Home > Economics - General > Unfair exchange

Unfair exchange

June 1st, 2011

Ten years or so ago, the Australian dollar was worth about 50 US cents on foreign exchange markets. I bet a small amount with a colleague that within five years, $A would have achieved parity. My reasoning was simple, elegant and wrong. By most estimates, the Purchasing Power Parity exchange rate[1] is around $A1.00 = $US0.70, so the Australian dollar was undervalued by around 40 per cent. It seemed to me that, within five years or so, the deviation should have not only been corrected but overshot in the other direction, giving a rate near parity.

I should have considered more carefully the saying, apocryphally attributed to Keynes, that the market can stay irrational longer than you can stay solvent. If deviations from PPP corrected within five years, speculators would bet on this happening, and the deviation would not be sustained at all. So, if PPP is false, it must stay false for long periods.

And that’s what’s happened. The Australian dollar has been above parity for some months now, and shows no sign of falling.

That raises some interesting questions. I’ll put up a few over the fold, and maybe update them as I go

* Everyone in Oz is ordering stuff direct from the US, and it’s killing local retailers. But when the rate goes back to 0.50 we might be sorry. Or perhaps the exchange rate is just precipitating a shift that would have happened anyway
* Evaluated at exchange rates rather than PPP, Oz income per person is well above that in the US (about 60 000 vs 47 000).
* This is mainly a reflection of $US weakness rather than $A strength. Despite its massive problems, the euro has been well above PPP (about $1.10) for years
* As far as global hegemony is concerned, exchange rates and not PPP estimates are what matters. If you want to buy a tinpot dictatorship or trade a shipload of weapons, what matters is the value of your cash, not the living standards of your citizens. So, the US is trying to maintain military hegemony despite having a GDP significantly lower, in exchange rate terms than that of the EU. That has to be a doomed endeavor if exchhange rates stay where they are.

fn1. As I’ve mentioned before this is not a fixed number. It’s an estimate of the relative price of a bundle of goods which in turn is derived from a model. Even disregarding problems in estimating prices for comparable goods, there is ‘right’ choice for the bundle of goods, and different choices can lead to differences of 10 per cent or so in the estimated PPP rate.

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  1. TerjeP
    June 1st, 2011 at 08:37 | #1

    Floating exchange rates is a second rate idea. We ought to have a global value reference such as gold or a commodity basket and exchange rates should be fixed relative to that reference. Conceptually like the ECU was used in the lead up to the Euro. Capital controls should be abolished and interest rates should float. We had one world money for much of recent history by virtue of the gold standard. Floating fiat currencies are a form of ponzi scheme run by government central banks. Governments should not even be printing the notes that act as the medium of exchange because it gives them too much power to monopolise and manipulate.

    Fiat money and floating exchange rates is the ultimate venue for bubbles and distortion that ripple throughout the economy.

  2. Alice
    June 1st, 2011 at 08:57 | #2

    Isnt the $A/USD it a reflection of the massives quantitative easings in the US ie low interest rates….ie the interest rate differential and poor economic outlook in the US?
    Little to do with any fundamental vaue of the $A and much more to do with the fundamental value of the $US. A lower value of the $US is also a lovely way to beggar thy neighbours in a global floating exchange system isnt it? Na na na na na – our exports are cheaper than yours. Japan mustnt be too fond of the $US dollar value right now. Lord knows the US needs something but cant help wondering if they outsourced lots of exporting industries under all the free capital markets nonsense they have been pushing for a couple of decades (no such freedom for labour), so it wont help as fast as they would like.

  3. W
    June 1st, 2011 at 09:40 | #3

    @TerjeP

    Floating exchange rates is the ultimate venue for bubbles?

    Given the current spectacular terms of trade, I’m pretty sure the floating exchange rate is mopping up a lot of inflationary pressure.

    http://www.rba.gov.au/publications/bulletin/2011/mar/pdf/bu-0311-10.pdf

    @Alice
    I think interest rate differentials play a part but I think the demand from China and India is not insignificant.

    A good summary here. (Also, aren’t you taking a break for a week?)

    http://www.rba.gov.au/publications/bulletin/2011/mar/pdf/bu-0311-10.pdf

  4. O6
    June 1st, 2011 at 09:58 | #4

    The Economist’s Big Mac PPP index has predicted a lot of the exchange rate changes we’ve seen in the last decade, but the timing has been as bad as PrQ’s, no doubt because of the irrationality PrQ mentioned.
    We’ve yet to see the real effects of internet retail, IMHO. So far it’s just damaging profits and killing dud business models (e.g. Borders). Because we don’t have delivery services based on real life (i.e. when people are at home to receive deliveries), internet hasn’t been able to attack non-discretionary expenditure. When we do, what happens to Westfield, Woolworths et al.?
    #1, we ought to do a lot of things, but that doesn’t mean we shall.
    With the extraordinary recent Chinese purchases of gold, the slow rise in the price of gold and the recent rapid but likely to be sustained rise in the price of silver, we’re seeing a lot of bets being placed on the collapse of the USD. This hasn’t happened for the reasons given above, but seems inevitable, in the sense that QE3 can only reduce further the worth of the USD.

  5. Ikonoclast
    June 1st, 2011 at 10:28 | #5

    I am always amused by people who believe that gold, a relatively useless metal apart from its electrical conductivty properties, is somehow a real, objective and intrinsic repository of value. I guess TerjeP (above) is really a Mercantilist. The Mercantilists were the last economic school to completely believe in the intrinsic value of bullion. Since the Mercantilists we have had the Physiocrats, Adam Smith, Ricardo, Marx and Keyenes (to name a few) who have all given us much better theories of value.

    How could gold provide a benchmark of value except by a process that is essentially as political-economic and market mediated as any other monetary exchange rate system? Gold (to find its value relative to other commodities) depends on perception and exchange rate decisions by all market players. This is no different from any other denomination of value.

    Gold merely appears to be better because it is;

    1. Relatively rare.
    2. Cannot be created ex nihilo like fiat currency.
    3. Chemically relatively stable and incorruptible.
    4. Not all that useful for practical purposes so practical purposes do not compete much.

    I do not count vanity uses like jewelry as practical, although this use is used to manipulate and inflate the perception of the value of gold. The four qualities above do not in any way prevent speculation in gold thus gold is still not a fundamental measure of value. Like all measures of value, its value is relative to other commodities and is affected by the same economic factors.

    Given that all economic values are always relative to all other values, floating exchange markets are in fact the most logical response to that relativity.

    I challenge TerjeP to offer cogent, logical reasons how and why a “gold standard” could provide an absolute standard of value. I also challange TerjeP to write to the justifiable argument that he is in fact follows four century old, outdated Mercantilist thinking.

  6. James Haughton
    June 1st, 2011 at 10:56 | #6

    But Ikonoclast, gold is shiny! Mmmm, shiny.

  7. Jim Birch
    June 1st, 2011 at 11:21 | #7

    Could it have been a good bet, anyway? Good bets win statistically not in every case. Not sure how you tot up the possible universes to get the MTBF for market irrationality though.

    Come to think of it, massed human irrationality can coast for 5 years no sweat.

  8. TerjeP
    June 1st, 2011 at 12:20 | #8

    I am always amused by people who believe that gold, a relatively useless metal apart from its electrical conductivty properties, is somehow a real, objective and intrinsic repository of value.

    Me too. Some gold bugs actually believe that. I don’t. However the gold standard was and would be an effective way to achieve global price stability. Not because gold is magic but because there are real costs associated with production and these costs tend to be pretty consistent over time. Outside of a global gold standard the value of gold is driven by other factors including as an inflation hedge.

    If you don’t like gold then go for a commodity basket like Keynes Bancor.

  9. TerjeP
    June 1st, 2011 at 12:23 | #9

    p.s. I’m not a mercantilist. I don’t think we should measure our success by the amount of gold we can accumulate in a vault.

  10. Chris Warren
    June 1st, 2011 at 12:29 | #10

    TerjeP :
    1) Floating exchange rates is a second rate idea. We ought to have a global value reference such as gold or a commodity basket and exchange rates should be fixed relative to that reference.

    2) Capital controls should be abolished

    3) interest rates should float.

    4) We had one world money for much of recent history by virtue of the gold standard.

    5) Floating fiat currencies are a form of ponzi scheme run by government central banks.

    6) Governments should not even be printing the notes that act as the medium of exchange because it gives them too much power to monopolise and manipulate.

    7) Fiat money and floating exchange rates are the ultimate venue for bubbles and distortion that ripple throughout the economy.

    Wow, 7 propositions and all wrong (or accidentally right but for wrong reasons).

    1) There should be a global standard for value. But it cannot be commodity based as different countries have different and changing productivities for gold or any basket of commodities. PPP wages (or GNP per capita) is a better guide. If you work for an hour as a plumber (bus driver etc) in Thailand then you should receive the same share of GNP as a plumber (or what not) working for an hour in Australia. These two amounts in local currencies should be equalised by the exchange rate.

    PPP’s are not relevant unless the productions in different states involved are purely domestic. This is not possible in a globalised world. I assume that the Big Mac index sorta works because the items in a hamburger are pretty much all purely domestically sourced.

    2) Capital must be tightly controlled. Most of the Australian deficit is the income deficit because of slack capital controls in the past.

    3) interest rates must be tightly controlled and balanced to actual movements in per capita GDP.

    4) You do not have world money if each country can adjust the value of their currency w.r.t. gold in accordance with their desires.

    5) huh? Issuing new debt to pay-off old debt may be Ponzi(?) but not “floating fiat currency”.

    6) Only government should print notes. Private notes (eg ‘tobacco’ notes in USA) lead to severe rorts. Private business will always print more notes than they have backing.

    7) the ultimate venue – is the logic of capitalism itself. Fiat notes and floating exchange rates are just desperate attempts to stave off economic crisis – but only by building a bigger one. This worked during the 50s, 60′s early 70′s until Nixon took an axe to the gold standard. Since then we have seen crisis after crisis after crisis and all manner of credit expansions, tariff cuts and populations expansions, unemployment ratchets, banking system crashes (US S&Loans), to now – whole country collapses.

    And the future looks worse.

  11. Oliver Townshend
    June 1st, 2011 at 13:31 | #11

    The idea that there are several theories for the exchange rate (or many other areas of Economics) interests me. It’s a similar concept to other areas, eg the Theory of Plane Flight, or String Theory, each of which have several competing theories, none of which completely describes the area. But, for instance, you can still build a plane that flies. A bit like Bridges being built prior to Newton.

    The difference is that in Economics, a market exists for each theory (eg PPP, Capital flows etc). This means that each theory is observable and provable, but also disprovable (at times). And that money can be made from the competition between each theory. This may be expressible as a Bayesian probability weighting each different theory, and possibly giving a deeper insight into how the market is actually operating (or being of no help at all in the long run …).

  12. canberra boy
    June 1st, 2011 at 14:33 | #12

    Some possible causes of the high exchange rate:
    *the historically high terms of trade;
    *the positive trade balance;
    *Australia is an attractive investment destination (due to both attractive relative interest rates, resource boom, and perceived general strength/stability of Oz economy);
    *overseas central bank diversification in reserve holdings involving massive A$ purchases.

    Obviously these factors are inter-related, and they all contribute to greater demand for the A$. As a side observation, the SMH article linked above notes that the Bank for International Settlements calculates the A$ share of global foreign exchange turnover rose from 3% in 1998 to 6.6% in 2007, and to 7.6% last year, behind the US dollar, the euro, the yen and sterling

  13. djm
    June 1st, 2011 at 16:48 | #13

    I’d like to propose Rule 36: any economic discussion can be derailed into an argument about the gold standard if a libertarian gets in early enough.

  14. Alice
    June 1st, 2011 at 20:32 | #14

    @djm
    Bloody libertarians – I wish they would take Ayn Rand (that silly escapee from the Soviet Union who came here and wrote Atlas Shrugged, held Greenspan’s hand when he got his first job in the Ford administration…who he wrote about Ayn Rand “it was a meeting of minds” (a meeting of extremist egotsitical minds) and proceeded to inflict extreme deregulation and “let the free market sing” policies on the US for DECADES.

    God I hate extremists…and god I hate Ayn Rand and now god I hate Greenspan. Extremists who let their egos rule their common sense.

    The great maestro? NO. The great libertarian who wrecked the US economy.

    Ayn Rand – really what would she know?? – she ran away from a too heavy handed soviet regime who confiscated her families aseets – one bitter chick that went to the other extreme thinking she could save the world by separating government from corporates by separating the economy from government (so she did it in the US with Greenspans power and Greenspans fawning admiration of her flawed views) – and made a freaking mess.

    I hate extremists in economic ideas, with no sense of balance. Their ego rules. They think they can solve the problems of the world and economies with something “Brand new” – their “personal vision”, their “personal brand new model”, “their miracle utopia” but its all ego. Greenspan was all ego.

    I have to be honest. These sort of egotists – they just wreck everything.

  15. Alice
    June 1st, 2011 at 20:50 | #15

    @W
    Who said I was taking a break for a week? Did Prof say that? I only take a break for a week of Prof tells me to.

  16. W
    June 1st, 2011 at 23:32 | #16

    @Alice

    Comment 15 in the new nuclear sandpit. Don’t take it the wrong way, I thought you may have missed it.

  17. TerjeP
    June 1st, 2011 at 23:59 | #17

    @Alice

    Your first paragraph seems to have open brackets that don’t get closed and wishes that don’t get finished.

  18. Alice
    June 2nd, 2011 at 08:57 | #18

    @W
    I might have W (missed it). Better check.
    Terje – I have one wish that doesnt get finished. That you for once would get your numbers right.

  19. Alice
    June 2nd, 2011 at 09:00 | #19

    @W
    Oops I did miss it. I shouldnt have called the new nuclear sandpit a cesspit but I wasnt as rude as Wilful…Im on hols now.

  20. Charles
    June 3rd, 2011 at 16:33 | #20

    [TerjeP
    June 1st, 2011 at 08:37 | #1
    Reply | Quote

    Floating exchange rates is a second rate idea. We ought to have a global value reference such as gold]

    Nothing screams “economic nonsense” more than a desire to base a money system on a commodity whose volume doesn’t increase and decease as the size of the economy does.

  21. Charles
    June 3rd, 2011 at 16:38 | #21

    “I’d like to propose Rule 36: any economic discussion can be derailed into an argument about the gold standard if a libertarian gets in early enough.”

    Given the Adam Smith pretty much dismissed it 1776, I would say that it’s proof positives that zombies live a very long time.

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