Kenneth Davidson has been one of the most consistent voices for sensible economic analysis in the Australian media for decades now (another I’d give a similar accolade to is Brian Toohey), and he’s written a brilliant piece in The Age and The Sydney Morning Herald on the specualtive bubble that is the Australian dollar.

Davidson lays out the causes and probable effects superbly in the length of a newspaper feature. The causes are that:

  • The bailout funds in the USA and UK in particular have cashed up financial institutions that don’t want to lend any more to mortgages (and have long ago forgotten how to lend to fund productive enterprises), so they’re looking for short term hot money gains;
  • The RBA’s flagging that it intends raising rates from 2-3% above rates in the USA and UK to possibly 4-5% above is a “sure thing” return on a currency that was already appreciating because of commodity sales to China;
  • This gives the hedge funds a sure fire double whammy gain:
    • borrow in the US or UK at 1% to buy $A and “invest” in floating rate bonds or shares (particularly in banks) and get a higher return (at least 2% better than the borrowing costs, and assured to rise); and
    • drive up the $A in the process, so that when you sell out, you get both a higher return and an appreciated currency in which it is denominated.

The most remarkable thing about this bubble is that the RBA’s “we’re raising rates now and we’re going to keep on doing it for a few months” messages are part of the cause, and yet they seem unaware of both the phenomenon and the dangers it poses. Davidson points out that Brazil, which is experiencing a similar commodity-driven currency appreciation bubble, is aware of the dangers and is doing something about it:

“The rising value of the Brazilian real and the Australian dollar against the US dollar has had a disastrous impact on both countries’ non-commodity export and import competing industries. Brazil’s popular and largely economically successful left-wing Government led by President Lula da Silva is meeting the problem head on. It has decided to impose a 2 per cent tax on all capital inflows to stop the real appreciating further.”

In the meantime, our RBA seems possibly even pleased that this short-term phenomenon is afflicting our manufacturing sector adversely.

Of course, like any speculative bubble, this has an end-game–and that’s when you think the rate rises have come to an end, sell out and watch the $A crash for those who are still holding it. Then the dollar (and Australian bank shares) will crash, and our economy will have acted as a dollar pump for the hedge funds.

Davidson also accurately notes that the RBA’s obsession with driving rates higher now is driven by the classic “fighting the last war” syndrome of believing that an outbreak of wage-driven commodity-price inflation is the main danger facing the Australian economy–just as it was in, oh, about 1973 (if you ignore private debt levels of course…).

He concludes that:

The world has moved on but the obsessive debate about wage inflation and union powers hasn’t. Since the beginning of the ’80s, the problem has been periodic bouts of asset price inflation. It is the biggest danger now.

Instead of controlling the unions, there should be control of financial institutions. The Australian dollar bubble and the incipient housing bubble should be micro-managed. Capital inflow could be dampened by a compulsory deposit of 1 to 2 per cent to be redeemed after a year to stop speculative inflow. Home ownership has become a tax shelter. The steam could be taken out of the rise in house prices if negative gearing was limited to new housing. This would obviate the need for higher interest rates that affect everyone.

It’s an excellent article–read it and pass it on. The more people who do read it, the higher it will rise in the newspapers’ online-indicators of reader interest, which will push it towards the top of the online page. And I’m heading out now to buy a paper copy of the SMH as well. Bravo, Kenneth Davidson.