We all dream about what we would do if a couple million dollars fell into our laps. It turns out, most of those stories don’t work out the way we would think.
Lottery winners don’t always make the best decisions. Instead, they buy luxurious houses and cars, and go on exotic vacations. Before long, all the money is gone and all they have left is a house they can’t afford to pay the taxes on.
If they would have listened to the advice of financial advisors, they would have been told to treat the money like a business that generates an income stream.
In doing so, they would have kept their job for a little longer and made more reasonable spending decisions. But alas, people don’t make rational long-term decisions. And neither do governments.
In resource economics, we use the term “Dutch Disease” to refer to a seemingly paradoxical situation in which a sudden inflow of money can create detrimental outcomes for the country’s economy. We sometimes use the related terms “Resource Curse” or “Paradox of Plenty” to speak largely to the same issues. “Dutch Disease” gets its name from this situation unfolding in the Netherlands during the 1970’s.
When the North Sea oil fields began flowing, a tremendous amount of money gushed into the surrounding countries. The result was not a sudden improvement in the Dutch economy, rather what occurred was a 500% increase in unemployment and the beginning of a recession. This seemingly paradoxical outcome got the attention of the authors of “The Economist” magazine, who coined the phrase.
Symptoms of Dutch Disease
A good description of the Resource Curse can be found in this book. It talks about how those infected with Dutch Disease tend to see their sudden resource wealth as a way to satisfy immediate needs.
They build large projects and embark on ambitious social programs. They try to mimic the actions of wealthy countries. And, they end up playing an international game of keeping up with the Jones’ without developing the underlying economy that can support the operations of the infrastructure projects and social programs. In the end, all they have is a house they can’t afford to pay the taxes on.
The resource industry becomes the largest driver of the economy. It overwhelms the rest of the economic activity, drawing the best talents from the labor pool. If the underlying economy is not large enough to care for it and also maintain other activities, those other activities are abandoned.
Then, when the exhaustible resource is depleted, the economy falters. Despite a period of good times, the economy ends up worse off then before. Hence the “paradox,” “curse,” or “disease” label.
The oil money also tends to detach the people from the government. The increase in public services and the decrease in taxes lulls them to sleep in new sports arenas and pillowcases full of money.
When it comes time to change course, the resistance is strong. Dutch Disease leads to a paralyzed government. It is unable to meet the expectations of the population and unable to raise the funds required to provide them.
Vulnerability to Dutch Disease
Not all economies are susceptible to Dutch Disease, just as not all lottery winners blow through their winnings and end up on welfare. Some economies/people have resistance to the disease.
A lottery winner that is financially savvy and already secure will be much more able to pull those winnings into their investment strategy. Likewise, a well developed economy is much more able to absorb the new sector and increase the economic activity in a sustainable way.
Those economies that are the most vulnerable are the ones that are not well defined when the oil starts flowing. If the inflow of new money exceeds the GDP of the country before the resource is developed, it will tend to take over the economy. Likewise, if the revenues flowing to the government are greater than their operating budget, and is expected to bring revenues for more than 20 years, the government tends to grow to the size of their new revenues.
Unfortunately, Alaska was very vulnerable to Dutch Disease. The combination of the young institutional systems and the magnitude of the capital inflows completely changed the State in every way imaginable.
The State had barely got its legs under itself before the oil began to flow. And it was a lot of oil. In 1969, in the lease sale directly following the discovery of Prudhoe Bay, the State treasury received $900 million (equivalent to $5.9 billion today) in bonus bids.
The prior year, the State budget was $128 million ($882 million in 2017 dollars). 10 years later, the operating budget had increased to $881 million ($2.9 billion in 2017 dollars) in 1979.
In 1981-82 the State legislature passed capital budgets totaling almost $7 billion ($16.8 billion in 2017 dollars). For reference, the total of all the capital budgets prior to 1981 add up to $1.4 billion.
Within just 5 years of the first barrel of North Slope oil reaching the market, the State repealed all personal taxes, established a payment to its residents, and invested heavily in new infrastructure projects.
The labor force simply did not exist to satisfy all of these government needs in combination with the needs of the labor on the North Slope. In response, Alaska paid premium wages, drawing workers out of their existing jobs and attracting workers from all over the world.
The population of the State nearly doubled between 1969 and 1986 as the money spent on building the Trans-Alaska Pipeline and North Slope infrastructure drew over a hundred thousand workers and their families from oil states like Texas and Oklahoma.
These people became Alaska residents, bought houses, and had children. With the increasing population, the culture of the State began to change. As did the role of the government. New roads, schools, and hospitals were needed to accommodate the new Alaskans. Increased levels of troopers and state employees were needed to regulate all the new activity. The State budget continued to grow.
For decades, oil money paid all the bills. It represented over 90% of the State revenues and an enormous share of the State GDP for decades.
When oil prices crashed in 2015, it sent the State into a economic recession. As the primary driver of the economy, we witnessed substantial job loss by the oil industry and the State government. The underlying economy was too weak to support the level of government to which the citizens have become accustom.
To push back against the recession, the State used fiscal policy tools to stabilize it. The legislature avoided implementing tax to reset the government to the new economic reality. Instead, it borrowed billions of dollars from savings accounts to maintain the unsustainable level of spending and prop up the economy.
There is little doubt that Alaska has been living with Dutch Disease for decades. The economy is oil-centric and has not been developed to support itself in any other way. The economy exports oil and imports almost all of its consumption goods, manufacturing nearly nothing at all.
The government was shaped by oil money and cannot muster the political will to transition to traditional and sustainable practices. And the population is detached from the government, unaware of the causes of the current fiscal situation or its solutions. Now that the disease has reached a critical stage, it is unclear if a treatment plan is available or if these disease is terminal.
The best book on the subject of treating Dutch Disease is “Escaping the Resource Curse.” This is a must read for an policy maker in the State. Let me discuss the treatment with an analogy.
Imagine an 18 year old winning a $1 million.
Chances are that he will go out and buy an expensive car and blow through the money in short order. But, if he is responsible, he may elect to live a reasonably moderate life. Let’s say he limits himself to spending $80,000 per year and earning 5% interest on the balance.
Feeling comfortable with his financial situation, he may not feel the need to work or go to college. Unfortunately, he didn’t plan very well. At age 39, he will receive a rude awaking when he realizes that his account is empty and he has no job skills that support an $80,000 per year salary. That number was not sustainable.
This situation could have been avoided. He could have done a better job realizing what a sustainable spending level was. If he had, he would have reduced his spending to $50,000 per year and the money would have lasted forever. If he really wanted to live that $80,000 lifestyle, he could have got an easy job paying $30,000 per year.
Alternatively, he could have went to college or vocational school to build valuable skills. By not dipping into that pot of money, he could retired young.
This is the situation Alaska finds itself now. If we continue to live above our means, the money will run out. We are now at a crossroads with enough time to take action, but it must be swift.
One option is to live a more frugal life (cut government services). Another is to build the skills we need to support a higher standard of living. To do this, we must invest in growing our economy and pay taxes out of the growth.
We are currently barreling toward a cliff. However, turning in either direction can save us. But if we continue to take no action, we will run out of time to do either. The treatment is strong leadership, forward planning, and long-term strategic thinking.
The Permanent Fund served a lot like a trust, preventing our predecessors from greatly overspending. But, it was not enough. Now we need to reevaluate our spending and saving plans, and decide what future we want to live in.
If we only think about the present, the result will look a lot like other Dutch Disease patients. And without treatment, it is a terminal disease.