"The Dutch disease is crippling Australia's economy," Australian Workers Union boss Paul Howes fumed this week after BlueScope Steel culled 1000 jobs and exited its export business in response to a $1bn loss.

Howes and a group of federal Labor MPs demanded action to prevent a temporary mining boom from permanently weakening the economy by hollowing out manufacturing: the so-called Dutch disease.

Proclaiming the worst manufacturing crisis since the 1930s Depression, Howes said the Reserve Bank must cut interest rates. The strong dollar had to be weakened. Canberra had to confront Beijing over its undervalued currency and require mining companies such as BHP to buy more locally made steel for their $430bn pipeline of minerals and energy projects.

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Yet most of Howes's demands would destabilise the economy rather than strengthen it because his Dutch disease is the wrong diagnosis. What's really happening is the rise of China and now India is shifting Australia's so-called comparative advantage towards the export of bulk commodities, mainly iron ore, coal and gas, and away from manufactured products such as steel.

Australia's economic reforms of the 1980s and 90s - including much lower import protection for local manufacturing - rightly diagnosed that nations prosper from trading with each other after specialising in what they do best. The difference now is that Australia's comparative advantage is being radically shifted by China's industrialisation and urbanisation.

And steel is central. China's annual steel production has surged in the past decade from 100 million tonnes to 700 million tonnes, nearly half global production.

The biggest industrialisation the world has seen dwarfs the previous surge of global steel output driven largely by Japan's 60s industrialisation, which opened up Western Australia's Pilbara iron ore region.

Among commodity exporters, Australia has been best placed to take advantage of the sharply increased prices China's steel-makers have been prepared to pay for their chief inputs: iron ore and coal. Since 2003, iron ore export prices have jumped from $US10 a tonne to $US140 a tonne and coking coal from $US50 to more than $US230.

"It's as if we woke up one morning and found the world had made us richer as a nation," Treasury secretary Martin Parkinson said this week.

This China-driven boom in resource prices has catapulted Australia's terms of trade - the ratio of export prices to import prices - to record highs. Parkinson reckons Australia's national income has grown 14 per cent more than national production since 2003 as a result.

Australians don't appreciate how their current prosperity depends on this. Imagine the counter-factual of cutting your income 14 per cent. Then imagine that the financial crisis actually did throw Australia into recession; the jobless rate was 9 per cent rather than 5 per cent; that Canberra took back the eight successive years of income tax cuts; and that petrol, computers and overseas holidays cost a lot more because of a weaker dollar.

As the economy restructures around our new comparative advantage, mining and energy has expanded from about 5 per cent to 10 per cent of national output. We've overtaken Brazil as the world's biggest iron ore producer. Resources have increased from one-third to more than half our exports. And the biggest resources investment boom in Australian history will peak in the next few years. Echoing the Pilbara in the 60s, this includes the new industry of Queensland coal seam gas to supply power to Asia.

Hence BHP Billiton's stunning 86 per cent bottom line jump to easily the biggest profit by an Australian company and one of the biggest by any global company. Iron ore alone posted an underlying profit of more than $13bn.

This bonanza will flow into government coffers through taxes and royalties; to workers through more jobs and higher wages; to shareholders through a 22 per cent dividend hike; and it will finance a further expansion of iron ore and coal capacity.

But the flipside of prosperously feeding the blast furnaces and power plants of Asia is that Australia is less able to compete with our biggest export market in making steel. It's why welders earn more than $300,000 constructing gas rigs off WA while BlueScope Steel is retrenching steel workers in Wollongong.

Chief executive Paul O'Malley spelled out the squeeze on BlueScope's export business, first from the soaring iron ore and coal input costs that boosted BHP's mega-profit, second from China's massive steel expansion and third from the strong dollar. "In a macro-economic or global steel situation where you have high raw material prices or costs, a high Aussie dollar, low steel prices and low demand in the Australian market relative to history you have a situation that is very difficult to fight against," he said.

But this doesn't mean the end of Australia's steel industry, only that its seven million to eight million tonne industry can't compete directly with China's 700 million tonne gorilla. So one of BlueScope's two blast furnaces will be mothballed as it focuses on the local market, where distance provides some natural protection. But it still has a global niche in coated steel products, such as its Colorbond. O'Malley says BlueScope is among the top three successful Australian companies operating in Asia. Unlike Howes, O'Malley does not call for action to weaken the dollar. "We can't defy the reality of the Aussie dollar," he says. "I think the terms of trade underpin the fact that it will stay there for some time."

A floating dollar remains sacred for Treasury, the Reserve Bank and even left-wing ministers such as Industry Minister Kim Carr. The currency's strength spreads the mining boom wealth by cutting import prices and financing our cheap overseas holiday boom. But it also crowds out the industries where our comparative advantage has weakened so that mining can expand without stoking inflation. Australia held down the dollar during previous mining booms, but this merely overheated the economy and spilled over into double-digit wage-price growth.

Instead, Labor is throwing a few hundred million dollars at the steel industry, largely to compensate for its looming carbon tax, and to help retrenched workers. And this week it appointed former Queensland premier Peter Beattie as an "envoy" to connect manufacturers to resource projects.

But Resources Minister Martin Ferguson insisted this was "not about mandating Australian content" in big resource projects: a form of protectionism that would push up mining costs. He rejected claims Australian manufacturers were being locked out of big project tenders. BHP Billiton's current Pilbara iron ore expansion included 90 per cent Australian content. The $43bn Gorgon liquefied natural gas project already had secured $14bn in Australian content.

Instead, Ferguson urged manufacturers to follow Australia's mining services firms, such as for logistics, engineering, legal services, financial services and catering. Because they were efficient, mining services companies already generated $9bn in annual exports. Canberra could help manufacturers understand why they failed to clinch resource project contracts. "Sometimes we have to teach them how to do their job," he said.

But Ferguson also let out that Australia had to "reinvent the productivity debate" that it had lost in the past decade. As Reserve Bank governor Glenn Stevens suggested yesterday, our productivity slump is aggravating the mining boom's manufacturing squeeze by lowering the economy's overall speed limit and keeping inflation simmering.

But recharging productivity will require policies - such as a less regulated job market, genuine tax reform and more market-based infrastructure - that Labor has rejected or bungled. And it demands a big budget surplus now in case China's growth hits a speed bump in the next few years. That's why the "patchwork economy" story being told by Julia Gillard and Wayne Swan is so inadequate.

As Stevens suggests, Australia couldn't resist the China boom's "profound" structural adjustment pressures even if we tried. As Treasury points out, Dutch manufacturing bounced back after its mining boom had passed. And we would only worry about catching the supposed disease if we disbelieved the longer-run China and India growth story. Even then, a more productive and flexible economy would be better placed to respond.