across the advanced world. Major forces of globalization and technological change have dispersed manufacturing activity across borders, increasingly concentrating the highest value-added stages of production in advanced economies.

In 1970, Canada’s manufacturing-to-GDP ratio was six percentage points below the average of members of the Organisation for Economic Co-operation and Development (OECD). Today, it is three percentage points behind. Likewise, the share of jobs in manufacturing has declined, but not as steeply as it has in our commodity importing neighbour to the south. Although the adjustment has been difficult, it has occurred over a longer period of time than the boom in commodity prices and, in general, Canada has not lost ground relative to other advanced economies.

Currency drivers

The coincident strength of commodity prices and the Canadian dollar in recent years has been treated by some as prima facie evidence of Dutch Disease in Canada. But this diagnosis ignores the fact that the Canadian dollar is influenced by diverse factors.

Commodity prices do play a role. Canada is a net exporter of commodities while our main trading partner, the U.S., is a net importer. This causes our respective terms of trade to move in opposite directions in response to commodity price changes. As a result, the Canada-U.S. exchange rate tends to appreciate when global commodity prices rise.

But this is just the beginning of the story, accounting for about one-half of the appreciation of our currency over the past decade. Other factors also play important roles.

Since 2002, the U.S. dollar has depreciated against many currencies, including those of both commodity exporters and importers. The Canadian dollar has appreciated against the U.S. dollar by an amount similar to that of the currencies of two major commodity importers, Japan and the euro area.

The bank estimates that 40% of the appreciation of the Canadian dollar since 2002 is due to the multilateral depreciation of the U.S. dollar.

The balance of the appreciation reflects forces other than U.S.-dollar weakness and commodity prices. In particular, a variety of attributes make Canada an attractive investment destination, including our sound public finances, resilient financial system and credible monetary policy.

These strengths limit the downside risk associated with Canadian assets, making Canada a rare safe haven in a risky world.

This status is reflected in the behaviour of Canadian 10-year yields, which tend to decline at the same time as risky assets such as global equity prices. This correlation suggests that money flows into Canadian bonds in response to increases in perceived risk. Indeed, by this measure, Canada’s safe-haven status is second only to the U.S. and the U.K. This was not always the case. During the Great Moderation, this correlation was essentially zero.

The symptoms we are seeing are not those of Dutch Disease but rather of structural changes in the global economy to which Canada must adjust. Although these changes create pressure, their overall impact is positive.

Analysis using the Bank of Canada’s main projection model — the Terms-of-Trade Economic Model (ToTEM) — illustrates how different types of shocks to the supply and demand for commodities impact the Canadian economy.

Regardless of the cause of a commodity-price increase, Canada’s improved terms of trade cause income, wealth and GDP to rise. In all cases, the Canadian dollar appreciates, but its adverse impact on our non-commodit
y exports is partially offset by the fact that a stronger currency reduces the cost of productivity-enhancing machinery and equipment, and imported inputs to production.

Consider three different cases that cause energy prices to rise 20%, or roughly the increase that occurred between mid-2010 and 2011.

When the source of the commodity-price increase is stronger U.S. demand, the impact on Canadian GDP is greatest: just over a 3% increase after five years is equivalent to about $57 billion. This is because the improvement in Canada’s terms of trade is strongly reinforced by greater demand for our non-commodity exports. In fact, this additional demand more than offsets the competitiveness losses in manufacturing and services stemming from higher wages, higher resource prices and a stronger dollar.

This scenario is the commodity cycle as we used to know it. It is fast becoming a historical artifact.

When, as is now the case, stronger demand from emerging Asia is the cause of the rise in energy prices, the net increase in GDP is about 1% after five years, or one-third of the impact of the U.S. demand shock. This response is muted because Canada has relatively little direct exposure to these export markets, and there is less demand to offset the competitiveness effects.

Finally, an increase in commodity prices driven by a transitory reduction in commodity supply generates the smallest GDP benefits — about 0.2% in the first year. In this case, the adverse impact of the appreciation is reinforced by the decline in economic activity in the rest of the world caused by the supply disruption.

The run-up in oil prices in the past few weeks is an example of a commodity shock that provides only marginal benefit to Canada.

In all three cases, the impact of increased economic activity in Canada on underlying inflation is largely offset by an appreciation of our exchange rate. This helps limit the direct impact of higher commodity prices on the prices all Canadians pay for food, gas and other commodity-intensive goods.

When commodity prices increase, revenues from the resource sector spread through the Canadian economy via three channels: fiscal redistribution, especially by the federal government; personal wealth increases, through income and ownership of stock; and interprovincial trade.

It is important to recognize that, for almost all the provinces, trade inside Canada has grown fast enough to offset a significant portion of the declines in international trade. Central Canada, for instance, suffered a real decline in international exports of $18 billion between 2002 and 2008, which was almost entirely offset by increases in interprovincial exports of $16 billion.

Some of this reflects increased sales to Western Canada from central Canadian machinery makers, primary metal producers and chemical companies.

Much of the gains in interprovincial trade volumes were in services rather than goods, which was where most of the declines in international exports occurred. Well-paid services — such as professional, mining and financial services — play a significant role in increased trade between Central Canada and Alberta.

Exchange rate

Some argue that the Bank of Canada could improve welfare by leaning against commodity-driven movements in the nominal exchange rate.

It is important to remember that with changes in the terms of trade, adjustments will follow. It is only a question of how. Our floating exchange rate helps achieve the appropriate adjustments without forcing difficult changes in wages, output and prices.

We can use ToTEM to simulate the effect of the bank leaning against a commodity-driven exchange rate appreciation through a reduction to the policy rate. In the short run, stabilizing the nominal exchange rate helps support non-commodity exports, as well as Canadian producers who face competition from imports. But this effort is futile. Over time, wages and inflation rise, causing the real exchange rate to appreciate. Non-resource exporters are faced with the same competitive challenges as they are today.

Moreover, this leads to a sustained period of above-target inflation, which unhinges inflation expectations. Monetary policy eventually has to tighten aggressively to restore price stability. The cost of this misadventure is lower output of about 1% and higher volatility in inflation, output and employment than when the exchange rate is allowed to do its work. The outcome could be even worse if the bank cannot quickly re-establish its credibility after betraying earlier commitments to Canadians.

So the bank does not intervene, except in exceptional circumstances, such as if there were signs of a serious near-term market breakdown, or if extreme currency movements seriously threatened the conditions that support sustainable long-term growth of the Canadian economy.

The bank does take the exchange rate into account in setting policy. The persistent strength of the Canadian dollar has been one of the reasons why monetary policy has been exceptionally accommodative for so long.

Conclusion

Building on our strengths requires that we respond appropriately to the opportunities the global transformation affords us. That starts with recognizing that the strength of Canada’s resource sector is a reflection of success, not a harbinger of failure.

The logic of Dutch Disease requires that we undo our successes in order to depreciate our currency. Taken to its natural conclusion, this logic dictates that we shut down the oil sands, abandon our resource wealth, have high and variable inflation, run large fiscal deficits and diminish our financial sector.

Such actions would weaken the Canadian dollar — but they would also weaken Canada.

In a world of elevated commodity prices, it is better to have them. Bank of Canada research shows that high commodity prices, regardless of the cause, are good for Canada. Rather than debate their utility, we should focus on how we can minimize the pain of the inevitable adjustment and maximize the benefits of our resource economy for all Canadians.