Unfair exchange?

by John Quiggin on May 31, 2011

Ten years or so ago, the Australian dollar was worth about 50 US cents on foreign exchange markets. I bet a small amount with a colleague that within five years, $A would have achieved parity. My reasoning was simple, elegant and wrong. By most estimates, the Purchasing Power Parity exchange rate[1] is around $A1.00 = $US0.70, so the Australian dollar was undervalued by around 40 per cent. It seemed to me that, within five years or so, the deviation should have not only been corrected but overshot in the other direction, giving a rate near parity.

I should have considered more carefully the saying, apocryphally attributed to Keynes, that the market can stay irrational longer than you can stay solvent. If deviations from PPP corrected within five years, speculators would bet on this happening, and the deviation would not be sustained at all. So, if PPP is false, it must stay false for long periods.

And that’s what’s happened. The Australian dollar has been above parity for some months now, and shows no sign of falling.

That raises some interesting questions. I’ll put up a few over the fold, and maybe update them as I go

* Everyone in Oz is ordering stuff direct from the US, and it’s killing local retailers. But when the rate goes back to 0.50 we’ll be sorry
* Evaluated at exchange rates rather than PPP, Oz income per person is well above that in the US (about 60 000 vs 47 000).
* This is mainly a reflection of $US weakness rather than $A strength. Despite its massive problems, the euro has been well above PPP (about $1.10) for years
* As far as global hegemony is concerned, exchange rates and not PPP estimates are what matters. If you want to buy a tinpot dictatorship or trade a shipload of weapons, what matters is the value of your cash, not the living standards of your citizens. So, the US is trying to maintain military hegemony despite having a GDP significantly lower, in exchange rate terms than that of the EU. That has to be a doomed endeavor if exchhange rates stay where they are.
I’ve corrected a couple of points of imprecision, noted in comments

fn1. As I’ve mentioned before this is not a fixed number. It’s an estimate of the relative price of a bundle of goods which in turn is derived from a model. Even disregarding problems in estimating prices for comparable goods, there is ‘right’ choice for the bundle of goods, and different choices can lead to differences of 10 per cent or so in the estimated PPP rate.

{ 40 comments }

1

P O'Neill 05.31.11 at 12:18 pm

One possibility is that the Chinese crash (economic or political) will take care of the overvaluation by dampening the commodity boom correlation in the A$.

2

Ian 05.31.11 at 12:31 pm

So you open your post by telling us about a prediction you had that was wildly wrong and you then proceed to make another forecast about something you think is unsustainable?

3

Emma in Sydney 05.31.11 at 12:48 pm

JQ is nothing if not courageous, Ian, in the Sir Humphrey sense. I myself am ordering up big from US and European retailers, and planning to travel. Make hay while the sun shines.

4

Tom T. 05.31.11 at 12:50 pm

What’s the mystery here? The US has effectively printed a ton of money between then and now; of course its currency will have depreciated.

5

mw 05.31.11 at 1:00 pm

If you want to buy a tinpot dictatorship or trade a shipload of weapons, what matters is the value of your cash, not the living standards of your citizens.

But the U.S. is paying its troops and building/buying its arsenal in dollars, too, so unfortunately, I’m afraid it’s more sustainable than it might seem. If you want to buy a tinpot dictatorship by providing weapons (a common approach), a low dollar is irrelevant or even beneficial — since a low dollar makes U.S. weaponry more, not less, competitive.

And are the consumer products that Australians are mail-ordering from the U.S. actually manufactured in the U.S.? Or are they Asian-manufactured goods that are cheaper to ship to the U.S. and then all the way back to Oz because of some combination of tax, retail efficiency, or other form of arbitrage?

6

Kevin Donoghue 05.31.11 at 1:15 pm

Ian, an exchange-rate prediction which comes right five years later isn’t “wildly wrong” by any means.

Tom T., you need to get your head around the fact that Australians print money too.

7

Chris Bertram 05.31.11 at 1:17 pm

_And are the consumer products that Australians are mail-ordering from the U.S. actually manufactured in the U.S.? Or are they Asian-manufactured goods …._

There was an interesting piece in the FT this weekend about how many products (such as iPhones) are assembled in China but from components made in the US or Europe. So the issue of where they are manufactured may not be a simple one to settle.

8

Chris Bertram 05.31.11 at 1:19 pm

9

Omega Centauri 05.31.11 at 1:55 pm

So, the US is trying to maintain military hegemony despite having a GDP significantly lower, in exchange rate terms than that of the EU. That has to be a doomed endeavor if exchhange rates stay where they are.

But, Europe is not trying to compete in that arena. So I don’t see that the ratio matters.

10

Henri Vieuxtemps 05.31.11 at 1:57 pm

Or are they Asian-manufactured goods that are cheaper to ship to the U.S. and then all the way back to Oz because of some combination of tax, retail efficiency, or other form of arbitrage?

I can’t imagine that they are shipped to the U.S. and then all the way back to Oz. It’s probably that US retailers negotiate the prices, and then, when they get an order from Australia, they get it shipped directly from Hong Kong to Australia.

It is surprising, though. I know US retailers usually won’t ship electronics (we are talking about electronics, right?) to Europe; is Australia different for some reason?

11

imajoebob 05.31.11 at 2:37 pm

The major component I see missing in this is the effect of investors/speculators in currency as a commodity, not as exchange media. Like oil, there are too many parties vested in currencies to allow the market to behave “rationally,” except in the macro view where it’s just another piece of all commodities.

It used to be just the National Banks that had the ability to prop up or deflate currencies, but the money in all the hedge funds is equal-or even greater than the leverage of governments. I’ve seen little about the effect of petrodollars on the current value of the Euro. As far back as 8 years ago there were rumblings that the Arab oil producers were investing heavily in the Euro as the dollar started to fall (and the US continued to threaten global war), even to the point where there was talk of switching the basis price from $US to Euros. With all the problems some of the individual countries in the EU are having, and the inability of the EU to actually control the individual banks within those countries, there is no reasonable explanation for the strength of the Euro. The Central Bank’s authority has not (yet) been truly tested.

In Greece there is growing sentiment that they are bearing much, if not most of the hardship necessary to protect the other EU countries from the worst of the downturn. Ireland is feeling some of that pain, too. And now it’s spreading to a few more countries. What if Greece, Ireland, Spain, Portugal, and a couple other countries worried they are next in line force Germany, Italy and France to start printing more money? What if Greece simply tells the Bank to get stuffed, and prints the money it needs to kick-start its markets?

The common interests of the EU are strong enough to stem this sentiment – for now. But none of that risk is reflected in the value of the Euro. The only explanation for its strength and stability has to lie in the exchange markets. If the OPEC countries are as heavily invested in the Euro as was rumoured, then they have every “rational” reason to manipulate the Euro’s value. We can take this a step further and link the value of crude to the need to prop up the Euro, and we might even see that the over valuation of the Euro is a large component of the current high price of crude; what the left hand is spending on the Euro the right hand is collecting for the oil.

This is all a long (very long) way to go to say that the while individuals see currency as a method of exchange for goods and services, the financial markets see it as just another set of commodities, ready to fall prey to the speculators. These speculators are no longer a rogue, niche segment of investors; they are a large, powerful segment of the markets. They’ve insinuated themselves into every key exchange, and use the individual components to hedge their bets – which is another way of saying they’ve moved the risk from their ledger onto ours.

By moving the risk around the speculators are able to use the different countries against each other. Right now there’s no incentive for Ozzies to object to currency speculation – they’re reaping great benefit. The same was true for Americans in the late 90’s, and the Europeans in the mid-decade. The Japanese, one of the largest holders of liquid assets, has been in the doldrums for 20 years as they’ve had to stabilize different currencies year after year.

There’s something to be said for the compartmentalized, revolving booms and busts as a way to mitigate the overall effect. Every one of these busts and booms has winners and losers, but it’s becoming apparent that the same small group of people are winners every time. And once they’re done fleecing one segment they take their con game and move it down the street. Until we find the wherewithal to regulate speculation the rest of us are stuck shouldering ALL the risk.

12

Tim Worstall 05.31.11 at 2:53 pm

I’d second @1. If China even stumbles, let alone crashes, metals and coal (the two are intimately linked through the iron industry) prices are going to crash.

13

Myles 05.31.11 at 3:40 pm

I’d second @1. If China even stumbles, let alone crashes, metals and coal (the two are intimately linked through the iron industry) prices are going to crash.

Even deferring to your much greater expertise in the commodities markets, I don’t think this is very likely. The demand for metals isn’t going to crash; it’s going to come from another country, depending on how much of the metal in question is used in construction and how much in production. Coal is another matter, although I don’t see any other developing being able to seriously skip coal if they need to get their power generation expanded pronto to meet the presumed China shortfall.

Everyone in Oz is ordering stuff direct from the US, and it’s killing local retailers. But when the rate goes back to 0.50 we’ll be sorry

The other side of the coin is that if consumers spent the money saved from the American purchases on other, additional Australian services, we might see a lot of that loss recouped in a perhaps unexpected ways.

Evaluated at exchange rates rather than PPP, Oz income per person is well above that in the US (about 60 000 vs 47 000).

Pretty visible in Canada right now as well. Because the USD has sunk so much, European car makers are holding on certain models from the U.S. market (because they can’t price it properly, given how they’ve priced the higher-end models, which are often made in the U.S., such as at Spartanburg, SC), but releasing them on the Canadian market.

So, the US is trying to maintain military hegemony despite having a GDP significantly lower, in exchange rate terms than that of the EU. That has to be a doomed endeavor if exchhange rates stay where they are.

Very true, even limiting to investments. As the dollar is low and other first-world currencies are high, U.S. companies will be seriously incentivized to sell off investments and holdings in other Western countries, and more importantly, will be disincentivized to buy up investments in other Western countries. As a Canadian I of course welcome this, but how this is going to play out in Europe, where certain sectors have traditionally had very strong U.S. ownership (Opel-Vauxhall, etc.), is going to be extremely interesting.

14

Satan Mayo 05.31.11 at 4:14 pm

Tom T., you need to get your head around the fact that Australians print money too.

Next you’ll be saying it isn’t Obama’s anti-capitalist attitude that caused the uniquely American financial crisis.

15

Bloix 05.31.11 at 4:34 pm

By 2004, the Australian dollar reached about US$0.70 or a bit above – i.e., at about what John thinks it should have been based on PPP – and stayed there until 2007, then went up and then fell back to his target range in 2009. His prediction that it would reach parity in 2006 was based on his belief that the market would “overshoot.” Instead, it reached a more-or-less correct valuation, by John’s lights. John’s error was that he believed that the market would be irrational, when in the event it proved to be more-or-less rational.

So how can he now say that it didn’t reach parity in 2006 is an example of the principle that “the market can stay irrational?” I don’t get it.

16

Martin Bento 05.31.11 at 4:37 pm

You bet on parity? Not parity or better or parity or worse, but parity? That’s like betting the Dow will hit some specific number, rather than be above or below a target. Please let me know of any bets of this nature you plan to make in the future.

17

Michael 05.31.11 at 6:21 pm

As far as global hegemony is concerned, exchange rates and not PPP estimates are what matters. If you want to buy a tinpot dictatorship or trade a shipload of weapons, what matters is the value of your cash, not the living standards of your citizens.

I dont see it this way at all. Global hegemony is a function of how many resources a state can muster to go out in the world and push people around (i.e. aggregate GDP). I can’t think of any plausible exchange rate by which the US would cese to be a hegemon. For now, they are just so much bigger and have far greater reach than everyone else combined.

the euro has been well above parity for years.

Is parity really the right value with which to judge whether a currency is over/undervalued? You seem to be implying that parity means the currencies trade at a “fair” value (but correct me if I am wrong)? For instance, the Yen is currently very high at the moment (currently around 81 YEN to the USD). Consider the following: “Despite its massive problems, the Yen has been well above parity for years.” Funny isn’t it? So if we don’t talk about parity when determining if the Yen is over/undervalued, why is the Euro different?

18

Doug 05.31.11 at 6:23 pm

I just had a quick look at dollar-euro since May 1999. The series (quick and dirty monthly average bid prices at oanda.com) starts at €1 = $1.03, hits a low of €1 = $0.85 in Nov 2000, peaks in July 2008 at €1 = $1.57 and finished May 2011 at €1 = $1.43.

Dollar-yen has been more managed; you have to look even beyond the 20-year series to get a 100% fluctuation, $1 = ¥158 in April 1990, $1 = ¥83 in April 1995 and again $1 = ¥81 in May 2011.

But neither series inspires much confidence in a correlation between major reserve currency exchange rates and PPP.

19

Doug 05.31.11 at 6:28 pm

Is parity really the right value with which to judge whether a currency is over/undervalued?

It isn’t. If I remember correctly (and I may not, it has been 10 years and more) the euro was designed to have an exchange rate of €1 = $1.17–$1.18 or thereabouts, based mostly on the dollar-mark rate.

20

SamChevre 05.31.11 at 7:08 pm

I think the reason that the inflation hawks are being hawkish in the US has been clearly demonstrated.

Relative to Euros, Australian dollars, Canadian dollars–the US dollar is losing value. Whatever officially-measuerd inflation does, “my dollars buy less stuff” is the common informal definition of inflation.

21

Michael 05.31.11 at 7:25 pm

Doug, yes, thats what I was getting at. But I have a feeling a lot of people think that parity is some magical number whereby real information can be gained about states by seeing if a particular currency is above or below parity vis-à-vis some other currency. In fact, this is an easy thing to look for to see if someone has any idea what they are talking about when it comes to currencies.

On a related note, what’s with the title of this post: Unfair exchange? What is a “fair” exchange rate anyway? The original post claims that PPP can stray far from the nominal exchange rate for some time, but the nominal exchange rate is determined by an irrational market. So if not PPP or the nominal rate, then what?

22

BT 05.31.11 at 7:54 pm

Carry trade, anyone?

Interest rates are currently higher in Australia than in the US. Returns on A$ denominated assets are generally higher than on US$ denominated assets right now. Plus the commodities boom.

Yes, the US$ is weakening, and so it should to address their trade deficit.

But watch the A$ crash to .80 US cents if the Aussie housing market collapses and the RBA drops rates to zero.

23

Emma in Sydney 05.31.11 at 9:05 pm

mw @5, it isn’t just electronics. Clothes, books, shoes, and many other products are heaps cheaper to buy from US online retailers than to buy in a shop here, and often better quality, wider range of sizes and so on. Market size has something to do with this, and also lazy greedy Australian retailers who have only just woken up to having some competition. The rise in our currency has basically completely offset the shipping costs, for instance, for American clothes, which were cheaper and better to begin with.
Many of them are made in cheap labour countries (Mexico, Costa Rica, Ecuador as well as China and Thailand), but then so is the expensive stuff in Australian stores. My mail order clothes parcel are often shipped from Sweden or European mail centres, but I imagine they’ve been to the US at some point. My new boots, bought from a British company offering free 48 hour shipping to Australia, cost about one third of what a similar product would cost in a shop here, so it’s not just US dollar rates that are advantageous at the moment. As BT notes, though, it will all crash at some stage.

24

Walt 05.31.11 at 9:09 pm

SamChevre, what you’re describing is known as “depreciation”. “Inflation” is when the price of a typical basket of goods goes up. Unless the typical basket of American goods is heavy in authentic ugg boots and pet kangaroos, depreciation against the Australian dollar is not inflation. Words have meanings.

25

John Quiggin 05.31.11 at 9:09 pm

I fixed a couple of mental typos on parity, mentioned in comments above. For the Euro I meant to write PPP, not 1 for 1 parity. And of course I didn’t offer the really silly bet on exact parity.

I agree that a crash in the $A rate seems inevitable, unless the US has massive inflation and we don’t. But, if it’s inevitable, traders should be able to make arbitrage profits by selling now.

26

chris 05.31.11 at 9:36 pm

But, if it’s inevitable, traders should be able to make arbitrage profits by selling now.

Doesn’t that require that they be able to time the crash more precisely than “it will have to happen eventually”? This is what that aphorism about the market remaining irrational is all about, isn’t it?

27

Antoni Jaume 05.31.11 at 9:46 pm

Doug 05.31.11 at 6:28 pm

” If I remember correctly (and I may not, it has been 10 years and more) the euro was designed to have an exchange rate of €1 = $1.17–$1.18 or thereabouts, based mostly on the dollar-mark rate.”

I believe that the value of the ECU, which was the antecessor of the Euro but for the name, was inicially defined as a basket of currencies equal to 1 dollar.

28

John Edmond 06.01.11 at 12:29 am

@10 No, Australia is the same as Europe when it comes to the shipping of electronics. However, we have sites like PriceUSA which make the purchase for you and then ship it out.

Irrespective of the weak US dollar local Australian retailers are stuffed. You should’ve seen the sputtering of a visiting English friend after she discovered that, thanks to Amazon UK’s free shipping and removal of VAT, Australians pay 20% less for British products than she did. I just wish I could have been there when she read about Cameron Government’s change to the VAT import threshold. The idea of charging people for the privilege of being charged VAT is ingenuous.

29

spyder 06.01.11 at 1:06 am

Well, all i can add to this:
A kid i have known all of his life (born near the same time as my youngest daughter and her lifelong friend), now with dual Aussie/USA citizenship, is running a NSW website urging folks in Oz to purchase US yachts.

30

Francis Xavier Holden 06.01.11 at 1:48 am

Or are they Asian-manufactured goods that are cheaper to ship to the U.S. and then all the way back to Oz because of some combination of tax, retail efficiency, or other form of arbitrage?

Last 6 shirts (blue button down oxford cloth) I got from Landsend were Made in Malaysia, just a few (9) hours north of here by plane, shipped to Dodgeville, Wisconsin, then shipped to me in Melbourne Oz – all for less than I could have purchased 2 shirts here. If I could get decent blue button down Oxfords here which I can’t. And I can specify half sizes and precise sleeve length – which cannot be done here.

I have not purchased any clothes in Oz – with the exception of underpants for about 3 years. I get quality suits, shirts, socks, sports jackets, shoes all online and overseas. (Some of it Made in USA, some UK, some Italy, some China, some Spain etc, socks direct from Turkey). In most – nearly all cases – what I want is simply not available in Melbourne at any price.

Those were there is a close substitute available locally then the online overseas price is 50% to 70% cheaper.

Some of those savings go to my tailor for fitting and alterations, some goes on dining out (not suitable for online trade) – in many cases it is purchases I would not have made locally anyway due to lack of choice or quality.

Theres not much artificiality /arbitrage involved – No VAT on most UK purchases – thats 20% now, but soem UK places chareg it anyway as its too much paperwork to dedct it fo rsmall businesses. Usually no USA sales taxes. No Oz GST but that is only around 10%. Despite teh bleating of Oz retailers none of these are enough to make any real differnece to purchases.

Plus I have to pay postage or extortionate courier costs.

Most online overseas service is superior to even high end bricks and mortar stores here in Oz. I can have alive chat on video if I want at 12 midnight on a Friday night with a shoe seller in UK – order the shoe and have it delivered to my doorstep (literally doorstep not Post office) by the following Tuesday. These shoes, when they are available here are ~$600 aud – delivered to me they are ~$280 aud.

I’m not sure I’m typical – most men don’t seem to buy 4 or 5 pairs of shoes a year or a few suits etc etc but I’m sure that in other fields the experience is much the same.

Oh and I buy 95% of my books online – at half price and delivered. And I do it with pleasure after Borders here went into receivership taking $150 of mine in gift vouchers – which cannot be redeemed.

The more sub par Australian retailer who are closed down the better in my world.

31

Francis Xavier Holden 06.01.11 at 1:53 am

I didn’t mention that a lot of the clothes are superfine Australian merino wool – shipped out of here raw – woven in Italy or UK – made up elsewhere – Asia, EU, into garments and shipped back here.

32

imajoebob 06.01.11 at 2:56 am

@31/FXH – isn’t that the fault of Australian economic planners? They didn’t see the value in an integrated system, only for the wool and/or meat. I’ll bet there were a number of weavers and clothing manufacturers that would have been a better investment than the supports they gave the livestock farmers.

33

Tim Worstall 06.01.11 at 8:44 am

@ 13

“Even deferring to your much greater expertise in the commodities markets, I don’t think this is very likely. The demand for metals isn’t going to crash; it’s going to come from another country, depending on how much of the metal in question is used in construction and how much in production. Coal is another matter, although I don’t see any other developing being able to seriously skip coal if they need to get their power generation expanded pronto to meet the presumed China shortfall.”

That’s not quite how it works. It’s the difference between demand and supply capacity that drives commodity prices. Well, umm, D’oh, of course. But most mining enterprises are capital heavy, running cost light. So once you’ve built something then you keep it chuntering along. And demand only needs to change a little bit in such a scenario for prices to be very volatile.

Iron ore currently (well, a few weeks ago, last I looked) is $160 a tonne. A decade ago pig iron (ie, no O2 or O3 in there any more and already run through a blast furnace) was $100. Pig iron is now $350.

There’s no particular shortage of iron ore around the planet. It only need China to stumble and that FOB price for iron ore will tumble. For it’s not “people need iron”, it’s “what are they willing to pay for iron given current capacity constraints”. And if demand falls a bit, dipping below current production capacity, no reason at all why iron ore won’t go back to $50 a tonne.

Re coal, there’s really two markets: metallurgical coal (for iron making mostly) and steam. Metallurgical coal prices would take the same nose dive on a Chinese stumble.

34

reason 06.01.11 at 8:50 am

JQ
re Euro exchange rate. Do the PPP calculations allow for the effect of VAT? VAT taxes imports but not exports, whereas income tax based tax systems tax exports but not imports. This surely must effect he equilibrium exchange rate.

35

Western Dave 06.01.11 at 12:42 pm

@13 What Tim said. Once a mine is open it’s pretty cheap to operate until it gets played out. Removing the overburden or sinking the shafts is what is costly. Once a mine makes back it’s initial investment (the risky part), it’s almost all gravy. The price of uranium since 1981 is so low and the regulatory rules so high that there haven’t been any uranium mines operating in New Mexico since the early 1980s. Yet a friend of mine recently retired having spent the last 40 years as a uranium miner. His job? Travel to the different mines and maintain the ventilation equipment and electrical systems just in case the price point for U308 ever hit the mark where they could re-open the mines. (One mine, Crownpoint, has been trying to reopen for years as a leach mine but the Navajo tribe has it tied up in court fearing groundwater contamination). U308 recently hit above $70 and rumor was mines would re-open but then Japan happened.

36

Tim Worstall 06.01.11 at 1:00 pm

@35, a tad more detail. In Australian iron ore mines the real cost is running the railway to the coast so as to be able to export. Once you’ve paid for that it really is pretty much all gravy (they’ve mountains out in the Outback that are almost pure ore, nearly but not quite shovel it straight into a furnace stuff).

37

Michael 06.01.11 at 1:51 pm

Everyone in Oz is ordering stuff direct from the US, and it’s killing local retailers. But when the rate goes back to 0.50 we’ll be sorry.

Where is the data to back this up? 1) The data on total retail sales in Australia continues on its upward, somewhat jaggad trend. 2) in 2010, Australian imports from the US grew by only 2.3%. How are these reconsiled with Australian retailers being killed because of imports from the US?

38

peter 06.02.11 at 9:33 pm

Satan Mayo 05(#14): “Next you’ll be saying it isn’t Obama’s anti-capitalist attitude that caused the uniquely American financial crisis.”

But wasn’t the Global Financial Crisis of 2008 a result of the financial markets correctly predicting an Obama Presidency and reacting negatively in anticipation of the big-spending, nationalizing, car-manufacturer-owning, birth-certificate-hiding socialism he was to introduce? No question, Obama caused the recession that preceeded his election and he did so to ensure his victory!

39

derrida derider 06.03.11 at 3:47 am

Actually, John, PPP has been higher than 70c for some time – the Penn tables have had it at about 77c for the last decade (which casual comparison of prices of non-tradables would suggest is about right). It’s higher than it used to be a couple of decades ago because Australian inflation has generally been a little lower than US inflation.

The distinction between how exchange rates affect citizen’s living standards and how it affects power relations between states is an important one. But then it’s not only exchange rates where the distinction matters – GDP growth is another one. It does not matter to US-European relations, for example, that per capita GDP growth in Europe has mostly been higher than per capita US growth in recent decades. It does matter for those relations that European aggregate GDP has been growing less.

40

John Quiggin 06.04.11 at 12:38 am

Thanks for the update on PPP. I’ll keep it in mind.

“It does matter for those relations that European aggregate GDP has been growing less.”

Not really. Europe (more precisely the EU) has got a lot bigger over that period. In the sense relevant for geopolitics, Germany’s population grew by 25 per cent in a few weeks in 1989 (actually more, since the existence of East Germany clearly imposed costs on West Germany). And while the increment in GDP was much smaller, it was still substantial once the adjustment process was over.

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