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All disciplines are beset by various fallacies, but it’s reasonable to say that economics suffers more than most. The trouble in part stems from a lack of basic economic literacy, but also due to the fact that, at its heart, economics is the study of human interaction. As with all social sciences, it is far from an exact science and divining fundamental truths isn’t always straightforward.
Nevertheless, economists have made great progress over the years and it would be foolhardy to dismiss much of what they have to say, at least in terms of the structure and consequence of our commercial interactions (it’s a different story when it comes to economic forecasts.) Yet regrettably it seems that is exactly what many of us do, including our most influential policy makers.
Take the example of international trade, a topic that provokes highly emotionally charged debate. Yet the absence of any concrete understanding, from both proponents and critics, is quite stark. Most argument revolves around one of the biggest economic fallacies of all: that there is competition between trade partners. In point of fact, there is no such thing.
To understand why this is so, we need to appreciate that trade is, to borrow a phrase from Robert Nozick, a capitalist act between consenting adults. In other words, trade is entirely voluntary: people, companies, and countries will only ever trade when both parties see the exchange as beneficial. Under a system of voluntary exchange, it is incorrect to view trade between two parties as competitive; rather it is cooperative and mutually beneficial.
When Australia sells iron ore to China, it is not competing with the tiger economy (it may be competing with another country that also wishes to sell ore to China, but there is no completion between China and Australia in this case). And the only reason we would sell our ore to China is if we get something in return; we aren't silly enough to give our commodities to the Chinese for free.
Currency exchanges obscure this underlying fact, but at its heart international trade is an exchange of goods and services. We provide ore to China because they have something that we want in return (things like clothing, household goods, etc). Yes, we could produce this stuff ourselves, just as China could choose to mine ore within its own borders, but both parties are happy to trade because of the comparative advantage each country has in regard to these respective goods.
Think of it this way, there are two ways for Australia to produce, say, T-shirts (at, of course, an appropriate T-shirt-to-ore conversion ratio, whatever that would be). Either way we get T-shirts. it is just that one method may be much more efficient than the other.
So when you think about it, Australian clothing manufacturers are not in competition with Chinese clothing manufacturers; they are competing domestically with the minerals industry. It all comes down to focusing on the things you are comparatively good at, and out-sourcing things that you are less comparatively good at. From an economy wide perspective, there are huge efficiency gains to be made here, even though particular industries and individuals may suffer (of course, others will necessarily benefit).
The point to note though is that, on a net basis, there is really no significant net loss of jobs or income; just a transfer to other areas of the economy. In our example, a loss of income in the clothing manufacturing sector is essentially offset by a gain in the minerals sector. You can argue for or against our trade relationship on this basis, but don't make the common mistake of thinking that the Chinese are “stealing our jobs”. It is not just overly simplistic, it is downright wrong. Nevertheless, many people will claim that lower wage rates and corporate regulations in places like China reduce our international competiveness. The other thing to note is that, because we do not live in a barter economy, we use currency as an economic intermediary - even on an international basis. However we must appreciate that the Australian dollar is useful for one thing and one thing only: to purchase Australian goods and services. (Note that foreign investment ultimately rests on this too; foreign entities that invest in Australian financial products receive a return in Australian dollars, and again this is of use only if you want Aussie goods and services, or if you can trade the currency to someone else who wants Australian goods and services). Likewise the Chinese yuan is useful only for acquiring Chinese goods and services.
So the exchange of currency is fundamentally driven by the supply and demand of goods and services between trade partners. The relative exchange rate will simply reflect this underlying fact. For example, if there is a greater demand for our goods and services relative to our demand for Chinese goods and services, it will provide a very powerful tail wind for the Australian dollar, relative to the yuan. Things can quickly become complicated when you consider the network of global trade partners, but the fundamental principle is quite straightforward.
Note that such an understanding highlights another great economic fallacy; that a ‘weak’ currency is good for the economy. Yes, it’s good for exporters, but it’s equally bad for importers. Some may argue that you need to look at whether a country is a net exporter or importer, but again there is no such thing in the long term. A trade surplus or deficit is defined over specific intervals, but in either case Australia is either accumulating foreign currency or its trade partners are accumulating our currency. In the case of the latter, you can bet that our trade partners will wish to spend their Australian dollars at some stage, or trade it with some other country that does: over time it is a ‘zero sum’ game.
As is often the case, it depends on your perspective (hence the heated argument between various interest groups), but the point is that broad statements over the relative exchange rate are usually unhelpful and misleading. (It’s the same thing with the notion that high interest rates are ‘bad’; depositors would strongly disagree.)
So what is to be made of all of this? Of course it is difficult to properly enunciate the argument in the necessary detail in this forum, but hopefully it has given you food for thought. Those trading currency would do well to take the time to understand the dominant and fundamental factors that are the ultimate drivers of exchange rates.
For the rest of us, an understanding of the reality of international trade can help us better understand policy proposals, and help us cut through the mountain of misinformation and fallacious reasoning that dominates public debate.
Make the markets work for you
Andrew Page
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