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The Labor Party is itching to meddle with the Australian economy and the trade deficit
Gerard Jackson
Bob McMullan, the ALP Member for Fraser, made it abundantly clear that the Labor thinks it know not only how to manage the economy — which is bad enough — but also how to deal with our “appalling trade performance” (The Age, We must act now on trade crisis, 24 July 2006).
I’m the first to agree that there is something very much amiss with the trade deficit Australia has been running for some years. But the problem here is that McMullan and his ALP mates simply do not get it. (I should point out in all fairness that the Liberal Government is no better on this score).
McMullan appears to think there is a contradiction between our trade deficit and “the fact that our terms of trade are now more favourable than at any time in 50 years”, even though he comes close with the observation that the country is “heading back towards the bad old days of being just a quarry and a farm”. At this point he goes off the economic rails, arguing that we need “trade negotiation strategy”, “reformed export support” and “revitalised trade promotion”.
Our would-be economic planner is obviously of the opinion that the market has once again failed the Australian economy as evidenced by our “trade failure is in export of manufactures and services”. Naturally, what the country needs is “a long-term plan” to deal with the trade crisis. This code for political direction of the economy. What it actually reveals is that McMullan and his mates — like the Liberal Party — has not got a clue to what is happening
Unfortunately he overlooked the fact that trade occurs because of differences in prices. This observation should be the starting point for any debate on the flow of goods and services. So what we need to do is examine those economic forces that influence the prices of exports and imports.
In a free market where money stocks and therefore currencies are stable exchange rates will also be stable. The key here is money supply. Once any country begins to expand its money stock while others remain constant there will be a downward pressure on the exchange rate. In plain English, the inflating country will find that it currency will depreciate against other currencies.
Where the exchange rate is falling imports become more expensive and exports cheaper. Changes in the money supply have therefore also brought about an unfavourable change in the terms of trade. Now this assumes that the exchange rate is allowed to freely float. However, if a country finds itself stuck, whatever reason, with an overvalued currency its exports will decline and its imports will increase.
But imports must be paid for. Although it is true that exports are ultimately the price of imports money is the intermediary through which this process is accomplished. But where the currency is overvalued payments must come through the capital account. In other words, borrowing. This means that so long as the currency remains overvalued the country will continue to accumulate a foreign debt.
I believe this is why the foreign debt now exceeds 50 per cent of our GDP. Therefore the problem is not caused by free trade agreements, subsidised imports or an “insatiable rise in consumer spending”, as some commentators think, but a loose monetary policy.
(Although a world of rapidly changing money supplies and severe political uncertainty would complicate the situation it would still not halt the fundamental economic forces at work).
Those who focus on consumer spending, a mounting foreign debt or the trade deficit never stop to ask where all of this spending comes from. They never stop to ponder how debt can actually exceed what was saved or why we cannot seem export our way out of our trade deficit. The answer is credit expansion — the very thing that sparked a housing boom has been driving the current account deficit.
From John Howard’s 1996 March election win to May this year, currency has risen by 122 per cent, bank deposits by 138 per cent and M1 by 120 per cent. When you examine the Reserve Bank’s figures in detail it becomes obvious that the overwhelming expansion in the money supply was in the form of credit. Unfortunately money supply is not something the great majority of economic commentators bother with, let alone politicians.
Because we are in a world of continuously changing money stocks the situation becomes very murky. China has been running a reckless monetary policy that has driven up its demand for raw materials. (I am told that Chinese currency and credit is still growing at more than 20 per cent pa). The result is that China massively increased its demand for Australian resources.
This had a double effect: Firstly, it improved the terms of trade for Australians and hence made imports cheaper. Secondly, this in turn reduced the cost of importing capital goods while simultaneously striking at foreign demand for manufactures and services. Considering the current situation I suggest that Mr McMullan carefully note the observation made by Bernie Fraser when he was Governor of the RBA (1989-96):
In simple language, loose monetary policies have gravely distorted the price structure. This is a problem that no amount of meddling by politicians can correct. Only the market can make the final and necessary adjustments.
Gerard Jackson is Brookes’ economics editor
BrookesNews.Com
Monday 31 July 2006
If demand runs ahead of capacity, it will spill over into imports and widen the current account deficit (CAD). This is what happened in 1989-90 when the deficit reached 6 per cent of GDP. On this occasion the CAD is not expected to increase to the very high levels reached during the lat 1980s. (Reserve Bank Annual Report, 1994).