Emeritus Professor Max Corden, of Johns Hopkins University, formerly of Oxford University and now back at the University of Melbourne, is probably Australia's most distinguished living economist. So when he writes on what we could do about "Dutch disease" we ought to take note.
What follows is my account of his paper for the Melbourne Institute, The Dutch Disease in Australia: Policy Options for a Three-Speed Economy. As is often my custom, it will consist largely of direct quotes, indirect quotes and paraphrases of his paper. This practice is known as "reporting". If I misreport his views, feel free to criticise; but don't be silly and accuse me of stealing them.
Corden is an expert on Dutch disease - the economists' term for a situation where a boom in one export industry leads to an appreciation in the exchange rate, which reduces the profitability and the output of other export and import-competing industries.
He starts by dividing the economy into not two, but three sectors according to how they're affected by the boom. First is the "booming sector" (mining and related industries, in our case), then there's the "lagging sector", consisting of the other trade-exposed industries hard hit by the high dollar (part of manufacturing, agriculture and tradeable services such as tourism and some education).
But then there's the "non-tradeable sector" consisting mainly of those service industries whose prices are determined only by domestic supply and demand. This third sector is important because it's the largest part of the economy and "there are almost certainly net gains" from the boom.
The gains arise because the boom causes increased domestic spending on non-tradeables and because of the reduced prices of imported items.
Corden argues there are three broad options for the government to choose from in responding to the difficulties Dutch disease causes for the lagging sector.
Option 1 is "do nothing". "The real exchange rate appreciation is an inevitable consequence of the terms of trade boom and the capital inflow, both of which have benefits," Corden says.
"Some industries rise and some decline, and some declines, in any case, may be temporary. The government can help in the adjustment process, but should not try and stop or slow up adjustment," he says.
"This is one point of view, though it may not be politically attractive," he says. But "doing nothing" doesn't prevent the government from fostering the flexibility of the economy, improving the skills of the labour force, removing obstacles to people moving, temporarily assisting losers, providing information or improving infrastructure.
Option 2 is "piecemeal protectionism". "Of the various groups of industries adversely affected by Dutch disease it is manufacturing - or perhaps particular manufacturing industries, or even firms - that are usually selected for deserving special assistance, whether in the form of subsidies or import tariffs," Corden says.
But this option is "highly undesirable" and "based on questionable economic thinking". (Note that when Corden uses the term "protection" he's including subsidies as well as import tariffs.)
What's wrong with piecemeal protection? Apart from all the usual arguments against protection, there's one that applies particularly to Dutch disease, but is usually overlooked. Corden calls it the "general equilibrium effect".
"Suppose extra protection is provided for the motor car industry," he says (writing well before last week's announcement of extra assistance to General Motors). This reduces imports of cars, as is the intention of the policy, but will lead to extra appreciation of the exchange rate.
If all manufacturing industries were significantly protected there would be a substantial appreciation, which would actually worsen the Dutch disease effects on other industries in the lagging sector - agriculture, tourism and education exports.
Similarly, protection for selected manufacturing industries would have adverse effects on other industries in the lagging sector, including those parts of manufacturing that didn't receive the extra assistance.
"These losers would thus suffer not only from the effects of the mining boom but also from the political success of their industry colleagues in extracting protectionist measures from the government," he says.
It's been suggested that the miners should be required to source various supplies domestically rather than import them. A similar requirement could be imposed on government spending and on private suppliers to the government.
Such requirements would also lead to greater exchange-rate appreciation than otherwise. They would thus benefit some industries and workers but, through their aggravation of the Dutch disease effect, would damage other industries and workers.
The third option the government could choose in responding to Dutch disease is "fiscal surplus combined with lower interest rate". The government cuts spending or increases taxes to achieve or increase a budget surplus.
This would have a contractionary effect on demand in the economy, but its reduction of inflation pressure would allow the Reserve Bank to ease its monetary policy and lower the official interest rate. This, in turn, would lead to some depreciation of the exchange rate because our lower interest rates relative to those in other countries would reduce the net inflow of capital to Australia.
So the Dutch disease effect would be moderated, but at the cost of politically difficult changes in taxation and spending.
The advantage of this option is that it benefits all lagging-sector industries evenly. But, Corden argues, it's just one way of providing "exchange-rate protection". So it, too, creates winners and losers.
All tradeable industries benefit from the lower exchange rate (including the miners), but the much larger, non-tradeable sector loses from it by having to pay more for imports. The lower dollar also reduces the incentive to invest in Australian development.
I conclude from Corden's analysis there's no easy, costless way to ameliorate the downside that comes with the blessing of the mining boom. There are just options that carry more disadvantages than others.
