Peter Costello’s trade deficit fallacies and the credit crunch, part I
Gerard Jackson
Treasurer Peter Costello recently stated that the trade deficit “…is our number-one challenge at the moment and that is being affected by the exchange rate. It is being affected by capacity constraints in the Australian economy and we have got to make sure that we can deal with those.”
This is the Treasury’s Keynesian line and contains two dangerous fallacies. The first one being that our trade deficit is basically an exchange rate problem. The second one is that the trade balance is also affected by “capacity constraints.”
Does any of this really matter? Well, as soon as any Treasurer begins to talk publicly of trade problems, capacity constraints and bottlenecks one should start preparing for a credit crunch. To understand why this is so it is necessary to expose the fallacies that are at the root of these so-called problems.
When Australia expands its money supply not only is the demand for Australian goods and services increased, so is the demand for imports because the increased stock of money now exceeds Australians' demand to hold money. This raises the demand for imports causing a current account deficit to develop.
Moreover, foreigners (the recipients of Australian dollars) now find themselves in an identical situation. They too are now holding more dollars than they need. They unload these excess dollars by buying Australian exports or foreign currencies.
This causes more dollars to hit the foreign exchange market thus forcing down the exchange rate. (I have assumed that Australia is inflating faster than its trading partners.)
Naturally depreciation leads to higher import prices. This in turn misleads many commentators to claim that depreciations are inflationary.
(This argument was used by Weimar politicians to conceal the real cause of the devastating inflation ever visited on Germany. It can never be sufficiently stressed that basically it is inflation that causes depreciation, not the reverse).
In 1957 Mr. J. J. Polak, a Keynesian economist employed by the International Monetary Fund, embarked on a study to integrate money and credit factors into the Keynesian model.
He assumed that velocity was stable and that nominal income would rise if money supply doubled. (In reality, of course, there is no proportional relationship between changes in the money supply and changes in general prices).
His study found that if a country engaged in credit expansion nominal incomes would rise, imports would grow and a balance of payments 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.
Actually there was absolutely nothing new in Polak’s findings. Prof. von Mises precisely described this process in his article the Balance of Payments and Foreign Exchange Rates published in Mitteilungen des Verbandes Oesterreichischer Banken und Bankiers, 1919.
Hence credit expansion raises nominal incomes which suck in imports causing a deficit on the current account: this in turn results in a loss of foreign reserves as the central bank struggles to maintain an untenable exchange rate.
From this it follows that there are only three ways in which balance can be restored: (a) the deficit country must cease credit expansion, (b) other countries must inflate their economies or (c) the deficit country must devalue its currency until the deficit is eliminated.
To the Keynesians, however, balance can at least be partially restored by induced movements in incomes and imports. According to this theory when Australia increases her demand for imports income rises in her trading partners’ export industries.
Thus through the foreign-trade multiplier (another Keynesian fallacy) total income will rise thereby increasing the demand for Australian goods. This very plausible theory quickly supplanted the classical theory.
A fundamental error in the Keynesian analysis of the balance of payments is to focus attention on income and capital flows. This has convinced policy makers and opinion leaders that the way of dealing with the ‘balance-of-payments problem’ is to try and influence flows in the capital account section of the balance of payments. This is an exhumation of long discredited mercantilist thought.
It is because Keynesians have stubbornly insisted on sticking to income effects that the roles prices and money supply play have virtually dropped out of sight. With regards to the balance of payments (of which the trade balance is a part), money truly does not matter for the Keynesian. This is why the relation between the money supply and the balance of payments is rarely referred to in Australian papers and magazines.
Another serious error in the Keynesian approach to the balance of payments is the assumption of idle resources. Hence a rise in the demand for exports stimulates output by utilising idle resources.
The classical economists rightly assumed full employment and correctly deduced that an increase in the demand for exports would only change relative prices, including wages. The result being that exports would rise but production for the domestic market would fall.
However, consumers would be compensated by increased imports. Therefore the benefits to the Australian consumer would not come from increased export income but from increased specialisation of trade and the division of labour as well as a more efficient allocation of resources.
The Keynesian approach comprises a cluster of mercantilist fallacies: it has resulted in competitive devaluations, deficits and growth-induced export surpluses. If a simple rise in exports, or export income, could generate economic growth then why not subsidise exports. Then, of course, there is always devaluation.
In arguing for an export surplus to promote growth Keynes only managed to resurrect a mercantilist fallacy that the classical economists believed they had permanently laid to rest.
In fact, governments that deliberately maintain balance of trade surpluses are stealing from their own citizens by subsidising deficit nations’ living standards.
When a country deliberately tries to maintain an undervalued currency it must buy foreign exchange which in turn increases the country’s money supply (unless it sterilises the inflow) and this then stimulates the economy. Unfortunately most observers tend to ascribe the increased stimulation to the export industries.
(It is argued by the Chicago school, and Keynesians, that only when resources are fully employed will the growth in the money supply induced by a surplus raise the price level. On the other hand, the Austrians would argue that this is not necessarily so for reasons concerning the heterogeneity of capita).
What is not generally recognised by economic commentators is that persistent international imbalances cause severe malinvestments which badly distort the capital structures of trading nations. This is an economic fact that Austrians have been pointing out for years.
Samuel Brittain a well-known economist with the Financial Times and a Keynesian by training, was astute enough to spot this and wrote an excellent description of the situation.
“...if an imbalance is allowed to persist too long, a deficit country acquires an excessively home-based industrial and commercial structure while the surplus country becomes excessively export-oriented... This makes adjustment needlessly painful and difficult when it does come, and there is the risk of high transitional unemployment while resources are being transferred. Shop assistants in Britain cannot be transferred overnight to engineering establishments which do not yet exist while Volkswagen workers cannot move straight away into the German social services. These very facts themselves provide ammunition for those who oppose parity changes, and the eventual adjustments are all the more sudden and severe when at last they come.”
What is remarkable about this item is that Brittain apparently fails to see, as the Austrians do, that even in the absence of trade imbalances inflation will still cause widespread malinvestments resulting in recession.
So What Determines The Exchange Rate?
In the words of Prof. Mises “Exchange rates are determined by the relative purchasing power per unit of each kind of money.” This is the purchasing power parity theory of exchange rates.
If, for example, Australian prices doubled while those of our trading partners remained unchanged then the purchasing power of the Australian dollar would be halved, not only in terms of Australian goods but also in terms of foreign currencies. It is absurd to think that a country can debase its currency at home without affecting the price of foreign exchange.
This was certainly not lost on the Spanish Scholastics. The flood of New World gold and silver into Spain raised prices and depreciated the Spanish escudo against other currencies. This period was named by economic historians as the “price revolution.”
These schoolmen, as they were called, found themselves faced by the baffling phenomenon of continuous inflation. Their intelligence and knowledge allowed them to meet the intellectual challenge. In 1553 the famous Salamanca theologian the Dominican Domingo de Soto applied a rigorous supply-and-demand analysis to foreign 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.”
In short, the purchasing power of money determines the exchange rate. (If only our own foreign exchange experts and economic commentators were able to practise the same forensic skills as those venerable scholars). So now we have it. Purchasing power parity determines exchange rates.
So what is the monetary situation in Australia? From January 1996 to September this year currency grew by 72.7 per cent, bank deposits by 108.3 per cent and M1 by 100.3 per cent. And what does the Treasury give us as part of the trade deficit problem? Capacity constraints. That it ignored money supply is a clear indication of the extent to which the Treasury is governed by Keynesian fallacies.
Purchasing Power Parity: What is it?
It is based on the simple principle that the market has a tendency to equalise prices for the same goods — and money is a good. Therefore money will flow to where its purchasing power is greatest because the value of money is the same everywhere.
Critics, however, were able to point out that goods that are physically identical sell for different prices in different locations. One of Mises’ achievements was to show that “the exchange-ratio between commodities and money is everywhere the same. But men and their wants are not everywhere the same and neither are commodities.” (Theory of Money and Credit).
Mises refined the Ricardian analysis into the purchasing-power-parity theory of exchange rates in order to explain differences in the purchasing power of co-existing moneys. Unfortunately only Gustav Cassel’s version of purchasing power parity is known to most economists.
This version ignores the Austrian stress on locational differences in explaining differences in prices for physically identical goods. Cassel, as do most economists, defined purchasing power as the inverse of the price level. The Chinese-American economist C. Y. Wu accurately summed up the real situation when he wrote:
“The purchasing power parity theory is that the rate of exchange would be in equilibrium when the purchasing power of the moneys is equal in all trading countries. 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 and is a sound doctrine. But unfortunately the term purchasing power in connection with the theory sometimes implies the reciprocal of the general price level in a country. While so interpreted the theory becomes that the equilibrium point for the foreign exchanges is to be found at the quotient between the price levels of the different countries. That is an erroneous version of the purchasing power parity theory.”
Our chain of reasoning leads to the conclusion that deficits and surpluses are the results of governments endowing money of different values with the same legal tender thus setting in train Gresham’s Law. It follows, as already stated, that the exchange rate is determined by the purchasing power of the currency — and not the balance of payments — which varies because the quantity of money varies.
(Strictly speaking, it is the money relation, i.e., the supply of and demand for money that determines purchasing power).
As Mises said: “The doctrine according to which foreign exchange rates are determined by the balance of payments is based upon an illicit generalization of a special case.” (A detailed explanation of this special case is given in Human Action, Third Revised edition, Henry Regenery Company, 1966, pp. 452 – 458).
Unfortunately, because most dealers think the balance of payments determines the exchange rate they rarely ask what determines the state of the balance of payments? The answer is the general level of prices and the buying and selling induced by differential price margins.
Part II deals with Treasury fallacy of capacity constraints and the balance of trade.
Australian Reserve Bank blames others for its own folly
Gerard Jackson is Brookes’ economics editor
BrookesNews.Com
Monday 7 February 2005