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The Australian economy, manufacturing and the exchange rate
Gerard Jackson
There is considerable dispute about whether the Australian economy is running into capacity constraints. Most commentators have accepted the view that the growth in imports is due to the inability of domestic producers to keep up with “excess demand”.
However, Treasury head Dr Henry argues that the fault lies with the boom in commodity prices which has driven up the exchange rate, thus encouraging consumers to switch from domestic consumption to cheaper foreign producers. (This used to be called the Gregory thesis). Therefore it is not capacity constraints that that is hindering output but an overvalued currency.
That the volume of consumer imports has risen strongly as a share of household consumption during the last three years would seem to lend weight to Dr Henry’s thesis.
Let us do what our economic commentators never do and return to the laboratory, i.e., economic history. When the world was on a gold standard the kind of phenomenon that Dr Henry is using to explain away our balance of trade deficit simply never arose.
Let us assume that we are in the nineteenth century and there is a country call A. It is suddenly discovered that A contains masses of valuable raw materials. Naturally the demand for A’s currency will rise. Does this mean that A’s manufacturers will suffer because of an overvalued currency?
According to the classical theory gold would flow into A causing domestic prices to rise. This would make domestic products more expensive relative to imports which would cause a deficit in the balance of trade. The effect would be a gold outflow that would restore equilibrium by driving prices down again. (This process was described by David Hume in an essay published in 1752).
The remarkable success of the gold standard in stabilising international trade and currencies in the nineteenth century seemed to vindicate Hume’s analysis. However, his thesis that gold flow movements and thus money supply changes would only occur in prices turned out to be flawed. In
In the 1920s F. W. Taussig (a Harvard economist) did a historical study of the gold standard and found that the balancing process operated far more smoothly and rapidly than could be explained by changes in general prices. He discovered that any rise in exports would be quickly countered by rising imports without the change in general prices that the classical theory had predicted.
Additionally, the quantity of imports did not appear particularly responsive to price changes. (The latter is a frequent complaint about Australia’s imports.) It was quite apparent that the classical theory was incomplete and that some other factor or factors were be at work.
The solution to the puzzle lies in the time it takes a changing money supply to act on prices and the degree to which the effect on prices can be offset, or even intensified, by a change in the demand for money.
When, for example, 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 emerge. Moreover, foreigners (those lucky 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 a depreciation leads to higher import prices. This in turn misleads many commentators — especially those paid to know better — to claim that depreciations are inflationary. This argument (it does not deserve to be called a theory) was used extensively by Weimar politicians to conceal the real cause of the devastating inflation they visited on Germany. It can never be sufficiently stressed that basically it is inflations that cause depreciations, not the reverse.
There is an abundance of empirical evidence to support this monetary explanation. 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 a Keynesian framework.
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.)
What he found is 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 balance of payments: 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, (c) the deficit country must devalue its currency until the deficit is eliminated.
In our world of constantly changing money stocks and interest rate manipulation currencies can be overvalued for sometime causing dangerous international imbalances to develop. Unfortunately it is not generally recognised by economic commentators that these persistent imbalances cause severe malinvestments which badly distort the capital structures of trading nations.
This is an economic fact that the Austrian school has been pointing out for years. But the Austrians were not the only ones. 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.
With regards to the balance of payments or the current account, money truly does not matter for the Keynesian. This why the relationship between the money supply and our trade deficit is rarely if ever referred to in the Australian media.
Gerard Jackson is Brookes’ economics editor
BrookesNews.Com
Monday 30 May 2005