Is monetary policy destroying the country’s manufacturing base?

Gerard Jackson

Any paper relating to industry policy that the Institute of Public Affairs sponsors deserves to be carefully read. This is precisely what I did with their Thumping the Table: Key Questions for the Labor Party’s Industry Policy (authored by Sinclair Davidson and Chris Berg, January 2007). It ought to be extremely difficult for any economist to write a paper on industry policy that is basically worthless. Unfortunately, Davidson and Berg managed to do just that. Kim Carr, Minister for Innovation, Industry, Science and Research, believes that “market failure” is the reason manufacturing has dropped to 11 per cent of GDP. Davidson and Berg opine that Carr’s view

does not seem to acknowledge the beneficial reallocation of resources (labour) to their most efficient use. . . . Profit seeking firms should eagerly pursue the competitive advantage provided by innovative business practices or products.

Davidson and Berg are clearly arguing that not only is there no market failure but that the market is succeeding in allocating resources to where they are most valued. At least they are half right. There is no market failure. What they overlooked, however, is the possibility of monetary failure. This is not surprising considering that orthodox economics totally ignores the existence of the production structure and treats money as being strictly neutral. Put simply: if a country runs an overvalued currency for sometime could this affect its manufacturing base? Yes it can.

The response of orthodox economists is to assert that a fall in manufacturing as a proportion of GDP is to be expected in a progressing economy. According to this view as the quantity of manufactured goods increase the law of diminishing marginal utility sets in and consumers increase their demand for services while reducing their demand for manufactures in relation to their incomes. If this were true of Australia then there would not have been an increased demand for foreign goods1 at the expense of Australian manufactures. Sometimes a reference is also made to the industrial revolution where it is argued that the fall in agriculture as a proportion of GDP as industrialization advanced proves that a similar fall in the ratio of manufacturing to GDP is only to be expected.

This opinion reveals a gross misconception about the industrial revolution. Now a pre-industrial society might have something like 85 per cent to 90 per cent of the population on the land. We can deduce from this that the agricultural population consumed most its own products. It would therefore be producing for its own consumption and not a market and that its agricultural surplus would be quite small. In terms of a production structure agricultural output and consumption can be seen as a single rectangle. This kind of economic situation makes famine a very real threat. (The years 1148-59 were one of famine in India. France endured 8 famines during the eighteenth century with the 1709 famine killing more than one million out of a population of 20 million. Henry Hazlitt The Conquest of Poverty, Arlington House, 1976, p. 15).

Although industrialisation massively reduced the number of people tied to the land it is largely overlooked by the great majority of economists that the rectangle had changed into a triangle showing that the production structure had lengthened and had become more complex and fruitful, indicating that more and more agricultural output was being produced for the market rather than direct consumption. As industrialisation raised real incomes the amount spent on food rose while falling as a per centage of real incomes.

My point is that the experiences of agriculture prior to and during the industrial revolution cannot be used to explain the current state of manufacturing. This in itself does not mean that there is something wrong with the present ratio of manufacturing to GDP, only that it should not be taken for granted that this ratio is an expression of some inexorable economic law. This brings us to international trade. And why do people in different countries trade with each other? Simple: because of differences in prices. When Ludwig von Mises was refuting the balance-of-payments theory as an explanation for exchange rates he made the indisputable point that

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. (The Theory of Money and Credit, Jonathan Cape Limited, London 1971, p.250).

It is perfectly clear or it should be  that if no such differences existed then international trade would not emerge. However, the case is more complex than this. As a country becomes more capital intensive  raising real wages in the process  there develops a tendency for labour intensive industries to migrate to labour intensive economies. This is an economic phenomenon that always needs to be taken into account when discussing the effects of international trade on domestic manufacturing. (Unfortunately this phenomenon is rarely if ever mentioned by our economic commentariat). It follows that since trade depends on differences in prices anything that affects the structure of prices must also affect the pattern of trade.

Therefore if a country has an overvalued currency one would expect exports to fall and imports to rise. It is not too difficult to draw the conclusion that if this situation was a lengthy one then serious imbalances would develop. Is this really possible? According to Samuel Brittain, a highly respected economist with the Financial Times, it most certainly is, and he wrote an excellent description of the situation.

…if an imbalance is allowed to persist too long, a deficit country acquires an excessively home-based industrial and commercial structure while the surplus country becomes excessively export-oriented… This makes adjustment needlessly painful and difficult when it does come, and there is the risk of high transitional unemployment while resources are being transferred. Shop assistants in Britain cannot be transferred overnight to engineering establishments which do not yet exist while Volkswagen workers cannot move straight away into the German social services. These very facts themselves provide ammunition for those who oppose parity changes, and the eventual adjustments are all the more sudden and severe when at last they come2.(Cited in A. James Meigs’ Money Matters: Economics, Markets and Politics, Harper & Row, 1972, pp. 350-352).

Once we establish that the structure of international prices can be distorted we must then set out to determine the cause. And we don’t have to look any further than monetary policy. In today’s world a loose monetary policy resulting in an overvalued currency and a growing current account deficit would certainly cause distortions to the production structure. Older economists certainly had no problem in pinpointing monetary policy as the culprit. As one of these economist said:

In a free economy the principal cause of a cumulative deficit in a country’s international payments is to be found in inflation . . . In a country whose currency is not convertible into gold, inflation leads to its continuous devaluation in terms of foreign currencies. (Michael A. Heilperin, International Monetary Economics, Longmans, Green and Co., 1939, p. 123).

It should now be even clearer that when a country continues to inflate while labouring under an overvalued currency this has the effect of artificially lowering import prices while raising the prices of exports thus imposing a disadvantage on domestic producers. (It requires little thought to realise that the effect of an overvalued currency is akin to a tax on exports to the amount of the overvaluation). In a addition it is also conceivable that some firms that had solely produced for the domestic market will now find themselves undercut by foreign competition, meaning that non-tradable goods had now entered into international trade. It could be argued that our trade flows can be explained by the law of comparative advantage. Anyone who takes that stance hasn’t read David Ricardo.

A new tax too may destroy the comparative advantage which a country before possessed in the manufacture of a particular commodity. (David Ricardo, Principles of Political Economy and Taxation, Penguin Books, 1971, p. 269).

Ricardo’s observation is clearly in line with the analysis that an overvalued currency amounts to a tax on exports. Unfortunately neo-classical economists ignore the fundamental fact that money is not neutral. On the other hand, the Austrian school continues to stress that inflating the money supply will distort the pattern of production. It ought to be clear that the neo-classical assumption that monetary expansion only affects the price level and not the structure of relative prices is not only untenable but also dangerous to boot. (Richard Cantillon, Essay on the Nature of Commerce in General, Transaction Publishers 2001, chap. VI. The book was originally written sometime in the 1720s and circulated as a manuscript. It was finally published in 1752). Haberler stressed this very fact:

… the process of inflation always leaves behind it permanent or at least comparatively long-run changes in the volume of trade and in the structure of industry. The impact effect is a change in the direction of demand. At he points where the extra money first comes into circulation purchasing-power expands; elsewhere it remains for a time unchanged. (Gottfried Haberler, The Theory of Free Trade, William Hodge and Company LTD, 1950, p. 54).

Today’s economists are ignorant of the vitally important fact that the classical economists debated the issue of international trade within the framework of a gold standard. (The same also goes for the Bullion Controversy when the note issue was strongly debated3). These economists recognised that the question was one of sound money and that abandoning gold in favour of a note issue would eventually lead to the sort of problems that we are now facing.

It is therefore ridiculous to dismiss this argument, as did Mr Des Moore, on the grounds that it is not within the “traditional explanation”. For those of you who have doubts about this matter allow me to draw your attention to Joseph Schumpeter’s observation that “the ‘classic’ writers without neglecting other cases, reasoned primarily in terms of an unfettered international gold standard”. (The History of Economic Analysis, Oxford University Press, 1994, p. 732).

We are obviously dealing with a complex subject and one that cannot be clarified with a short article. However, this does not exonerate the IPA. It published a paper that was utterly devoid of any economic reasoning. There were no references to exchange rates, monetary policy4, the structure of prices or capital theory. The possibility that monetary policy may have gravely undermined Australia’s manufacturing base is an important issue that needs to be thoroughly investigated. We cannot decide one way or the other merely by examining the ratio of manufacturing to GDP.

Like it or not Kim Carr’s concerns are not only very real and serious they are also shared by ordinary members of the public. It is a sad reflection on the IPA that they thought these concerns could be condescendingly dismissed.

On a personal note: Davidson and Berg finished with what can only be described as a plea for a carbon tax. It’s time someone told this pair that Co2 is not a harmful emission: it is a nutrient. Moreover, it is a myth that the science is a settled question. A more sincere approach would call for a No Regrets policy. Industry policy needs to be condemned  but not because it involves “making things” that will require more electricity and hence more Co2 but because it endangers living standards. Now that the CIS and the *IPA seem to have joined forces in a push for a carbon tax, I think it’s about time that those donors who are engaged in “making things” should seriously reconsider their support for these ‘think tanks’.

*A correction for the preceding statement: I was under the impression that the Institute for Public Affairs supported a carbon tax. Yesterday Jenny Marohasy, an employee of the IPA, went on ABC National and attacked the idea of anthropogenic global warming. I therefore apologise to the IPA for giving our readers a false impression of where the institute stands on this contentious issue.

Gerard Jackson is Brookesnews’ economics editor


The views represented in articles republished on the this site reflect the views of the original author and do not necessarily reflect the views of the Australian Protectionist Party


  1. A great article Gerard, one that I not only found self explanatory but also educational, as it has allowed me to join that extra dot that the murky world of economics so often befuddles those of us with who have limited mental capacity on this very important subject!

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