The Canadian Dollar and the Dutch and Canadian Diseases

Abstract

With the spectacular rise of the dollar, along with rising natural-resource prices during the first decade of the 21st century, Canadians heard a great deal about Dutch disease. Many politicians and pundits blamed the phenomenon — in which a country’s currency, inflated by rising commodity prices, renders manufacturing exports increasingly uncompetitive — for rising unemployment in the Canadian manufacturing industry. But a close look at what happened during that period reveals that the Dutch disease mechanism was only part of the story. The other part, and quantitatively the most important, is an affliction of an altogether different providence: Canadian disease.

Canadian disease is the economic trouble that can be caused by Canada’s extraordinarily heavy reliance on the United States as a trading partner. As a consequence, a sudden depreciation of the U.S, dollar will deteriorate the competitiveness of Canadian manufacturing exporters. Such a phenomenon was at work during the "Great Appreciation" of the Canadian dollar between 2002 and 2008 — the largest such appreciation on record in this country. The depreciation of the U.S. dollar is a phenomenon that is independent of the resource boom and the resulting consequences on the Canadian economy cannot be endorsed to a Dutch disease. Almost 2/3 of the employment losses that are exchange rate related in the trade-exposed manufacturers in Canada during the 2002–2008 period could be attributed to the Canadian disease.

The Canadian dollar is partly driven by commodity prices, and the appreciation of the Canadian dollar exerts a negative impact on manufacturing industries that are exposed to international competition. This phenomenon can be coined as a Dutch Affair. The Dutch Affair becomes a disease in the long run when the non-renewable resource is depleted and the manufacturing base is gone. New manufacturing activities might not reappear due to a variety of obstacles. In Canada, we may only have a Dutch Affair, not Dutch disease. Only the future, however, will reveal if the Affair is likely to become a disease.

In the short- and medium-run, the net effect of the commodity boom is clearly positive. However, a commodity boom is a phenomenon analogue to a change in terms of trade and it creates winners and losers that are not necessarily located in the same geographic area. The high level of decentralization of the Canadian federation and the growth of natural resources as a share of Canadian exports heighten our vulnerability. Enhancing the working of the fiscal federalism might well be the most efficient policy strategy in the short- and the medium-run in order to adequately share the benefits of the boom.

The economy does remain particularly vulnerable to Canadian disease, despite a slight recent increase in the diversification of Canadian export markets. The reality is that Canada remains closely tied to the U.S. market by virtue of geography, and therefore, is drawn by the pull of trade "gravity". It will be difficult for Canada to diversify its export markets sufficiently to immunize itself against Canadian disease.

Keywords: Dutch disease, Canadian disease, Canadian dollar, Dutch Affair, Canadian economy

JEL Classification: F30, F20, P45, F00, F42, G15, F31, N70