There seems to be two schools of thought about the current direction of the Australian economy. On the one hand we have Terry McCrann of the Herald Sun whose approach could be summed up as Happy Days are Here Again. Then there is the gloomy Tim Colebatch of The Age whose mournful economic predictions are reminiscent of Cassandra's unheeded warnings. While McCrann tells us that so long as consumers keep on spending the economy will continue to zip along, poor old Tim is stuck on Australia's trade deficit. The real problem here is that both of them are wrong. Unfortunately their erroneous line of thinking tends to dominate economic debate -- not that there is much of a debate in Australia -- in the developed world, particularly America.

Colebatch points out that since 19801 Australia has "run trade deficits in 22 of the past 26 years, and in the past four years" and that our exports of goods as a proportion of the global export of goods has fallen from "1.12 per cent in 1996 to 0.94 per cent in 2004" (The Age, Gambling with our trade, 26 September 2006). His response to this situation is to argue that free trade deals with much bigger economies like the US and China are bad for us because it would worsen our trade deficit. What we really need, therefore, is an industry policy. To support this view he drew he drew attention to the statistics that apart from housing the country's output of goods dropped by nearly 4 per cent in the period June 2005 to June 2006 and that last year our trade deficit in manufactures was $92 billion.

These days one cannot talk about trade deficits without bringing in the foreign debt. And so it is with Colebatch. He tells us that our "net debt to the world jumped by $62 billion, easily a record, as the banks borrowed heavily overseas" and that ready access to foreign money has encouraged the banking system to fund ever-higher house prices. These figures allow him to reject the views of Treasury officials Jason Harris and John Hawkins who told the House of Representatives that there was nothing to worry about with respect to our foreign debt because markets always allocate resources to their most valued uses (The Age, Foreign debt interest hits record high, 4 September 2006).

I've quoted Colebatch at some length because this is an important issue and its one that is gaining prominence. What is missing from Colebatch's articles is any reference to prices. (The same goes for other commentators). He seems to have forgotten that trade between countries only takes place because there is a difference in international prices. This simple fact appears to have been overlooked by every member of our economic commentariat.

Let us go to 1752, the year in which David Hume published his Political Discourses. In this work he refuted mercantilist fears that a country could be drained of all its precious metals if the authorities did nothing to reverse its deficit on its balance of trade. He used the specie-flow mechanism to explain that an outflow of gold would be deflationary while an inflow would be inflationary. Hence the movement in relative prices levels would reverse the flow and restore equilibrium. In the 1920s some economists led by Professor Frank W. Taussig of Harvard discovered that the specie-mechanism moved much faster and far more smoothly than economists had thought. In fact, the movement took place without any change in price levels. This had to mean that an increase in exports would be countered by an increase in imports before a change in relative prices occurred. As Professor Lloyd A. Metzler observed:

Even before the [Keynesian] theory of employment was developed, historical studies thus indicated that the balancing of international payments and receipts might be attributable to economic forces not considered in the classical theory...the missing link in the classical theory became almost self-evident: ...[it] was found to be largely the result of induced movements of income and employment. (Theory of International Trade, in Howard S. Ellis [ed.) A Survey of Contemporary Economics, 1948).

In 1957 J. J. Polak, a Keynesian-trained economist with the IMF, set out to integrate monetary and credit factors into the established Keynesian income-expenditure framework. He noted that when a country implemented a policy of credit expansion it raised nominal incomes. This increased the demand for imports which in turned generated a current account deficit. He concluded that increasing the money supply changed the demand for domestic and foreign goods, services and securities before any significant change in general prices occurred. (The reader should note that Polak's findings confirmed the very important insight of the Austrian school of economics that money is not neutral).

In plain English, Polak discovered that when the supply of money exceeded the demand to hold money the flow of imports would increase. There was absolutely nothing knew in Polak's findings. If these economists had paid greater attention to the history of economic thought they would have learnt that some members of the classical school had got there before them. David Ricardo argued that with respect to international trade a shift in purchasing power was sufficient to restore equilibrium without any movement in relative prices. In his response to Henry Thornton Ricardo pointed out that

If ... we agreed to pay a subsidy to a foreign power, money would not be exported while there were any goods which could more cheaply discharge the payment. The interest of the individuals would render the export of money unnecessary [italics added]. (The High Price of Bullion, 1810).

This is a basic supply-and-demand approach to international prices. (Nevertheless, I find his analysis curious given his rigid adherence to the quantity theory). Ricardo was influenced by Peter Lord King who stressed that the demand for money was always uncertain and variable. King, unlike Ricardo, correctly argued that money was not neutral and, following in Cantillon's footsteps, that increases in its supply result in an arbitrary redistribution of income and wealth. (We call this the Cantillon effect, An Essay on the Nature of Commerce in General, written in 1725 but first published in 1755)2. King observed, that

sometime must elapse before the new currency can circulate through the community and effect the prices of all commodities.

So even before an increase in the money supply makes its presence felt in the form of rising prices an increase in nominal incomes has already created an unfavourable balance of trade. We cannot finish without taking note of the monetary observations of the brilliant Charles James Fox who preceded Peter Lord King. Fox vigorously attacked the opinion that Britain's unfavourable trade balance had nothing to do with the 1797 suspension of gold payments. He fully understood that the gold drain was Gresham's law in action.

This brief but necessary foray into monetary history reveals just how intellectually barren the current debate on the balance of trade is -- and that includes the Treasury. Using the insights of these nineteenth century pioneers we can see how increases in relative money stocks can distort the international structure of relative prices, even to the extent of shifting manufacturing enterprises offshore. Moreover, we can also see that those economic commentators who cavalierly dismiss concerns about the state of manufacturing on the grounds that the "traditional explanation" holds do not know what they are talking about.

The lesson is that a basic understanding of the gold standard is extremely helpful in gaining an understanding of what really lies at the root of our trade deficit.

1. Colebatch should have looked at monetary figures for that period. From December 1980 to June 2006 currency increased by 728 per cent, bank deposits by 1,278 per cent and M1 by 656 per cent. These figures show that the greatest expansion was in bank credit.

2. It's not unusual, I regret to say, for an economist to approvingly refer to the Cantillon effect and then start talking treating money as neutral.

Note: rather than endure the tedious process of once again refuting McCrann's dearly held belief that consumer spending drives an economy and that about 70 per cent of spending is consumption, I refer the reader to the following links.

Australian economy: why the jobs figures are dangerously misleading
Getting the Australian economy wrong -- the consumer spending fallacy
Australian economy: budget surplus myths meet the "China Syndrome"
Australian economy: how the money supply is affecting the trade deficit and output