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November 2, 1999

The Fall 1999 issue of the Austrian Economics Newsletter features an extended interview with Frank Shostak, now available on line.

Dr. Shostak is chief economist of Frank Shostak is chief economist at Ord Minnett Jardine Fleming, Sydney, Australia, one of the largest brokerage houses in that country, and serves on the editorial board of The Quarterly Journal of Austrian Economics.

He received his bachelor's degree from Hebrew University, master's degree from Witwatersrand University and PhD from Rands Afrikaanse University, and has taught at the University of Pretoria and the Graduate Business School at Witwatersrand University. He is a frequent contributor to the Asian Wall Street Journal, among many other popular and scholarly venues.

Here is his client letter, distributed in late October 1999:

The fall in the value of the US dollar in relation to the Yen came as a complete surprise to most economists. However, Ord Minnett Jardine Flemming has been predicting the dollar’s fall since November of last year.

So what caused this sudden fall in the US$? The key factor behind the rise was the strong increase in the US monetary momentum since 1993. Year-on-year the rate of growth of money M3 increased from a –0.7% in March 1993 to 11% in December 1998. This rise in the monetary momentum was instrumental in the fall of the US dollar to 104 yen, after climbing as high as 145 Yen in August 1998.

The conventional view holds that the earlier strength of the US dollar could be attributed to the fact that the US economy was much healthier than the Japanese economy. The sudden weakening of the dollar, then, is seen as a response to the perception that the Japanese economy has begun to recover.

This view, however, addresses only one half of the equation: the demand for currency. In order to fully understand the dollar’s weakening, and to assess future movements, the other half of the equation needs to be addressed as well. Namely, the supply of the currencies in question.

Looking at changes in the supply of a currency can do much to explain movements in its exchange rate. A comparison over time, for example, of the rate of growth of the money supply versus the rate of growth of a country’s economic activity, gives the "excess money supply rate of growth." This rate of growth in excess supply is an important clue in forecasting the likely direction of the currency’s rate of exchange on the market.

In order to establish this, one needs only to compare the excess money supply rate of growth of one country to that of the other country. The currency of a country whose excess money supply is growing faster will weaken over time. Conversely, the currency of a country whose excess money supply is growing at a slower rate will appreciate in relation to the first country. This is precisely what has happened between the US dollar and the Japanese Yen.

This way of thinking runs contrary to the popular view that exchange rates are determined by the state of the balance of payments. According to this view, a widening in the balance of payments deficit raises the demand for and lowers the supply of foreign currency and this leads to the depreciation of the domestic currency. This theory suggest that if local prices are going up for whatever reasons this gives rise to more imports and less exports, i.e. widening of the balance of payments deficit. In other words if domestic price increases exceed price increases abroad, other things being equal this will cause a balance of payments deficit and domestic currency depreciation.

The Austrian school, led by the late economist Ludwig von Mises, however, holds that this cannot be so. As long as the money supply is not expanding peoples nominal income will not increase. Consequently no deterioration of the balance payments will take place. According to the Austrian school the exchange rate of a currency like the price of any other good is determined by its relative scarcity in relation to the demand to hold currency.

Just like any other good, both supply and demand determine the price, or the exchange rate, of a currency. The exchange rate between two currencies will tend to equal the ratio of their purchasing power. In other words it is the relative purchasing power that determines the currencies rate of exchange.

Furthermore, as long as the exchange relations exist between two different currency areas, economically the money of one area necessarily functions as the money of the other area, since both moneys must be utilised in effecting an exchange between the two areas. Consequently the purchasing power of currencies is established with regard to a good in the same location.

According to the Austrian framework changes in the exchange rates should closely mirror changes in the purchasing power of respective currencies. Changes in the purchasing power in turn are determined by the relative scarcity of currencies in relation to their demand-that is, by the excess money growth.

Using the Austrian framework, Ord Minnett Jardine Flemming’s ‘Daily Market Focus’ report from the 12th of November 1998 has been predicting that the dollar would weaken against the Yen. This prediction was based on the excess money M3 growth differential between Japan and the US, lagged by 34 months. The excess money growth differential between Japan and the US fell from 4.9% in August 1996 to –7.2% in June 1997--meaning that the excess money supply grew faster in the US. The use of a lagged differential is in accordance with the Austrian view that when money is injected into the economy it always starts at a particular point-specific individuals and companies, in a specific part of the production process-and that it takes time for it to spread from this point of entry to the economy as a whole.

In the November 12th report, our analysis had confirmed that the US dollar peaked at 145 yen. We maintained this stance in the subsequent reports, suggesting that the dollar is likely to fall sharply within a time span of 6 months. Our latest analysis suggests that the dollar could continue to weaken until at least August of 2000.

Note: The views expressed on Mises.org are not necessarily those of the Mises Institute.

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