The visible hand in economics

Over US$0.80 we go

Posted on: July 23, 2007

So, we broke 80cents US last night, on the back of expectations that the RBNZ will increase the OCR on July 26th. This led to the Dominion post terming us the strongest-performing currency in the world

Should the government intervene here? Is this a market failure caused by speculators and Japanese housewives that don’t understand the true risks?

I’m willing to stick my neck out here and say, I don’t think a strong exchange rate is that bad. Sure, non-food manufacturing is struggling, but no matter what the exchange rate is non-food manufacturing tells me they are struggling. A strong exchange rate keeps firms costs down, which has allowed domestic firms to increase margins without increasing prices, thereby removing a hell of a lot of inflationary pressure.

I believe the strong exchange rate is built on strong economics fundamentals (such as strong or improving commodity prices, and high interest rate relative to the rest of the developed world and a weak US economy), and I don’t think the current level is the end of the world, and I’m willing to bet that the manufacturers who are telling us it is are bluffing.

However, I know a lot of people will disagree with me. If so, tell me how and why you would intervene to change the currency (bonus points to anyone that tries to say lowering the OCR will reduce inflationary pressure, that cracks me up).

3 Responses to "Over US$0.80 we go"

The currency is high because of inflow of capital. Capital inflow is high because interest rates are high. Interest rates are high due to the OCR set by the Reserve Bank. The Reserve Bank has set the OCR high in order to hold down inflation.

How is a high interest rate an example of ‘strong fundamentals’? I don’t understand that.

There is no real solution other than to address the underlying inflationary pressure. The issue is what is causing that inflationary pressure.

I don’t buy the argument that high employment and economic growth are doing it. Other countries with stronger economies don’t have the same problem. In fact, our growth rate has been decidely average and only looks decent in comparison to the period when Birch/Peters were in charge of our finances.

I don’t claim to have the whole answer as to inflation, but a large part of it is due to people choosing to invest in property rather than productive activity. And that choice is a rational response to law and regulations that have been introduced since Labour took office. Of course there are other countries with more socialist governments than ours, but it’s rare for so much anti-business legislation to be passed in such a short time without serious economic consequences.

The inflow of capital is not the only reason for the high exchange rate. An increase in global demand for primary commodities has lead to an increase in the price of primary commodities. That implies that the demand for New Zealand commodities must increase, increasing demand for the New Zealand dollar.

Furthermore the capital story is not solely based on interest rates, if New Zealand businesses are paying high dividends or if share prices are growing strongly (which they seem to be) then there is an incentive for foreign investors to buy New Zealand dollars to buy shares.

Also the exchange rate is relative to other countries. Our exchange rate is at record highs against the US$ and the yen, but not against the pound, or the euro or the Aus$. Those records were hit back in 2005.

So the fundamentals I’m talking about are the high price for non-food commodities, the strong performance of the NZ stock exchange, the high interest rate and the weak US$ (in terms of all currencies).

Now, the cause of inflationary pressure is two-fold: Strong domestic demand (from growth in private and public consumption), and weak productivity growth. Simply put, the demand curve is shifting right faster than the demand curve, increasing prices. Now you put weak productivity growth down to a lack of investment, however gross fixed capital formation was very strong through 2004-2006.

Government legislation does have to take some of the blame for weak productivity growth (the RMA). However, I think part of the reason is that the capacity constraint of the economy was hit back in 2004, and since then we’ve been borrowing and trying to spend our way into economic growth. Here is where I agree with you, in so far as individuals have used houses as a form of saving, they have drained funds from productive investments.

The tax benefits for houses are debatable (except for the huge benefits from running it as a LAQC), however with a yield of less than 3%pa, housing seems like a strange long-term investment to me. As the house is solid, and exists, it gives people security, and thats something we can’t take away from people.

I forgot to conclude, oppps. Well my conclusion is that, in the short run we have to keep rates high to kill off inflationary pressures. Otherwise the role of government should be structural, to increase the capacity of the economy. Labour has not been completely bad at this, the apprenticeship program they introduced was a great idea. Also even if their motives were suspect they did cut the business tax rate.

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