How much damage will the US dollar do?

There is growing alarm, especially in the developing world, over what impact a surging US dollar may have. Many economists and analysts note there is a strong chance of destabilising capital flows and extreme financial market volatility.  I would agree and in the Australian context we too are only just seeing this play out. Although as I noted yesterday, it’s likely that investors also harbour grave concerns over policy mismanagement as well.   

But the cost to Australia isn’t just limited to financial market volatility. Indeed the spillovers are potentially quite serious in the short-to-medium term, especially in regards to national income, which has already been dealt a solid blow following the decline of the Australian dollar.

Since July, the currency has lost about 8 cents against the US dollar, or just over 8 per cent, to be at its lowest level since February. Now, this is a sizeable problem because according to the Australian Bureau of Statistics, prices for a large proportion of household purchases (roughly 40 per cent) are subject to currency effects.

That’s not to say that we import 40 per cent of everything that we buy. It’s just that 40 per cent of the stuff we buy is at the world price -- or often above (think Apple i-stuff, or electronics more generally, jeans, sneakers, books, and all manner of consumer items).  

An 8 per cent decline on the Australian dollar in turn makes 40 per cent of our purchases more expensive. If we get another 8 per cent reduction in the currency that many are calling for, then consumer incomes will be 6 per cent lower than they otherwise would have been. Naturally one of the most visible effects of the weaker currency will be on petrol prices. Consumers should be prepared to pay a lot more at the bowser.

More generally, the broader health of the economy could take a sizeable turn for the worse -- in particular on the external accounts.

Firstly, it is likely that the trade deficit will expand dramatically. A surplus is rare at the best of times, and indeed we have only really sustained a trade surplus on four occasions over the last couple of decades. Three of those were associated with a downturn.  On the one occasion when it wasn’t, the currency was in fact well over parity and pushing its highest level in several decades ($1.10).

In a similar vein, the current account deficit will widen substantially. Currently at around 3 per cent of GDP, the deterioration in the trade deficit brought on by a weaker currency alone could easily lift the deficit to 4 or 5 per cent of GDP.

Now recall that the current account deficit must be funded. It represents outflows against which Australia must borrow. At the moment we’re borrowing about 3 per cent of GDP or so from foreigners to fund imports, borrowing and interest on borrowings.  The weaker exchange rate could see that rise to 6 per cent of GDP or more -- every year. That’s money we are borrowing from foreigners and it gets added on to our foreign debt. Very basically it means our foreign debt will be rising by 6 per cent every year.

In that regard a weaker currency represents a loss of income, not only to our current generation, but future ones as well. We’re poorer and our children are too. That it is currently a policy goal goes to show just how ridiculous economic policy making has become in this country.

A lot of Australian economists and policy wonks have spent a great deal of time complaining about the drop in national income that supposedly follows from a fall in the terms of trade. I outlined why this was a false concern here. The great deceit is that a fall in the exchange rate actually does more to cut purchasing power and national income -- does more damage -- than any fall in the terms of trade ever could.

Of course, the extent of the damage or disruption will depend greatly on the speed of adjustment, and a number of other factors. Yet the scope for harm is considerable. Unfortunately, our policymakers and politicians are oblivious.