Thank you for explaining some tricky foreign exchange issues.  My
questions and comments are below.
~ Vincent

> > 
> > David Hillary wrote:

> gold for money fixes the nominal exchange rate with other economies to
> the price of gold, in terms of their currencies. If inflation fears are
> ignighted in a large open economy, the price of gold will rise, as will
> the nominal exchange rate of the SOE. This exchange rate movement has
> almost nothing to do with the factors that equilibriate international
> trade and finance for the SOE. Thus the appreciation of the nominal
> exchange rate leads to downward pressure on domestic prices (deflation).
> Thus the real effective exchange rate is arbitrarily jacked up,
> exporters and import competitors go broke, deflation drives the real
> interest rate in the SOE sharply upward, asset prices crash and a
> recession is likely to occur.  

But if inflation is occuring in the other countries, wouldn't it be likely
that the other countries' inflation for prices of products the SOE exports
might match their inflation for the price of gold, thus causing the SOE
exporters to receive the same amount of gold in exchange for their exports
as before?  I can see your point if the price of gold rises speculatively
out of proportion to other products, but speculative rises in gold's price
don't seem to last all that long.

> Yes, deflation and inflation, when the nominal interest rate is fixed at
> the world interest rate or a large economy currency interest rate, has
> very large effects on asset prices. If the demand for fixed assets is
> expected to grow in nominal terms by 5% p.a. along with inflation and
> replacement costs, and the nominal interest rate is 5%, the that is the
> same as a zero discount rate with price stability. An asset expected to
> last 20 years will be worth 20 times the current annual hire. If the
> interest rate stays at 5% but price stability is expected, the asset
> falls to 13.09 years hire. If the price level is expected to fall 5%
> p.a., the asset falls to 9.08 years hire. I guarantee that the property
> market will crash in Ireland when the inflation ends and the deflation
> starts and the nominal interest rate is about the same. Inflation and
> deflation have consequences.

What do you mean by "annual hire"?  How do you arrive at these figures of
20, 13.09, and 9.08 years hire?

> > 
> > The
> > > inflation and deflation in a SOE that used gold would be significant and
> > > arbitrary, and cause asset prices in the SOE to be highly volitile.
> > 
> > No.
> If the price of gold in terms of other currencies rises and falls
> substantially, as it does now, a gold economy will suffer appreciations
> and depreciations of its exchange rate which will force price level
> adjustments to occur. Price level adjustments will inflate or deflate
> asset prices.

The asset prices themselves might be volatile, but at any given point in
time, wouldn't the amount of goods that the asset can be traded for still
be the same, because the prices of the goods also rises and falls along
with the asset prices?

> > 
> > The
> > > situation would be similar to SOE such as Hong Kong, where the currency
> > > is fixed to the USD.
> > 
> > No.
> Hong Kong's nominal interest rate and nominal exchange rate are imported
> from the USA. Thus if Hong Kong's Trading partners currencies depreciate
> against the USD, the HK dollar appreciates against its trading partners
> and its real effective exchange rate rises. If this appreciation was not
> warranted from HK fundamentals, HK price level must fall. This is what
> happened in 1998-2001, and HK has suffered deflation of 3-5% p.a. during
> this time, ending inflation of 4-6% p.a. (and crashing the property
> market and causing a deep recession in the process).
> > 
> > Property prices fell by around 40% in 1998 in Hong
> > > Kong as inflation turned to deflation. Unemployment rose from about 2%
> > > to over 6%, real GDP fell by over 5%. By contrast Taiwan and Australia,
> > > both highly exposed to the Asian Crisis, continued to register
> > > significant growth and asset prices did not crash and unemployment did
> > > not rise. This is largely because their nominal exchange rates fell,
> > > reducing the need for adjustment and the extent to which sticky prices
> > > cost output.

I am not too familiar with this situation, but from your description it
would seem Hong Kong had no good option available.  The U.S. is also a
major trading partner.  If its currency stayed on par with its other
trading partners and devalued with respect to the U.S. dollar, then
wouldn't it have been just as bad or worse for them?

Also, isn't a lot of the volatility in real estate asset prices
attributable to the high degree of leverage that banks allow with real
estate?  If the real estate market has become a speculative credit bubble,
then it deserves to pop anyway.  Credit of the type that causes
speculative bubbles would be a lot harder to obtain in a gold economy. 
Thus, I'd think the asset prices would fluctuate as you say, but not as
drastically as in the popping of a credit bubble.

> The real effective exchange rate (REER) is a combination of the nominal
> exchange rate and the differential inflation. Where the nominal rate of
> a SOE is fixed, wheather to another currency or to a commodity,
> adjustment cannot occur in the REER except by differential inflation. So
> kiss goodbye to price stability if your SOE fixes its exchange rate
> either to another currency or to a commodity. And BTW, hold your wealth
> in financial assets diversified accross economies if you live in Ireland
> or HK or such a SOE, because the house you live in (don't own it) and
> the shares in your local service companies will be anything but safe
> investments when inflation turns to deflation!

I'm open to a better alternative than gold if you have one, but what would
you suggest?

~ Vincent

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