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Bad Economics Caused Our Economies Current Account Problems

Economics / Austrailia Mar 11, 2008 - 11:22 AM GMT

By: Gerard_Jackson

Economics The current account deficit, rising prices and our deteriorating foreign debt situation has caused the Reserve Bank of Australia to raise the cash rate from 7 per cent to 7.25 per cent. Bank assets are a useful guide to monetary policy. These fell by 36.25 per cent from May 2007 to January 2008. These figures suggest that the RBA means business and will continue to raise rates until it brings spending under 'control'. Unfortunately this cannot be done without bringing the economy to a grinding halt. So how did we arrive to this situation?

Back in 1999 much was being made of our current account deficit, which at that time was one of the highest in the OECD. This gave rabid anti-marketeers like Kenneth Davidson, left-wing economics commentator for the equally left-wing Age , an excuse to launch more verbal broadsides against free-market policies. Davidson's anti-market economic views should be taken note of because they mirror those of most journalists and other enemies of the market.

Davidson accused the Howard Government and its advisors of believing in the twin deficit fallacy, according to which a current account deficit will disappear once the budget goes into surplus. On one occasion Davidson named several countries that had both surpluses and current account deficits. This comparison, he believed, falsified the twin deficit theory. He was absolutely right. But being Davidson, he then got it wrong. According to him, the current account deficit created Australia's then net foreign debt of $240 billion. This is absolute nonsense. The debt was largely produced by the vulgar Keynesian policies that he is always promoting in his columns.

To put it crudely, our rapidly expanding money supply sucked in exports and thus generated a severe current account deficit. Ordinarily this would drive down the currency and eliminate the deficit. That this did not happen to the necessary degree strongly suggests that our currency is overvalued in relation to certain other currencies. It's the overvaluation that creates the debt. But ultimately, the fault lies with slack monetary policies — the kind vulgar Keynesians like Davidson are forever preaching. From January 2007 to December currency rose by 8.7 per cent, bank deposits by 14.7 per cent and M1 by 13 per cent. It is easy to see from these figures that credit expansion has been driving the money supply.

Unfortunately, by pointing out that current account deficits are not wrong in themselves, most free-market commentators carry on as if every current account deficit is harmless. This only damages the free-market cause. I'll illustrate my argument with two historical cases from Britain and the US. For about 100 years the US had a current account deficit. There was absolutely nothing wrong with this situation. Thousands of American entrepreneurs borrowed abroad, mainly from Britain, who then used the funds to import capital goods into the US.

This borrowing-to-invest program helped lay down the foundations of the world's most powerful economy. Eventually the American economy was able to meet virtually all of its needs for capital goods out of its own savings. Unlike today, there was no monetary disorder. Britain was on a gold standard and made loans in gold and in turn expected to be repaid in gold. (Actually, lenders expected to be paid with paper that was redeemable in gold). This was the key.

Even though US imports exceeded exports for nearly 100 years there was no financial crisis because the difference was made up by foreign gold and not phoney bank deposits. So long as countries abided by the rules of what Keynes destructively called a "barbarous relic" the kind of severe monetary and exchange rate disturbances that the world continually suffers from today were out of the question. This brings us to Britain. By 1914 income from foreign investments and loans were allowing her to annually import $US3 billion of goods even though she was only exporting $US2 billion annually (1914 dollars). In other words, her trade deficit was funded by foreign earnings.

We should be able to now see that what matters are not current account deficits per se but how they come about. If they are caused by loose money policies then trouble lies ahead. The monetary explanation for the deficit also explains why a country can have domestic surplus and still run a current account deficit, just as Australia is doing right now. It was not until America fully adopted Keynesian 'pump-priming' that she ran into genuine balance-of-payments problems.

This reasoning exposes as man-in-the-street economics Davidson's claim that the deficit was being largely driven by massive imports of information technology. Even if he were right there would be nothing to fear. Private companies are borrowing abroad, just as they did in nineteenth century America, to invest in profitable opportunities at home. If these fail, then only the foreign lenders suffer along with the Australian borrower. If, however, the imports are a product of slack money supply then the free market should not be held responsible for the consequences.

To complain, as Davidson did, that no matter what the IT deficit would continue to grow was just plain silly. Exports are the price of imports. This means that sooner or later IT imports had to be paid for out of exports. If we wish to continue importing certain goods then we must either redirect spending from other foreign goods or sell assets. This fact should be blindingly obvious to anyone with any economics training. Yet it seems to have completely by-passed Davidson and other anti-market critics. And he has the gall to assert that the Government and its advisers "are unqualified" in economic matters.

To the likes of Davidson it's all the fault of "mindless competition" and "privatisation", as if he were still longing for Soviet-type central planning. If, as he asserted, telecommunications manufacturing would be killed off by backroom deals with the likes of the Packer and Murdoch media empires how could he logically argue that "mindless competition" should be considered the culprit? In any case, the very term "mindless competition" is specifically designed to prejudice readers. But then Davidson might really believe that consumers and producers are mindless.

He accused the government of deliberately arranging tendering and outsourcing so as to favour foreign giants like IBM. Of course, he provided no evidence. But why would any government deliberately do this anyway? We were not told. Nevertheless, the accusation raised an important question that still needs to be answered. If our own IT firms need government contracts to survive in the market place then this basically suggests that they either (a) too inefficient to compete, (b) that the economy is too small to accommodate all of them or (c) there is insufficient venture capital to fund them.

But note, if he is right about government actions, how in heavens name can he blame free-market policies? Unfortunately, the only thing consistent about Davidson is his hatred for free markets. In one of his articles finished with a tirade against our "anti-environment, anti-R&D and anti-universities" government, overlooking the fact that the government is also concerned about the effects of raising taxes.

In any case, there is no correlation between economic growth and the amount spent on research and development, let alone the number of universities. Japan progressed very nicely by buying the fruits of other countries R&D, mainly America's. She would still be doing nicely if she had implemented market policies instead of the kind of interventionist policies advocated by Davidson. Finally, Davidson has complained bitterly about the alleged lack of R&D here and the inability of Australian IT companies to grow. Yet any individual who financially succeeds with IT investment in Australia is immediately attacked by Davidson for being wealthy and "privileged" and any capital gains (profits) they make are savaged.

Yet Davidson and his mates still call for more progressive taxation to bring these people down, only he calls it equity. How stupid and contradictory can anti-market journalists be? Very, is the answer - particularly if they work at The Age . Unfortunately the Chomskyite Davidson's hatred does not stop with free market economics. He accused President Bush of attacking Iraq so as to gain access to oil and military bases ( The Age , What America wants: it's the bases, stupid , July 15 2004). Bush is also accused of waging "war against women" ( The Age , The truth about George Bush's anti-AIDS push , February 10 2003) and of provoking that lovely bunch of dictators in Beijing.

And from whom does this fanatical Bush-hater get his facts? From the equally mendacious and fanatical Chomsky. In fact, Davidson is so fond of Chomsky he has even plagiarised him.

By Gerard Jackson

Gerard Jackson is Brookes' economics editor.

Copyright © 2008 Gerard Jackson

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