Money supply has been comparatively flat for sometime. However, it began to accelerate last April with bank deposits rising 5 per cent to August and M1 by 4.2 per cent in the same period. (The RBA is very tardy with its monetary aggregates.) This averages out annually at 12 per cent and 10 per cent respectively. I think it is fairly safe to conclude that monetary growth is still expanding. The monetary figures strongly indicate that it is the RBA's loose monetary policy that is driving house prices and is therefore the real inflationary threat. Oddly enough, when the likes of Bill Evans discuss prices and inflation money supply is never mentioned. And yet if we are going to discuss inflation in terms of an expansion in demand (increased spending) it is surely illegitimate to ignore the source of this additional demand.

It is also being argued that infrastructure bottlenecks — along with housing — are threatening to raise the inflation rate and push up interest rates. Another fallacy. The Reserve recently announced that it expects Australia will soon experience a resource boom — driven mainly by Chinese economic growth — that could last for years giving the country a growth rate of 3 per cent or more. But Chinese demand for our resources could leak into the rest of the economy encouraging "capacity pressures re-emerging in the near term".

Bottlenecks are symptoms of distortions in the capital structure. They are warning of impending problems that cannot be overcome with additional expenditure. Now an enormous amount of Chinese development is being driven by credit expansion. This monetary process creates unsustainable distortions, particularly in the higher stages of production. I fear, therefore, that our infrastructure bottlenecks are really the creation of an unsustainable Chinese increase in the demand for Australian resources that will eventuate in a considerable amount of wasted capital.

Glenn Stevens, the Reserve's governor, crowed that mining investment which has jumped from 1.5 per cent to 5 per cent of GDP over the past five years could rise even further. I rest my case. While investors respond to China's growing demand for Australian resources it was recently reported that "business investment is plunging". (Yes, it is a recession, Terry McCrann, Herald Sun, 4 June 2009.) It seems to me that manufacturing is going to find it increasingly difficult to raise the necessary investment funds, thanks to the resources boom. (Not to worry, Australia's economic commentariat assure us that this is the law of comparative advantage at work.)

Irrespective of what our economic punditry asserts, we really need to recognise the fact that if we accept that China's boom is being driven by credit expansion then it in turn is doing grave damage to Australia's capital structure, particularly manufacturing, which is bound to have a detrimental effect on living standards in the long term. It is argued that this cannot be the case so long as we maintain a floating exchange rate. This opinion is based on a very superficial view of the supply and demand for currencies that ignores purchasing power parity.

It is accepted in economics that a sustained increase for a country's products can bring about a rise in the exchange rate unless offset by a sufficiently large monetary expansion. It ought to be obvious to any economist that such a rise would mean a movement in the exchange rate away from its purchasing power parity, meaning that though the exchange rate between that country's currency and the currencies of its trading partners has been determined by supply and demand there now exists a divergence between their domestic purchasing powers. In this sense the country for whose exports demand has increased now has an overvalued currency. Dr Frank Shostak fingered the problem with a floating exchange regime:

The so called floating exchange rate does not really belong to a free market. In a truly free market we would have a gold standard. Under the current floating exchange rate system the central banks' monetary policy continually causes exchange rates to deviate from the underlying rate as set by the relative purchasing power of money. So in this sense the rate of exchange can become either overvalued or undervalued.

If this line of thinking is correct then Australian manufacturing is doomed to shrink even further as a proportion of GDP. And the theory of comparative advantage won't have a damn thing to do with it.

A comment on the orthodox approach to purchasing power parity

This is based on the idea that the foreign exchange rate is to be found in the quotient of the price levels of two countries. This approach is wrong through and through. purchasing power parity can only have any real meaning when referring to goods that are to all intents and purposes the same for consumers. This means they not only have to be technologically similar but also in the same location. A house in inner Melbourne in not the same as a house in inner Sydney even though they might be identical in every other respect. What this means is that PPP cannot be given a value.

It was Karl Gustav Cassel who invented the term purchasing power parity and who calculated it by dividing relative price levels. Despite the fact that he later modified his approach considerably most analysts still use what is basically the quotient approach. Nevertheless, Cassel's original approach was reasonably accurate with respect to the currency situation in post-WWI Germany. (Gottfried Haberler, The Theory of Free Trade, William Hodge and Company LTD, 1950, pp. 37-8.)

Gerard Jackson is Brookesnews' economics editor

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