Commodities and Exchange Rates

By: Gerard Jackson | Sun, Mar 11, 2007
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The striking thing about a great many journalists who feel free to comment on economic matters is their appalling mediocrity, not to mention their open hostility toward the free market. This is not bile or spite on my part, far from it. Economics is a vitally important subject. Inept economic policies can destroy countries and ruin millions, which has happened a number of times through history.

Therefore media commentators must not only consider their thoughts very carefully before going into print they should make every effort to leave aside any political prejudices they may have. Unfortunately too few past this test, which brings me to Kenneth Davidson of The Age, a paper infamous for its intellectual pretensions and moral grandstanding -- not to mention the scale of its leftist bigotry.

Davidson, an alleged economist, argues that loosening up Australian labour markets has helped to maintain confidence in the dollar. He also thinks that the Australian dollar is commodity driven. This thinking is still within mainstream economic commentary. Unfortunately the mainstream is very wrong. Though the currency may appear commodity driven it is not. (A fact that would become immediately clear if we were on a gold standard). This misunderstanding has led economic observers to state that the balance of trade determines the exchange rate*. The likes of Davidson therefore deduce from this that commodities must be abandoned in favour of other products -- meaning manufacturing -- if exchange rate instability is to be averted.

Imagine a world on a gold standard in which a country whose exports consisted entirely of manufactures suddenly discovered vast quantities of valuable minerals within its borders. This would cause a considerable inflow of gold without permanently altering the exchange rate. Why? The classical theory predicted that the gold inflow would be reversed because it would raise domestic prices by inflating the money supply and thus restore equilibrium. However, in the 1920s economists led by Professor Taussig found that currency flows reversed themselves before any impact on general prices could be felt, a state of affairs the classical theory did not predict. The reason is simple: the gold inflow raised domestic incomes which increased the demand for imports before it could have an inflationary influence on general prices.

It is now argued that because we use paper money the classical theory no longer holds. Not so. Let us assume for a moment that the world's money supply consists completely of paper and that money stocks are held constant. It follows that the classical analysis still applies. Exchange rates will be determined by purchasing power parity. Our favoured country will find that its exchange rate rises as foreigners demand more of its currency in order buy commodities (its exports).

But exports are the price of imports. Because the commodity producing country prints money in exchange for foreign currency, nominal incomes will rise as will the demand for imports. To pay for these imports foreign money will have to be bought through the central bank who will then sterilise the domestic notes to prevent a monetary expansion. Readers will clearly see that the whole process is designed to mimic a gold standard.

What if there is no central bank? It still makes no difference. Foreigners will have to exchange their currencies directly instead of through a central bank. This means that though the domestic stock of money will remain unchanged certain individuals now hold foreign currencies as part of their cash balances while money stocks in the commodity importing countries will have fallen by the same amount. But the rise in the demand for imports by the commodity exporting country will prevent deflationary effects from arising in the commodity importing countries.

This brings us back to Professor Taussig's finding that before 1914 countries' balance of payments quickly adapted themselves to changing circumstances before any changes in price levels occurred, suggesting that the classical theory was incomplete. We now see that the rise in nominal incomes exceeded the demand to hold money which raised the demand for imports. In other words, a short-run process offset the classical long-run adjustment process. (I have assumed throughout that capital flows are completely free).

In the real world of continuously expanding money stocks exchange rates are always adjusting and currencies are always moving down. This fact is concealed from most people because prices are relative, including the prices of other currencies. Hence a currency can look as if its rising while in fact it is falling -- it just so happens that other currencies are falling faster. But it's always the market that gets the blame for monetary disorders and not the monetary authorities.

Therefore the argument that the Australian dollar is commodity driven cannot be used to excuse the silly claim that "the logic of the global shift from the age of industry to the age of information is that there is no future in commodity trade". The logic of which is that the government must direct investment from commodities "in favour of high-value added goods and services", a policy that Kevin Rudd, leader of the Australian Labor Party, seems to support.

To begin with, if high value-added industries were that profitable why aren't shrewd capitalists abandoning dying industries for them? Why do we need far-seeing people like Kim 'il' Carr to direct them? Because value added does not necessarily mean profitable. I am prepared to speculate that Australian mining is probably adds more value per worker than electronics.

Why? Because it is extremely capital intensive, as is oil production, steel, cars, etc. (Readers should recall these facts next time some pompous politician or journalist yaps on about value-adding and hi-tech). To tell the truth I would be much more impressed if supporters of central planning were more prepared to put their own money where they are so keen put the taxpayers' money.

*In 1801 Walter Boyd's Open Letter to Prime Minister Pitt triggered a vitally important debate -- from which our current crop of so-called free market advocates appear to have learnt nothing -- on the link between monetary expansion and exchange rates.



Author: Gerard Jackson

Gerard Jackson

Gerard Jackson is Brookes economics editor.

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