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Does the Fall in Australia’s Manufacturing Hold a Lesson for US economy?

Economics / Austrailia Sep 17, 2007 - 08:54 PM GMT

By: Gerard_Jackson

Economics Australian manufacturing is now about 11 per cent of GDP, the lowest ratio in the OECD. For years I have been warning our so-called free marketeers that the condition of manufacturing needed to be addressed. Their insouciant response is that the decline of manufacturing — no matter how severe — as a proportion of GDP is only to be expected in an advanced economy. In support of this assertion they appeal to the law of diminishing marginal utility and the concept of comparative advantage.

First and foremost, it is illegitimate to use the concept of diminishing marginal utility in this context. That they cannot see this tells us a great deal about them. (In any case, if they were right about the application of this law then the demand for foreign consumer goods would be falling instead of rising). As for comparative advantage, none of them seem to be aware of the fundamental fact that this law rests on a sound monetary policy. I have pointed out before that comparative advantage was formulated in the context of the gold standard. This view was immediately dismissed — even though Schumpeter made exactly the same point. In his own words:

In the first place, the ‘classical’ writers, without neglecting other cases, reasoned primarily in terms of an unfettered international gold standard. There were several reasons for this but one of them merits our attention in particular. An unfettered international gold standard will keep (normally) foreign exchange rates within specie points and impose and ‘automatic’ link between national price levels and interest rates. (Joseph Schumpeter, The History of Economic Analysis , Oxford University Press, 1994, p. 732).

I have been making the same argument for years, stressing that any country that runs a very loose monetary policy in tandem with an over-valued currency is in grave danger of distorting the pattern of trade by artificially lowering the prices of foreign manufactures while simultaneously over-pricing its own manufactures. This would result in an excessive inflow of imports that many domestic manufacturers would not be able to compete against. Misled by distorted price signals some of these manufacturers might even decide to move their operations offshore.

In other words, excessive monetary growth distorts relative prices to the disadvantage of domestic producers. (It’s always possible, I suppose, that our free marketeers find this suggestion far too difficult to grasp). As usual, I’m not saying anything new or even anything out of the mainstream. In 1970 Samuel Brittan, a very mainstream economist with the Financial Times , made the same point, arguing that

[i]f an imbalance is allowed to persist too long, a deficit country acquires an excessively home-based industrial and commercial structure while the surplus country becomes excessively export-oriented... This makes adjustment needlessly painful and difficult when it does come, and there is the risk of high transitional unemployment while resources are being transferred. Shop assistants in Britain cannot be transferred overnight to engineering establishments which do not yet exist while Volkswagen workers cannot move straight away into the German social services. These very facts themselves provide ammunition for those who oppose parity changes, and the eventual adjustments are all the more sudden and severe when at last they come. (Cited in A. James Meigs’ Money Matters: Economics, Markets and Politics , Harper & Row, 1972, pp. 350-352).

For some years now a number of American commentators have also been expressing concerns about the condition of US manufacturing. Some have gone overboard, blaming China’s manipulated currency for the ‘decline in domestic manufacturing’ and the increase in offshore investments. Last month, however, the Wall Street Journal published The death of manufacturing in America is a myth by Joel Kotkin. He found that in value terms the US was producing 42 per cent more manufactures than in 1982. Ergo, manufacturing was sound. Unfortunately we cannot actually deduce from Kotkin’s figures that US manufacturing is in a healthy state. Hayek stated the problem clearly when he wrote:

Here again we have to repeat what was asserted at the beginning of the book: statistics can never prove or disprove a theoretical explanation, they can only present problems or offer fields for theoretical research. (Friedrich A. Hayek Monetary Theory and the Trade Cycle , Augustus M. Kelley Publishers, 1975 p. 232)

In other words, statistics need a theory to interpret them. Let me try and make my point even clearer by using the J-curve theory, according to which a devaluation initially aggravates the current account before reducing the flow imports and expanding exports. The result, we are assured, is that the current account deficit will disappear, and perhaps even go into surplus. All things being equal, the J-curve obviously works its magic by reducing the price of exports in terms of other currencies which in turn raises the prices of foreign goods in terms of own currency. For example, if the dollar lost half its value overnight the prices of imported goods would double while the prices of domestic goods would fall by 50 per cent in terms of other currencies. Hence the theory explains the changes in imports and exports. In plain English, movements in the exchange rate alter the structure of domestic prices. As one economist put it: cannot deny that foreign exchanges affect internal prices. (Michael A. Heilperin International Monetary Economics ,Longman’s, Green and Co. 1939. p. 132)

It should be clear, therefore, that statistics alone cannot support the proposition that monetary policy has been hurting Australian manufacturing. But we get a different picture if we argue in terms of an inverted J-curve. Instead of exports expanding and the current account going into the black, the reverse happens: imports become cheaper while our exports become more expensive, driving the current account into the red. This is an indisputably correct application of the J-curve thesis. If our self-appointed guardians of free market thinking had any genuine respect for logic — let alone economics — they would concede the point. Unfortunately, they would sooner see the economy collapse rather than publicly admit that they made a mistake.

Ordinarily the conceited behaviour of this bunch would not matter a dam except for the fact that Liberal Party politicians have swallowed their economic nostrums. The result is that the Liberal Party (for the benefit of American readers, liberal in Australia means conservative) finds itself utterly defenceless against the allegations that it allowed manufacturing to be sacrificed on the altar of ‘neo-liberalism’. So now the Liberal Party finds itself fighting on two economic fronts (the other one being labour markets) — well it dam well serves it right for taking economic advice from a bunch of bunnies.

If any readers think that what I’ve written so far indicates that I’m fed up with the current fiasco — they are absolutely right. I have tried to explain to numerous people that if the manufacturing question is not dealt with we would be back to wholesale interventionism — which is exactly what Rudd is promising. And why not? He recently noted that manufactured exports grew by nearly 15 per cent a year during the Labor governments of 1983 to 1996 while growing by barely 2 per cent a year under the Howard Government*. No amount of sneering by our self-appointed defenders of the market can conceal the fact that Rudd has a valid point and that it will resonate with the electorate, and that includes a lot of Liberal voters.

What is needed is some genuine economic thinking instead of empty shibboleths.

*Since John Howard was elected in March 1996 there has been an unprecedented increase in the money supply. From March 1996 to June 2007 currency rose by 103 per cent, bank deposits by 188 per cent and M1 by 169 per cent. To my knowledge, not a single mainstream commentator has drawn attention to these figures. As far as our economic commentariat is concerned money does not matter.

The Liberal Party fails on Australian manufacturing and “industry policy”

Gerard Jackson

Gerard Jackson is Brookes' economics editor.

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