The exchange rate fallacy: Currency war or a race to save the global economy?

This is from

Faced with a stubbornly slow and uneven global economic recovery, more countries are likely to resort to cutting the value of their currencies in order to gain a competitive edge.

Japan has set the stage for a potential global currency war, announcing plans to create money and buy bonds as the government of Prime Minister Shinzo Abe looks to stimulate the moribund growth pace…

Economists in turn are expecting others to follow that lead, setting off a battle that would benefit those that get out of the gate quickest but likely hamper the nascent global recovery and the relatively robust stock market.

This pretty much is what I would call the ‘exchange rate fallacy’ – hence the belief that monetary easing in someway is a zero sum game where monetary easing works through an “unfair” competitiveness channel and one country’s gain is another country’s lose.

Lets take the arguments one-by-one.

“…countries are likely to resort to cutting the value of their currencies in order to gain a competitive edge.”

The perception here is that monetary policy primarily works through a “competitiveness channel” where a monetary easing leads to a weakening of the currency and this improve the competitiveness of the nation by weakening the real value of the currency. The problem with this argument is first of all that this only works if there is no increase in prices and wages. It is of course reasonable to assume that that is the case in the short-run as prices and wages tend to be sticky. However, empirically such gains are minor.

I think a good illustration of this is relative performance of Danish and Swedish exports in 2008-9. When crisis hit in 2008 the Swedish krona weakened sharply as the Riksbank moved to cut interest rates aggressive and loudly welcomed the weakening of the krona. On the other hand Denmark continued to operate it’s pegged exchange rate regime vis-a-vis the euro. In other words Sweden initially got a massive boost to it’s competitiveness position versus Denmark.

However, take a look at the export performance of the two countries in the graph below.

Starting in Q3 2008 both Danish and Swedish exports plummeted. Yes, Swedish dropped slightly less than Danish exports but one can hardly talk about a large difference when it is taken into account how much the Swedish krona weakened compared to the Danish krone.

And it is also obvious that such competitiveness advantage is likely to be fairly short-lived as inflation and wage growth sooner or later will pick up and erode any short-term gains from a weakening of the currency.

The important difference between Denmark and Sweden in 2008-9 was hence not the performance of exports.

The important difference on the other hand the performance of domestic demand. Just have a look at private consumption in Sweden and Denmark in the same period.


It is very clear that Swedish private consumption took a much smaller hit than Danish private consumption in 2008-9 and consistently has grown stronger in the following years.

The same picture emerges if we look at investment growth – here the difference it just much bigger.


The difference between the performance of the Danish economy and the Swedish economy during the Great Recession hence have very little to do with export performance and everything to do with domestic demand.

Yes, initially Sweden gained a competitive advantage over Denmark, but the major difference was that Riksbanken was not constrained in it ability to ease monetary policy by a pegged exchange rate in the same way as the Danish central bank (Nationalbanken) was.

(For more on Denmark and Sweden see my earlier post The luck of the ‘Scandies’)

Hence, we should not see the exchange rate as a measure of competitiveness, but rather as an indicator of monetary policy “tightness”.When the central bank moves to ease monetary policy the country’s currency will tend to ease, but the major impact on aggregate demand will not be stronger export performance, but rather stronger growth in domestic demand. There are of course numerous examples of this in monetary history. I have earlier discussed the case of the Argentine devaluation in 2001 that boosted domestic demand rather exports. The same happened in the US when FDR gave up the gold standard in 1931. Therefore, when journalists and commentators focus on the relationship between monetary easing, exchange rates and “competitiveness” they are totally missing the point.

The ‘foolproof’ way out of deflation

That does not mean that the exchange rate is not important, but we should not think of the exchange rate in any other way than other monetary policy instruments like interest rates. Both can lead to a change in the money base (the core monetary policy instrument) and give guidance about future changes in the money base.

With interest rates effectively stuck at zero in many developed economies central banks needs to use other instruments to escape deflation. So far the major central banks of the world has focused on “quantitative easing” – increasing in the money base by buying (domestic) financial assets such as government bonds. However, another way to increase the money base is obviously to buy foreign assets – such as foreign currency or foreign bonds. Hence, there is fundamentally no difference between the Bank of Japan buying Japanese government bonds and buying foreign bonds (or currency). It is both channels for increasing the money base to get out of deflation.

In fact on could argue that the exchange rate channel is a lot more “effective” channel of monetary expansion than “regular” QE as exchange rate intervention is a more transparent and direct way for the central bank to signal it’s intentions to ease monetary policy, but fundamentally it is just another way of monetary easing.

It therefore is somewhat odd that many commentators and particularly financial journalists don’t seem to realise that FX intervention is just another form of monetary easing and that it is no less “hostile” than other forms of monetary easing. If the Federal Reserve buys US government treasuries it will lead to a weakening of dollar in the same way it would do if the Fed had been buying Spanish government bonds. There is no difference between the two. Both will lead to an expansion of the money base and to a weaker dollar.

“Economists in turn are expecting others to follow that lead, setting off a battle that would benefit those that get out of the gate quickest but likely hamper the nascent global recovery and the relatively robust stock market”

This quote is typical of the stories about “currency war”. Monetary easing is seen as a zero sum game and only the first to move will gain, but it will be on the expense of other countries. This argument completely misses the point. Monetary easing is not a zero sum game – in fact in an quasi-deflationary world with below trend-growth a currency war is in fact a race to save the world.

Just take a look at Europe. Since September both the Federal Reserve and the Bank of Japan have moved towards a dramatically more easy monetary stance, while the ECB has continue to drag its feet. In that sense one can say that that the US and Japan have started a “currency war” against Europe and the result has been that both the yen and the dollar have been weakened against the euro. However, the question is whether Europe is better off today than prior to the “currency war”. Anybody in the financial markets would tell you that Europe is doing better today than half  a year ago and European can thank the Bank of Japan and the Fed for that.

So how did monetary easing in the US and Japan help the euro zone? Well, it is really pretty simple. Monetary easing (and the expectation of further monetary easing) in Japan and the US as push global investors to look for higher returns outside of the US and Japan. They have found the higher returns in for example the Spanish and Irish bond markets. As a result funding costs for the Spanish and Irish governments have dropped significantly and as a result greatly eased the tensions in the European financial markets. This likely is pushing up money velocity in the euro zone, which effectively is monetary easing (remember MV=PY) – this of course is paradoxically what is now making the ECB think that it should (prematurely!) “redraw accommodation”.

The ECB and European policy makers should therefore welcome the monetary easing from the Fed and the BoJ. It is not an hostile act. In fact it is very helpful in easing the European crisis.

If the more easy monetary stance in Japan and US was an hostile act then one should have expected to see the European markets take a beating. That have, however, not happened. In fact both the European fixed income and equity markets have rallied strongly on particularly the new Japanese government’s announcement that it want the Bank of Japan to step up monetary easing.

So it might be that some financial journalists and policy makers are scare about the prospects for currency war, but investors on the other hand are jubilant.

If you don’t need monetary easing – don’t import it

Concluding, I strongly believe that a global “currency war” is very good news given the quasi-deflationary state of the European economy and so far Prime Minister Abe and Fed governor Bernanke have done a lot more to get the euro zone out of the crisis than any European central banker has done and if European policy makers don’t like the strengthening of the euro the ECB can just introduce quantitative easing. That would curb the strengthening of the euro, but more importantly it would finally pull the euro zone out of the crisis.

Hence, at the moment Europe is importing monetary easing from the US and Japan despite the euro has been strengthening. That is good news for the European economy as monetary easing is badly needed. However, other countries might not need monetary easing.

As I discussed in my recent post on Mexico a country can decide to import or not to import monetary easing by allowing the currency to strengthen or not. If the Mexican central bank don’t want to import monetary easing from the US then it can simply allow the peso strengthen in response to the Fed’s monetary easing.

Currency war is not a threat to the global economy, but rather it is what could finally pull the global economy out of this crisis – now we just need the ECB to join the war.

About these ads

The luck of the ‘Scandies’

This week we are celebrating Milton Friedman’s centennial. Milton Friedman was known for a lot of things and one of them was his generally skeptical view of pegged exchange rates. In his famous article “The Case for Flexible Exchange Rates” he argued strongly against pegged exchange rates and for flexible exchange rates.

Any reader of this blog would know that I share Friedman’s sceptical view of fixed exchange rates. However, I will also have to say that my view on exchange rates policy has become more pragmatic over the years. In fact one can say that I also in this area have become more of a Friedmanite. This could seem as a paradox given Friedman’s passionate defence of floating exchange rates. However, Friedman was not dogmatic on this issue. Rather Friedman saw exchange rate policy as a way to control the money supply and he often argued that small countries might not have the proper instruments and “infrastructure” to properly control the money supply. Hence it would be an advantage for certain countries to “outsource” monetary policy by pegging the currency to for example the US dollar. Hong Kong’s currency board and its peg to the dollar was his favourite example. I am less inclined to think that Hong Kong could not do better than the currency board, but I nonetheless think Friedman was right in the sense that there fundamentally is no difference between using for example interest rates to control the money supply and using the exchange rate.

In his highly recommendable book Money Mischief Milton Friedman discusses the experience with fixed exchange rates in Chile and Israel. Friedman documents Chile’s horrible experience with fixed exchange rates and Israel’s equally successful experience with fixed exchange rates. It is in relation to these examples Friedman states that one never should underestimate the importance of luck of nations. That credo has been a big inspiration in my own thinking and has certainly helped me understand the difference in performance of different economies during the present crisis. It is not only about policy. With the right policies this crisis could have been avoid, but on the other hand despite of less than stellar conduct of monetary policy some countries have come through this crisis very well. Luck certainly is important.

The Scandinavian economies provide an excellent example of this. Denmark and Sweden are in many ways very similar countries – small open economies with high levels of GDP/capita, strong public finances, an overblown welfare state, but nonetheless quite flexible product and labour markets and a quite high level of social and economic cohesion. However, Denmark and Sweden differ in one crucial fashion – the monetary policy regime.

Denmark has a fixed exchange rate (against the euro), while Sweden has a floating exchange rate and an inflation targeting regime. The different monetary policy regimes have had a significant impact on the performance of the Danish and the Swedish economies during the present crisis.

2008-9: Sweden’s luck, Denmark’s misery

When crisis hit in 2008 both Denmark and Sweden got hit, but Denmark suffered much more than Sweden – not only economically but also in terms of financial sector distress. The key reason for this is that while monetary conditions contracted significantly Sweden did not see any major monetary contraction. What happened was that as investors scrambled for US dollars in the second of 2008 they were selling all other currencies – also the Swedish krona and the Danish krone.

The reaction from the Danish and the Swedish central banks was, however, very different. As the Danish krone came under selling pressures the Danish central bank acted according to the fixed exchange policy by buying kroner. As a result Denmark saw a sharp contraction in the money supply – a contraction that continued in 2009 and 2010, but the peg survived. The central bank had “won” and defended the peg, but at a high cost. The monetary contraction undoubtedly did a lot to worsen the Danish financial sector crisis and four years later Danish property prices continue to decline. On the other hand when the demand for Swedish krona plunged in 2008-9 the Swedish central bank allowed this to happen and the krona weakened sharply. Said in another way the Swedish money demand dropped relative to the money supply. Swedish monetary conditions eased, while Danish monetary conditions tightened.

It is often said, that Sweden’s stronger economic performance relative to Denmark in 2008-9 (and 2010-11 for that matter) is a result of the relative improvement in Swedish competitiveness as a result of the sharp depreciation of the Swedish krona. However, this is a wrong analysis of the situation. In fact the major difference between the Swedish economy and the Danish economy has very little to do with the relative export performance. In fact both countries saw a more or less equal drop in exports in 2008-9. The big difference was the performance in domestic demand. While Danish domestic demand collapsed and property prices were in a free fall, domestic demand in Sweden performed strongly and Swedish property prices continued to rise after the crisis hit. The difference obviously is a result of the different monetary policy reactions in the two countries.

This is basically luck – the Danish monetary regime led to tightening of monetary conditions in reaction to the external shock, while the Swedish central bank to a large extent counteracted the shock with an easing of monetary conditions.

2012: The useful Danish peg and the failures of Riksbanken

Today the Danish economy continues to do worse than the Swedish economy, but the luck is changing. And again this has to do with money demand. While the demand for Swedish krona and Danish kroner collapsed in 2008-9 the opposite is the case today. Today investors as a reaction to the euro crisis are running scared away from the euro and buying everything else (more or less). As a result money is floating into both Denmark and Sweden and the demand for both currencies (and Swedish and Danish assets in general) has escalated sharply. So contrary to 2008-9 the demand for (local) money is now rising sharply. This for obvious reasons is leading to appreciation pressures on the Scandinavian currencies.

Today, however, the Danes are lucky to have the peg. Hence, as the Danish krone has tended to appreciate the Danish central bank has stepped in and defended the peg by expanding the money base and for the first time in four years the Danish money supply (M2) is now showing real signs of recovering. This of course is also why Danish short-term bond yields and money market rates have turned negative. The money markets are being flooded with liquidity to keep the krone from strengthening. Hence, the Danish euro peg is doing a great job in avoiding a negative velocity shock. For the first time in four years Danes could be true happy about the peg.

On the other hand for the first time in four years the Swedish monetary policy regime is not work as well as one could have hoped. As the demand for Swedish krona has escalated Swedish monetary conditions are getting tighter and tighter day by day and the signs are pretty clear that Swedish money-velocity is contracting. This is hardly good news for the Swedish economy.

Obviously there is nothing stopping the Swedish central bank from counteracting the drop in velocity (the increased money demand) by expanding the money base and legendary Swedish deputy central bank governor Lars E. O. Svensson has been calling for monetary easing for a while, but the majority of board members in the Swedish central bank seem reluctant to step up and ease monetary policy even though it day by day is becoming evident that monetary easing is needed.

Good policies are the best substitute for good luck

Obviously neither the Danish nor the Swedish monetary policy regime is optimal under all circumstances and this is exactly what I have tried to demonstrate above. The difference between 2008-9 and 2011-12 is the impact on demand for the Danish and Swedish currency and these differences have been driven mostly by external factors.

Obviously one could (and should!) argue that Sweden’s problem today is not the floating exchange rate, but rather the inflation targeting regime. If Sweden instead had been targeting the (future) nominal GDP level then Riksbanken would already had eased monetary policy much more aggressively than has been the case to counteract the contraction in money-velocity.

Finally, it is clear that luck played a major role in how the crisis has played out in the Scandinavian crisis. However, with the right monetary policies – for example NGDP targeting – you are much more likely to have luck on your side when crisis hit.


Related posts:

Milton Friedman on exchange rate policy #1
Milton Friedman on exchange rate policy #2
Milton Friedman on exchange rate policy #3
Milton Friedman on exchange rate policy #4
Milton Friedman on exchange rate policy #5
Milton Friedman on exchange rate policy #6
Is monetary easing (devaluation) a hostile act?
Danish and Norwegian monetary policy failure in 1920s – lessons for today
“The Bacon Standard” (the PIG PEG) would have saved Denmark from the Great Depression
Bring on the “Currency war”
Exchange rates and monetary policy – it’s not about competitiveness: Some Argentine lessons

Milton Friedman on exchange rate policy #5

The euro – “a great mistake”

The European Monetary Union came into being in 1999, with the euro being introduced at the same time (as “account money”, and in 2002 as physical currency). Milton Friedman was an outspoken critic of this project, and his criticisms can be traced all the way back to “The Case for Flexible Exchange Rates” from 1953. The basic idea behind the euro is that to exploit the full potential of a single European market for goods, capital and labour – the inner market – a single common currency is essential. Friedman opposes this idea, as his view is namely that free trade is best promoted through floating exchange rates when wage and price formation are sluggish.

In Friedman’s eyes the euro area is not an optimal currency area, as the European goods and labour markets are still heavily regulated, and so prices and wages are relatively slow to adjust. At the same time, the mobility of labour between the euro countries is limited – due to both regulations and cultural differences. If this situation is not changed, it will, according to Friedman, inevitably lead to political tensions within the EU that may reach an intensity the European Central Bank (ECB) cannot ignore.

An asymmetric shock to one or more euro countries would require real national adjustment (price and wage adjustments), as nominal adjustments (exchange rate adjustments) are not possible within the framework of the monetary union. In Friedman’s view this would spark tension between the countries hit by the asymmetric shock and those not affected. Thus the euro might actually fan political conflict and the disintegration of Europe – which is in diametric opposition to the founding idea behind the single currency.

For Friedman the euro is not primarily an economic project. Rather, Friedman views the euro as basically a political concept designed to force further political integration onto Europe. Friedman believes that in the long run no country can maintain its sovereignty if it abandons its currency. The integration of the goods, capital and labour markets in the euro member countries is a prerequisite for the euro to function, and according to Friedman this can only happen through further political integration – something he fears will lead to the formation of a European superstate.

Recent developments unfortunately have proven Friedman’s analysis right…

Milton Friedman on exchange rates #4

Always floating exchange rates?

The theoretical literature often distinguishes between completely fixed exchange rates on the one hand and freely floating exchange rates on the other. Milton Friedman has pointed out, however, that this sharp distinction often does not apply to the exchange rate regimes that are used in practice. As well as the two “extremes” (completely freely floating exchange rates in which the central bank never intervenes, and a firmly fixed exchange rate with no fluctuations allowed), a common system is to have fixed but adjustable exchange rates – or rather exchange rate bands. The Danish krone, for example, can swing freely within a band of +/- 2¼% around the “fixed” euro exchange rate of 7.44 kr. per euro.

The three global majors, the US dollar, the Japanese yen and the European euro do float freely against each other – as do a number of smaller currencies, such as the Swedish krona, the British pound, the Korean won and the New Zealand dollar. However, even such in principle freely floating exchange rates do not prevent the central banks of these countries from being active in the FX markets from time to time.

A system with fully fixed exchange rates is in practice the same as a monetary union and involves the complete abolition of any form of monetary independence. One example is Hong Kong. The Hong Kong Monetary Authority is obliged at all times to exchange US dollars for a fixed amount of Hong Kong dollars (7.8 Hong Kong dollars per US dollar). This means in essence that Hong Kong is in a monetary union with the USA – the only difference is that Hong Kong has its own banknotes. A second example is the European Monetary Union, where all members have given up monetary independence and left all monetary policy decisions to the European Central Bank.

An example of a system with fixed but adjustable exchange rates is the European fixed exchange rate mechanism, the EMS. Members of the EMS pursued a mutual fixed exchange rate policy – or more correctly, exchange rates were allowed to float within a narrow band and the various central banks were obliged to ensure (via for example changes in interest rates or intervention in the FX market) that they remained there. Denmark, Latvia and Lithuania currently follow a fixed exchange rate policy within the framework of a similar system, ERMII.

According to Friedman, however, a system of fixed but adjustable exchange rates is the worst of all worlds. Such a system means that the country abandons the option of an independent exchange rate policy. However, at times the need to use the exchange rate policy for “domestic purposes” – for example to tackle an asymmetric shock – will be irresistible, and the country will then either have to adjust exchange rates (devalue or revalue), or completely abandon the fixed exchange rate policy. This will, meanwhile, cause uncertainty in the FX market about just how “fixed” the policy is in reality. Thus a system with fixed but adjustable exchange rates will always be a potential “target” for speculative attack: one has so to speak closed the door, but not locked it. In a monetary union with irrevocably fixed currencies one has, in contrast, closed the door, locked it and thrown away the key – there is simply no doubt about how solid the fixed exchange rate policy is and thus speculation in exchange rate movements will therefore cease.

Hence for Friedman the choice is between either a freely floating exchange rate or some form of monetary union. Friedman has over the years presented the criteria by which to choose between the two exchange rate regimes. Basically there are six criteria that a small country (A) should consider when deciding its exchange rate policy in relation to the “rest of the world” (country B):

1.     How important is foreign trade for the economy of country A?

2.     How flexible are wages and prices in country A?

3.     How mobile is labour across national borders?

4.     How mobile is capital?

5.     How good is monetary policy in country A and the “rest of the world”?

6.     How are political relations between country A and the “rest of the world” ?

These criteria in fact define what in modern economics literature is termed an optimal currency area[1]. If there are close trade ties, high wage and price flexibility, and high capital and labour mobility between country A and the “rest of the world”, there is, according to Friedman, no reason why the two countries should not form a monetary union with a common currency.

Friedman stresses, however, that a country should not abandon its monetary policy independence to another country if that country is expected to pursue a poorer monetary policy than the first country itself would have done. Friedman places greatest emphasis on this criterion.

Despite Milton Friedman typically – and rightly – being labelled as the standard bearer for floating exchange rates, he often stresses that the choice is not easy, and he has repeatedly emphasised that countries have achieved both good and bad results with fixed and floating exchange rates. He points out for example that in 1985 Israel successfully implemented a fixed exchange rate policy against the dollar that helped cut inflation without causing any negative long-term economic repercussions.

By way of contrast, Chile implemented a fixed exchange rate policy against the dollar in 1976. Results were good for the first year following the implementation. However, when US monetary policy was seriously tightened between 1980 and 1982, causing the dollar to surge, monetary policy in Chile also had to be tightened: Chile suffered a serious economic setback, and in 1982 it abandoned its fixed exchange rate policy.

Friedman used the two cases above to underline that identical exchange rate policies can lead to different results. The outcome of the fixed exchange rate policy depends on how “lucky” one is with regard to the monetary policy in the country whose currency one has fixed to. Israel was lucky to introduce a fixed exchange rate policy at a time when monetary policy was relatively accommodative in the USA, while Chile was unlucky to fix just before US monetary policy had to be vigorously tightened. Or as Friedman says:

“Never underestimate the role of luck in the fate of individuals or of nations.”[2]

[1] The theory on optimal currency areas can be traced in particular back to Robert Mundell, see eg, Mundell, R. A., “A Theory of Optimal Currency Areas”, American Economic Review, Vol. 51, No. 4, September 1961, pp 657-665.

[2]”Money Mischief”, page 241.

Milton Friedman on exchange rate policy #3

The fears of economists and politicians with regard to flexible exchange rates can largely be traced back to the policies of the 1920s following the collapse of the gold standard. The most famous criticism of flexible exchange rates is probably that made by the Estonian economist Ragnar Nurkse. Nurkse[1] claimed that the 1920s demonstrated that flexible exchange rates are destabilising.

Friedman, however, is fiercely critical of Nurkse’s view. First of all Friedman claims that currency speculation is stabilising and, second, that much of the historical volatility that can be observed in flexible exchange rates is in fact due to poor economic policy – primarily poor monetary policy – and not a result of “currency speculators”.

As mentioned Milton Friedman claims that currency speculation is stabilising not destabilising. The purpose of currency speculation is basically to buy cheap and sell expensive. If a currency deviates from its fundamental value – ie, is overvalued or undervalued – it would be rational for the “currency speculator” to expect that the currency would sooner or later move towards its fundamental exchange rate. If the currency is, for example, undervalued – ie, is cheap relative to the fundamental exchange rate – it would be rational to expect that the currency will eventually strengthen, and thus the rational speculator will buy the currency. If the majority of speculators act in this way, the exchange rate will all else equal be driven in the direction of the currency’s fundamental value – thus currency speculation is stabilising. Friedman argues furthermore that speculators who do not speculate rationally – ie, who sell when the currency is undervalued and buy when it is overvalued – will not earn money in the long run. Such speculators will soon be looking for a new job, and thus there will be a tendency for the number of “stabilising speculators” to be relatively greater than the number of “destabilising speculators”.

According to Friedman floating exchange rates will remain relatively stable if the FX market is left to its own devices. However, the problem is that governments and central banks have had problems keeping their hands off. Even in the 1920s and after the collapse of Bretton Woods in 1971 when flexible exchange rates were the norm, governments and central banks intervened in global FX markets. Friedman claims this has actually increased volatility in FX markets rather than stabilised exchange rates. As both the 1920s and the 1970s were marked by inappropriate monetary policies, this further contributed to unstable exchange rates. Put another way, floating exchange rates require sensible monetary policy. This implies that to ensure low and stable inflation one must let the supply of money grow at a low and stable rate.

Flexible exchange rates provide no guarantee of sensible monetary policy, but they are a precondition for an independent monetary policy. If a small country pursues a fixed exchange rate policy it will automatically be forced to follow the monetary policy of the nation(s) that dominate the currency system. This will be a particular problem if the “small” country’s economy is hit by what in the modern theoretical literature is called an asymmetric shock.

An asymmetric shock is an economic event (for example a strike or a shift in fiscal policy) that only affects one of the countries in a fixed exchange rate mechanism and not the others. One example of this is the reunification of Germany. Both fiscal and monetary policy were eased considerably in Germany at the time of reunification. This stoked inflationary pressure in Germany to a level that caused the German central bank, the Bundesbank, to tighten monetary policy again in 1992. Most EU currencies were at the time linked to the German mark under the European Monetary System (EMS). In the early 1990s, the other EU countries were struggling to break out of a period of low growth and the majority of the European economies had absolutely no need for the monetary tightening they were indirectly subject to via their fixed exchange rate policy with Germany. In 1992 Milton Friedman predicted the consequences for the EMS[2]:

“I suspect that EMS, too, will break down if Germany ever becomes unwilling to follow those policies, as it well may as a result of the unification of East and West Germany.”

The EMS broke down (partially) in 1993, proving Milton Friedman – as had been the case with the Canadian fixed exchange rate policy 43 years earlier – correct.

See also my posts in this series:

Milton Friedman on exchange rate policy #1

Milton Friedman on exchange rate policy #2


[1] Nurkse, Ragnar, “International Currency Experience: Lessons of Interwar Experience”, Genéve, 1944.

[2]“Money Mischief”, page 245.

Milton Friedman on exchange rate policy #1

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.


Get every new post delivered to your Inbox.

Join 3,172 other followers

%d bloggers like this: