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Will the exchange rate kill manufacturing
Gerard Jackson
In a previous article I took Professor Sinclair Davidson and Chris Berg to taskfor their approach to manufacturing. I now realise that my original assessment was far too generous. What does it say about the current state of economics in Australia when two economists can write a paper attacking the idea of market failure being used to justify industry policy without once referring to the possibility that the real culprit is a mismanaged monetary policy?
There are those in the Government who believe that manufacturing as a proportion of GDP is far too small and that this is the result of market failure that must be corrected by intervention. Our establishment right thoroughly disputes this view, arguing that the present ratio of manufacturing to GDP can be explained in terms of comparative advantage, which also means that labour and capital are now more efficiently employed.
My argument is that these market economists failed to consider that an overvalued dollar — despite being floated — resulted in a great deal of manufacturing bcoming uncompetitive thereby reducing the manufacturing-GDP ratio. Moroever, that a loose monetary policy aggravated the stituation. The reaction from the right was a blast of personal abuse accompanied by the dogmatic assertion that comparative advantage explains the shift. Furthermore, they declared, it is impossible for a floating currency to become overvalued because its exchange rate is always determined by supply and demand. And that's that.
Having joined the assault Professor Davidson now seems to have backpedalled somewhat. In an article for the Wall Street Journal (Australia Will Survive the Greenback's Fall, 9 November 2009) he freely admitted that the rise in the Aussie dollar against the US dollar will affect Australian manufacturing (my very point). There were no references to comparative advantage. In his opinion Australian firms have nothing to fear from a falling US dollar, and by extension any depreciating currency. All that is needed is for these firms to become more efficient. To call this approach extremely simplistic is to put it very mildly indeed.
Davidson is clearly implying that these firms are now seriously inefficient. (That politicians could use his argument as an excuse to justify higher taxes on industry evidently eluded him.) Moreover, even if these firms improved their efficiency a stage would eventually be reached where further improvements would not be possible. The last point needs to be stressed because the idea behind a policy of depreciation is to use the exchange rate to eliminate your competitors' advantage. (Between the wars this was called "exchange dumping".) This brings us to the Dutch disease which Davidson correctly defined as
The situation where strong demand for a mineral-rich economy's commodities pushes the currency up, which in turns makes the manufacturing sector less price competitive.
He then blundered badly when he said that it was "just another form of creative destruction". This is pure nonsense. Schumpeter made it clear that "creative destruction" was a "history of revolutions", one
that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one. This process of Creative Destruction is the essential fact about capitalism. It is what capitalism consists in and what every capitalist concern has got to live in. (Joseph A. Schumpeter, Capitalism, Socialism, and Democracy, George Allen and Unwin LTD, 1957, p. 83.)
Schumpeter was writing about entrepreneurship and innovation not exchange rate movements. It doesn't matter how brilliant an entrepreneur is, if a foreign competitor can use a falling exchange rate to continually undercut him then he has no choice: He must either close down his operation or move offshore. The same situation prevails if the problem is an overvalued currency. Not according to Davidson. He argues that so long as the supply and demand for a currency balances then it cannot be overvalued. The implication here is that the currencies relative purchasing power parities are always equalised.
Eli F. Heckscher explained that if foreign demand for a country's goods rises then that country must either let its exchange rate move accordingly or expand its money supply. Heckscher was refuting Gustav Cassel's theory that the quotient between the price levels of the two countries would always provide the equilibrium point for their exchange rates. (Chi-Yuen Wu, An Outline of International Price Theories, George Routledge & Sons LTD, 1939, pp. 259-60.) But once it was shown that this is not the case then an increase in the demand for country A's goods now means that the difference between the new exchange rate and the old one is a measure of the divergence between their relative purchasing power parities, even though supply and demand are equalised.
In other words, A's currency is now overvalued. Now A could try and offset the increase in its exchange rate by having its central bank print notes and then pay them directly to the exporters. This would obviously be an attempt to mimic the gold standard. However, this is not possible in a world where bank credit and paper currencies are continually expanding. In such a world monetary disequilibrium is the order of the day.
It is my contention that in the 1980s a loose monetary policy combined with an overvalued US dollar (only Australia's establishment right think this situation is impossible) caused much of American manufacturing to become uncompetitive. Critics countered that a monetary expansion would have driven down the currency, and that overvalued currencies are impossible when exchange rates float. (The last point has already been taken care of.) In other words, there is a strict inverse relationship between the exchange rate and the money supply. If the critics are right then the statistics should support them. They don't, as the following chart demonstrates.
BrookesNews.Com
Monday 23 November 2009
From January 1979 to January 1985 the dollar index rose by 44.6 per cent while M1 rose by 54.8 per cent. The period January 1996 to January 2002 saw the index rise by 22.9 per cent and M1 by 56 per cent. How can this be? During 30-year period M1 virtually forms a straight upward sloping curve. According to the critics the dollar index should therefore have formed a straight downward sloping curve. One would have to be wilfully blind not to see that the US dollar was overvalued in the 1980s and that this must have had a damaging effect on America's capital structure. It is no coincidence that it was at this time that the term "rustbelt" made its appearance. And it is certainly not a coincidence that the rustbelt largely consisted of capital goods-producing firms. It has been
estimated that from 1981 to February 1985, the US dollar had become overvalued by about 40 per cent on a trade-weighted basis with respect to the nation's main trade partners. This led to a doubling of the trade deficit from $70 billion to $140 billion in 1985 and to the loss of more than 2 million jobs... The same (but to a much smaller extent) seemed to have occurred during the latter part of the 1990s, when the dollar became gradually overvalued with respect to most other currencies. (Mordechai Elihau Kreinin and Michael G. Plummer, Empirical methods in international trade: essays in honor of Mordechai Kreinin, Edward Elgar Publishing, 2008, p. 44.)
Turning to Australia we find the same thing, as shown by the chart below. An inverse relationship between the money supply and the exchange rate seems to hold from February 1975 to July 1986, after which it breaks down. Now it gets really interesting. In July 1986 the exchange rate stood at 49.3. Come May 2001 it is still 49.3 even though M1 had rocketed by 457.6 per cent. If the critics were correct the dollar should have dived. Instead it largely fluctuated within a range of 50 to 60. The exchange rate then steadily rose from 49.3 in May 2001 to 72.8 in May 2008, a rise of 32.3 per cent. At the same time M1 rose by 52 per cent. So much for the simplistic (Ricardo-Wheatley) view that there is a strict inverse relationship between the exchange rate and the money supply. To support this mechanistic theory in the face of the statistical evidence would indeed be "atrocious economics", if not "incredibly stupid".
But what about comparative advantage? Any competent economist knows that an industry's comparative advantage can be taxed away. It is also known that an overvalued currency has exactly this effect. Unfortunately Australia's establishment right has adopted the absurd view that it is impossible for a floating currency to become overvalued, even though this is precisely what is happening right now to the US dollar as Asian central banks act to prevent their currencies from appreciating.
What the world is facing as I have said elsewhere is a grave monetary disorder. Not only does Professor Sinclair Davidson refuse to acknowledge the situation he made it patently clear that he like the rest of our right is totally clueless on this matter. Hence his ridiculous suggestion that the answer to a falling US dollar was for Australian firms to become more efficient. But the problem is that inflation creates malinvestments and distorts the pattern of international trade. As Haberler put it:
... the process of inflation always leaves behind it permanent or at least comparatively long-run changes in the volume of trade and in the structure of industry. The impact effect is a change in the direction of demand. At the points where the extra money first comes into circulation purchasing-power expands; elsewhere it remains for a time unchanged.... successive waves of [monetary] expansions then prices and foreign exchange rates may remain for sometime out of equilibrium with each other. [Italics added.] (Gottfried Haberler, The Theory of Free Trade, William Hodge and Company LTD, 1950, p. 54-55).
Davidson is a fellow of the Melbourne-based Institute of Public Affairs. This in effect means that from now on only Davidson's views on manufacturing and exchange rates will be aired. No debate will be permitted. So much for the those who contribute to the IPA in the naive belief they are funding an organisation firmly committed to the principle of an open and honest exchange of ideas.
Gerard Jackson is Brookesnews' economics editor