Is China Driving the Australian Economy Out of Business?

By: Gerard_Jackson

I have written several articles drawing attention to the possibility that monetary policy may have reduced the ratio of manufacturing to GDP, only to have my concerns dismissed by the likes of Des Moore, a former Treasury official, as not being part of "the traditional explanation". But I was not saying anything new or radical. The possibility of an overvalued currency reducing the size of a country's manufacturing base is sometimes called the "Dutch disease" or the "dual economy".

This happens when foreign demand for a country's primary products, e.g., gas or oil, artificially raises the exchange rate which in turn makes domestic manufacturing more expensive relative to foreign manufactures. The result is a current account deficit. If this situation is maintained current account deficits will accumulate and the production structure 'of which the manufacturing base is a part ' will be severely distorted. Sooner or later these distortions will have to be dealt with.

Although Terry McCrann is fully aware of the "Dutch disease" , which is more than can be said of other commentators, he utterly failed to understand the forces at work even though he admitted that an overvalued currency can drive firms offshore. (Herald-Sun, China's rise bears different fruit, 18 April 2008). According to his line of thought everything is basically sound because of the huge number of jobs that have been created. (I>Herald-Sun, 'Two-speed' claims ring hollow, 11 April 2008).

The fallacy here should be obvious to any serious student of economics. First and foremost: so long as there is sufficient land and capital available widespread persistent unemployment cannot emerge in a free market. It follows from this that so long as labour costs are at least kept in line with the marginal value of the workers' productivity unemployment will not be a mass phenomenon, even when monetary policy has caused the manufacturing base to shrink. And monetary policy is the key to the problem. Therefore McCrann's conclusions are worthless in this respect because his employment figures tell us nothing in themselves about any detrimental changes to the production structure brought about by monetary expansion.

The view that an increase in the demand for Australian raw materials raised the exchange rate to the disadvantage of manufacturing invites more questions than it answers. The most important question being: why didn't the exchange return to its market rate as determined by the theory of purchasing power parity? This brings us to what was known as the "transfer problem" which is still very much with us. This "problem" dealt with the process by which international payments are transferred from one country to another and how transfers that disturb the balance of payments are corrected.

Under a gold standard the kind of exchange rate disturbance that we have been experiencing for years would be quickly dealt with. Let us say that a highly industrialized country discovered massive deposits of copper ore that could be cheaply extracted. The classical explanation has it that gold would flow in and raise domestic prices. This would reduce exports of manufactures and increase imports. The increased demand for imports would reverse the gold flow until domestic prices were at the level determined by their purchasing power parity.

In fact, what would really happen ? as was experienced at the time is that foreign demand for the country's raw material would raise domestic incomes which would rapidly increase the demand for imports without having to ship gold. Hence the transfer occurred without any changes to the domestic price level or the production structure.

The situation is very different , though the principle remains the same in a world where only paper money is allowed. China has engaged in massive credit expansion, one of the effects of which has been an enormous demand for raw materials, particularly in Australia. In order to buy Australian raw resources China must acquire Australian dollars. Now those who sell dollars acquire yuan in exchange. The dollars do not leave the country. They remain here and are used to buy Australian factors of production, including labour services.

Basically one of two things can happen when Australian dollars are exchanged for another currency. (The process is not quite as simple as I am making it out to be). The banks can use the foreign deposits to expand domestic credit and hence the money supply. (This happened in the 1960s with Eurodollars) or the deposits can be 'sterilized' so that the stock of money remains unchanged. If sound money policies were the order of the day, those who dealt with China would find that the quantity of dollars would increase in line with the amount of yuan that was exchanged.

This process would be an imitation of the gold standard and would have the same effect and would therefore eliminate any current account and exchange rate problems. But a world of paper currencies is one of continuously changing monetary stocks, severe exchange rates disturbances, chronic current account deficits, large-scale malinvestments, etc. In other words, world-wide inflation. If I am half-right then Australia's monetary policy will have been very loose. And this is exactly what we find. From March 1996 when Howard won his first election to November 2007 bank deposits rose by 224 per cent and M1 by 200 per cent.

Unfortunately the significance of these figures are completely lost on Mr McCrann. We already know that an obvious effect of an overvalued currency is to cheapen imports. But according to Mr McCrann

. . . the stuff we buy back from China (and, again, other similar places) that's made out of this increasingly expensive raw material is actually getting cheaper. Consumer goods. . . For example, plasma TVs have dropped in price by 25 per cent-30 per cent, just since Christmas. . . Those falling prices are of course cutting inflation. But also making it harder for the Reserve Bank to cut consumer spending with those interest rate rises.What it wants to achieve is to cut inflation even more, because of all the other pressures forcing up prices. (Herald-Sun, Our Budget to get a coal-fired boost, 13 April 2008)

Our analysis explains these 'cheap' goods terms of a monetary disorder created by loose monetary policies. (I am not disputing that part of the price declines is due to falling costs of production). In plain English, the process that Mr McCrann asserts is "cutting inflation" is in itself a product of inflation. Unfortunately Mr McCrann's ego does not allow for a sensible critique of his economic views.

The above raises the question of whether the damage done by inflation can be reversed. As Gottfried von 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 he points where the extra money first comes into circulation purchasing-power expands; elsewhere it remains for a time unchanged. (Gottfried Haberler, The Theory of Free Trade, William Hodge and Company LTD, 1950, p. 54).

By Gerard Jackson
BrookesNews.Com

Gerard Jackson is Brookes' economics editor.

Copyright © 2008 Gerard Jackson

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