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Tilting at Windmills: What to do about Dutch Disease

March 4, 2012

1-minute read

In response to Ontario Premier Dalton McGuinty’s complaint about oil and the exchange rate, several (conservative) commentators argued that this “Dutch disease” is not what ails Ontario manufacturing.

Andrew Coyne took a different tack yesterday, agreeing that petroleum development drives up the exchange rate to the detriment of manufacturing and hence Ontario’s economy, but concluding that nothing can or should be done about it.

While I don’t necessarily accept Coyne’s conclusion, he is correct that this debate has lacked clear policy prescriptions. McGuinty certainly didn’t offer any. Three possibilities follow.

1.) If the problem is an overvalued exchange rate, the obvious solution is for our central bank to lower it. The Bank of Canada has an unlimited capacity to sell Canadian dollars to bring the exchange rate down to more competitive levels. The Japanese, Swiss and Brazilian central banks have all recently made such interventions in currency markets.

2.) Another option would be to restrict oil extraction, but doing so would entail economic costs for the oil-producing provinces. We do not know how much oil production would have to be forgone to lower the exchange rate by a cent or how many manufacturing jobs that might create.

Of course, there are strong environmental and conservation rationales for limiting oil extraction. A more competitive exchange rate could be a positive side-effect of environmentalist or conservationist policies. But Dutch disease alone does not mean that Canada’s economy would be stronger with less petroleum development.

3.) Collecting higher royalties and taxes from oil extraction could decrease development at the margin, but would benefit the producing provinces through higher revenues. Reducing the super-profits currently accruing to oil companies would reduce the inflow of foreign funds to buy equity in these companies and hence the exchange rate.

It’s worth noting that only hypothetical restrictions on petroleum development pit regions against each other. The other options - central bank intervention and/or higher royalties and taxes on oil extraction - would be beneficial across Canada, if one accepts the premise that our dollar is currently overvalued.

Erin Weir is an economist with the United Steelworkers union and a CCPA research associate.

UPDATE (March 9): I discussed these issues on TV Ontario yesterday.

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