Foreign policy and economics blogs will overlap in subject matter today as the Pentagon announces it has discovered $1 trillion in mining reserves in Afghanistan, a country with a GDP of $12 billion. One issue that will be discussed much is ‘Dutch Disease”, which describes the negative economic outcomes that can often be associated with a high level of resource wealth like oil or minerals. I can’t tell you much about the necessary or sufficient conditions for avoiding Dutch Disease, or how likely it is for Afghanistan, but I can give a brief overview of how “Dutch Disease” is supposed to work.
One mechanism by which resource wealth translates to negative economic outcomes is the so-called “spending effect”. This is where a large increase in resource export revenues causes a large increase in demand which drives up the price of non-tradeable goods relative to tradeable goods because the prices of the latter are determined on the world market. This effect can also work via currency appreciation, which further hurts the competitive position of local non-resource tradeables.
An example of this would be a huge growth in the diamond industry driving up the prices of haircuts and homes because they are non-resource tradeables whose prices are determined locally. These higher consumer prices then increases the reservation wage high enough that the costs in the local clothing industry, a non-resource tradeable whose prices are determined on the world market, go above world prices and thus the industry suffers.
Another related mechanism is the crowding out effect, where other industries are crowded out as resource related industries dominate and soak up inputs like labor and energy. One example would be that there is simply not enough energy for the manufacturing sector, as the energy industry enters into long-term supply contracts with mineral and oil extraction companies, and supply remains relatively fixed.
One important industry that can be affected by both the spending effect and crowding out is manufacturing, which due to learning-by-doing and backward and forward linkages is often an important engine for economic and human capital growth in developing countries.
It is my impression that Dutch Disease is a controversial subject area in economic development, and I look forward to a healthy debate on it in the blogosphere. A question for bloggers who know more about Afghanistan: prior to this discovery, would Afghanistan becoming the next Saudi Arabia be considered a best case or worst case scenario?