Governments around the world currently are trying to respond to the declining value of the U.S. dollar. Several Asian countries have intervened in currency markets to try to soften the blow. Brazil has imposed a tax on the capital inflows seeking returns from an appreciating real. Australia, however, is taking a different-and better-approach: Doing nothing.
The central bank is operating monetary policy solely in line with domestic economic conditions. With the economy rebounding and underlying inflation still above the 2%-3% target band, that has meant increasing interest rates from their emergency low levels-by 0.25 percentage points at two consecutive meetings, most recently last week. This hike, coupled with strong global demand for Australia's mineral exports, has pushed the Australian dollar up 45% against the greenback since February. It is possible that the Australian dollar could eventually reach parity or even beyond.
This is an unusual policy stance, especially in the Asian context. Central banks in the region are buying the U.S. dollar in the hope of restraining its fall and promoting their own country's exports by keeping them from appearing relatively more expensive in dollar terms. And domestic exporters have been howling.
But Australia is on the right track. A depreciating U.S. dollar is a market signal that the U.S. needs to export more and save more. It is a symptom of extremely loose monetary policy and high government spending in Washington. It is also a warning about inflation, given a dollar today buys fewer goods than it did a year ago. U.S. policy makers are reinforcing this cycle by refusing to reform America's "too-big-to-fail" financial system and avoiding tough decisions on spending priorities. In a sense, the falling dollar is a signal that the U.S. needs reform at home.
Central banks abroad that buy dollars to control the dollar's fall are both ignoring and subverting these market signals. Their dollar purchases are placed into reserves that are often recycled into purchases of U.S. government debt, enabling the profligacy that's causing the problem in the first place. Meanwhile, this policy effectively imports U.S. inflation. Inflation is a tax on initiative and innovation; it leads to severe economic dislocation and allows governments to avoid making the kinds of efficiency-boosting reforms that would be in their best interests anyway.
Australia's decision not to follow suit will be controversial in a country that fears "Dutch disease", the situation where strong demand for a mineral-rich economy's commodities pushes the currency up, which in turns makes the manufacturing sector less price competitive. Minerals comprise 8% of Australian GDP but 48% of total trade. In the extreme, the fear is that Dutch disease could force manufacturers out of business entirely, as supposedly happened in the Netherlands after oil was discovered offshore in the 1950s.
The normal prescription lies in various nonmarket actions such as creating a sovereign wealth fund to keep commodity revenues offshore, or entry taxes, or various subsidies such as government "innovation funds" to boost the "competitiveness" of domestic manufacturers. No doubt rent-seekers in Australia will be lining up the arguments for subsidies and various protections as prices for Australian goods and services rise on international markets.
But Dutch disease is just another form of creative destruction, and Canberra should not fear it. Economist Joseph Schumpeter recognized that while economists fixate on price competition, business also competes on cost and quality. If the prices of Australian goods and services are rising on world markets, this provides a clear incentive for Australian firms to either reduce their costs or to improve the quality of their offerings.
Rather than seek out government protection and subsidies, export-oriented firms should be innovating in response to a strengthening currency. This ultimately benefits consumers and, very often, the firms themselves. Similarly, governments should not be buying U.S. dollars and undermining market signals; they should consider reforms like tax cuts and red-tape cutting that allow firms to respond to market signals more quickly. Central bankers Glenn Stevens's lack of concern on the exchange rate should, in particular, force Canberra to reconsider plans to re-regulate labor markets and to reconsider its expensive and economically wasteful emissions trading scheme that would make manufacturers significantly less competitive.
Seen in this light, a weak greenback can have its advantages for the rest of the world. The U.S. is an exporter of intellectual property and business know-how that often forms the basis of innovation. If more countries followed Australia's lead, they would force the U.S. to bear the consequences of its fiscal irresponsibility, while also gaining more purchasing power to buy U.S. assets and technology on the cheap to help reform their own economies. What a smart idea.
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