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Aid: A new strain of the “Dutch”

With the recent discussion of Dutch Disease and how it is affecting (or not) the Canadian economy, we thought this was an opportune time to review the effects of this “curse” on developing countries. In this post we will relate the consequences of Dutch Disease to large aid flows, present some solutions and, in the process also shed some light on a, personally, important and intriguing Development Economics issue.

The term Dutch Disease was first mentioned in a 1977 edition of The Economist and it was used to describe the problems afflicting the Dutch manufacturing sector. Generally, it is related to the effects of shifts in production patterns – namely between tradable and non-tradable goods – that arise due to large changes in wealth. The latter can be caused by the discovery of natural resources, a drastic change in its world price or when large aid inflows take place.

To illustrate this concept, imagine a country that neither has natural resources nor receives aid. The only way for its citizens to buy imports is through exports, hence exporters generate foreign exchange and importers buy the foreign exchange off them. Thus, for the export producing country, exports’ value results from the need of paying for imports. Now, let natural resource exports – aid in our case – come into place. As resources are sources of foreign exchange, exports lose their value domestically. Id est, non-tradables become more expensive and so resources get rechanneled into producing them. As you can infer the problem lies with the inflow of foreign exchange; and aid, in its most basic form, is nothing more than an inflow of foreign currency. Therefore, the large shift in domestic demand caused by foreign aid leads to a consumption boom, expanding the non-tradable sector and squeezing the tradable one, damaging precisely the economic sector most in need for development[1]. Empirically, this topic is being studied by Raghuram Rajan (2005)[2], in which he shows that aid tends to retard the growth of labour-intensive exports activities needed for diversification.

Some solutions have been proposed by the academia and no consensus has been reached. For instance Paul Collier[3], the author of The Bottom Billion[4], suggests that countries should use their aid in creating import demand – aid automatically creates import supply – through technical assistance, this is, importing skills, which decreases the likelihood of Dutch Disease. Moreover, Collier argues that aid spent in developing the export sector may avoid infection, because, after an infrastructure improvement at ports, aid is scaled back and there is no further Dutch Disease, just a better port, for example. Nonetheless, William Easterly[5], the author of The Elusive Quest for Growth[6], puts forward the idea of “conditional adjustment lending”, where aid should be conditioned on policies with very specific stringent targets concerning indicators such as inflation, exchange rates and average black market premium, reforms on the public sector, budget deficit as a percentage of GDP, real interest rates and corruption levels.

In summary, Dutch Disease on developing countries appears to have a harmful effect, undermining growth. Basic forms of aid do not relief the problem and, instead, can be considered as a Dutch Disease catalyst. As Easterly put it “The operation [aid] was a success for everyone except the patient […] much lending, little adjustment, little growth (…).” On the other hand, Canada, a developed country, states that it is healed due to its diversified economy (and, personally, good institutions). Thus, developing countries must aim to diversify their economies and improve the foundation of their institutions (if they want to be cured).

Mariana Tavares no 64

Miguel Vian no 634

[1] This reasoning is in par with the concepts behind the TNT model as non-tradables have to be produced internally and tradables can be imported to satisfy changes in domestic demand.

[2] Rajan , Raghuram G. and Arvind Subramanian, 2005, What Undermines Aid’s Impact on Growth?, IMF Working Paper No. 05/126

[3] Professor Collier is the Director for the Centre for the Study of African Economies at The University of Oxford

[4] Collier, Paul, 2007, The Bottom Billion, Oxford

[5] Professor of Economics at New York University specialized in economic growth and foreign aid.

[6] Easterly, William, 2001, The Elusive Quest for Growth, MIT Press


Author: studentnovasbe

Master student in Nova Sbe

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