Vincent Youngs wrote:
> David,
> Thank you for explaining some tricky foreign exchange issues.  My
> questions and comments are below.
> ~ Vincent
as are my replies
> > >
> > > 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.

If (USD) inflation fears and inflation are ignighted, say between March
and May 2001, the price level in the USA might rise say 4%. But if this
inflation is expected to persist, the price of gold will rise a hell of
a lot more than 4%! Perhaps 30%. Thus the real price of gold in terms of
US perchasing power has increased by more than one quarter, as has the
real effective exchange rate of the gold for money SOE. Like the stock
market, the price of gold is determined by *expected* events, the
outlook for the future, which can change drastically in a matter of
months given a few political events, a few statistics, a few
bankruptcies and a speech by the Fed chairman. The price level, however
takes a few years (at least) to adjust to an economic shock when the
nominal exchange rate is fixed, requiring a price level adjustment. The
cause of this difference is price rigidities particularly in the labour
market, property rental market and supply contracts. (By contrast stock
and commodity prices are perfectly flexible.) 

> > 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?

annual hire is just the 'rental' value of the building, which is the
'rent' of the property less the ground rent of the land. 

The figures are calculates as follows:
P=sum{n=1 to 20):(((H1*(1+g)^(n-1))/((1+d)^(n-1)))
where P is the market price of the asset, n is the year, H1 is the Hire
vaue in year 1, g is the Hire growth rate, and d is the discound rate.

This simplifies to 
P=sum{n=1 to 20):(H1*((1+g)/(1+d))^(n-1))

where d=g=0.05 the answer is simply: 
P=sum{n=1 to 20):(H1)

Where d=0.05 and g=0 the answer is:
P=sum{n=1 to 20):(H1*(1/1.05)^(n-1))

where d=0.05 and g=-0.05 the answer is
P=sum{n=1 to 20):(H1*(0.95/1.05)^(n-1))

The easiest way to calculate these values is to use a spreadsheet.

> >
> > >
> > > 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 asset prices, in terms of gold will be volitile. The price of gold,
in terms of foreign goods will be volitile. If the economies (to
simplify model as a US economy using USD and a SOE using gold for money)
are in equilibrium then political/monetary events cause inflationary
fears to ignite, then the price of gold (exchange rate of SOE) will
rise, and deflation will commence in the SOE. Asset prices in the SOE,
in terms of gold, will plunge, but in terms of USD may stay the same,
increase or decrease. A more realistic model would seem to predict that
the fall in SOE asset prices would occur with a lag after the exchange
rate appreciation (e.g. if expectations are adaptive or take time to be
formed after the information becomes available). Compared to replacement
costs, however, asset prices *will* be volitile, because replacement
costs are fixed to gold money, and adjust over time via
inflation/deflation. The difference between the depreciated replacement
cost of capital assets and their market value determines the extent of
construction/supply (i.e. if the market prices exceeds the depreciated
replacement cost then there is a profit in supplying capital assets).
Thus foreign monetary events can cause malinvestment by influencing the
exchange rate, the rate of change of the domestic price level (inflation
rate), the price of capital assets and thereby the capital investment
quantity. Even if the quantity of imports a capital asset can buy is
unchanged, the profitability of construction can change.

> >
> >
> > >
> > > 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?

Well over 2-3 years and a HK-US inflation differential of about 7% p.a.
has produced a approx 18% devaluation of the HK-US real exchange rate.
This 18% devaluation cost the HK economy lost output as the labour
market and property market went into dis-equilibrium and a deep
recession (peak to trough about 7% fall in real output over a few
quarters) resulted. The HK economy normally grows at around 5% p.a., so
for real GDP to fall 5% over a year is a loss of output of around 10%
from the trend. The rebound saw real GDP increase 14.3% over 12 months,
but this is still less than making up for lost output. Thus the
macro-economic adjustment of the price level cost output and jobs and
wealth. The property market fell by around 40%, the unemployment more
than doubled from around 2-3% to 6.3%, the sharemarket fell by around
50%, real GDP plunged. That makes New Zealand's 1998 recession
(unemployment up from around 6% to 7.5%, real GDP fell 0.3%, property
and shares flat or down 10-20%) seem very mild -- the nominal exchange
rate fell substantially instead.    

Its less costly to change the clocks and time one hour than it is to
reschedule every activity by an hour. The nominal exchange rate is the
clock, the activities scheduled are the prices in the domestic economy.
Changing one commodity price is much less than changing the price of
every good, service, wage and property rental. However, nominal exchange
rate volitility has its own cost. 

> 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.

Real estate bubbles are partly caused by bouts of inflation, as may be
occassioned when macro-economic shocks require an adjustment increasing
the price level and the real exchange rate, and partly cause by land
allocation institutions. A shock implying future inflation as an
adjustment *will* cause a real estate boom because it increases the
expected nominal rent/hire of real estate. Conversely an opposite shock
will cause a real estate market crash. Land allocation institutions
determine land values. Freehold title to land without regular and heavy
land value taxation generates high and volitile price rent ratio land
titles, which will respond strongly to changes in expected rent growth
rate and or discount rate. This is a terribly inefficient way of
allocating land and harmful to macro-economic stability. Imposing a high
rate of land value taxation deflates land values and desensitises land
value from macro-economic shocks. Proper land value taxation (I
recommend 20% p.a.) will reduce the absolute wealth effects of
macroeconomic shocks affecting the expected rent growth rate or the
expected discount rate by over 95%. Land in Australia is worth about 1.5
years of Australian GDP, which is obviously a huge value, and
eliminating this as a source of wealth effects would do much to enhance
macro-economic stability. 

Taxation of nominal interest income and non-taxation of imputed property
rentals and capital gains increases the extent to which
inflation/deflation changes the returns on the different asset classes.
This taxation distortion could be eliminated by taxing real rather than
nominal interest (or eliminating taxation of interest) and by taxing
capital gains.

I believe that domestic inflation and deflation, occassioned by the need
for macro-economic adjustment within common currency areas, can cause
mal-investment in capital and reduce economic efficiency. Investments
that would not otherwise be viable, become viable if inflation is
expected, and investments that would otherwise be viable become unviable
if deflation is expected. The extent of the windfall or loss occasioned
by inflation/deflation is equal to the market price of the asset times
the inflation differential. A more direct taxation based method of
stabilsing asset prices, and eliminating mal-investment is to tax the
market price of assets multiplied by the inflation differential. This
will eliminate the incentive for mal-investment and will stablise real
and nominal asset prices when expectations change. Based on purchasing
power parity theory, real exchange rates should be stable in the long
term, and so negative taxes during deflation should be fundable from
accumulated revenues during inflation. Thus this tax could offer the
benefits of a common currency without the costs of asset price
volitility and mal-investment. However I am reluctant to commit to this
idea because I know that real exchange rates can appreciate or
depreciate over the longer term, because non-tradables can change in
reletive price.

I have been thinking about currency and the banking system a lot in the
last four months and I now understand it, something I could not honestly
say a year ago. The banking system and the currency and lending and the
capital account have been subject to so much intervention in times past
in various places (and presently in mny too) that it is hard to believe.
First they got involved with minting coins. Then they got involved with
minting notes. Then they got involves with checking accounts and bank
account balances and the liquidity of the financial system. Because they
wanted to avoid bank failures and lost deposits, they insured bank
deposits and then to reduce their exposure they introduced prudential
regulation of banks. Then they couldn't control inflation and started
regulating imports and the capital account and imposing price controls.
I get the impression the free market monetary institutions are important
for preserving free market institutions elsewhere in the economy. This
insight into just haw rediculous banking and monetary regulation has
been in various times and places (in supposedly democratic capitalist
countries), gives the answer to your comments about credit causing real
estate booms. If the central bank had a loose monetary policy and the
government insures deposits and banks lose incentive to be prudent, then
clearly irresponsible lending will occur and a bubble will form and
burst. A deregulated banking sector free from deposit insurance and
prudential controls will enable market standards of prudence and
reputation to ensure an efficient lending and deposit taking practices.
I have lived most of my life under such institutions and can sometimes
forget what happened when i was very young and what happens in other

> > 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

I suggest that you adopt an investment strategy appropriate for your
needs and psychology. If you like to invest in real estate fine, just
make sure you don't invest it all in HK or Ireland before the market
crashes. If you like to invest in blue chip shares the same applies,
don't put em all in Ireland or HK or similar places. If you live in nz
or oz don't invest in the USA because when the nz and aussie dollars
recover you will lose a third of your capital. If you live in Japan or
Singapore or somethere else where capital is not productive and interest
rates are close to zero, invest in somewhere where you can get a premium
with minimal exchange rate risk. If you live in the USA invest in Europe
and wait for the USD to ease back and take advantage of the
opportunities in Europe. If you live in Europe invest in Europe, just
don't put it all in Ireland. If you think the exchange rate of your
country will fall, and don't think world equities are heading for a
crash buy a world index fund and sell when you think your currency has
bottomed out. If you think that global stagflation and depression are
around the corner, but gold, guns, canned food, a safe, and plenty of
battery and solar panels.

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