The reason why dollar rates are fluctuating
Gerard Jackson
When it comes to exchange rates consternation reigns. When, for example, the Australian dollar was sinking John Stone, former secretary to the Treasury and well-known economic rationalist, summed up the subsequent confusion when he stated "we should pay less attention to economic theories (particularly when they are actively promoted self-interested parties in the financial markets) and concentrate on 'what works'" (Dollar could use less speculation, The Australian Financial Review 20/9/00).
In short, there was is no known theoretical explanation for the dollar's fall, and by implication this extended to exchange rate movements in general. Stone's economic commentary was bound to encourage a call for exchange rate controls — and so it did.
He rather smugly told us that economists and merchant bankers advised the then-government "that foreign exchange-markets were inherently self-equilibrating via the benevolent effects of speculators; that domestic producers who found their pricing plans thrown into disarray could always 'cover' through the forward exchange markets; and other such fairy tales" (italics added).
I think it would be fair to conclude from Stone's article that he opposed the lifting of capital controls in 1983 and would not have been sorry to see them reintroduced. His thinking on this subject apparently springs from a fundamental error in the Keynesian approach to balance-of-payments problems, and that is to focus on capital flows and incomes — and even the dreaded speculator.
Despite his caustic view of the free-market economic advice that overrode his own, it was as right then as Stone was wrong and still is. What was missing from the advice is the same thing that seems to be missing from Stone's economic vocabulary, and that is money supply.
Money markets will remain in equilibrium (at least within a narrow band) so long as relative money supplies are kept more or less in check. But continual monetary injections will destabilise exchange rates. This is why the kind of exchange rate mayhem from which we have suffered was absent during the gold standard, that "barbaric relic", as Keynes chose to mischievously call it. And this is why speculation becomes more active: markets begin to anticipate declines in purchasing power. Regardless of Stone's sneering reference to speculators, it is not they who are at fault but the central banks.
In other words monetary expansion is the root cause of any currency's decline, not greedy speculators. A similar situation occurred in Spain during the 16th and 17th centuries when she imported large quantities of gold and silver from South America, which in turn triggered the "price revolution". Prices in Spain rose relative to its trading partners causing the escudo to depreciate against other currencies.
In 1553 the Dominican Domingo de Soto, a Salamancan theologian and a prominent Spanish Scholastic, rigorously applied supply-and-demand analysis to the problem of Spanish exchange rates. He observed that "the more plentiful money is in Medina the more unfavourable are the terms of exchange and the higher the price must be paid by whoever wishes to send money from Spain to Flanders....And the scarcer the money is in Medina [i.e., the greater its purchasing power] the less he need pay there, because more people want money there than are sending it to Flanders."
What we have here is the purchasing-power-parity theory of exchange rates that explains their determination in terms of the relative purchasing power of moneys. (Ricardo also developed the same theory). As von Mises put it: "Exchange rates are determined by the relative purchasing power per unit of each kind of money."
Leaping 404 years to the year 1957 we find a Mr J. J. Polak, a Keynesian and IMF economist, arriving at the same conclusion. Polak tried to integrate money and credit factors into the Keynesian approach. He assumed velocity to be stable and that nominal income would rise if the money supply was doubled.
He found that if a country implemented a policy of credit expansion nominal incomes would rise, imports would grow and a current account deficit would emerge. He concluded that money supply changes will induce changes in demands for domestic and foreign goods, services and securities before any significant change in prices occurs. This conclusion is in keeping with the classical theory which saw no reason why domestic prices should precede a fall in the exchange rate.
Actually there was absolutely nothing new in Polak's findings. In his classic Theory of International Trade (1933) Gottfried von Haberler stressed the same point. He in turn had been deeply influenced by his mentor Prof. von Mises who detailed this process in his article the Balance of Payments and Foreign Exchange Rates, published in Mitteilungen des Verbandes Oesterreichischer Banken und Bankiers, 1919.
(That Polak was unaware of the work of these Austrians — not to mention the classical economists — amply demonstrates the extent of Keynesian intellectual insularity, of which John Stone et al. seems to be an Australian example).
So the line of reasoning is that credit expansion raises nominal incomes, sucking in imports which causes a current account deficit to emerge. (This is not to say that every current account deficit is caused by credit expansion). It therefore follows that there are only three ways in which balance can be restored: (1) the deficit-incurring country must cease credit expansion, (2) other countries must inflate their economies, (3) the deficit country must allow its currency to depreciate.
What we basically have is a supply and demand situation. Let us take a quick look at the Australian situation. From August 1993 to August 2000, M1 grew by 107 per cent and M3 by 79 per cent while the currency grew by 54 per cent. In June 1999 credit was growing at an annual rate of 13 per cent, the highest annual rate since early 1996. It was credit expansion that fuelled consumption, drobe down the dollar and caused debt to pile up, not economic growth.
The above analysis is alien to Keynesians who believe, as Stone seems to, that balance in the current account can be restored, or at least a good part of it, by inducing 'desirable' movements in incomes and imports while blithely ignoring the money supply changes.
Some might object, particularly those involved in the money markets, that it is the condition of the balance of payments that determines supply and demand in the foreign exchange market. But this is rather begging the question. What should be asked is what determines the state of the balance of payments? The answer is the buying and selling of tradables induced by differential price margins.
Unfortunately, none of this seems to have been referred to in the media; certainly not in The Australian Financial Review, the Age or The Australian. There have been several brief references to purchasing power parity, which at least is something. However, even here the writers were clearly referring to the Casselian version of PPP which is based on the reciprocal of the general price level.
Outlining von Mises version of PPP, which is in the classical school, C. Y. Wu wrote: "If the term purchasing power refers to the power of purchasing commodities, which are not only similar in technological composition, but also in the same geographical situation, the theory becomes the classical doctrine of comparative values of moneys in different countries . . ." (An Outline of International Price Theories, 1939). Nonetheless, we should still be grateful, no matter how small the mercy, that PPP occasionally gets a mention.
What should be put to rest are absurd claims that Australia's currency problems are due to lack of R&D. If this is so why did the dollar fall significantly in 2000 against the Albanian Lek? Perhaps Tirana had become Europe's Silicon Valley and somebody forgot to tell us.
The dollar also took heavy falls against the Vietnamese dong, the Polish zloty and the Ethiopian birr, no doubt because of these countries massive investments in high-tech projects and R&D. A another explanation for the fluctuating dollar was Ross Gittins view that "our exchange rate is cyclical" (No need to panic over mighty Aussie, Sydney Morning Herald, 26 May 2003). The preceding analysis reveals just how silly Gittins' view is.
In his article, John Stone said he had "never actually claimed to be [an economist]". Just as well, considering his article's poor intellectual content. Dr Frank Shostak's highly instructive The trade balance and the value of the dollar — what is the relationship? demonstrates that if our self-appointed free marketeers paid some attention to what he had to say on economic matters the free market case would be greatly strengthened. Fat chance.
Gerard Jackson is Brookes' Economics Editor
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