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Australian economy: Why a devaluation won’t save us
Gerard Jackson
The economic slowdown has encouraged calls for devaluation in the belief that this will stimulate exports and economic growth. As Yogi Berra said: “Déjà vu all over again”. In Why lower $A is good for us (The Age 17 March 2001) Ross Gittins expressed the same fallacious view, arguing that a falling dollar will increase the demand for Australian exports and so stimulate economic growth. Ergo! This will automatically avert a recession.
Before exposing the fallacious thinking behind this argument let’s delve a little further into its reasoning. When the dollar falls it makes Australian goods cheaper in terms of our trading partners’ currencies, which should lead to an increase in our exports. The obverse is that imports become more expensive. It’s that simple — or is it?
The process is called substitution. Labour and capital that would otherwise be used to satisfy domestic needs are redirected by prices changes to the production of exports. But where is the economic growth? Redirecting labour and capital from one line of production to another, even if it is for exports, does not promote economic growth.
Economic growth comes from extending our capital structure which in turn is fuelled by savings. It should be perfectly clear, therefore, that for increased exports to stimulate growth they would have to raise savings. They don’t and, of course, no one ever argued that they did, including Mr Gittins.
One can resort to the argument that where labour and capital are idle then bringing them on line to produce for exports raises output and by definition increase growth. The error here is to confuse growth with output.
It should be obvious that a greater utilisation of labour and capital is not the same as an addition to the capital structure. On the other hand, it does raise the question of why labour and capital was underutilised in the first place. And this brings us to those processes that devaluation brings into action.
People quite rightly associate growth with rising living standards — but a falling currency mean falling living standards. By redirecting labour and capital to from production for domestic use to production for exports domestic consumption falls. These exports are now sold in terms of a falling dollar, meaning that we receive fewer imports per unit of exports. (Economists call this a shift in the terms of trade). We can now see the double whammy here: first production for domestic use is curtailed while value of our exports fall.
The effect is to lower real wages. We can see this more clearly if we look at expanding export industries. We know their expansion can only be made possible by a falling dollar. But this also means that workers in those industries would have their real wages cut by the adverse terms of trade that a falling dollar would create.*
We end up producing more for less. In short, rather than stimulate economic growth or raise real incomes the falling dollar becomes a sneaky way to lower living standards by cutting real wage rates. That the increased production and employment that a falling dollar would create actually makes people better off is an illusion.
Unfortunately, the situation is even worse than I painted it. Australia imports the vast majority of its capital goods. This amounted to $84 billion in 2001 of which $57 billion consisted of intermediary goods. A falling dollar would obviously make it more expensive to extend the capital structure, the very thing that is fundamental to our living standards.
How did Australia reach its present economic state? There are those who argue that ‘economic rationalism’ (market economics) is the villains. To put it bluntly, they don’t know what they are talking about. Others make vacuous claims about the ‘new economy’ and such like. They too don’t know what they are talking about.
The real villain is the monetary policy of the Reserve Bank. From December 1999 to December 2004 M1 has grew by 105 per cent and bank deposits by 113 per cent. As currency was barely 20 per cent of M1 for 2001 we can deduce that credit expansion is the major component of monetary expansion and the most dangerous.
In short, monetary expansion has driven the dollar down. Some readers have disagreed with me on this point by arguing that the dollar has been holding its own against the US dollar. If they had looked at the situation a little closer they would have seen that the US dollar has actually been falling, leading one to conclude that both currencies have been falling in tandem.
In addition, it is the Reserve’s rapid monetary expansion that accounts for our rising tide of debt and growing current account deficit. Some will argue that this is a mistaken view because prices should always rise, at least significantly, before excess money starts fuelling a current account deficit. The mistake belongs to the critics. Monetary expansion frequently affects the exchange rate before it visibly influences prices.
Some commentators assert that is market sentiment that is driving down the US dollar anyway, inviting the question: What determines this sentiment? The answer, I believe, is that the markets are reacting to the economic consequences of the Fed’s loose monetary policies. In other words, they are merely reflecting economic reality. The same hold’s for the Australian dollar.
*It’s possible that the effects of a falling dollar on the prices of imported consumer goods could be offset somewhat by foreign firms’ rapidly increasing their productivity thus giving the impression that devaluation is ineffective in dealing with ‘excessive’ imports. (To keep things simple I have ignored the Marshall-Lerner condition). Nevertheless, if the devaluation is large enough prices of imports must rise.
Gerard Jackson is Brookes’ economics editor
BrookesNews.Com
Monday 18 April 2005