More evidence that only economic hypochondriacs fear the Dutch Disease

02/22/2013 by John Clinkard

For the second time in the past six months, a compelling analysis has questioned the existence of the Dutch Disease, the theory that the net benefits of a booming resource sector are more than offset by a shrinkage in manufacturing activity made less competitive by an appreciating currency.

For those who may have missed it, early in September of last year, Bank of Canada Governor Mark Carney presented a speech titled simply “Dutch Disease” to the Spruce Meadows Round Table in which he noted that “while the tidiness of the argument (for the Dutch Disease) is appealing and making commodities the scapegoat is tempting, the diagnosis is overly simplistic and, in the end, wrong.”

He supported this conclusion based on the fact the Canadian economy is highly diversified, the currency is influenced by a multitude of factors and rather than hurting the economy, “higher commodity prices are unambiguously good for Canada.”

The Governor demonstrated that regardless of the cause of higher commodity prices, the resulting improvement in Canada’s terms of trade (a strengthening in export prices relative to import prices) contributed to an increase in the country’s wealth and Gross Domestic Product.

Further, although the effects of a stronger currency hurt non-commodity exports, including manufacturing, these adverse effects are partially offset by the effective reduction in the cost of productivity-enhancing machinery and equipment and of imported production inputs.

More recently, in a paper titled Dutch Disease, Canadian Cure, Phillip Cross, Research and Editorial Coordinator at the MacDonald-Laurier Institute, presents a much more rigorous analysis which effectively debunks the theory that Canada’s manufacturing shrank after being inflected by the Dutch Disease. Based on his analysis, which focuses on the period 2002 to 2010, the output of a majority of firms in Canada’s manufacturing sector increased up to the start of the 2008 global recession.

Moreover, this steady growth occurred despite weakness in the automotive, clothing and forestry sectors that was caused by significant structural changes in those industries in both Canada and in the United States at the same time. Consequently, they were not materially affected by currency movements.

For example, between 2002 and 2009, output of the U.S. auto manufacturing sector shrank by 35% while in Canada it contracted by a slightly smaller 34% despite the fact the Canadian dollar appreciated by approximately 25% against the U.S. currency.

Both the Bank of Canada and Cross point out that the steady gradual appreciation of the Canadian dollar was not just due to higher commodity prices but that it was significantly influenced by a multilateral weakening in the value of the U.S. dollar together with a strengthening pattern of international investment in Canada.

Probably the clearest evidence of the immunity of Canada’s manufacturing sector to the dreaded Dutch Disease is the fact that since the recovery started early in 2009, it has expanded faster than all but three of Canada’s eighteen major industry groups. Moreover, as noted in the previous Economic Snapshot titled “Stronger Manufacturing (particularly Autos) Should Help Drive Ontario Into 2014,” this strengthening trend should continue into next year.

Manufacturing Output – Canada vs U.S. vs the Exchange Rate

Manufacturing Output – Canada vs U.S. vs the Exchange Rate
Data Sources: Statistics Canada, Bank of Canada, U.S. Federal Reseve Board/Chart: Reed Construction Data, CanaData.