Leigh Harkness on Bank Welfare

Leigh Harkness is back with his unique perspective on the Australian macro-economy for another guest post, this time on “Bank Welfare”.

Banks have prospered under the floating exchange rate system.  They have been able to lend as much as they like without any concern about affecting the balance of payments.  The exchange rate adjusts to ensure that their lending activities do not affect foreign reserves.

Life for the Reserve Bank has been easier, also.  Speculators no longer threaten the currency, nor the level of foreign reserves.  The Reserve Bank only has to concern itself about excessive credit growth that may cause inflation.

To control inflation, the Reserve Bank has been using interest rates.  This suits the banks because when monetary policy is eased, they can profit from credit growth; when monetary policy is tight, they can profit from the higher interest rates.

The floating exchange system has allowed bank credit to grow at an average rate of 11% per annum since it was introduced.  However, real growth in the remainder of the economy has been much slower at only 3.7% per annum.  Even including inflation, GDP has been growing at less than 7%.  That means that the ratio of bank credit to GDP has been rising at around 4% per annum.

That difference is going to mean that one day the economy will not be able to sustain the growing level of debt.  At that point, banks may not be so impressed by the floating exchange rate system.  But when that happens, the rest of the country is likely to support the banks with new measures.  Our monetary system cannot be allowed to fail.

For industry, the floating exchange rate system has produced a volatile exchange rate that is not conducive to long-term investment.   It cannot rely on the price of imported substitutes remaining as they are in the medium term.  Also, it has resulted in slower economic growth.   Before the US floated its exchange rate, the real rate of economic growth in Australia was 4.8%.  (The Australian dollar was tied to the US dollar when it floated.)  Since the US float, the rate of economic growth in Australia has fallen to 3.2% per annum.

One of the main reasons for the slower rate of economic growth has been the elimination of the export multiplier.  Under fixed exchange rates, if exports increased, additional money would flow into the country and stimulate the economy.  That stimulus would continue while export income was greater than spending on imports.  For example, if a country spent one eighth of its income on exports, if exports increased by $1 billion, income in the economy would have to grow by $8 billion before it returned to equilibrium.  It was the disequilibrium that generated economic growth.

Under the floating exchange rate system, if exports were to rise by $1 billion, the exchange rate would have to rise to raise imports by $1 billion.  Equilibrium is attained immediately, not by raising national income to raise imports but by making imports cheaper.  As national income does not rise, domestic demand must shift away from domestic products to imports.

That is, the floating exchange system requires Australian industry to become uncompetitive.  This requirement has devastated manufacturing industry in Australia, as it has in the US.   Also, the growth of mineral exports has reduced the incomes of other exporters, particularly the agricultural sector.

The shift away from domestic industries is evident in the following diagram.  It charts the percentage of GDP earned from goods and services for the domestic economy.

Workers have suffered also as a consequence of the floating exchange rate system.  Unemployment in Australia averaged less than 2% between 1950 and 1973.  Since then, an unemployment rate of around 5% is considered full employment.  Also, the rate growth of real wages has halved.

Floating the exchange rate system has protected the banking sector.  However, like any form of business welfare, it imposes large costs on the remainder of the economy.   If Australia had maintained the rate of economic growth that it expienced from 1959 until March 1973 (when the US dollar was floated), real GDP in Australia would be more than double its current level.

The Australian economy may be prepared to sacrifice half its income to support the monetary system, and the banks that manage that system.  However, how much longer will this weakened economy be able to support the banking industry before it crumples under the weight of debt?

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  1. Leigh thank you for another excellent post. I’m not picking an argument with any of it but perhaps i come at it from a slightly different angle!

    ‘Speculators no longer threaten the currency, nor the level of foreign reserves’

    I’d still maintain that speculative money is governing our exchange rate. If the currency trade is 140 times that necessary to cover our imports and exports something else is going on!
    As such the exchange rate is being pushed up by loose monetary policy, 0 interest rates elsewhere. So I think speculators do still threaten the currency but it is just that we are, at the moment, flavour of the decade! The speculators threaten us, not by pushing the currency down, but by pushing the currency above an equilibrium level on the basis of the Current Account.
    I don’t think the floating exchange rate system, of itself, forces our industries to become uncompetitive. If we limited the speculative element, and reduced our willingness to sell the nation off, the the exchange rate would be at a sustainable level. However I’m inclined to agree that in the real world this floating exchange rate policy is a disaster.
    JMO and open to ideas!

    • Currency trades for exports and imports are not perfectly aligned. So speculators are a necessary part of the floating exchange rate system.

      It is not the fact that the exchange rate is variable but the requirement that international receipts and payments must be equal that forces import competing industries to be uncompetitive. That is, if rising exports increase the supply of foreign currency on the foreign exchange market, imports must increase also to raise the demand for foreign currency to equal the supply. Without an increase in national income, the only way we can increase our imports is to stop buying domestic products and buy imports instead. That requirement kills domestic industry.

      • Alex Heyworth

        We could buy overseas assets. That would be the sovereign wealth fund we so urgently need to avoid the Dutch disease.

    • The Philippines have not just talked about it: they have done it. They have been shifting demand back to domestic goods for the last 10 years. In 2000, only 45% of GDP came from production to supply the domestic market. In 2009, that had increased to 68%.

      They import the same amount as they did in 2000. They have been able to reduce unemployment and raise their GDP.

      External debt levels have halved as a proportion of GDP from 72% in 2003 to 33% in 2010. External debt has stayed the some, they doubled GDP.


        • I have compared Australia to the Philippines because both have floating exchange rates. In the 1980s and early 1990s, both had large current account deficits equal to the growth of bank credit.

          In the late 1990s, the Philippines acknowledged this and did something about it. The Reserve Bank of Australia attributes the current account deficit to foreign investment and continues not to recognise that there is any relationship between bank credit and the current account deficit.

          The Central Bank of the Philippines started managing their currency as well as their banks. They no longer require international payments to equal international receipts. Australia has maintained faith in its ‘pure’ float. This is despite Australian industries being put out of business because of cheap imports and growing domestic and foreign debt.

          Since 2003, the Philippines have turned their current account deficits to surpluses. They have reduced the burden of debt. The economy is growing more rapidly and unemployment is falling.

          Australia with its wealth of resources and highly educated and skilled workforce continues to have current account deficits and low rates of economic growth. It has a rising debt burden.

          Although the policy in the Philippines may have been ad hoc, its Central Bank has modified monetary policy to improve the economic prosperity and welfare of its people.

          The monetary policy of Australia’s central bank is contributing to the demise of its domestic industries and the rise of domestic and foreign debt. It is looking after economic prosperity and welfare of the banks; not the economic prosperity and welfare of the Australian people.

  2. Leigh we could start buying our own country back? Then we wouldn’t be increasing imports

    • If we are going to increase our exports, we are going to increase our imports. The big question is how to buy more Australian. Then we would be better off and be able to afford to buy our country back.

      Under our current exchange rate regime, shifting our spending to domestic investments rather than imports is just going to raise the exchange rate, reduce exports incomes and make more Australian industries less competitive. It would not work.

      If the Reserve Bank were to cap the exchange rate at say US$0.75, it would raise incomes of export industries and make Australian import competing industries more competitive. This would stimulate the whole economy.

      Some may say that this is inflationary. However, inflation is caused when the growth in the money supply is greater than the growth in GDP. Holding the exchange rate down would increase the money supply. But it also increases GDP. So money from increased export incomes is far less inflationary than money from increased bank debt.

      I am not advocating that the RBA cap the exchange rate. However, you would appreciate what a difference a lower AUD would have on the economy.

      I would not be surprised if the US Federal Reserve intervenes in the US exchange rate. It would provide them with a means of stimulating the economy that raises national savings, not national debt.

  3. Nice article but a bit one-sided.

    It cunningly mentions what happens in a fixed exchange-rate system when a nation’s exports exceed it’s imports (more money to spend, yay), but forgets to mention what happens when the opposite takes place (deflation without devaluation).