Naturally, this deregulatory lunacy also drove also drove the dollar down from US91¢ in 1983 (the year of the float) to the current rate of US75¢. Now according to Feil

These rates do not reflect the state of the Australian economy at those times. Speculation and technology have pushed economic theory about relative exchange rates out the window.

All of this is rubbish. Unfortunately Feil is not alone in spouting this nonsense. It may come as a surprise to him but John Stone, a so-called arch economic rationalist, also made a similar statement, even going so far as to assert that

we should pay less attention to economic theories (particularly when they are actively promoting self-interested parties in the financial markets) and concentrate on ‘what works’ (Dollar could use less speculation, Australian Financial Review, 20 September 2000).

The difference between Stone and Feil on this point is that Feil at least recognized that theories explaining exchange rates do exist while Stone seemed to be saying that they do not. We are not likely to find out what Mr Stone really meant because Australian self-appointed defenders of the market are not inclined to debate points of theory. The manner in which they screwed up the labour market reform debate is evidence of that.

On the other hand, Feil’s comment that floating the dollar “pushed economic theory about relative exchange rates out the window” is pure nonsense. Now I supported the float, and still do. However, I also realised that the absence of any real theory of money an exchange rates would cause policy problems that would be blamed on deregulation. This is precisely what happened.

With the world’s trading countries operating loose monetary policies speculation and rapid exchange rate fluctuations were bound to occur. None of this would have happened if relative money supplies had been more or less kept in check. But what Feil and Stone clearly do not understand is that continual monetary injections will destabilise exchange rates. This is why the international monetary system under the gold standard was a stunning success. Therefore the only time exchange rate problems emerged was when a country deviated from the standard.

Feil’s statement that rates under the float “do not reflect the state of the Australian economy” is just mumbo-jumbo. Rates are supposed to ultimately reflect purchasing power and not the alleged state of the economy. Professor Ludwig von Mises stressed this very point when he recalled how in 1919 a banker had claimed that the Polish mark should never have dropped to 5 francs because

Poland is a rich country. It has a profitable agricultural economy, forests, coal, petroleum. So the rate of exchange should be higher.

But as Mises said of those who preached that the state of an economy should determine its exchange rate:

These observers [men like Stone and Feil] do not understand that the valuation of a monetary unit depends not on the wealth of a country, but rather on the relationship between the quantity of, and the demand for, money. Thus, even the richest country can have a bad currency and the poorest country a good one. (On the Manipulation of Money and Credit, Free Market Books, 1978. The article was first published in 1923).

In other words monetary expansion is the root cause of any currency’s decline and not speculation or the absence of government controls.

Sixteenth and seventeenth century Spain provides us with a laboratory-like example of a what happens when a country rapidly expands its money supply while its trading partners’ money stocks remain comparatively stable. Importing massive quantities gold from her South American colonies, which in turn triggered the “price revolution”, caused Spanish prices to rise relative to those of her trading partners causing the escudo to depreciate against other currencies. Fortunately Spanish economists of the time were a lot better than our bunch. 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, observing 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.

De Soto was using the concept of purchasing power parity to explain Spanish exchange rates in terms of the relative purchasing power of moneys. As von Mises put it: “Exchange rates are determined by the relative purchasing power per unit of each kind of money”. In 1957 we find a Mr J. J. Polak, a Keynesian and IMF economist, arrived at the same conclusion.

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.

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.

The above 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 January 1983 to November 2005 M1 increased by a staggering 989 percent while currency expanded by a more modest 473 per cent. I put to Mr Feil that it was reckless monetary expansion that fuelled consumption, drove down the dollar and caused debt to pile up, not deregulation.

One shouldn’t be too hard on Mr Feil considering that our so-called free marketeers are no better. If they are not prepared to recognise the significance of money supply — or even debate it — why should anti-marketeers like Feil act any differently?

Gerard Jackson is Brookes’ economics editor

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