The US recorded a trade deficit of $725.8 billion or 5.8 per cent of GDP in 2006. That’s roughly equal to Australia’s entire GDP. With short-run interest rates having risen, the income component of the current account deficit is bound to start growing rapidly soon. If the trade deficit doesn’t turn around this will generate an unsustainable explosion in debt and deficits.
What can’t be sustained won’t be, so it’s safe to predict that the trend shown will be reversed sometime soon. What’s harder to predict is the mechanism by which this will happen.
The optimistic theory was that strong US productivity growth, aided by the moderate depreciation of the early 2000s would lead to a revival of the US export sector. This seems to have worked for Boeing, but nowhere much else, and both the depreciation and the productivity boom have now run their course. And the loss of traded-sector jobs (mostly manufacturing) that took place in the recession hasn’t been reversed, suggesting that US businesses don’t anticipate any big growth in this area.
A really big depreciation would be another possibility, but nothing like this is priced into US interest rates at present. It seems likely that the US dollar is being held up by foreign central banks. This process must unwind some time, and its impossible to tell whether the process will be orderly or chaotic. Even so, it’s hard to imagine a depreciation large enough to restore balance in time.
The third possibility is a reduction in US demand. It doesn’t seem likely that this will come from the public sector: there’s no hint in the latest Bush budget that chronic deficits are a problem. So a big decline in household consumption is needed to restore balance, and also to repair household balance sheets, which look bad now and will look worse if housing prices fall.
Such an increase could result from a general recognition by households of the need to save more, but it seems more likely to result from an increase in long-term interest rates. Again, we come back to the observation that no such increase is being priced in by the market.
Australia is, of course, in a very similar position. Suggestions that our deficit problems would right themselves when the drought ended or when coal exports started moving have proved false. Our adjustment process will almost certainly be tied up with that of the US.
John Quiggin 
Peter2,
Depends on what you mean by bearable. As a back of the envelope (and very rough – apologies to the proper economists reading this) calc, a 70% of GDP debt, carried at 5% interest (for a good borrower) means a servicing cost of 3.5% of GDP p.a. So, of 100 units of value produced in a year, 3.5 units go on servicing cost. Assuming GDP grows at around 3% (a reasonably fast rate for a developed economy) the entire GDP growth (and more) walks out the door each year. This type of debt will then not be sustainable – GDP is not growing enough to keep the debt steady to GDP.
In the case of the US, however, most of their debt is in USD and so (if fixed rate) can be inflated away, possibly improving its sustainability but not necessarily its long term ability to borrow.
Peter 2,
Your question is quite incisive, and I believe it important to point out that the question of whether a big current account deficit (or foreign debt) is a problem is yet another one upon which economists disagree.
I believe that much of the doomsayers’ pessimism arises from the fact that most were educated in a world of fixed exchange rates, where sustained and large CADs DID cause serious problems in the real economy. In short, if a country ran large and/or persistent CADs, it was FORCED to either increase interest rates or devalue the currency (assuming it had run out of foreign exchange reserves). The former option would cause the usual monetary contraction most are familiar with, the latter would likely generate a mix of inflation and lower purchasing power.
However, since most of the West has moved to floating exchange rates, Governments have essentially chosen to take back autonomy over monetary policy at the expense of control over their exchange rates. Hence, when our CAD has occassionally hit 7% of GDP in recent decades, Governments have not been forced to increase interest rates – they have tolerated a depreciation in the currency instead.
Depreciations have similar impacts to the earlier devaluations (theoretically) – higher inflation and reduced purchasing power.
Indeed, the election-time obsession about our ‘national’ debt seems odd. Why should you or I care that our companies are borrowing $billions from overseas investors and p*ssing it up against the wall – how does that affect me? In essence, it doesnt – if some homeowner defaults on a loan (originally sourced overseas), then the bank repos his house and writes off the debt, and the foreign investor gets burnt. As a result, he may not lend to said bank again, or may even decide that ALL Aussies are a bad risk, and increase his interest rate on loans to Aussie companies. So, all Aussies might be tarred with the same brush and have to pay higher interest rates (and pay more for imports, if the currency has also fallen) – I consider these the ‘externalities of foreign indebtedness’.
So far, so good. Slightly higher interest rates, slightly more expensive imports and overseas holidays – big deal, you might think.
However, as noticed during the Asian crisis (1998), high CADs and/or foreign debt in particular countries which had attracted speculative capital inflow (‘hot money’) could have much more severe REAL economic impacts. You can read more about the chain of causation in Paul Krugmans book ‘Depression Economics’, but essentially, a Russian (and I think, Korean??) loan default led to foreign investors ripping hot money out of these countries, but also ripping money out of countries whose only relationship to Russia and Korea was that they were in the rough general area, and they were kinda developing countries. So, Malaysia and Thailand were forced to either accept massive depreciations or jack up interest rates for no real good reason other than some Wall Street jocks had decided that they had suddenly become riskier places. As you can imagine, interest rates of 70% plus and depreciations in the order of several hundred percent caused severe economic dislocations – massive inflation and unemployment.
So to answer your question, high foreign indebtedness and/or high CADs CAN make countries vulnerable to similar changes in perceived risk.
Peter2,
Depends on what you mean by bearable. As a back of the envelope (and very rough – apologies to the proper economists reading this) calc, a 70% of GDP debt, carried at 5% interest (for a good borrower) means a servicing cost of 3.5% of GDP p.a. So, of 100 units of value produced in a year, 3.5 units go on servicing cost. Assuming GDP grows at around 3% (a reasonably fast rate for a developed economy) the entire GDP growth (and more) walks out the door each year. This type of debt will then not be sustainable – GDP is not growing enough to keep the debt steady to GDP.
I dont think this is right. In the first year say, all GDP growth goes into paying interest on debt, but now (in the next year) we have the same debt, and higher GDP. So debt/GDP ratio is lower. Provided we can just service the interest, GDP growth will reduce our debt burden.
Peter2,
You are assuming that the $ amount of CAD remains constant, whereas Andrew R is assuming that the CAD/GDP ratio is remaining constant.
Personally, I think Andrews assumption is more in keeping with reality (and economic orthodoxy). As GDP increases, we would expect people to increase their consumption of imports, presumably in proportion to the increase in income (in the absence of any countervailing evidence).
Having said that, not sure what any emprirical studies say?
JQ:
As a matter of mathematical identities, if not economics, aren’t there a variety of ways things could play out?
For example, the trade deficit could be reduced by improving terms of trade for the USA. For example, if the price of US imports fell sharply, no more deficit.
Also, isn’t it up to the holders of the debt to decide when the debt load of the borrower is too high. For example, China could trade goods for ever increasing amounts of federal reserve notes forever. They can accept negative interest. They can pursue whatever policy they want to. Technically, dollar merchantilism is not unsustainable. I don’t believe economic theory postulates rational governments, only rational individual actors.
Or US consumers could simply consume less stuff. The US economy is so far removed from any real needs that we wouldn’t even notice. We buy fewer but higher fuel efficiency cars a year less often, buy 1 less video game, 1 fewer pair of shoes, shave a few hundred square feet off the house, drop 10% fewer bombs, put a few more kids in each classroom. Big deal. Its bascially like going back 5 years. I was there is 2000, it wasn’t so bad.
For the US population as a whole we spend a little over 4 hours per day working. We spend over 2 hours per day watching TV. We can get the 5% of GDP back by taking 12 minutes from the TV and going back to work.
What makes these economic predictions so difficult is that investment and saving depend on consumer preference and consumer preference is a moving target. Just take GM, they invested a lot of “saved” money, but demand didn’t grow for their product so the savings didn’t amount to much.
Take a look at cross-cultural happiness statistics, we’re way past what is needed for happiness.
Andrew’s numbers are fine in terms of order of magnitude. The confusion arises when he says that ‘3.5 units go on servicing cost’ and that this ‘walks out the door’. It walks out the door in the sense it reduces our net worth by that much, so we have to forgo that amount of consumption some time. But the point is that we aren’t paying the servicing cost now, and this is why the liability is still growing. If we were paying it, we’d have a trade surplus.
If the trade balance was around zero then, on Andrew’s numbers, there would be a current account deficit (consisting of our net servicing of foreign liabilities) roughly equal to a year’s growth, and therefore the liabilities would grow about five percent, and thus the ratio of liabilities to GDP would grow slightly. Howver, the trade balance is neither positive nor zero: it’s actually in deficit as well, so the liabilities are growying even faster.
But Peter2’s question is still the right one to ask. Simulation models in fact predict that current account defcits, arising on the basis of differences in countries’ productivity growth and demographics – should be much bigger than the real world ones we are worrying about. The problem is that these are based on absurd assumptions about people’s forsight, smooth market clearing, and so on. Everyone obeys mysterious transversality conditions and instantaneosuly leap to saddlepoint paths whose meaning can barely be explained in plain English.
A alternative answer to Chris’s is that although lots of business do have debts equal to 70 percent of their income (I assume you mean profit, not turnover or value added), these are usually secured against physical property. But a lot of businesses do fail and the assets are forfeited. There are also a plenty of bankruptcies. In any case, the foreign debt is not incurred as part of some comprehensive national business plan, but the result of hundreds of thousands of independent borrowing decisions. If these decisions are all based on the same misleading signals – in particular overvalued real estate and an overvalued currency – it’s quite likely that the overall ‘business plan’ is wrong. This is not so much of a problem to the extent that the liabilities are in the form of equity because the foreign investors share in the risk, but around half of our foreign liabilites are in fact debt.
Majorajam: I’m happy to go along with with your last comment. I’m just not quite sure about the significance of the imbalance you refer to between the nature of the liabilities and the assets.
Chris,
We could test this thinking a little with a modern example. Today France and Germany have a fixed exchange rate with regards to eachother. Lets say France runs a sustained and large CADs with Germany then you are saying France is FORCED to either:-
a) Devalue its currency (no longer an option under the Euro)
b) Have a different interest rate (unlikely in a unified Euro credit market).
So if one of these option is to be forced and yet neither can be, then what exactly are you predicting?
In practice neither would happen. Interest rates would remain largely harmonized and the exchange rate would remain fixed. What would actually happen is an outflow of currency to the nation with the trade surplus. This would tend to cause prices of wages and assets in France to fall (slight monetary deflation) and prices of wages and assets in Germany to rise (slight monetary inflation) until producers in France caught up with those in Germany in terms of comparative advantage.
Also this process would be ongoing and ever adjusting meaning that a sizable and problematic CAD would never arise in the first place.
We could have used California and Texas in our example. Or Queensland and NSW. Or Newcastle and Sydney. Strangely we would not be surprised in these latter examples if the booming economy (ie the one producing in surplus) was to experience price rises, whilst the one in relative slump (the one producing in deficit) was experiencing price falls. We would not think of them as “suffering” inflation or deflation at all. We seem to have a definite prejudice in the way we think of inflation and deflation in terms of nations versus smaller economic regions.
Under the fixed exchange rate system known as the gold standard it is only slightly more complex because currency does not flow natively across borders but rather is destroyed in one nation as it is created in the other. Although this complexity is not sufficiently different to matter.
Regards,
Terje.
You seem to be getting better at understanding these things, Terje. Congrats.
Now, go and read the entry on deflation, and tell me why you think that this statement might be incorrect:
‘…a definite prejudice in the way we think of inflation and deflation in terms of nations versus smaller economic regions’
Terje, I’m sorry to dempen your trail-blazing ardour, but there is in fact a vast literature on ‘optimum currency areas’ that deals with the issue you are raising. Your examples are all cases of neighbouring areas that are well integrated and the barriers to labour mobilty are low. Between countries where that is lacking, it makes sense in terms of trade flows to have a flexible currency that realigns prices and wages all at once rather than relying on domestic deflation (via the painful route of business failure and unemployment) as the mechanism. The problem with flexible exchange rates is that the trade-related flows are swamped by asset-related flows that may not be terribly rational, so the signals get distorted.
James,
The US’s curious asset liability mismatch is not the be all and end all of its precarious net international investment position, but it is certainly worth noting, and it is certainly a double edged sword. On the one hand, along with the historically extant “exorbitant privilege”, the AL mismatch has substantially flattered the NII numbers in the face of a deteriorating current account (with 2004 being a banner year in that regard). On the other, (based on back of the envelope calculations), in the event of a significant downturn in the global economy and its attendant effect of equity prices, (see EAFE and Lehman Agg returns in 1990 for example), this AL mismatch alone could easily add around 2% of GDP to the current account deficit. To put that in context, at the moment where export growth gets clobbered and, independently, the net liability to GDP position deteriorates with shrinking output, our (smaller) foreign assets will depreciate substantially more in value than our (larger) foreign liabilities.
If that doesn’t sound good, it’s because it’s not.
Exorbitant privilege rests on the ‘moneyness’ of US financial claims- i.e. the whim of international investors. To the extent those claims start looking more shaky, that privilege goes, and with it, the stability of the NIIP.
Terje,
You are wrong – France and Germany do not have a fixed exchange rate arrangement, they share a single currency.
A very important difference.
But the mechanism you have described is similar to how external equilibrium was achieved under fixed exchange rates, thus:
CAD; led to
depleting forex reserves; led to
inability for Govt to continue to ‘prop up’ value of currency (assuming forex exhausted); led to
decision to either increase interest rates or devalue currency either of which; led to
disinflation; led to
increased competitiveness; led to
current account balance
The main advantage of a fixed exchange rate system over a single currency area is that you have the option of a devaluation, which essentially limits the ‘task’ of restoring external balance to the tradeable goods sector, rather than initiating a general monetary contraction (and in some cases, recession).
The other important thing that Krugman notes is that the ‘contagion effect’ I described above tends to only happen (so far) to ‘non-first-tier’ companies.
But I also think we are far from having a checklist of what countries can do to avoid catching a ‘hot money flu’.
That is, when Brazil or South Korea or Russia have a CAD of 6-7% of GDP, alarm bells go off – but sometimes they dont. (And this doesnt necessarily depend on whether their Govt budget deficit or foreign debt is high either).
However, when the US has yawning budget and CA deficits for as far as forecasters can tell, and national debt is extremely high, there has not been any run for the exits (nor even a depreciation).
Why? Maybe because the US has never defaulted on its debt (except I think maybe during the Civil War?), maybe because of the US dollar’s defacto reserve currency status.
Theres certainly no exact science to it.
One thing is certain, coming back to Prof. Quiggin’s original thread – what cant be sustained wont be.
Economics, particularly anything to do with financial markets is really really funny, because you often get episodes similar to Wile E. Coyote’s running off a cliff – everyone knows whats going to happen, but it can take a long time for it to start. But when it starts – oh boy!
Whoops – I mean countries not companies.
Freudian slip, given my day job.
Current Account statistics are assembled by governments. Governments wish to monitor economic and financial conditions that pertain in the geographical region over which they claim sovereignty.
However, the figures themselves overwhelmingly signify commercial relations between private entities who declare their economic activities within one jurisdiction or another.
This is an obvious point, but there may be some subtle corollaries.
Current Account deficits exist in jurisdictions that are the place of financial reporting of a nett surplus of entities that buy more than they sell across these judisdictional boundaries. Current Account surpluses exist in jurisdictions that are the place of financial reporting of a nett surplus of entities that sell more than they buy across these judisdictional boundaries.
Imagine you are responsible for the operations of an entity that reports in a jurisdiction with a Current Account Deficit. But further imagine that your entity in fact runs a trade surplus (i.e., it exports more than it imports). There are probably tens of thousands of firms in the US that report to the IRS that they export more than they import.
How do these successful export firms experience a CAD created by their neighbours?
1. In the normal course of things it has no effect.
2. A Central Bank attempt to rein in trade deficits may result in higher interest rates which will impact on the profitability of their businesses.
3. Falling confidence in the state of the national economy may cause currency devaluation which tends to increase the cost of foreign borrowing but which also lowers the cost of exports in foreign currency terms.
4. The firms that import more than they export are exhibiting their uncompetitiveness on the world market. Over an extended period of time (say 40 years) this suggests insufficient productivity, which in turn suggests inefficiency in investment decisions. This in turn suggests that a jurisdiction that is host to a large number of nett importers over an extended period of time is lagging in adding value.
5. This inefficiency may have an indirect effect on even the successful nett exporting firms. The national government collects both the information about Current Accounts and taxation revenues. The state of affairs described in 4 above would tend to depress the ability of these firms to pay tax. Lower tax revenues would impact on the ability of governments to provide infrastructure, from freeways to educational systems.
Am I wrong to conclude that this last point is how persistent CADs have impacts on the lives of persons living in jurisdictions that persistently report them?
Katz,
I assume we are referring to a free floating exchange rate jurisdiction that is not susceptible to ‘contagion’.
Going through your possible scenarios:
1) Yes, no effect in general.
2) Correct, but then that is the central bank’s (most likely) unnecessary action that has caused the impacts, not a currency depreciation per se.
3) Yes, this is a real, albeit mostly immaterial impact – most currency depreciations have much less impact on profitability than most other business costs. In any case, these can be hedged for a minor cost.
4) I dont know why Wattyl’s or Arnott’s uncompetitiveness would have any material impact on my bakery, or coal mine???
5) This one is a bit of a stretch and is more about tax competitiveness. Im not saying theres not a connection, but it would be at the margin.
I personally think that Governments get far too worked up about ‘external imbalances’ and subscribe firmly to what Prof Quiggin calls the ‘consenting adults’ view of trade and finance. (and am happy to pay a bit extra for imports and overseas holiday as punishment for holding $A-denominated assets).
I am familiar with the work of Robert Mundell. I first became interested in it in 1997 when I was living in Europe and reading so much about the then planned Euro. It was from Robert Mundells articles and website that I became interested in the gold standard, supply side economics etc. So I know who the trail blazers are.
The mainstream press will characterise a nation as “suffering” inflation in a way that they never will for a booming subsection of a national economy. It is the mainstream press and common dialogue on the topic when I used the royal “we” to say “…a definite prejudice in the way we think of inflation and deflation”.
“I personally think that Governments get far too worked up about ‘external imbalances’ and subscribe firmly to what Prof Quiggin calls the ‘consenting adults’ view of trade and finance.”
Thanks Chris, this is the thinking that was rattling around in my mind, but didn’t have a sufficient grasp to articulate.
Terje,
I know that you are a bit of a gold standard bug, so I will ask you:
How would a modern day gold standard overcome the problems experienced in the 18th-19th Cs. whereby massive new gold discoveries would lead to significant inflation?
Also:
What is inherently more stable about a gold standard than fixed exchange rates? One relies on the vagaries of gold discoveries and commodity speculation while the other relies on the credibility of the US Government – neither of which I would put much money on.
Terje,
I certainly agree (if that is what you were saying earlier) that people get unnecessarily worked up about ‘our’ foreign debt, and ‘our’ trade imbalance.
However, I think that the current economic expansion is certainly being shown to be having very differential effects across the country, and these are being highlighted by media, commentators etc.
Eg, the (until recently) massive gap in housing prices between Sydney and everyone else, along with stories about people going bush or moving to Tassie.
Also, the booming tax revenues in Qld and WA driven by commodity exports juxtaposed with these countries being net beneficiaries of the Cth Grants Commission process.
And if I see another story about how many ‘Mexicans’ are moving to Brizvegas, Perth and the G.C., I might do so myself!
…. not to mention all those ‘millioaire tradesmen’ and blue collar workers in the right industries that really do not seem to have suffered financially from getting a uni degree!!
You are right when you say that France and Germany actually share a single currency. However it is not an important difference.
In terms of the mechanism of adjustment that you outlined I disagree somewhat.
In terms of devaluing the national currency a central bank has unlimited power (they call it a printing press). In terms of increasing the value of the national currency any central bank with adequate collateral (gold, bonds or foreign currency) can increase the value. It would be trivial for the RBA to drive the value of the Australian dollar to AU$1 = US$100 next week if it had the political will to do so. The consequences for our economy would be awful however it would be technically simple. Likewise it could easily drive the dollar down to US$0.01 easily. All they need do is engage in open market operations. They have all the market power required, and no lack of collateral.
Under a fixed exchange rate regime (such as the gold standard) a CAD would lead to a decline in forex reserves (or gold or bonds). However it would also lead to a decline in national currency (M0). So the governments ability to “prop up” the national currency is not depleted at all. It is merely the act of decreasing M0 that achieves the disinflation and there is no need for a change in interest rates.
In the days of the gold standard (pre WWI) when banks were confident that the exchange rates were fixed the credit markets were much more global. Interest rates were more unified. You could borrow from an English bank or a US bank and shop for the interest rate you liked because the exchange rate was fixed.
A gold standard (or a similar unifying unit of account) gives you fixed exchange rates and lower and more stable interest rates. The gold standard also gave us price stability in not just consumer prices but also in commodity prices, something that has been severly lacking over the last 35 years.
When the UK induced deflation by going back on the gold standard in 1925 it increased the value of the pound significantly to bring it back to par with the pre WWI gold price. The Australian pound retained parity with the British pound because that was the target that Australias monetary authority were using (1 aussie pound = 1 british pound). Even though both countries experienced painful deflation (which played some part in bringing on the great depression a few years later) the actual ability of the monetary authorities to hit their target was never in question. All they needed to do was reduce M0 and the value of the currency increased to meet (or retain in Australias case) their target.
Your inference that a CAD would weaken the market power of a central bank (or currency board) is simply not correct.
Advocates of floating exchange rates traditionally argued that the “price” of currencies should be determined by the “free market”. This is a cruel joke because national governments have an absolute monopoly on the production of national currency. Any notion that there is a “free market” in currency is farce.
Your implication that a fixed exchange rate regime is somehow volatile and unstable is not correct.
Terje,
Before I respond to your post, I need a bit more of an understanding of your thinking.
Could you be so good as to answer my earlier questions, namely:
How would a modern day gold standard overcome the problems experienced in the 18th-19th Cs. whereby massive new gold discoveries would lead to significant inflation?
What is inherently more stable about a gold standard than fixed exchange rates? One relies on the vagaries of gold discoveries and commodity speculation while the other relies on the credibility of the US Government – neither of which I would put much money on.
Also:
please explain which link in my CAD logic chain you disagree with?
Point of clarification – when I have discussed ‘fixed exchange rate regimes’ I am talking specifically about a Bretton-Woods type arrangement, where currencies are fixed in terms of each other, not in terms of some other thing. Hence i have considered a specie standard as a seperate type of regime.
Yes, this sounds like semantics, but I think it has given you the wrong impression that I think a gold standard is more volatile or unstable than a Brwtton-Woods arrangement.
Not true – all i am saying is that until there is an infallible central bank carefully churning out a consistent supply of money, there will ALWAYS be fluctuations in the money supply. The only difference is how it happens – under a gold standard, new gold discoveries caused significant inflationary episodes. Under Bretton-Woods, Nixon’s desire to avoid choosing between guns and butter caused the subsequent stagflation.
Also, what emprirical evidence do you have that suggests the gold standard brought:
lower and more stable interest rates. The gold standard also gave us price stability in not just consumer prices but also in commodity prices, something that has been severly lacking over the last 35 years.
?
As far as I remember from my undergrad days, a chart of the inflation rate during the gold standard period went up and down like a drunken sailor.
On the other hand, inflation during the post war period was well-behaved, due to the US Government also being so.
If I had to choose between a gold standard and a Bretton-Woods, Id pick the latter every time.
Terje,
It is merely the act of decreasing M0 that achieves the disinflation and there is no need for a change in interest rates.
Another question for you:
Assuming an unchanged money demand schedule, how does decreasing M0 lead to disinflation without a change in interest rates?
Terje,
You say:
Your inference that a CAD would weaken the market power of a central bank (or currency board) is simply not correct.
Actually, thats not what Im inferring – what I am saying (and what you should remember from your Mundell-Flemming) is that Governments have to choose between independence in monetary policy OR independence in setting an exchange rate. They cannot have both.
Under a fixed exchange rate, or a gold standard, Governments choose a targetted exchange rate, but lose autonomy over their monetary policy (they have to set a monetary policy consistent with their exchange rate, or change that exchange rate).
Under a floating regime, Governments abandon control of their exchange rate, in exchange for autonomy in setting monetary policy. As you say, they control their money supply, and can decide to let the printing presses roll (or reduce the money supply) – but they cannot let the printing presses roll AND determine their exchange rate.
I do not know which part of this fairly textbook analysis is controversial?
To start with let me quote Robert Mundell on this issue:-
~~
“From 1560 to 1914, England’s price index remained fairly constant. There were waves of gentle inflation and deflation but they tended to cancel out. World War I brought inflation followed by post-war deflation, and, with the onset of the great depression, Britain went off gold. From that time forward, Britain lost the monetary discipline it had since the time of Alfred the Great. The inflations since Britain left gold in 1931 and especially since the breakup of the anchored dollar system in 1971 have been the highest in Britain’s history, higher by several orders of magnitude. In the quarter century after 1971, Britain’s price level rose 7.5 times! Over this period, Britain lost its centuries-old reputation for monetary stability and the pound ceased to be a leading international currency. “
~~
It is true as you suggest that new gold discoveries (in for instance California and Australia) lead to world inflation. However the amount of inflation was not at all significant. During the 1800s inflation almost never exceeded 3% in any given year. From 1800 to 1900 the price level actually halved in Britian reflecting an average deflation of under 1% per annum. Of course in boom towns there was localised periods of inflation much as there is today in any boom town.
The system is subject to automatic stabilisers, not vagaries. These stabilisers are why gold, when used as currency, has sucessfully delivered price stablity since antiquity.
Under a gold standard the producers of gold (ie gold miners) have no pricing power at all. The nominal price of their product is fixed by virtue of the monetary system. Under a gold standard an ounce of gold will have a price equivalent to one ounce of gold. It is a tautology that gold miners have no control over. However the nominal input costs for gold miners, things such as land, wages, mining equipment, transport etc are all vulnerable to inflation. A labourer that charges one ounce of gold per week this year may next year charge two ounces. If the quantity of gold coming to market causes inflation then gold miners (especially marginal gold miners) are quickly sent broke. Unlike other producers the gold miner can not pass on higher input costs via an increase in the price of his product. The system is self regulating in so far as excessive production of gold rapidly and automatically becomes unprofitable.
In areas that enjoyed a gold rush (ie boom towns) there were certainly localised inflations. However this is no different to the localised inflation enjoyed in any boom town. If you read any history from the gold rush frontiers there is always lots of complaint from gold miners that their profits were quickly eaten away by the cost of supplies. The automatic stabilisers were always exerting their influence.
When I first heard the claimed benefits of the gold standard I was quite sceptical. The website http://www.globalfindata.com has hundreds of years of price data for commodities and currencies as well as interest rate data. The website allows you to easily plot currencies and commodities against eachother in various base prices (eg dollars, pounds, gold ounces) often across hundreds of years. The data I encountered there left me with no doubt at all that the claim is true and accurate. Unfortunatly that website now charges an access fee of several thousand dollars per year and the free sample data is no longer accessible. When it was I spent months pouring over the data and reviewing charts.
However I can share the following chart that I did copy at the time. It shows the normalised US dollar price of gold and oil. Prior to 1970 you can see that gold (shown in red) was without price volatility which of cause is a trivial outcome of a gold standard. However you can also see that oil (shown in blue) was without price volatility in the Brenton Woods era. Post 1970 the volatility is obvious.
Our modern monetary system delivers consumer price stability. However it leaves commodity prices (which respond more immediately to monetary errors and overshoots) in a very volatile state.
I will have to address your other questions later. Good evening for now.
As a followup to my previous post, what I was trying to say (in my own clumsy way) was that under floating exchange rates, while Government’s are essentially monopoly suppliers of their own currencies (and can hence dictate supply), they cannot also simultaneously set the price, because that will partly depend on demand for the currency (which the Government does not control).
Terje, will set out my thoughts on your gold standard views when I get a chance – have been busy earning my ounces today!
Prelim thought while I remember: from memory, average real GDP growth rates were also much lower during the gold standard period than during the Bretton Woods arrangements or currently – happy to hear any contrary views?
Intuitively that would make sense (particularly given Terje’s inflation stats) – in most years, supplies of gold would have been growing fairly slowly as a % of the existing stock. Hence, money supply growth would have been extremely low (though not necessarily stable over time). In essence, this suggests that the gold standard put a monetary straitjacket on the international economy, such that money supply growth was lower even than potential real output growth. Though I suppose I would need to see unemployment stats to assess whether that was the case or not.
Another question for you, Terje – by gold standard, do you mean the original gold standard, that was discontinued in the 1930s, or do you also include the post-war US dollar denominated, gold-backed fixed exchange rate regime?
Chris C,
Just a quick response – the old monatrist equation (MV=PQ) could answer your question on the straitjacket – if M is fixed (or growing slowly) and Q is an external then either V or P can change. Freidman would argue that V is fixed (or only changes slowly) so it would be the price level that changes. Others argue that V can change, but it is not necessary for Q to only vary as M increases.
Hi Andrew,
Yes, I suppose the assumption underlying my monetary straitjacket theory is that I dont subscribe to the quantity theory. Hence, someone who rejects the quantity theory can argue that if gold supplies grow too slowly, real output will grow slower than potential.
At least Friedman advocated money supply growth equal to potential real output growth.
OTOH, under a gold standard, one would have to hope that gold was dug up at a rate approximately equal to potential output growth – and there really would be no reason why these to rates of increase should be the same. The result – monetary straitjacket and sub-potential GDP growth.
… by contrast, if you are a monetarist, you would say that any difference in the respective rates of growth of gold supply and real GDP (which is determined exogenously) would be manifested purely in inflation/deflation, so no real impact.
PrQ: Derick, a current account deficit is sustainable indefinitely if i
> CAD/GDP=g*(Debt/GDP) where
> g is the growth rate of nominal GDP, and debt is foreign obligations (including equity).
I have done a little work on this. Here are the Australian results..data for for 2004-05, ABS 5204.0 (Annual National Accounts)
CAD~net lending to RoW = -55.7b table 14
GDP current prices = 891.5b table 1
g=6.4% table 1
Debt = liabs to RoW 1138.6b – assets with Row 621.7b = 516.9b table 16
CAD/GDP= 6.2%
g*(Debt/GDP) 3.7%
Does this mean we should be panicking yet?
Maybe we should be undertaking some ex-post rationalisation as in the USA. There is quite an industry out there writing arguments for and against the proposition that there is unmeasured “dark matter” which makes the “real” US CAD a lot more favourable. This dark matter takes the form of liquidity services (suitcases of US$ in circulation outside US), insurance services bundled with other financial instruments, and unpaid knowledge transfers principally through direct foreign investment by US companies.
A prominent contrarian to the dark matter proposition has declared it to be more cold fusion than dark matter.
In turn this has sparked a sideline debate about appropriating physics labels for economics concepts. This is nothing new. We appropriated the “big bang” years ago.
Listening to the ABC science show today I heard physicists discussing the “ultimate reality of life” (no I have not mistaken the science show for an episode of Hitchikers). A good proportion of the labels used for the concepts being discussed had been appropriated from theology.
So if economics keeps on the dark matter and cold fusion label appropriation path, we might find ourselves with PROVIDENCE as a term in our equations, and an intelligent design theory of markets!
They can and do set the price. Previously China had no problem setting the price of Yuan to US dollars. The rate was set at 8.28 yuan to the dollar. One might ask how could they do this whilst having no control over demand for the Yuan. The process was simple. They control the supply every hour of every day that the currency markets are open to match demand. This process is called “open market operations”. It is exactly how the RBA controls interest rates in Australia.
Central banks can and do control the price of their currency and a monopoly on supply is all they need to do it. Of course in controlling the price they will need to constantly adjust supply consistent with their objective.
A fixed exchange rate is nothing more than a decision to modify supply continuously to match demand at the target price.
This is also how they fix the exchange rate between $5 notes and $20 notes at 4:1. There are plenty of times in history when denominations did not exchange at the relevant nominal ratio simply because central banks failed for one reason or another to match supply to demand at the target price.
In the 1800s Britian and the USA grew faster than today. However China is probably growing faster today than it was in the 1800s. Without qualification I think your claim is meaningless.
If you have a gold standard and gold supplies don’t grow as fast as the economy then you would get deflation unless you use money, and money substitutes (eg credit) more efficiently. Deflation is only an issue for economic growth if you have sever institutional barriers. The deflation from 1800 to 1900 in Britian was far too mild to matter. Institutionalised prices would have had no problem keeping pace.
I was talking mostly about the pre WWI situation. However in my view any monetary system in which the value of the national currency is constant or near constant in value relative to a specific weight of gold is a gold standard. A central bank could run a gold standard without even owning any gold.
Neither do I. Or at least not as it is defined by either Austrian economists or Monetarist.
Austrians = base money supply should be fixed in quantity.
Monetarist = base money supply should grow at a fixed rate.
I subscribe to a price rule not a quantity rule as per the supply-side school of economics (Jude Wanniski + Robert Mundell).
Except all the empiricle evidence points the other way.
The gold standard got a reputation of being deflationary because of what happened after the US civil war and after WWI in Britian (Churchill 1925 and all that). Neither of these events had anything to do with gold or its rate of production and everything to do with the chosen gold standard re-entry price.
Rather than a gold stardard I would be happy to adopt what Keynes proposed with the Bancor. Which was a monetary policy that targeted a basket of commodities rather than what we have today which is a monetary policy that targets a basket of consumer goods.
Terje
All of these issues have been the subject of intense debate for two hundred years, since the Bank of England suspended convertibility in 1797. There is not a single point you are making that hasn’t been raised a thousand times and rebutted a thousand times, (more or less adequately in the eyes of the gold standard proponents). The fact of the matter is that if you gathered the world’s 100 most eminent monetary economists in a room, only about one quarter of them would in general favour fixed over floating exchange rates as appropriate to this pointy in history, and of those one or two at best would favour convertibility to some precious metal.
I’m not saying that the majority is always right, nor that you shouldn’t try to form your own opinion. But I am saying that the fact that the vast weight of expert opinion is against you, should you pause. If all of those experts, who have looked at the question in much greater depth than you, have got it wrong, it must be because they all blinded by some kind of delusion or prejudice. I know that there are people on the ‘Austrian’ fringe who claim that this so, but do you find it plausible yourself?
Why don’t you keep an open mind, read a bit more widely – starting with standardctexyt books on international macroeconomics – and drop the presumption that Robert Mundell is some kind of Galileo.
James,
I am open minded. Why do you think I hang out at a website with prominent economists? Being open minded does not mean accepting majority opinon just to avoid being part of the minority.
I would be happy to be the recipient of new information or ideas that may change my outlook. Mean time I remain one of the 25% in the room that think that fixed exchange rates are typically superior to floating exchange rates (ceteris paribus).
Regards,
Terje.
Terje says:
You’ve fundamentally misunderstood this fairly basic point. Chris was saying that governments control supply, but cannot use this ability to simultaneously control exchange rates and interest rates/inflation.
You have yet to come up with a convincing argument as to why inflation/deflation doesn’t matter.
My point is that there isn’t much ‘new information’ involved here. It’s mostly old information, and there are plenty of textbooks that set it out systematically, which I suggested you read if you care so passionately about the issue.
And it wasn’t just fixed rates you were advocating, but metalic convertibility. That is, as I said, the position held by a tiny fringe.
Now that I understand what specific currency regime you mean, Terje, I must say I agree with James Farrell.
But you are wrong to suppose that fixed exchange rates are for all intents and purposes are the same as the gold standard are the same as the Bangor.
The respective benefits and costs of the various exchange rate regimes are quite well-known, as are the very important differences.
Mine, and most non-Austrian economists’, problems with the gold standard are that there is no reason why the production of gold should be growing at a rate consistent with sustainable, non-inflationary growth. The two things are driven by completely different factors – hence the gold standard did indeed lead to massive swings in general inflation, not only during the Californian and Australian gold rushes, but also in Roman times, and during the Iberian conquests of the New World (suggest you read the relevant section of Paul Kennedy’s “Rise and Fall of the Great Powers” about the massive inflation arising from Spanish imports of American gold).
Your explanation of why gold rushes cannot lead to generalised inflation does not stand up to empricial evidence.
Moving onto fixed exchange rates, you are right to say that such a system provides exchange rate certainty. However, if there are imbalances in international trade or capital flows, these are manifested in either increasing (China at present) or decreasing (USA, 1970s) foreign exhange reserves, and parri passu, the dmoestic money supply. If sustained, at the prevailing fixed exchange rate, this will change domestic interest rates and/or inflation. If a country does not want this to occur, it must either devalue or revalue its currency. As pointed out, it cannot exercise simultaneously an autonomous monetary policy AND a fixed exchange rate.
In short, fixed exchange rate = exchange rate certainty + loss of autonomy of monetary policy.
For modern day examples of the monetary impotence and interest rate instability that can come with a fixed exchange rate, would suggest you look at swings in interest rates and output and employment in Argentina in the 1990s and in Hong Kong, Malaysia during the Asian crisis.
However, with a floating rate, the situation is reversed – the RBA has perfect freedom to move interest rates wherever it wants, but cannot simultaneously achieve a specific exchange rate.
Floating rate = independent monetary policy + loss of control over exchange rate.
Further, you are wrong to suggest that it is our floating exchange rate regime that has led to asset price inflation and/or commodity price inflation.
For a start, commodity prices are not set in Australia – that is a given.
The perceived failure of the RBA to control asset price inflation is due solely to the RBA’s apparent omission of asset prices from its considerations of making monetary policy. It quite easily could have targetted a specific rate of asset price inflation or basket of asset and consumer prices – it chooses not to.
Important point to add, is that there are good reasons why countries have gone off fixed exchange rates.
Partly it is that Governments find it more important to reduce unemployment and inflation than have their currency at some arbitrary exchange rate.
Partly it is that nowadays capital flows swamp trade in goods and services, so that no country that has any sort of significant current account imbalance could long maintain an exchange rate incompatible with market fundamentals.
Derrick,
I think rather than getting focussed on debt/GDP ratios and their rates of growth, we should ask how such unsustainable rates of growth will work themselves out.
Prof Quiggin has laid out the possible scenarios in his prefacing blog.
Personally, I am not yet convinced that any of them justify us doing something about ‘our’ foreign debt or ‘our’ current account, as long as Government foreign-denominated debt or Government imports are low.
Why? Because only those two factors will have a significant impact on me – through higher future taxes.
The other ‘externalities of foreign indebtedness’ (higher interest rates, more expensive imports and overseas holidays) as I have ineloquently termed them, I can either choose not to incur or hedge against.
If I was living in a SE Asian/Eastern European/Latin American country at risk of contagion, I might not have such a sanguine view of things …
The fundamentaly point you make is not misunderstood.
I agree that you can’t hit two targets with a single arrow. If Australia choose to fix our exchange rate to the the US dollar then we would be lumbered with the monetary policy of the USA. When the USA was on a gold standard things worked well and a fixed exchange rate with the USA was a good choice. When the USA had a less disciplined monetary policy then clearly a fixed exchange rate with the US dollar was no longer a smart thing to do. The Hawke government was right to float the currency in so far as the US dollar was no longer a useful monetary target.
Neither matters economically when they are the natural product of economic expansion and or contraction. Such general price rises or falls in such circumstances accurately reflect the abundance or scarcity of resources.
However Inflation and deflation may matter politically. And they will certainly matter when they are the product of a decline in the basic value of money.
Inflation also matters when it intersects with institutional factors such as progressive income taxes. And deflation matters when it intersects with institutional factors such as long term lease contracts, fixed salary contracts, minimum wage legislation and other price rigidites.
You are either confused or attacking a straw man. I am never said they were the same. What I said was that a common currency and a fixed exchange rate were largely the same within the confines of the example that I discussed.
You can go back and reread what I actually said:-
https://johnquiggin.com/index.php/archives/2006/02/11/what-cant-be-sustained-wont-be/#comment-44109
Lets be clear, I am not an Austrian economist. I certainly don’t oppose fractional reserve banking as many modern Austrian economists seem to.
Please quantify massive? I don’t regard a 3% annual inflation as massive.
The spanish had a mercantile system. The government expended great resources to bring excessive quantities of gold to Spain and the inflation induced was the product of government action not a process of trade or excessive gold mining.
We can play “yes it does” and “no it doesn’t” all day long. As I have stated above I think you need to quantify “massive”.
Yes thats what I said. Trade imbalances lead to a change in the domestic money supply just as they would in a single currency. The amount of EURO in France and Germany respectively will change if they have a recurring trade imbalance.
In a single currency market (or fixed exchange rate regime) unified credit markets will ensure minimal difference in interest rates. So most of the effect will be in the general price level.
Your word “must” is misplaced. The word “may” would be better suited. The country has a choise about the policy response it adopts. It also has a choice about which consequences it will accept and which it will seek to modify with policy mechanisms.
A country can abandon fixed exchange rates to reduce export induced inflation, however that does not mean it should.
Yes I am very familiar with both situations. Which particular aspect of these do you think is important?
Which is just what I said earlier.
Are you refering to the Australian dollar price of commodities? Australia on its own is certainly unable to produce the commodity price stability of the 1960s, however it could do a lot better with a monetary standard based on gold or on a more general commodity price basket.
Yes.
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