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Is Monetary Policy Destroying Our Manufacturing Base?

Economics / Money Supply Feb 06, 2008 - 12:30 AM GMT

By: Gerard_Jackson

Economics In both America and Australia the fear that the manufacturing base is shrinking to the detriment of the economy seems to garner more by the week. Australia's Labor Government has expressed the opinion that the fall in manufacturing as a proportion of GDP is of deep concern. Our so-called free market commentators mock this view, arguing that it is a historical trend that merely indicates that consumer demand has largely moved from manufacturing to services, and this is only to expected as an economy grows richer. In defence of this viewpoint they invoke the law of diminishing marginal utility. This law states that demand for a good will fall as more of it is produced. Hence the shift to services.


Unfortunately they have greatly misunderstood this law. It only applies to homogeneous goods. It is a gross error to apply it to a group of heterogeneous goods. Moreover, if they were right then one would expect the demand for foreign manufactures to also fall. In fact, the US and Australia find themselves 'flooded' with imports. At this point our deep thinking free marketeers resort to the law of comparative advantage which explains why a country imports goods even though it is more efficient in producing them. Now this is a perfectly valid law. However, what is overlooked is that it was formulated within the framework of the gold standard. As Schumpeter put it:

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. (Emphasis added). (Joseph Schumpeter, The History of Economic Analysis , Oxford University Press, 1994, p. 732).

The reasoning should now become clear: A severe monetary disequilibrium can dislocates exchange rates can badly distort the international patter of trade and production. This fact was debated at length and considerable detail during the "bullion controversy that was triggered in 1801 by Walter Boyd's Open Letter to Pitt. ( A Letter to the Right Honourable William Pitt on the Influence of the Stoppage of Issues in Specie at the Bank of England, on the Prices of Provisions, and other Commodities , 2nd edition, T. Gillet, London, 1801, p. iii).

Henry Thornton played a prominent part in the controversy, and in doing so made significant contributions to monetary theory. England had suspended gold payments in 1797, allowing banks to print their own notes which led to inflation and a disordered balance of trade. This is made clear by the following quote from Thornton:

I t is obvious, that, in proportion as goods are rendered dear in Great Britain, the foreigner becomes unwilling to buy them, the commodities of other countries which come into competition with our's obtaining a preference in the foreign market; and, therefore, that in consequence of a diminution of orders from abroad, our exports will be diminished. . . . But not only will our exports lessen in the case supposed; our imports also will increase: for the high British price of goods will tempt foreign commodities to come in nearly in the same degree in which it will discourage British articles from going out. (Henry Thornton, An Enquiry into the Nature and Effects of the Paper Credit of Great Britain , (1802), London: George Allen and Unwin, 1939, p. 198).

The importance of Thornton's analysis for the balance of trade was indirectly emphasised by David Ricardo when he wrote:

A new tax too may destroy the comparative advantage which a country before possessed in the manufacture of a particular commodity; or the effects of war may so raise the freight and insurance on its conveyance, that it can no longer enter into competition with the home manufacture of the country to which it was before exported. (David Ricardo, Principles of Political Economy and Taxation , Penguin Books, 1971, p. 269).

What these classical economists were saying is that prices matter and that inflationary and tax policies can do considerable damage to exports and therefore domestic manufacturing. However, today's economic commentariat see things very differently. For instance, they grossly misinterpret the great imports of manufactures as being deflationary . But as Wicksell pointed out:

A more important factor is the rise in the supply of imports, and the fall in the demand for exports, which is brought about by a rise in domestic prices, for this in itself exerts a downward pressure on prices. (Knut Wicksell , Interest and Prices , Sentry Press New York, 1936, p. 79. [First published in 1898]).

Wicksell clearly understood that far from being deflationary ' or anti-inflationary ' a great flow imports that exceed exports is due to the central bank's inflationary monetary policy acting through interest rates. Whichever way we turn we therefore find ourselves facing the central bank's monetary policy and its effect on the structure of prices. Mises made an observation that no economist would dispute:

. . . the volume of foreign trade is completely dependent upon prices; that neither exportation nor importation can occur if there are no differences in prices to make trade profitable. (Ludwig von Mises, The Theory of Money and Credit , The Foundation for Economic Education Inc., 1971, p. 250).

Therefore, whatever affects prices affects trade. If the government had a policy of putting a 10 per cent tax on exports while giving importers a 10 per cent subsidy we would have no hesitation in calling it insane. A currency that is overvalued by 10 per cent has exactly the same consequences. It raises export prices by 10 per cent while lowering import prices by the same amount.

It follows that a currency that has been overvalued for sometime might find that its industrial structure has not only become more domestic oriented but that part of it has been shifted abroad in response to the differences in international prices cause by the dislocated exchange rate.

Yet our economic commentariat deny the legitimacy of the above line of reasoning and its genesis. Des Moore - who seems to have become the economic spokesman for our rightwing - condemns this line of thinking as being outside the "traditional explanation". But as we have seen, our economic commentators are the ones who have deviated from the "traditional explanation". It is they who refuse to follow the economic logic that comes from studying the effects of monetary policy on exchange rates and the structure of prices.

By Gerard Jackson
BrookesNews.Com

Gerard Jackson is Brookes' economics editor.

Copyright © 2008 Gerard Jackson

Gerard Jackson Archive

© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Comments

Sile McGrath
07 Feb 08, 14:07
Manufacting base equals power

I agree with you. Have you read Kevin Phillip's "American Theocracy:The Peril and Politics of Radical Religion, Oil, and Borrowed Money in the 21stCentury"? He does a bang up job on the history of the economic rise of the Dutch, Spanish, the British and then Amerian rise to power all based on a MANUFACTURING base. Each lost their power when they exchanged the creation of goods for a financial sector.

Looks like its China's turn again. He also gets into other factors unique to America...the christian conservatives and how they've helped to push us over the edge.


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