What To Do About Dutch Disease?
In response to Ontario Premier Dalton McGuintyâ€™s complaint about oil and the exchange rate, several (conservative) commentators argued that this â€œDutch diseaseâ€ is not what ails Ontario manufacturing.
Andrew Coyne took a different tack yesterday, agreeing that petroleum development drives up the exchange rate to the detriment of manufacturing and hence Ontarioâ€™s economy, but concluding that nothing can or should be done about it.
While I donâ€™t necessarily accept Coyneâ€™s conclusion, he is correct that this debate has lacked clear policy prescriptions. McGuinty certainly didnâ€™t offer any. Three possibilities follow.
1.) If the problem is an overvalued exchange rate, the obvious solution is for our central bank to lower it. The Bank of Canada has an unlimited capacity to sell Canadian dollars to bring the exchange rate down to more competitive levels. The Japanese, Swiss and Brazilian central banks have all recently made such interventions in currency markets.
2.) Another option would be to restrict oil extraction, but doing so would entail economic costs for the oil-producing provinces. We do not know how much oil production would have to be forgone to lower the exchange rate by a cent or how many manufacturing jobs that might create.
Of course, there are also strong environmental and conservation rationales for limiting oil extraction. A more competitive exchange rate could be a positive side-effect of environmentalist or conservationist policies. But Dutch disease alone does not mean that Canadaâ€™s economy would be stronger with less petroleum development.
3.) Collecting higher royalties and taxes from oil extraction could decrease development at the margin, but would benefit the producing provinces through higher revenues. Reducing the super-profits currently accruing to oil companies would reduce the inflow of foreign funds to buy equity in these companies and hence the exchange rate.
Itâ€™s worth noting that only hypothetical restrictions on petroleum development pit regions against each other. The other options – central bank intervention and/or higher royalties and taxes on oil extraction – would be beneficial across Canada, if one accepts the premise that our dollar is currently overvalued.
UPDATE (March 9): I discussed these issues on TV Ontario yesterday.
Erin, I do think that our banks enjoy very much the strong petrodollar, in a classical staples fashion.
So they would be against such a policy move, thus its not only a question of regions but also of economic structure.
I made the same point about the banks a couple of years ago. Great minds think alike!
It would help if people in Alberta understood how the equalization program works. Some there imagine that every time the price of oil rises and the Canadian dollar goes up that it is another deserved nail in the coffin of Ontario and Quebec.
Oh and there is a fourth option: nationalisation of the resource sector. Which is about as likely as the other 3.
Looks like our friend Mr. Gordon was reading your blog posting Erin. Why is it when I scan the globe and mail I can always spot a headline and know with 100% confidence that the author of the article is Stephan Gordon. Uncanny, or is it just my ability to spot outliers. I think Stephan must sit down, pick out what he thinks is the top economic story of the day is, and write up posting to go totally against what was siad the day before. I think that is his trick to get readership and hence why the Globe keeps publishing him. Another example of a market failure.
Stephen had a similar post on the same issue last week. He may well be correct that, for the country as a whole, the oil boomâ€™s current economic benefits outweigh the current costs of its exchange-rate impact on manufacturing.
I think that, in the longer-term, we would be better off collecting more revenue from oil production, conserving a little more oil for future use, and thereby also retaining more manufacturing capacity.
I tripped over two things in Stephenâ€™s post today. First: â€œA higher exchange rate forces employers to pay higher wages.â€ I think he means that a higher exchange rate increases the purchasing power of wages.
Second: â€œPerhaps the best one-sentence explanation of the logic behind the Dutch disease argument is Yogi Berraâ€™s. â€˜Nobody goes there anymore,â€™ he once said of a St Louis restaurant, â€˜itâ€™s too crowdedâ€™.â€ Didnâ€™t Yogi say that about Coney Island?
yes I agree on your first statement regarding Gordon’s argument. This also assumes that currency markets and the transmission mechanisms are efficient at evaluating and adjusting import prices. With that I refer to the price stickiness that we have witnessed in Canada. Apparently these are supposed to be short term, which now seemingly are longer term and essentially defined as higher costs of doing business in Canada. Others critical of this essentially label it as monopolistic rent seeking and opportunism by US multinationals.
So at the end of the day I am not so sure about that purchasing power of wages. And hey, if those higher exchange rates create a whole lot more unemployment or a lessening of the proportion of good jobs in the economy, then again, I don’t see this argument’s legitimacy.
I also have another quote from Yogi Berra, that may help Mr. Carney and the BOC bring down the loonie to a competitive 80-85 cents. ‘if you know where you are going, you might actually get there’. That statement, if instilled properly within the forex will carry those speculators away to the short selling side quite fast.
An “over-valued” exchange rate creates problems for the manufacturing sector, agreed. It may not be as simple as the Dutch disease argument suggests, however.
Exchange rate determination has been a controversial subject for decades. Few specialists argue that the Ricardian species flow mechanism still operates. Most think short term monetary flows matter a lot, since the daily volumes of FX trading dwarf goods trade.
In the Canadian context, the interest rate differential with the U.S. has been the best predictor of direction of exchange rate movement. Has this changed since the zero bound era at the Fed?
It seems to me that the U.S. have been operating a competitive devaluation, as did the U.K., and even the Eurozone could be said to have attempted with its clumsy, tardy bailout operations.
Canada needs to address the structural problems around foreign ownership identified many years ago, and adopt the new innovation strategy mentioned here recently by Paul Tulloch, and developed by Jimbo and the CAW. Otherwise our manufacturing future is problematic. Transfer pricing matters, and so does the exchange rate. but R&D and procurement and public ownership all matter as well.
I have been a severe critic of Can monetary policy. Since the Rasminksy era it has mostly been harmful and often incredibly wrong-headed. Carney has been running a neutral policy, and I find this a pleasant contrast to his predecessors. Think of Dodge musing about Canada adopting the U.S. dollar, or Crow running a 500 basis point differential with the U.S. or Bouey pushing short term rates up to the 20 percent level, for example.
Getting some international rules on exchange rates would be helpful to all, and should be a priority, but China bashing and other American pre-occupations pre-dominate in Ottawa. It would be good to get a debate going on international alternatives to saying Me Too after the U.S.
I would have thought the most obvious solution to Dutch disease is to follow the lead of the Norwegians and create a sovereign wealth fund to invest resource revenues in foreign assets – that way we get activity in the sector, but not the overvalued exchange rate.
I agree with Andrew on the need for a sovereign wealth fund. That was the plan the Lougheed government adopted, including making loans at below market rates to other provinces from the Heritage Fund.
Good point. I see that as an extension of option #3. We would need to collect the resource revenue before saving it in a fund.
“follow the lead of the Norwegians and create a sovereign wealth fund to invest resource”
Ah that would explain why Statoil* owns more of Hibernia than the people of NFLD.
Who owns Statoil you ask? The people of Norway. Novel idea that!.
An extension of No. 4 then.
Oops my bad, Statoil owns a bigger share of Hibernia not the Norwegian sovereign wealth fund (NSWF). The NSWF gets its money from statoil and the royalty regime. Sorry I put the cart before the horse:),.
Amazing the cash that flows when you have a royalty regime that is 40% + of the take, plus over two thirds of the profits after the royalty take. It is like someone, somewhere, in Norway knows what they are doing.
*Statoil ASA, trading as Statoil and formerly known as StatoilHydro, is a Norwegian energy company, formed by the 2007 merger of Statoil with the oil and gas division of Norsk Hydro. The Government of Norway is the largest shareholder in Statoil with 67% of the shares. The ownership interest is managed by the Norwegian Ministry of Petroleum and Energy.
“Why is it when I scan the globe and mail I can always spot a headline and know with 100% confidence that the author of the article is Stephan Gordon.”
Because he is your doppelgÃ¤nger (in the German sense). By the way he got bested last week by political scientist out of Montreal last week on the CBC. Very amusing.
Restricting foreign ownership of natural resources is another way to immediately bring down the value of the loonie.
Why so negative Jim? Just increase the domestic content and the foreign will take care of itself.
Why not peg our dollar to 70 or 80 cents USD?
Or possibly to even under cut the Chinese currency?
The other issue tied to this is that we need Smart Trade instead of free trade…
Otherwise we will limit our economy to resource extraction …