Letters on Economics

Ian McNamara, 'Australia All Over', ABC radio, Sunday morning program.

Economic Growth

Sent 14 August 2010.

Dear Ian,

Last week you were spurning economic growth. I am also repulsed by some aspects of economic growth. Economic growth that is generated by deliberately pushing people into debt is disgusting. Yet to raise our economic growth, we subsidized people into debt with the first home buyers scheme.

Economic growth that is generated by trading our finite resources for imported products, including food, that we are capable of producing ourselves is also distasteful. It is even more abhorrent when one realizes that the export of those resources is destroying our manufacturing industries and raising unemployment.

As Dick Smith explained, growth that comes just from bringing in more people so that we can be kept busy building houses for them can erode our own welfare. It causes urban congestion and leaves us with inadequate education, health and transport infrastructure and services.

But not all growth is bad. Growth that uses our resources more effectively and efficiently to meet our needs is welcome. For example, economic growth from advances in medicine that enable us to return from hospital in days rather than weeks, is superb. Also, growth that provides us with more efficient transport is excellent.

Economic growth that employs people who are unemployed, or under employed, is also welcome. It raises our self esteem and enables us all to contribute more to our society as well as to our own welfare.

Furthermore, economic growth that raises our wealth and welfare, rather than raising our debt, is marvellous.

So don’t reject all economic growth. Some economic growth is constructive.

Regards

Leigh

Ian McNamara, 'Australia All Over', ABC radio, Sunday morning program.

Floating exchange rate, debt and economic growth

Sent 14 May 2010.

Ian

Following your comments last Sunday, it would be wise to distinguish between the two major forces in the economy: those that create debt and those that create growth and prosperity.

Money constrains expenditure to income (production)

When we sell our goods and services to the economy, the money we earn enables us to buy the equivalent of what we have produced, or contributed to the economy. That is, money constrains our expenditure to our income; what we buy to what we sell; our demand to our supply (Says law).

Creating extra money causes expenditure to exceed income

You would be aware that a forger is a person who steals from the economy by creating money. They use the forged money to buy goods without selling any goods or services to the economy. If they were to create a large amount of forged money they would cause the country to buy more than it produced.

Foreign debt is created when expenditure exceeds income

If a country buys more than it has produced, then it is either going to:

run down stocks; or
import more than it exports.

There is a limit to the amount that stocks can be run down and if it does happen, it causes hyper-inflation. Usually, the extra spending causes imports to exceed exports and leads to a current account deficit. This is likely to reduce foreign reserves if the country has fixed exchange rates. It is likely to increase foreign debt if the country uses the floating exchange rate system.

Bank credit the source of extra money

Of course forgeries are not responsible for our foreign debt. Bank credit is the main means that we create additional money in our economy. The government does create some money and uses it to finance expenditure. But that is less than 5 per cent of the total. More than 95 per cent of the growth in the money supply in our economy is from bank credit. So it is not high exchange rates (as generally believed) that causes us to buy more than we produce; it is the creation of additional money through the growth of bank credit.

Creating money creates domestic debt and foreign debt

The banks create money when we borrow and this raises total domestic debt. When we spend that money, we are spending more than we have earned and that creates additional foreign debt. So for every extra dollar of money we create from bank credit, we produce two dollars of extra debt: a dollar of domestic debt and a dollar of foreign debt. It is no wonder that debt is a major world economic problem.

Source of economic growth

The second effect to consider is the source of economic growth. In the days of fixed exchange rates, if we increased our exports by more than our imports, we would earn more money than we spent. The extra money we earned would enable us to increase our spending on local products and imports. Our income would continue to grow until our spending on imports increased to equal our income from exports. When imports were equal to exports again, we would be in equilibrium: the money coming into the country being equal to the money going out and our income would stop growing.

For example, assume that we spent 10 per cent of our national income on imports. If exports increased by $100 million, our national income and spending would have to rise by $1,000 million before our additional spending on imports increased $100 million to equal our additional income from exports. (This is the trade multiplier.)

The important point to note here is that disequilibrium and the process of achieving equilibrium raised our income and made us more prosperous. When the economy reaches equilibrium, our income stops growing.

In the process, additional money is created. It is created because we have produced more than we have consumed; because we have saved. It raises foreign reserves rather than foreign debt.

Floating exchange rate constrains growth

Under the floating exchange rate system, if we increase our exports the exchange rate rises to make imports cheaper so that;

imports equal exports and the additional foreign currency earned from the increased exports is used to pay for the additional imports; and
we shift our spending from domestic products to buy those imports so that the additional domestic currency spent on imports can be used to pay domestic currency to the exporters for their increased exports.

The shift in spending from domestic products to imports reduces the income of those domestic industries supplying the domestic economy. The extra income earned by exporters is earned at the expense of those other industries supplying the domestic market. That is, the increased income from export of minerals and energy is undermining our manufacturing and agricultural industries.

With floating exchange rates, equilibrium between international payments and receipts is attained daily on the foreign exchange market. There is no opportunity for additional income from exports to raise our national income and bring prosperity. Equilibrium between foreign payments and receipts is achieved by changing the relative price of domestic products and imports. As we increase our exports, the share of our income spent on imports rises and the share spent on domestic products declines. Equilibrium is not attained by raising income as under the fixed exchange rate system so trade no longer brings economic growth.

Money and debt

During the days of fixed exchange rates we had two sources of additional money: increased exports, and bank credit. As mentioned above, money from increased exports came from savings that would raise our foreign reserves. Increased bank credit increased our spending above our income and would deplete foreign reserves. So with fixed exchange rates it was important to regulate bank lending so that the additional imports from bank credit did not deplete foreign reserves.

When we floated the exchange rate, we eliminated the source of money that came from increased foreign reserves. That left us with only one main source of additional money: bank credit. That money caused us to buy more than we had produced.

Also, because we need additional money for the economy to grow we needed to fill the vacuum left by the termination of money from trade with increased money from bank credit. That is why the banking system was deregulated. (The US floated first and then deregulated the banks to get out of a recession; the “oil crisis”. We in Australia first started to deregulate banking and then had to float our exchange rate as it was not possible to maintain a fixed exchange rate with a deregulated banking system.)

The need for bank credit left us in a terrible dilemma. If we increase bank credit to increase prosperity, we also raise our foreign debt. Also, money from bank credit has proved to be more inflationary than money from trade and savings. Hence we need more money to compensate for inflation. This has driven us deeper into debt.

Current economic policy

Now we have convinced ourselves that foreign debt does not matter. So our Reserve Bank concentrates on managing monetary policy to control inflation. While the growth of bank credit is seen as necessary for prosperity, we consider that bank credit that causes inflation to exceed 3 per cent is excessive and must be constrained. So bank credit is constrained, not by restricting the amount of money the banks can lend but by raising interest rates to discourage us from borrowing.

So this where we are with monetary policy:

we have a floating exchange rate system that stops us prospering from the growth of exports;
we are dependant on bank credit (or bank debt) to prosper but it causes us to buy more than we produce and raises our foreign debt; and
we have an interest rate policy to whip us into line if we dare to borrow too much from the banks and raise inflation.

The solution

The solution to all this is not necessarily to return fixed exchange rates. Given the right incentives, the finance market can be induced to adjust the exchange rate in such a way that it creates money from trade to achieve full employment with low inflation. It can do this more effectively than a central bank and do so with more stable exchange rates and interest rates.

This is an attempt to explain briefly what I have come to understand about the relationship between the exchange rate system, foreign debt and the demise of our manufacturing and agricultural industries. I hope you find it useful.

Regards

Leigh Harkness

Ian McNamara, 'Australia All Over', ABC radio, Sunday morning program.

How to Beggar your Economy

Sent 6 May; referred to 9 May 2010.

Dear Ian

Last Sunday you stated that China was undervaluing its currency and thereby undermining US manufacturing industry.

As a member of the IMF, China has agreed to avoid manipulating its exchange rate to gain an unfair advantage over other members. This is the “beggar thy neighbour” provision of the membership agreement.

A country can beggar its neighbour if it sets its exchange rate too low. The neighbouring country buys cheap imports from the first country instead of buying its own products. Industries in the exporting country with the low exchange rates prosper, while industries in the importing country collapse.

Your statement implies that China is beggaring the US economy in this way.

However, the US already had trade problems with Germany, Japan and the Asian Tiger economies before China came onto the scene. These economies could not be accused of beggaring the US economy.

Also, prosperity in a low exchange rate country usually causes prices to rise and so neutralise any earlier benefit from a low exchange rate.

Inflation in China should be making the US more competitive. But it is not.

For a country to do a good job of destroying its manufacturing industries, it really needs to adopt a “beggar thyself” policy. That is, the government must set up an exchange rate system that stops the country earning any more money from exports. If the country does increase its exports, the exchange rate must rise to make imports cheaper. In that way, any additional income earned from increased exports is spent immediately on increased imports.

The US has the floating exchange rate system which is designed to stop the country earning any more money from exports. That is, it has a “beggar thyself” policy.

So it is not China that is beggaring the US economy; the US is beggaring itself.

Regards

Leigh Harkness

It appears that the underpants industry has been hit by the Dutch Disease. In the 1960’s, Dutch income from the natural gas fields in the North Sea drove up the value of the Dutch guilder. That made Dutch products less competitive on domestic and export markets. As a result, Dutch industries suffered. This effect became known as the Dutch Disease.

In Australia, mineral exports keep the value of the Australian dollar high. The high value of our dollar makes imported underwear cheaper than local underwear and so we buy imported underwear and the Australian underwear manufacturers go out of business.

The disease is widespread in Australia. In the 1960’s and 70’s we spent around one eighth of our income on imports and around seven eighths on local products. In the last ten years we have been spending around one fifth of our income on imports and so our spending on domestic products has fallen to around 80 per cent of income. Consequently, Australian industries competing with imports have suffered.

The Philippines once had a bad case of the Dutch Disease. Filipinos working overseas were remitting so much money back home that the value of the Peso became very high. By 2003, imports were so cheap that Filipinos were spending more than half their income on imports. That meant that they were spending less than half their income on domestic products. This devastated local industry.

The central bank of the Philippines is required by law to provide monetary policy that is conducive to balanced and sustainable economic growth. Therefore, it acted to stabilise the exchange rate. As a result, spending on imports has fallen back to nearly one quarter of income and so nearly three quarters of income is spent on domestic products. With their new and higher incomes, Filipinos are buying more local products and about the same amount of imports as they were in 2003.

So there is a cure for the Dutch Disease for countries that want to do something about it.

You may be aware from history that King Richard had trouble financing his crusades. He decided to print more money to pay his soldiers and suppliers. That additional money eventually ended up being spent on imports from across the channel.

The foreign traders did not want King Richard’s money. They wanted gold. As a result, King Richard had to convert the money he printed into gold, and his gold reserves declined rapidly.

To solve that problem, King Richard established a new trading system. He told everyone that it was a brilliant system and no-one could disagree with him.

Under the new system, traders sold their exports overseas and used the money they earned to buy other goods which they imported and sold on the local market.

No money was allowed to leave, or enter, the country. So the King did not have to exchange his money into gold. His gold reserves were saved.

However, it created new problems. Traders took pots and pans etc. and sold them overseas. In exchange they bought food and clothing to sell back home.

This upset the food and clothing manufacturers back home. In the past, when exporters came back with money, they would spend some of that money buying local food and clothing. Hence local suppliers prospered from exporters’ success.

But now the traders were not bringing back money. Instead they brought back food and clothing. The exporters were now competing with the domestic suppliers.

As exports increased, imports of food and clothing increased, also, and the domestic food and clothing industry declined.

Many people realised that they should buy local food and clothing. But they could not afford them and had to buy the cheaper imports. So the local industries died out.

Really, this story is not about King Richard but about President Richard Nixon. His crusade was not in the Holy Land, but in Vietnam. He created money to finance that war. As a result, US gold reserves declined rapidly. He stopped converting US dollars into gold and in 1973 set up a new trading system. In 1983, Australia adopted the same system.

Richard Nixon’s system has the same effect in the US and Australia as King Richard’s system in the story.

We may want to buy Australian products to support local industries. But Richard Nixon’s system not only stops money leaving the country, it stops money entering the country. As we increase our exports, we must spend that money buying more imports. Those additional imports compete with and destroy local industries supplying the local market.

That is why it is now difficult to find Australian produce and products in our supermarkets.

Last Sunday you read a letter from Brian promoting free trade. This followed a call from Emily urging us to support to Australian industries. We need more free trade if we are to support Australian industries.

In April last year you read my sequel to Jack and the Beanstalk. Jack’s milking herd produced too much milk for his little village. His mother allowed him to export his milk to the larger town, provided that he spent all the extra money he earned in the town.

Jack had free trade, but his spending was restricted. That distorted trade, forcing Jack to import goods from town to distribute in his village. Village businesses were ruined because they could not compete with Jack’s imports. The local businesses would have prospered if Jack were allowed to spend his money in the village.

Like Jack, we can freely trade products. And like Jack, we are restricted from bringing extra back money to spend in our country.

Individually, we are free to bring home the money we earn from exports. However, as a nation, we are prevented from bringing in any extra money.

We have a foreign exchange market that swaps money between people taking money out of the country with people bringing money in. When we increase our exports and try to bring in more money, the market inflates the value of our dollar to reduce export incomes and to increase imports, by making imports cheaper. The system distorts trade to prevent any extra money flowing in.

This system is known as the floating exchange rate system. It acts as a moat to protect the country’s gold and foreign reserves. The US, and a few other large economies, adopted the system in 1973 during the Vietnam War because President Nixon wanted protection for US gold and foreign reserves. Australia adopted the system in 1983 during a period of financial deregulation when Treasurer Paul Keating wanted protection for Australia’s gold and foreign reserves.

This system is a barrier intended to stop money leaving the country. But it is also a barrier keeping money out.

It prevents us bringing into Australia the additional money we earn from increased exports. Instead we must spend that money on extra imports. These imports destroy Australian industries, particularly those competing with imports.

Brian is correct when he calls for free trade. Emily is also correct when she calls on us to support Australian industries. If we are to support Australian industries, we must have free trade not only for our goods but also for our money.

Last week you said that no-one predicted the current financial crisis. Yet I thought you and many of your listeners did.

For many years, you have talked about the need to buy Australian, the current account deficit and the rising foreign debt.

Those comments reveal an understanding that it was unsustainable for our economy to continue to buy more than it produced and to borrow from the rest of the world.

The official position was that if the banks wanted to lend the country into debt that was their problem. We were told that the financial system was deregulated and the banks had a right to do whatever they like. When our industries could not compete with cheap imports, these officials applauded the benefits of globalisation. They accused our industries of being inefficient and unproductive. These officials said that the market was always right and eventually the market will sort these things out.

Now that the market attempts to sorts things out, these same officials call it a financial crisis and spend billions of our dollars to intervene in the market in a vain attempt to force it to continue on its unsustainable course.

If the world was allowed to stop lending us money, we would have to buy Australian products and our industries would be internationally competitive. We would have a current account surplus and we would start paying off our foreign debt.

The problem is that our financial system is unstable. Paul Keating admitted as much when he told us last time that “this is was the recession we had to have”. But officials deny that there is a problem with our financial system.

It is possible to change the financial system to make it stable and sustainable. For example, the Philippines once had current account deficits like ours. But they made some changes and since 2003 they have had current account surpluses, growing foreign reserves and the rate of economic growth has been rising, reaching 8% last year.

But while our officials deny there is a problem with the system, our financial instability will persist.

Last week, when you were discussing inflation with Kerin, he said that demand pull inflation was caused by “too much money chasing not enough goods”.

To really figure out what causes inflation we need to know how we can have too much money and not enough goods.

We have two sources of money to spend: the money we earn and the money we borrow.

When we sell our time, resources and products to the economy, the money we earn entitles us to buy goods up to the value of what we have sold. Spending that money is sufficient money chasing ample goods. It does not cause inflation.

If we borrow money, provided someone had saved the money lent, that money would enable us to buys no more goods than the lender was entitled to. Spending that money is sufficient money chasing ample goods. It would not cause inflation.

But what if we could borrow from an institution that created its own money to lend, without savings? In that case, the money we borrowed would allow us to buys goods that other people were entitled to. This would create too much money chasing too few goods. Such money would cause inflation.

Many financial institutions can only lend the money that has been saved with them. But there is one class of financial institution that can lend when there has been no savings. It is mainly the lending of that class of financial institution that creates too much money chasing too few goods, and causes inflation.

Have you heard the story of what happened to Jack, after he cut down the beanstalk?

Using the gold that he had collected, Jack and his mother bought a dairy herd. Initially, they sold their milk in the village and used the money they earned to buy all they needed.

But as the heard grew, it produced too much milk for the local village. So Jack persuaded his mother to let him take the excess milk to the town market and sell it there.

His mother was reluctant about him going to the town market again, but eventually relented. However, she stipulated that he was not to bring any of the money he earned in the town back to the village. She did not want to upset the village economy.

So Jack started taking milk to town and the business grew. He used the money he earned to buy fruit, meat and vegetables from town. Soon Jack was buying everything he needed in the town and they did not need to buy much from the village. Jack would come back from town with so much food and things that he would give some to his neighbours.

While Jack and his neighbours prospered, other people in the village did not. The village grocer and butcher found there businesses were declining, as did the local market gardener and dress maker.

Jack also noticed that his sales of milk to the village were declining. He congratulated himself on the wisdom of expanding his business to the town market. Jack prospered while the village economy continued to decline.

Ian, the Australian economy is like Jack’s village. Like Jack, we have a rule that we are not to bring into Australia any additional money we earn overseas from exports. It might cause inflation. So we must spend on imports all the money we earn from exports.

Consequently, when we increase our exports, as we have in mining, we are required to buy more imports. When we buy more imports, we buy less of the same Australian products and so Australian industries that compete with those imports go out of business.

If Jack were allowed to bring home the money that he earned from his sales at the town market, he would have spent it in the village and the village would have prospered with him. But he had to live with his mother’s wisdom.

Similarly, if Australian exporters were allowed to bring in the additional money they earned from exports, they would spend that additional money in Australia and all Australian industries would prosper. But we have to live with the wisdom of those who mother us.

Peter Lloyd and Gary Sampson believe that little can, or should, be done to assist car makers (“Car makers don’t deserve aid”, April 14).

But what if government policy in another area is responsible for making the local industry uncompetitive?

Australia has a policy of eliminating the effect of international transactions on the domestic money supply. It adjusts the exchange rate to ensure that foreign receipts equal foreign payments.

It means that if there is a boom in mining exports, other exporters and import competing industries such as car manufacturers are made less competitive to retain the balance.

The system was designed to support Milton Friedman’s prescription of monetary targeting. Monetary targeting has been abandoned, but Friedman’s exchange rate system lives on, well past its used-by date.

The system does not permit national savings in the form of foreign reserves and increases foreign debt. It provides unstable and distorted exchange rates. It slows economic growth because it does not allow the proceeds of export growth to stimulate the economy. Also, it kills import competing industries and exporters with small margins, such as farmers.

Lloyd and Sampson acknowledge that the exchange rate is causing damage to the car industry but dismiss it because it is just as damaging to other industries.

If, for its own reasons, the government persists with a policy that has damaging effects on industries, should it not compensate those industries for the damage caused by that policy?

Lloyd and Sampson are correct is saying that “the bottom line is that the difficulties facing the automotive industries can be traced to economic fundamentals.” It is the macro economic fundamentals that are the problem, and if they are not changed, little can be done to save many Australian industries.

Robert Shiller claims that there are deep factors that underlie the difference between China’s high saving rate and the US’s low saving rates (China’s virtuous circle, 7 September). There are deep systemic factors that can explain the differences. But, they are not the behavioural factors that Shiller stipulates.

The psychology and behaviour of the passengers is largely irrelevant to the destination that these diverging systems will take them.

China has a fixed exchange rate system. It requires Chinese exporters to raise foreign reserves when they convert their foreign income into domestic currency. These additional foreign reserves contribute directly to national savings. These savings rise regardless of business or consumer feelings and behaviour.

When US exporters repatriate their foreign income, they must swap their foreign receipts for US dollars from those making foreign payments. The floating exchange rate system prevents trade income contributing to foreign reserves and national savings. Savings are quarantined from the exchange process regardless of the feelings and behaviour of US businesses and consumers.

These systemic differences are much more significant in explaining the differences in savings rates than the elusive “shame of the poor” and the feelings of “collective sacrifice” that Shiller asserts to be the deep factors.