Soaring dollar reflects strong economy

With the New Zealand dollar surging tonew post-float highs on a regular basis, the viability of exporting is underthreat for those outside the dairy sector.   The pressure on exporters has seen US professor Steve Hanke recently assert that our economy is in a "death spiral".   Hestated that "you get a flood of capital coming in chasing the high interestrates, and the flood of capital, of course, aggravates the inflation problem"leading to even higher interest rates.

It’s a confusing step in logic to statethat the flood of capital aggravates the inflation problem.   The normal view isthat the rising dollar actually lowers the domestic price of tradablegoods and, therefore, inflationary pressures.   For example, if the US/NZexchange rate was still at 62c (as it was a year ago), petrol prices would beclose to $2/litre, and the price of a two-litre bottle of milk would be anotherdollar higher than it already is.

There are only two conceivable transmissionpaths by which the influx of capital might add to the inflation problem.   Path one:more foreign funds could keep longer-term interest rates down and encouragemore borrowing.   Path two: imports are more affordable so real demand continuesto grow strongly.   But any effects from the first path have actually diminishedthis year as fixed mortgage rates have risen markedly.   And the inflationaryeffect of the second path is doubtful – the volume of goods consumed will grow,but only because prices have fallen in the first place.

Economics wouldn’t be such a source ofintrigue (and confusion or controversy) if it wasn’t for conflicting orunorthodox ideas.   But those ideas need to be founded on a strong theoreticalbasis.   Professor Hanke appears to have a fundamental flaw in his logic,enabling him to reach the conclusion that we should abandon the floatingexchange rate and peg the New Zealand dollar to the US currency.   A quickinternet search of previous statements by Professor Hanke shows that he hassomething of a fetish for fixed exchange rates.

It is overly simplistic to blame the high New Zealand dollar on interest rates alone.   The higher currency also representsa natural response to high commodity prices for our exports.   The inflationaryimpact from the high dairy prices would be significantly larger than it alreadyis if the dollar was not as high as it is.

A sustained period of stability in worldfinancial markets has also encouraged foreign investors to keep investing theirmoney in New Zealand.   Our current slow rate of economic growth, the largecurrent account deficit, and the risk of a currency correction all make New Zealand a relatively risky proposition.   But asset prices globally have been steadilyrising and global economic growth is ticking along nicely, so the perceivedchances of investors suffering significant losses are low.   Consequently, thesavings from Middle East oil exporters and Asian countries keep on pouring in.

By advocating a fixed exchange rate,Professor Hanke is ignoring the range of factors besides interest rates that aredriving the New Zealand dollar higher.   He also implicitly promotes the viewthat a small group of policymakers would have greater collective wisdom insetting an appropriate exchange rate than market forces.   In New Zealand, one only has to look back to the "crawling peg" exchange rate regime of the early 1980sto find an example of the authorities fighting the market and losing.   Ultimatelythe crisis was only resolved by a 20% overnight devaluation of the dollar inmid-1984 followed by the float of the dollar in early 1985.

Exchange rate movements will alwaysresult in winners and losers.   Typically the complaints seem to be loudest whenthe New Zealand dollar is strong.   Exporters suffer, while consumers of importsare the only beneficiaries.

In contrast, there are few complaintswhen the dollar is weak and imports are expensive.   Households are a disparategroup, and unlike exporters or business groups, do not have a definitespokesperson to make sure their opinions are heard.   But the widespread natureof the gains enjoyed by consumers as a result of the high dollar should not beignored.

One final point: with dairy farmersenjoying a huge income boost that looks likely to be reasonably sustained, nowshapes as the ideal time to force farmers to fully face the costs of dairyproduction.   It is clear that the large number of dairy conversions over thelast decade is causing environmental stress in terms of water usage and carbonemissions.   Charging for water, for example, would prevent marginal land frombeing used for dairy farming and ensure that agricultural production decisionsare made with the longer-term implications for the economy in mind.

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