How do exchange rates, oil prices and fiscal deficits affect our lives within the economy?

Sep 30, 2020

Welcome to Finance and Fury, the Say What Wednesday edition.

This week’s question continuing on the from Raj in last two weeks episodes – interesting topic on how factors affect the real economy – which is us –

1. so this episode will to continue on a similar line –will focus on the remaining factors that can affect the real economy - fiscal deficits more and then the real inputs to the economy, like forex, oil prices and trade imbalances
2. All previous factors – like interest rates can affect our lives and hence affects the real economy – influencing the decisions we make – similar – the yield curve – whilst not directly affecting our lives - can indirectly affect it by decisions that banks make – such as what interest rates to charge or pay on fixed rate loans or term deposits respectively

 

Before we go on – important to remember that the real economy is the combination of our economic interactions – so it is almost impossible to forecast the degree to which one factor is affected by the other – but you can get an idea about in what direction they are affected -

 

Fiscal deficit – what does it mean – The government is spending more than it earns and gets into debt –

1. The actual effect on our lives - All depends where the money is spent –
   1. For the individual – public debt in the fiat economy is progressively becoming less relevant to our day to day lives –
      1. Back before fiat currencies – a public (Government) debt may have been a concern – as taxing the population was one of the only recourses to dig themselves out of that hole
      2. Today – every country is in debt – and they can just keep issuing more debt as all money is debt – so just have a CB create more money and use it to buy the debt of a government – hence lending them the money

• When the money comes due – then simply issue more debt to repay the principal – almost like a balance transfer for the individual on credit cards – but on a much larger scale and can be done essentially indefinitely – until confidence and CBs ability to print money ceases

2. So the major determinate on how deficits can affect the individuals in the economy and hence the real economy depends on where the money is spent – major spending areas:
   1. Infrastructure – can improve our lives and daily functions – helps to improve the economic function as well
      1. But the degree to which this has an affect is hard to measure – covered episodes on infrastructure – called “Can public infrastructure spending help to boost a depressed economy?” – mixed bag – and comes back to the same question on how well the funds are spent – white elephant projects – or dig a whole to fill a hole –
      2. Even at the moment – lots of talk that shovel ready projects need to be implemented to help the economy through additional employment – but how? Those out of work are predominately in the hospitality and service industry – everyone I talk to in engineering an infrastructure are already busy – so are people who work in hospo going to go out and all of a sudden go and start working on fixing roads?

• In theory it might sound good – but in reality, the transaction of the economy doesn’t function this way

1. Fiscal stimulus – additional welfare/social security payments -
   1. This comes back to demand side economics – the individual has additional money to spend in the economy – so growth is meant to materialise
   2. Also falls into MMT – that government should monopolise currency and control the flow of a lot of the capital to maximise economic conditions – but this is theoretical -

 

Other economic factors - some specific ones mentioned in Raj’s question - forex rates, oil prices and trade imbalances – which either directly or indirectly are determinates of the real economy -

1. Oil prices – this is an interesting one – for the individual it might not seem like there is much impact beyond what it costs to fill up the car each week – so look at this first
   1. Petrol bills are a component of a weekly spend for most households – but how much depends on how far you drive – but also the cost of the petrol
   2. The Australian Automobile Association's (AAA) March 2019 Transport Affordability Index reported the average two-car Australian household (two adults, two children) pays $68.99 for fuel every week – this is equal to about $3,500 per year for a family in fuel costs
      1. This is back when fuel was averaging between $1.3 to $1.4 per litre – equal to about 51 litres each week for the family
      2. so if petrol prices goes down to $1 – then at the same usage of 51 litres – this means the family is spending $51 on fuel for the week – or about an $18 savings per week (26% reduction) – or a savings of $935 p.a.

• So this in theory can go towards other spending within the economy – however – it could also go towards debt repayment

1. Especially when debt levels are very high – so people may consider that additional savings should go into debt repayment – which doesn’t boost the economic output –
2. Also – in the measurement of inflation – this lowering of price is deflationary – if it is persistent – and doesn’t increase – as well as individuals not spending the saved funds on other areas of products or services – then CBs may lower rates out of this – but it is unlikely – as fuel is a smaller part of the CPI basket

1. Beyond fuel for the individual – the costs of lowering fuel prices are passed on in the form of lowering costs of supply –
   1. This is part of economic theory – when think about how goods are transported – does make up a minor cost overall – so isn’t that impactful at the single good level – but as an aggregate it could help – in theory – how the theory goes:
   2. If your country is a major importer - the shipping costs for lots of goods are cheaper when fuel and hence transportation costs are lower – so the goods that you buy are now cheaper – which is good for the individual – is also deflationary
2. At the top level – oil companies and fuel producers are affected based around prices that they can charge for fuel versus their costs
   1. Incentives and profits – the costs for most producers are stagnant when compared to the volatility of prices
   2. The Middle East and North Africa are very low-cost producers – at around $20 per barrel down. Worldwide, conventional oil production typically costs between $30 to $40 a barrel

• So if the price of oil is $100 – there are large profits to be made – hence these companies can expand their search for oil and upgrade existing infrastructure – however – if oil prices are $10 – producers lose money – so they have to shut down supply – but this then raises supply – and the lower cost producers survive –

1. Where this impacts the individual in the economy is employment – when prices were high the oil industry worldwide was booming – good salaries and lots of employment opportunities

2. Next comes the currency exchange - Forex – which is a dichotomy between the individual and companies within a country – that is because what is good for one might not be good for the other
   1. For the individual - The costs of buying products from overseas may be better or worse – depending on where the exchange rate lies –
      1. for countries that are heavy importers
      2. For countries that are exporters –

• But the goods that are imported/consumed is really what matters for the individual – example with Australia –
  1. We do have a big export market – resources, tourism and education - a lot of what we purchase from a day to day was likely produced overseas – things like clothing –
  2. Say we are buying goods from China – and the Chinese Yuan (renminbi) goes from 7 to 5 to one AUD – assuming the cost of production don’t change in China (big assumption) – almost a 30% drop in purchasing power for Australia – so like for like – now goods would be 30% more expensive for us to purchase

1. In a similar way – travel costs change – Australians are big travellers – so when our currency is high compared to others – cheaper to travel – I remember going to America in 2011 – was great – things were dollar for dollar – going over to the states at the start of this year – was technically more expensive – whilst the costs of goods in USD hadn’t changed by as much – 30% more expensive –
   1. But if travel is incentivised outside of your country – technically less spent domestically – so there is a feedback loop here – where if it is too expensive to travel for currency reasons – then people may go on holidays domestically which boosts the economy
2. When your currency is high when compared to others – is good for the individual but not for companies if you are exporters – as the reverse is true where the goods are now more expensive

1. For a company – selling a good at $1 AUD is the same regardless of if you do it domestically – or that is your prices to sell to overseas purchases – that price is generally based around the domestic cost to produce – if you sell 1,000 widgets, you have made $1,000 in revenue
   1. But if overseas buyers can now buy two of your goods versus one – well your demand will increase – and with it your total revenue – take the reverse example of the previously mentioned individual scenarios –
   2. Say an Australian company is selling widgets to consumers in the US – or even US companies – and our exchange goes from $1 USD to $1 AUD to $1 USD to $1.43 AUD – or $1 AUD to $0.7 USD – then that is an increase of 30% in what can be purchased by an overseas buyer in the US –
      1. All else being equal – they can now buy 30% more and hence – the Australian company’s revenues will increase by 30% at the same time – this is a simple example – but illustrated that the demand for goods with a global economy changes with exchange rates – this is good for export nations – but the reverse is true for import nations – now it is more expensive for the nation as a whole – and those companies that make up the nation may have less impact on the overall economy

• so unlike the individual – for a company (and technically individuals through those who own the business or are employed by it) – the lower your currency relative to the countries buying your goods and services – the better

1. This is where there is pressure on major exporter nations to keep their currencies low – whether it be artificially like china through a peg – or through monetary policy or other economic factors – the lower the relative currency the better for companies

1. Coming back to the individual in the form of investors – the unhedged position of investments can help or hurt
   1. Smaller follow on point – but if you own apple or amazon shares – they have to be in USD – so if the AUD depreciates then your investment values actually increase – but the reverse is also true – whilst is doesn’t have a massive impact on the economy – does affect the individuals investment values and returns
2. Finally - Trade imbalances – more or less a summary of the previous activity – how much the country is importing versus exporting
   1. It can signify certain realities though – such as what country is an importer or exporter – as well as the direction of currency (forex markets) are likely to move
   2. If you are a major exporter country – you might be considered productive – lots of goods or services provided by your country – hence you have low levels of unemployment – but also potentially cheap labour such as countries like China – hence why you have low unemployment and are a major exporter – but it depends on what you export
      1. Whether it be a service or capital-intensive industry – versus a labour intensive one
      2. Not a consumption nation – unless the production levels can keep up with consumption levels and more
   3. Major importer – you might be less focused on the production of goods – but may be more focused more on domestic services –
      1. Countries like the US have a huge negative balance of trade – but they are still doing pretty well as an economy
   4. When it comes to trades imbalances – don’t have much of an effect on the economy – they are a representation on what type of economy a nation has – and how well the country performs economically comes back to how productive a country is more so than the imbalance in trade

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