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