Is monetary policy killing Australian manufacturing?

Gerard Jackson
BrookesNews.Com
Monday 25 September 2006

Last week I put forward the idea that Reserve Bank of Australia’s monetary policy may be playing a significant role in shrinking manufacturing as a proportion of GDP¹. An interested reader showed the article to an Australian economist. His response was exactly what I would expect. He argued that other countries have high monetary aggregates so my argument should also apply to them. Moreover, inflation has been very low. Therefore the shift in manufacturing operations to other countries can be explained in terms of them having lower unit costs. It follows that the ‘conventional’ explanation that manufacturing will decline as a proportion of GDP once living standards reach a certain level is the correct one.

Before I explain where this economist went wrong let me restate my case. The monetary argument I employed rests on the obvious fact that prices guide production. From this it is deduced that if monetary policy misdirects spending in such away that the exchange rate becomes overvalued for a considerable length of time then imports of manufactured goods would rise at the expense of domestic manufacturers, forcing some of them to move their operations offshore and others to close down. This reasoning is based on another obvious economic fact — trade between countries is based on the international differences in prices. If country A has a comparative advantage² in the production of good P then it will pay country B to cease or reduce production of good P and redirect factors to the production of those goods in which it does have a comparative advantage.

As I have pointed out more than once, as a country becomes more capital intensive there will be a tendency for labour intensive firms operating in the tradable goods sector to move offshore as the price of domestic labour continues to rise. Now if a country is on a fixed exchange rate then a monetary expansion will flow to it trading partners manifesting itself in the form of increased imports and a current account deficit. Although Australia has floated the dollar that in itself does not mean that it cannot be overvalued. Hence having an overvalued currency, even when operating on a floating exchange rate , is analogous to a monetary expansion while on a fixed exchange rate. In short, the economic consequences are the same. Gottfried von Haberler explained that if the economy is not allowed to adjust to “successive waves of [monetary] expansions then prices and foreign exchange rates may remain for sometime out of equilibrium with each other”. (Theory of International Trade, William Hodge and Company Limited, 1950, first published 1933). In addition, the view that the decline in manufacturing as a proportion of GDP is only to be expected is in fact an empirical observation. There is no economic law that says this must be the case.

There is nothing new in my argument that a long-term monetary expansion combined with an overvalued currency can have a detrimental effect on domestic investment. More than 170 years ago Samuel Mountifort Longfield raised a similar point, only his was based on a redirection of spending on investment to spending on foreign luxuries rather than a continuous monetary expansion. (Three Lectures on Commerce and one on Absenteeism, 1835). Nevertheless, the basic principle remains the same. Then in 1970 Samuel Brittan, an economist with the Financial Times, made the same point, arguing that

[i]f an imbalance is allowed to persist too long, a deficit country acquires an excessively home-based industrial and commercial structure while the surplus country becomes excessively export-oriented... This makes adjustment needlessly painful and difficult when it does come, and there is the risk of high transitional unemployment while resources are being transferred. Shop assistants in Britain cannot be transferred overnight to engineering establishments which do not yet exist while Volkswagen workers cannot move straight away into the German social services. These very facts themselves provide ammunition for those who oppose parity changes, and the eventual adjustments are all the more sudden and severe when at last they come. (The Price of Economic Freedom: A Guide to Flexible Rates, London Macmillan and Co., 1970, p. 18).

This brings me to my critic’s objection that my argument cannot hold, at least in the case of Australia, because other countries have had very high monetary aggregates. Have they? Surely it depends on how money is defined. (Lay people have no idea how much confusion reigns in the economics profession when it comes to the definition of money). In 1801 Walter Boyd wrote a letter to Pitt the Younger in which he defined money (even then there was considerable debate on the subject) and in doing so made the definitive distinction between “ready money” and so-called money substitutes. In his own words:

By the words ‘Means of Circulation, ‘Circulating Medium’, and ‘Currency’, which are used almost as synonymous terms in this letter, I understand always ready money, whether consisting of Bank Notes or specie, in contradistinction to Bills of Exchange, Navy Bills, Exchequer Bills, or any other negotiable paper, which form no part of the circulating medium, as I have always understood that term. The latter is the Circulator; the former are merely objects of circulation.

This definition is in perfect keeping with AMS (the Austrian school of economics definition of money³). Therefore a definition of money should not include “objects of circulation”, e.g., CDs. Fortunately Australia’s M1 comes close enough to our definition for purposes of comparison and the same can be said for the US. However, the following US monetary aggregates do not contain travellers cheques because these are credit instruments and not money. From March 1996 to 4 September 2006 US money supply expanded by about 26 per cent: currency grew by 99 per cent while credit from demand deposits and deposits at commercial banks and thrift institutions grew by 85 per cent. (H.6 Money Stock Measures released by the United States Federal Reserve). Of course this aggregate hides the monetary fluctuations that occurred during that period. For example, From January 2003 to January 2004 M1 rose by 6.5 per cent. For 2004 to 2005 it rose by 4.7 per cent and only 1.2 per cent the following year. January to April this years saw it rise by a 0.6 per cent. This would be about 2 per cent annually. Nevertheless, US monetary expansion is still a very modest in comparison with Australia’s monetary growth. From March 1996 to July 2006 Australian currency grew by 95 per cent, bank deposits by 138 per cent and M1 by 125 per cent. I am willing to bet that not too many OECD countries could match this monetary expansion for the period surveyed.

It is my critic’s comment on money supply, at least with respect to the US, that does not hold up. There is also the fact that he completely misunderstood my argument. I never claimed that a monetary expansion in itself would cause manufacturing to shrink. I thought I had made it abundantly clear that the problem lay with an expansionary policy combined with an overvalued exchange rate. It is through this mechanism that the size of the manufacturing sector relative to GDP could be reduced. This is why Brittan could write of “an imbalance” in “a deficit country” and not merely an expansionary monetary policy. A little thought should have made our economist aware that the process I described can even be fitted into a Keynesian framework. For instance, the following was said by Bernie Fraser (a Keynesian) when he was Governor of the Reserve Bank of Australia (1989-96):

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).

When “demand runs ahead of capacity” we are talking about a loose monetary policy sucking in imports and aggravating the current account deficit. But if this is the case then it strengthens my argument that if the monetary expansion is allowed to continue the situation will damage domestic manufacturing. Bernie Fraser is not alone. Saul Eslake opined that “keeping the exchange rate for the Australian dollar higher than it might otherwise have been” strikes at the competitiveness of the “manufacturing and services” (ON LINE , Striking parallels: divergent paths, 11 May 2006). Unfortunately Mr Eslake failed to take his argument to its logical conclusion.

This brings me to my critic’s assertion that Australian inflation has been very low. But this is a question of definition and not measurement. The Austrians recognise two types of general price increases: a goods-induced change in prices and money-induced change. Moreover, a rising price level caused by a monetary expansion is, according to Austrian analysis, a symptom of inflation. In other words, it is a monetary expansion, irrespective of its impact on prices, that is the inflationary force. Using this definition as a guide we can see that the Reserve Bank of Australia has been pursuing a highly inflationary policy for some years now.

The real problem is not the ‘conventional’ explanation but the unfortunate fact that our economic commentariat has failed to grasp all of its ramifications. For example, they are blissfully unaware of the fact that their assumptions regarding manufacturing and foreign trade are based on sound money. But once we move to a regime based on a continual monetary expansion then ‘conventional’ explanation requires further elaboration.

This argument has enormous ramifications. Australia has one of the lowest — if not the lowest — ratios of manufacturing to GDP in the developed world. I am not saying that this is a bad thing, only that I think it needs to be re-examined in the full light of economic theory instead of being casually dismissed as fitting the traditional explanation. I have already shown there is much more to the traditional approach than these commentators realise. By failing to properly address the issue they have inadvertently helped fuel the rising clamour, some of it from within the Liberal Party itself, for an industry policy. Unfortunately our economic commentariat is more concerned with losing face than in eliminating economic fallacies or engaging in debates that might test their grasp of basic economic theory.