ECONOMIC AFFAIRS: by Colin TeeseNews Weekly
Global currency war and the new protectionism
, October 30, 2010
When the Australian dollar reached parity with the US dollar, political foreheads on both sides of Australian politics merely creased imperceptibly. Our leaders seem not to recognise that if the tentacles of a currency crisis are indeed beginning to take hold of the world economy, we won't escape their grasp.
Recognised even less are the dots connecting a looming currency crisis and the financial catastrophe of three years ago that all but demolished the world economy. Still less will any of this be connected with the so-called economic reforms so enthusiastically welcomed back in the mid-1980s. Yet all these events are related.
Back then, much of Australia warmly embraced the "reforms" that the newly elected Hawke/Keating Labor Government introduced, proclaiming them to be valuable new policy initiatives. Actually, they represented nothing more than Labor falling into line with the various elements of the newly-minted "Washington Consensus" - and a commitment to unregulated free market economics.
There was a commitment to low taxation, privatisation of public utilities and total market-based economics - including deregulation of financial controls and the floating the Australian dollar.
These measures were introduced with a fanfare of trumpeting by the then government as being necessary to revitalise what was claimed to be a moribund Australian economy. At the time the measures attracted wide acclaim in our community - including those who normally had no kind words for Labor governments.
The most widely endorsed elements of the changes, so gratuitously labelled "reforms", were respectively the reduction of tariff protection for manufacturing industry and agriculture, deregulation of financial markets and the floating of the dollar.
The damage done to the farm sector and manufacturing is a matter of public record and, notwithstanding the financial crisis of 2008, the policies responsible for this damage continue to enjoy wholehearted endorsement from both sides of politics and with much of the wider community.
The same holds true for the freeing up of capital markets and the floating of our dollar. These measures are, in many circles, still trumpeted as conferring lasting benefits on our economy.
However, nothing could be further from the truth.
But before we consider the "why's" and "how's" of the so-called "reforms", let us first understand what was actually done almost three decades ago with particular reference to the finance industry.
Back then, capital flows into Australia were subject to careful oversight. (The same was true for most of our trading partners.) Not that we wanted to restrict legitimate capital flows - foreign investment capital was as much welcomed then as it is now.
But if the government, through the Reserve Bank and the Treasury, were to manage the economy they needed to know what was happening with the movement of capital into and from Australia. How else could we know whether or not we were spending more overseas than we could afford?
Back then, speculation in currency movements wasn't a problem. It hadn't been one since the 1944 Bretton Woods agreement, as a result of which the US and its dollar looked after the trade and payments system of the Western economies. Under this arrangement there wasn't much scope for speculation. Each of the countries in the system maintained more or less stable currency positions with each other and with the US dollar.
The stability of these arrangements was only occasionally disturbed when one or another nation announced it was having trouble balancing its international accounts and needed to devalue its currency as part of the correction measures.
The US announcement in 1971 that it was no longer able to underwrite the international trading system from its dollar reserves changed all that. The immediate result was to usher in a period of currency instability lasting more than a decade.
The West's currencies were left without an anchor point. Allowing currencies to "float" up and down in value according to how the market valued them at any given moment seemed a sensible and realistic alternative once the mechanism for maintaining fixed relationship was withdrawn.
Total deregulation of financial markets, and permitting unimpeded capital flows into and out of countries, seemed a logical extension of the new circumstance.
In fact, the world would wait more than a decade for that second innovation, and another decade and a half before the dreadful consequences of this set of policy changes became apparent. Presumed logic was once again shown to have pointed us in the wrong direction.
In the period of instability between the early 1970s and 1983, our Treasury managed, quite skilfully, what was called a "dirty" float. Our currency was only partially subjected to the impact of market pressures; we still maintained nominal control over capital movements, while permitting the value of our currency to rise and fall largely in line with the movement of the currencies of our major trading partners.
What the Hawke/Keating Labor Government did was to discard this arrangement and introduce an unregulated, or "clean", float of Australia's exchange rate. This meant allowing the market alone to determine the value of our currency, and allowing capital flows into and out of Australia without government intervention of any sort.
It should be remembered that the government introduced this change over the objections of Treasury.
Superficially, there seemed a certain logic behind the idea of freely floating exchange rates in circumstances where currency relationships were no longer manageable. The same was imagined to be so for deregulating financial flows. But once more following the path of apparent logic let us down.
What wasn't fully understood was that the new policies opened the door to currency trading for speculative purposes on a significant scale. Under this stimulus, speculation in currencies quickly accounted for most of capital movements, whereas in a properly managed system capital flows should be largely confined to their true purpose - financing international trade and investment.
Properly managed, a floating exchange-rate system can, of course, play an important part in balancing international trade flows; but in that case it is not capital markets that determine the relative values of currencies but export volumes.
In such a system, the more a country exports, so correspondingly does the value of its currency rise in terms of other currencies.
As a nation's exports increase, so its currency rises in value thus making its exports less competitive and imports cheaper. Thereafter, its exports decline and its exchange rate falls. Such a mechanism, if allowed to work, can ensure that no one country can become a permanently dominant exporter and unbalance the system.
But it can't work unless all nations stick by the rules and allow relative export volumes to determine relative currency values.
Suppose a country is exporting strongly and it wants to avoid what would be the natural rise in its currency value. It can intervene to hold the exchange rate down; in that event it can increase its exports without paying the penalty of an increase in the value of its currency.
And that is precisely what happened after the Western economies were compelled to move out from the shelter of a system whereby the US underwrote a trade and payments system based on firm currency relationships.
Germany was the first economy to artificially hold down it currency value to maintain export competitiveness; its example was later followed by Japan and China.
The only way to make the system work would have been to have an international agreement to keep currency values in line with export performance. That was never on the agenda - not 30 years ago, and certainly not now.
And yet the system we are struggling along with now is not feasible; any feasible international trade and payments system must make it possible for all countries, overall, to pay for what they import by exporting.
At the moment that is not what is happening. Under the present unregulated arrangements, certain countries (notably Japan and China) are deliberately holding down the values of their currencies and continuing to expand their exports. As a result they have developed huge export surpluses while those buying their exports have clocked up debt.
Over time, their actions have helped produce a hopelessly distorted and unbalanced trading system with permanent and growing surpluses in the exporting countries and permanent deficits in the importing countries.
This imbalance was among the factors that helped draw the world economy close to total collapse in 2008. We are still wrestling with the consequ-ences of that for both the financial and the productive sectors of the economy.
More and more countries are beginning to recognise how these practices threaten the competitiveness of their exports - countries including Brazil, Mexico, Peru, Colombia, South Korea, Canada, Taiwan, South Africa, Russia and Poland. All have either taken action to protect their competitiveness by intervening to keep the value of their own currencies down, or are contemplating doing so.
If we believe what these countries say, the world may well be facing a kind of currency war. If so, Japan and China may have started a stampede in which they will be the biggest losers.
Where and how will it end? This is impossible to say. Any kind of arrangement that brings the world's currencies into harmony seems beyond reach.
"Beggar thy neighbour" policies seem inevitable. Meanwhile, there is another, as yet, unidentified element associated with currency manipulation.
Holding down one's currency makes one's exports more competitive, but it also make imports dearer and thereby acts as a protective device for domestic industries. A currency war in full flight, intentionally or not, will become the new version of protectionism.
Regrettably, up to this point there is no recognition of any of these issues in Australia, or how we might be affected.Colin Teese is a former deputy secretary of the Department of Trade.