The float we had to have
by Jim Minifie
Published at The Conversation, Thursday 12 December 2013
The Australian dollar was floated this day in 1983. By 1985, it seemed to take on water, list badly, and sink.
And that actually was the idea. The real exchange rate – roughly, the dollar rate, adjusted for inflation in Australia and its trade partners – had been too high, on and off, for years. A fall in the terms of trade – the price of exports divided by the price of imports – in 1985 sent the dollar down, spreading the fall in incomes to all who bought imports, and cushioning Australian producers that were exposed to trade.
That could and did happen with fixed rates, through policy decisions on the exchange rate or through domestic inflation. With a free market in Australian currency, these changes were smoother and faster. As things turned out, in the 20 years after the float, the exchange rate averaged about a third lower than its average value of the 1970s.
But there was another reason why floating had become irresistible by late 1983. Through the dying days of the fixed rate era, managing the balance of payments – the flow of funds into and out of the country – had been absorbing more and more of policymakers’ attention. Floating the dollar severed the link between the balance of payments and monetary policy (that is, policy to influence the money supply or interest rates). It permitted the RBA to set monetary policy as it saw fit to manage inflation and output.
Paving the way to reform
The 1983 float also paved the way for the economic reforms of the 1980s and 1990s. The exchange rate could adjust as tariffs were cut, quickly spreading the costs of adjustment. And tariff cuts, by reducing the market power of trade-exposed Australian firms and unions, helped to free up product and labour markets.
Floating also helped to expand the Australian financial system, by facilitating capital flows and helping Australian banks to develop a market through which to borrow freely from abroad in Australian dollars. In this way the float helped lay the groundwork for the banking booms of the late 1980s and the 2000s.
But all that flexibility and dynamism didn’t come for free. Exchange rate flexibility can tip over into volatility that firms find hard to manage. And the banking sector that expanded with the float created a new problem: the Australian economy might do better if interest rates were lower – leading to a lower exchange rate – but this might create a housing bubble.
Still too high…?
What of today’s rate? The exchange rate climbed strongly from the mid-2000s, in response to the banking and mining booms. The Australian dollar is somewhat down from its highs of US$1.10, and sits at around 90 US cents. But is the rate still too high? Any answer to that question amounts to a view on how the mining boom will evolve and how the rest of the economy will adjust.
Last week’s RBA monetary policy decision statement was blunt: “The Australian dollar, while below its level earlier in the year, is still uncomfortably high”. The agonies of Qantas and yesterday’s Holden exit (in which the high dollar was cited as one reason for its decision to discontinue manufacturing in Australia) are hardly due to the exchange rate alone, but show that their current cost base is unsustainable at today’s exchange rates.
There seems to be room for the dollar to fall further: economic growth is a bit below trend; unemployment is tending to rise; and labour force participation has fallen. The case for depreciation is further supported by a comparison of the cost of an identical bundle of goods and services across economies. On this basis, the Australian dollar is 30% overvalued compared to the US dollar and 20% overvalued compared to the euro.
But much of this apparent overvaluation is a result of high prices for Australia’s resource exports. This phenomenon is sometimes labelled the “Dutch Disease”, after the North Sea oil and gas boom that put cost pressure on other industries that were exposed to trade. High prices and the cost pressure on tourism, education and manufacturing are the flip side of the higher incomes that come with high resource prices.
…Or at justifiable levels?
Further support for the view that the Australian dollar is not much overvalued can be found in the data on national saving, capital inflows, and trade. If we were in the midst of a consumption boom funded by capital inflows and running a large trade deficit, alarm bells would be ringing. But Australia is currently saving more as a share of GDP than almost every other high income economy. The net flow of capital into Australia, at around 2% of GDP, is less than one third of its level during the 2003-2007 banking boom. And the trade balance – exports minus imports – is close to zero as a percentage of GDP.
Many remain concerned, however, that we need to get the dollar down now to support future growth in sectors such as tourism and manufacturing. But the case for such pre-emptive depreciation does not seem strong. A Grattan Report, The Mining Boom: Impacts and Prospects, studied countries that have experienced big rises and falls in their exchange rates. It found that production and exports in sectors like manufacturing bounce back quickly when exchange rates adjust.
So overall, while some would welcome a lower dollar, the case is weak for intervention (such as the RBA buying large quantities of foreign currency). A big fall in the terms of trade – if and when it happens – would reduce the dollar. But that does not mean intervention is needed now.
Nevertheless, there are things that policymakers can do to help the beleaguered trade-exposed sector, and most of them are good ideas anyway.
Helping our trade-exposed sectors
First, budgetary prudence would help to control Dutch Disease. Government budget deficits from 2006 to 2012 contributed to the “disease” in the first place, by driving up expenditure and adding to cost pressures. Looking ahead, budget discipline can help to ease cost pressures on those sectors.
Second, tougher financial sector regulation may permit interest rates to be reduced – removing one source of pressure on the exchange rate – without provoking a house price bubble. One option would be to follow New Zealand in tightening limits on loan-to-value ratios.
Third, policy settings for productivity and adjustment remain critical. That would help ease cost pressures. And if we do indeed face a big fall in incomes when this phase of the mining boom ends, a flexible economy will be key to minimising the pain of transition to new industries.
Thirty years on, the floating the dollar has helped Australia flourish as an open economy. But a floating rate is no panacea. Continued prosperity depends on Australia continuing to make tough policy choices.