The Myth of a Low Dollar

Hardly a day passes when we are not told in the media that the “high dollar” is ruining Australian industry, mining investment and agriculture. We are told that depreciation to 85 US cents, or even down to the record low of 48 US cents—a level recorded in April 2001—would be the salvation for jobs and export prowess! Of course buyers of imported goods, on the other hand, decry currency depreciation. Among them are not only overseas holiday makers, but also ordinary Australians who, for example, fail to understand why the Reserve Bank governor has lately been “talking petrol prices up”.

The government gave up on fixing the exchange rate—arguably the most important price in the economy—in 1983, when it was valued at around 90 US cents. Since then, the Australian dollar has moved up and down. From its historic low of 48 cents, the currency soared to 110 cents in July 2011 and has been trending down again since. Movements of the currency are often imbued with feelings of national pride or dejection. Journalists and politicians, who know little economics and simply echo what poorly informed spin doctors are saying, often use currency movements to judge the performance of the national government.

Why has the flexible exchange rate not meant the gloom and doom that some see in a high or low dollar? Why have the jeremiahs been so wrong in their forecasts? And what has de-industrialisation in Australia—as in most other mature economies—to do with a flexible exchange rate? Why this incessant public posturing and controversy?

A first point to make is that the flexible exchange rate has served as a shock absorber for the Australian economy, which is so dependent on the volatile raw material price cycle. With a pegged currency, we would have had periodic balance-of-payments crises, capital flight, capital-market controls, violent domestic boom-bust cycles, endemic uncertainty and probably much less economic growth.

When discussing political tweaking of the exchange rate, as many now demand, one should probably begin by recalling the protracted and heated debate in Medieval Europe about the “just price”, justum pretium, to which Thomas Aquinas contributed when he argued that price rises in response to rising demand were unethical. The problem with the just price is of course that justice is in the eye of the beholder: a high price is just in the opinion of the sellers, and a low price in the opinion of intending buyers. A more mature view—that the only price that matters is the market price, at which plans to buy equal plans to sell—only gained wider acceptance in the modern era. But this has not prevented buyers and sellers from lobbying political powers to intervene in markets and fix prices to the advantage of one group or another. Political operators often oblige such rent-seekers in order to gain political and material support for their party or themselves.

The advice by leading American economists to President Richard Nixon, during whose administration the earlier price-fixing of the dollar to gold and major currencies became untenable, was “to treat the dollar exchange rate with benign neglect”. My advice to the Australian government and the Reserve Bank is the same: “Treat the exchange rate with benign neglect.” Any fiddling with this important price by direct or indirect means will only produce deleterious unintended side-effects and injustices to some fellow citizens. Exchange-rate intervention is nowadays likely to end in tears.

Like any price, the exchange rate mediates between the conflicting interests of potential Australian buyers of US dollars (importers and Australians investing overseas) who feel a high rate is “just”, and sellers (exporters and foreign investors) who want a low rate. The free market depoliticises conflicts between demand and supply and reconciles conflicting interests, even if nobody is completely satisfied with the outcome.

In the political concert of public opinion, the relatively few well-organised exporters and politically well-connected major investors in Australia unfortunately have much more impact than the consumers and diverse importers. Indeed, some people, who now buy foreign currency to enjoy cheap overseas holidays, are reviled. They are told by the Labor Party that they do not deserve their good fortune, since the Howard government removed a third layer of taxation from pensions financed privately by their superannuation savings (the first tax take was on the original incomes; the second clip when the savings were paid into superannuation accounts). But such considerations have never stopped populist envy merchants, least of all when the owners of those savings are spending their own money overseas! In short, the political balance is always likely to favour tweaking the exchange rate towards depreciation. And there will always be the hope that inflationary consequences can be controlled or at least postponed.

The exchange rate of course expresses a relation of Australian money relative to the moneys of foreign jurisdictions, over which Australian authorities have no influence—not only at today’s valuations, but also at what millions of observers expect for the future. It is a price that influences not only sales of exports and purchases of imports, but also long- and short-term capital investments here and overseas, as well as borrowing by foreigners and Australians. To influence a time path of such a complex variable is foolhardy. It reveals an arrogant pretence of knowledge. It is better left to the dispersed, diffuse judgments of millions of self-interested market participants.

Interested observers, who decry a high dollar, often imply that a devaluation by x per cent will boost the profitability of exporters and import-competing producers by x per cent. In today’s economy, this is rarely the case, except in the very short run. What matters to profitability and international competitiveness is the difference between the value of output sold and the value of inputs, including those that are imported and become more expensive after a depreciation. In today’s globalised markets, Australian automobile manufacturers, for example, assemble not only Australian-made components, but also import a considerable share of their inputs from elsewhere. Part of the potential short-term gain from a depreciation is therefore immediately nullified by higher import costs. Farmers, who expect relief from a lower dollar price, soon discover that diesel and fertiliser costs, spare parts for their tractors and the prices of new equipment are going up. Operators in the Australian tourist industry may welcome a devaluation of the dollar. But will their bookings increase much, when the average daily price of airfares and accommodation of a Bali holiday goes up from $120 to $130, when they are facing weekend penalty rates and costly workplace regulations, and the average daily cost of a comparable Queensland holiday is, say, $200 anyway?

As the Australian economy is now highly integrated with world markets and our production for export incorporates more and more imported inputs, the net gain from depreciation is whittled down even in the short term. A depreciation of our currency of course still amounts to some limited short-run redistribution of incomes and wealth, typically from consumers and ordinary citizens to producers and shareholders. But in a small, open economy, like ours now, the redistributive impact is less and less and lasts a shorter time.

In the longer term, depreciation tends to trigger more imported inflation. Organised labour unions demand (and often get) wage increases, in particular at times when monetary policy is as easy and accommodating as it has been of late. Foreign buyers are now bidding up Australian real estate prices, first in the capital cities, but then radiating across the country. Likewise, many Australian shares are nowadays priced de facto in global markets; a currency slide drives up nominal share values. Established asset owners may feel more affluent, but economists call this a “money illusion”. Asset owners will not mind asset-price inflation—at least until the Reserve Bank does not see itself compelled to counter imported inflationary impulses by interest-rate increases. In such conditions, investors tend to buy assets and develop projects more hastily, and the chances are that more of these capital structures will turn out unprofitable than is usual. This is a long-term consequence of easy money and a depreciating currency, against which Economics Nobel laureate Friedrich Hayek warned as far back as the 1930s.

The boost that a currency depreciation may give to production and jobs can only be maintained if fiscal and monetary policies remain fiercely restrictive. Only then will the depreciation be absorbed into durable shifts in the quantities of what we produce, buy, sell and employ. Such strict restraint has all too often proved too tough a task for politicians who want to be re-elected and for monetary authorities who are committed not only to price-level stability, but also to high employment. The Reserve Bank Act of Australia assigns a confusing multiplicity of goals to monetary policy. This stems from Keynesian-tinged legislation of 1959 when it was still naively believed that monetary authorities could “print jobs”. Since then, eminent economists such as Jan Tinbergen, the 1969 Dutch Economics Nobel laureate, have shown that each policy objective requires a separate arm of policy to pursue it. International experience with monetary policy has certainly validated this theoretical insight: neither full employment nor inflation control is sustainably achieved by such over-ambitious policy assignments.

If currency depreciation were a path to economic salvation, then Australians could derive some inspiration from their biggest southern hemisphere competitor in global markets, Brazil. Since the creation of Brazil’s original currency, the real, 200 years ago, the country has suffered bouts of fiscal, monetary and union irresponsibility, currency devaluation and inflation. After the real became the cruzeiro (Portuguese for “Southern Cross”) in 1942, mocking birds took the name cruzeiro as a reference not only to the astronomical symbol, but also to astronomical depreciation-cum-inflation. The currency was periodically given new names—cruzeiro, cruzeiro novo, cruzado, cruzado novo, cruzeiro real—and two or three zeros were lopped off. Attempts at disciplined cost control were short-lived, because political lobbying against too high a currency was time and again successful and then led to imported and domestic inflation. This resource-rich country earned the epithet that it is “the land of the future—and will always be!”

Brazil’s poor track record is not surprising; the economy has suffered a cumulative depreciation of the original real against the US dollar by 2.75 quintillion per cent (2.75 x 10¹⁸ per cent). Depreciation has been like heroin to an addict, always leading to demands for more. Only in 1994 were the lessons of past depreciation policy learnt, when the classical liberal economist Fernando Henrique Cardoso—first as finance minister and from 1992 to 1993 as President—introduced a new real (R$), originally at par with the US dollar. Since then, Brazil’s currency has depreciated to about R$2 to the US dollar—by Brazil’s historic standards a modest slippage—and the economy has taken giant steps forward. Even left-socialist Presidents Luiz Inácio Lula da Silva and currently Dilma Rousseff have been careful to avoid the facile solution of giving in to the lobbyists’ protestations, “The real is too high; our industry needs depreciation to protect it from ferocious foreign competitors.” Even in the face of massive street protests in 2013, the lesson that exchange-rate manipulation offers no salvation has not been jettisoned. The policy consensus remains that industry, agriculture and mining must look to cost control by productivity increases and that the facile downward correction of the exchange rate would soon spell inflation pains for the poor.

Australian depreciation addicts should therefore note the economic history of their biggest economic competitor under the Southern Cross. They would soon discover that, in the eyes of the export and import-protectionist lobbies, there is no such thing as optimal and just depreciation and that there are no lasting benefits for wealth creation, only the suffering of the poor.

Australian depreciation advocates might also want to study the history of the Swiss franc. Capital flight and monetary easing in the rest of the rich world have repeatedly driven the Swiss franc to levels where Swiss export industries groaned under the high exchange rate. Sometimes, Swiss monetary authorities have fiddled with the exchange rate for a while, but eventually Swiss producers have always pulled out all stops to adjust domestic cost levels to the framework set by the exchange rate. This has not only driven cost-saving innovations, resourcefulness and discipline in the workplace, but also strict fiscal discipline, which is supported by a mature, educated citizenry.

In the final analysis, it is up to all of us to decide whether we want to go the road to Rio or to Zurich, whether we value social stability, social justice, internal peace and security sufficiently to forgo the seemingly facile solution of artificially “correcting the high dollar”.

Wolfgang Kasper has combined an academic career with policy-oriented assignments for the German Council of Economic Advisers, the Malaysian Treasury, the Reserve Bank of Australia, the Federal Reserve Bank of San Francisco, and the OECD in Paris. Despite these involvements he has remained a classical liberal