There is no doubt that Milton Friedman is my favourite economist (sorry Scott, you are only number two on the list). In the coming days I will share my interpretation of Friedman’s view of exchange rate policy.
Friedman’s contributions to both economic theory and the public debate have had considerable influence on the organisation of the global financial system and the choice of currency regimes around the world. This can best be illustrated by looking at the history of global financial and currency developments.
Prior to the First World War the international currency system was based on the gold standard. Individual national currencies had a particular gold value and could therefore be exchanged at a specified and fixed exchange rate. Thus the gold standard was a fixed exchange rate system. The First World War, however, led to this system breaking down – mainly as a result of the warring nations cancelling the gold convertibility of their bank notes: They financed their military expenses by printing money. This subsequently created a level of inflation that was incompatible with the gold standard.
Attempts were made to reintroduce the gold standard after the First World War, but the Great Depression of the 1930s, among other things, made this difficult. Nevertheless, the idea of fixed exchange rates still enjoyed significant political support, and there was broad agreement among economists that some form or other of fixed exchange rate policy was desirable. Hence a further attempt was made after the Second World War, and in 1944 the so-called Bretton Woods system was established, named after the US town where the agreement was made to set up a fixed exchange rate system.
The Bretton Woods agreement meant that the US dollar was pegged at a fixed rate to the price of gold, while the other participating currencies (the majority of global currencies) could be traded at a fixed rate to the dollar, thus once again establishing a global fixed exchange rate system. The system, which finally broke down in 1971 when the USA decided to abandon the dollar’s fixed peg to gold, was in many ways the main reason for Friedman’s huge involvement in the currency issue – both from an economic theory and from a political perspective. Friedman was an outspoken critic of the Bretton Woods system right from its creation to its final demise in 1971, and he supplied much of the theoretical ammunition that President Nixon used to justify his decision to “close the gold window”.
Friedman made his first major mark on the international currency system in 1948, when on 18 April he took part in a radio debate with the deputy governor of the Canadian central bank, Donald Gordon, discussing among other things Canada’s fixed exchange rate policy.
In 1948 Canada was pursuing a fixed exchange rate policy within the framework of the Bretton Woods system. However, the policy had given rise to a number of problems – including increasing inflation – and the government and central bank were considering major intervention in the Canadian economy in an attempt to maintain the fixed exchange rate. Among the proposals was one to significantly curb imports to Canada. So it would seem that the desire to maintain a fixed exchange rate policy was leading directly to protectionism. Since the 1940s this political connection has formed one of Friedman’s key arguments against a fixed exchange rate policy.
While the Canadian government attempted to defend its fixed exchange rate policy with protectionism and wage and price controls, Friedman’s approach was completely different: abandon the fixed exchange rate policy and let the currency float freely. Gordon rejected Friedman’s prescription for Canada’s ills, but 18 months later, in September 1950, the country’s finance minister, Douglas Abbott, decided to take Friedman’s medicine, announcing:
“Today the Government … cancelled the official rates of exchange. . . . Instead, rates of exchange will be determined by conditions of supply and demand for foreign currencies in Canada.” (Quoted from Schembri, Lawrence, “Revisiting the Case for Flexible Exchange Rates”, Bank of Canada, November 2000).
Friedman could chalk up his first major victory in the currency debate – while the next was to come in 1971 when Bretton Woods was abandoned. In the intervening years Friedman made a huge contribution to changing how currencies and exchange rates are viewed in economic theory.