Legacy of Dutch Disease in Iran's Economy

EghtesadOnline: It was a strongly-held belief that the abundance of natural resources (such as fossil fuels and certain minerals) in a country engenders economic growth.

News ID: ۷۴۹۵۴۸

26 January 2020

On the contrary, the performances of many resource-rich countries tend to prove the opposite. Or, rather, they tend to be poor partly because they are rich in natural resources, according to Financial Tribune.

Saeed Leylaz, a historian who relishes economics—that’s how he likes to be called, says the first time Iran fell under the charm of oil revenues, or was technically afflicted by the so-called "Dutch disease", was in the early 1960s, the Persian-language daily Iran reported.

“Symptoms of the Dutch disease reemerged in Iran’s economy in 1984-85 when oil exports jumped to $50 billion. Yet again, between 2002 and 2012, the country fell for oil revenues hook, line and sinker. And the last time windfall gains of natural resources misled an Iranian government was after the Joint Comprehensive Plan of Action, [the nuclear deal Iran signed with world powers in 2015],” he said.

“The populist nature of political structures is believed to be the cause of this disease and that is not just exclusive to Iran. Russia, Saudi Arabia and Norway have also suffered from bouts of the Dutch disease. Governments are quick to fall into disorder as soon as they get flushed with natural-resource money,” he said.

The origin of the phrase is the Dutch economic crisis of the 1960s following the decline of the manufacturing sector there after the discovery of the large Groningen natural gas field in 1959. Surprisingly, this positive development had adverse effects on important sectors of the country’s economy, as the Dutch guilder (the standard unit of money used in the Netherlands before the euro) became stronger, making Dutch non-oil exports more expensive and, therefore, less competitive.

In the classic economic model developed by W. Max Corden and J. Peter Neary in 1982, the economy of a country seeing a dramatic rise in revenues is divided into three sectors: the booming export sector that extracts natural resources such as oil, the lagging export sector which is mostly manufacturing and agriculture sectors, both of which are tradable sectors; and the non-tradable sector, which essentially includes retail trade, the services sector and construction.

Economists show that when a country develops the Dutch disease, the traditional export sector (manufacturing and agriculture) gets dumped by the other two sectors.

Leylaz noted that in the fiscal 1974-75, as Iran’s foreign revenues increased, the then government revised its long-term development plans with the illusion that oil income will keep flowing in.

“Petrodollars in effect wreaked havoc on all political and social structures of the country. Economically, a massive inflation hit the country, creating an inequality substantial enough to lead to a national breakdown. The Islamic Revolution saved Iran’s economy, as there was no recovery within the rigged old system,” he said.

“In the last 15 years of Pahlavi dynasty and despite the fact that food production outpaced population growth, the inclination toward buying consumer goods was so strong that in the fiscal 1977-78, Iran had already turned into an outright importer of food.”

Leylaz pointed out that between March 2001 and 2012, the country was afflicted by the same old problem “but thanks to our far bigger economy, it recovered from the shock in time and escaped a crash”.

The Resource Curse

Iran is a textbook embodiment of what economists call “resource curse”. The resource curse, also known as the paradox of plenty, refers to the irony of countries with an abundance of natural resources registering lower economic growth and worse development outcomes than countries with fewer natural resources.

A 1995 study of 97 developing countries by the economists Jeffrey Sachs and Andrew Warner found that the more important natural resources were to a country's economy, the lower was its growth rate. Of all the resource-rich countries they studied, only two were able to grow as fast as 2% a year, while a host of the resource-poor nations grew much faster.

“Abundance of natural resources in a country is like a double-edged sword. If natural-resource money is transferred into intergenerational wealth, it will be a blessing for the economy like Norway. But if these resources turn into a hurdle in the way of a country’s development, they could be viewed as a ‘curse’," Ali Marvi, professor of economics at Allameh Tabataba'i University, said.

“Governments’ access to oil resources makes them less dependable on tax revenues. They become distributors of oil revenues. They display an attitude of superiority and power toward people, as they play the role of a giver toward the people receiving the largesse. Consequently, they are no longer accountable for their decisions and behavior,” he added.

Marvi noted that oil money paves the way for the involvement of the government in all sectors, becoming bigger but losing its policymaking capabilities.

“One of the key economic indicators is the value of foreign currency. It is tangible by the people; they use it to evaluate the economic performance of the government. That’s why governments like to keep it low, at least during the period they are in office. Foreign currency rate in the long run is determined by the real performance of the economy and the balance of different monetary markets and capital market. In oil-rich countries, due to the availability of petrodollars, it is possible to reduce the nominal value of foreign currencies, though it will lead to the accumulation of natural forces of the economy, which will eventually drive up the value of foreign currencies,” he said.

“Governments have limited ability to keep their grip on the recoiling spring of foreign currency. That is why the second term of each administration is usually marked with a sudden jump in foreign currency exchange rates. But it is important for presidents to be elected for the second term even though their policies may not be in the interests of the people.”

The economics professor said when a country experiences a hike in revenues in the early stages, income grows as more foreign currency pours in.

“If the entirety rise in foreign currency is spent on imports, there will be no direct impact on the country’s money supply or demand for domestically produced goods. But if the foreign currency is converted into local currency and spent on domestic non-tradable goods, what comes next depends on whether the country’s nominal exchange rate—that is, the price of the domestic currency in terms of a key foreign currency, say dollar—is fixed by the country’s central bank or is flexible,” he said.

“If the exchange rate is fixed, the conversion of the foreign currency into local currency would raise the country’s money supply, and pressure from domestic demand would push up domestic prices. This would lead to an appreciation of the “real” exchange rate—which means, a dollar would buy fewer goods and services in the domestic economy than it did before. If the exchange rate is flexible, the increased supply of foreign currency would strengthen the value of the domestic currency and consequently increase the real exchange rate—in this case through a rise in the nominal exchange rate rather than a rise in domestic prices.”

He further said that in both cases, the appreciation of real exchange rate weakens the competitiveness of the country’s exports, and causes its traditional export sector to shrink, its imports to swell and finally its economic growth to decline.

Social Implications

Marvi believes that oil revenues incites many producers to opt for easy ways to earn more by bargaining for a cut from oil revenues that would ultimately lead to institutionalized rent-seeking behaviors.

“Apparently, a significant number of economic enterprises are supplying goods or services, but in actuality their existence depends on the allowances they receive from oil money,” he said.

“One of the main causes of inflation and unemployment is the behavior of oil-backed governments. Petrodollars hit production and exports through the Dutch disease and promote consumerism, particularly that of imported goods. Inflation frustrates people’s plans and destroys their confidence. Unemployment gives rise to social ills and creates uncertainty. The continuation of these effects threatens the health of the society.”

Marvi noted that the flattering of government or behaving in a servile manner is another undesirable public behavior that is observable in resource-rich countries.

“Unrealistic public expectations about oil revenues is another negative impact of oil on the society. So much so that they believe that the government must deliver all goods or services at very low prices. The government’s failure to do so is usually blamed on its inefficiency and corruption. People then tend to ignore all services offered by the government. Such an exaggerated image often results in weak tax compliance and legitimization of tax evasion,” he concluded.