We can survive Dutch disease: traps of resource boom

  YOU trot along to work every day. Things are going well but they could always be better.

YOU trot along to work every day. Things are going well but they could always be better.

The boss calls you in and tells you that your pay is about to be doubled.

What's the catch? No catch, is the reply, but you are told that there is a very serious shortage of people with your skills and the firm doesn't want to lose you.

Oh no, you've caught the Dutch Disease. It's the resource curse. It must end in tears.

But hang on. For the same effort, you are now earning double what you used to and there seems to be little prospect that your earnings will be cut any time soon. The Dutch Disease -- what's not to love?

So how can a very significant increase in Australia's terms of trade -- the ratio of export to import prices -- be anything other than good news?

To be sure, there are certain economic, financial and logistical challenges to meet. And more people will be required to work in the booming export sector.

But with competent economic management, the disease part of the Dutch Disease can be avoided and higher average incomes can be enjoyed by the population.

The Dutch Disease argument is deceptively simple. Increases in the price of the resources of resource-rich countries will be accompanied by a real appreciation of the currency. We have seen this happen with the rising Australian dollar. The non-booming part of the traded good sector, typically parts of manufacturing, may be adversely affected by the higher currency. Production and employment in manufacturing could even fall.

The booming resource sector will need additional workers and they may come from manufacturing. However, because employment in the resource sector is relatively small -- only around 160,000 direct jobs -- this impact will be relatively insignificant.

However, the non-traded sector, particularly services, will benefit from the higher incomes being earned in the resources sector and employment will therefore rise there. So indirectly, labour may be sucked away from manufacturing through this second-round effect.

So far, so good. The problem is said to arise because the boom is assumed to be short-lived or the resources run out. In Australia's case, we are not dealing with one commodity -- the common case of a Dutch Disease -- and so there is no real prospect of resources running out soon.

Assuming that the resources boom comes to a screeching halt -- for reasons that are unclear -- there will be little left of a decimated manufacturing sector to fill the gap. In the meantime, technology in manufacturing has moved on, so what is left is hopelessly uncompetitive.

There are a number of critical assumptions in this theory, including the dramatic and unexpected end to the resources boom and the inability of manufacturing to respond in the context of a real currency appreciation.

In the case of Australia, the recent figures actually point to a high degree of resilience in manufacturing, with consistent growth over the past year or so. Necessity, it would seem, really is the mother of invention and niche competitiveness can be a powerful force.

But let us continue the argument about the challenges that can emerge from a marked tick up in the terms of trade. Is the solution to sterilise the currency by offsetting capital inflows?

One way of reducing the rate of currency appreciation is to establish a sovereign fund, with the tax receipts paid by the resource industry being invested offshore.

There are several reasons why such a strategy is inappropriate for Australia. For one thing, the resources sector in Australia is made up of a number of commodities. In the case of Norway, for instance, there is only one commodity -- oil/gas -- and the life spans of the reservoirs are reasonably well-known.

Second, Australia is a capital-importing country, not a capital exporter. It would be strange for overseas investments to be made by a sovereign fund, while capital is needed here and can't be provided domestically.

Third, the politics of an Australian sovereign fund investing exclusively overseas are unlikely to be attractive -- after all, Norway is tiny (with a population smaller than Victoria's) and its citizens recognise the limited investment opportunities available in their own country.

And finally, there is a great deal to do in Australia before considering a sovereign fund; particularly, returning the budget to surplus. Moreover, state governments have some work ahead to re-establish their fiscal positions.

But the main thing is to acknowledge the good news in these developments and maximise benefits and distribute them to the population.

Judith Sloan is a professor at the Melbourne Institute of Applied Economic and Social Research, University of Melbourne