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 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.