“The Case for Flexible Exchange Rates”

I 1950 Milton Friedman was attached to the US Economic Cooperation Administration (ECA), which was charged with overseeing the implementation of the Marshall plan.

The ECA wanted to see a common European market and therefore a liberalisation of intra-European trade and a breaking down of customs barriers between the European countries. Most European nations were, however, sceptical of the idea, as they feared it would lead to problematic balance of payments deficits – and thus pressure on the fixed exchange rate policy.

Once again the political dynamics of the fixed exchange rate system were stoking protectionist tendencies. This was an important theme in the memorandum that Milton Friedman wrote to the ECA on the structure of exchange rate policy in Europe. This memorandum, “Flexible Exchange Rates as a Solution to the German Exchange Crisis”, formed the foundation for his now classic article from 1953, “The Case for Flexible Exchange Rates”, in which he presented his arguments for floating exchange rates. The main arguments are presented below.

Friedman’s basic argument against fixed exchange rate policies is fundamentally political. He pointed out that the combination of inflexible wages and prices and a fixed exchange rate policy would lead to imbalances in the economy – such as balance of payments deficits. Friedman feared – and as in the Canadian example above also observed – that politicians would attempt to “solve” these problems through widespread regulation of the economy in the form of trade restrictions and price and wage controls – precisely what Friedman wanted at all costs to avoid.

When prices and wages are very flexible, imbalances can be corrected relatively painlessly via wage and price adjustments. Thus there would be no great need for changes in exchange rates. In the real world, however, wages and prices are not fully flexible, says Friedman, and so imbalances can arise when pursuing a fixed exchange rate policy. Sooner or later these imbalances will put pressure on the fixed exchange rate system.

According to Friedman there are two ways to solve this problem: either regulating the movement of capital and goods across international borders or allowing currencies to float freely. There is of course a third option – make prices and wages more flexible. However, this would require significant reforms, and Friedman is doubtful that politicians would choose this route – even though he might constantly argue for such reforms.

Thus for Friedman there are in reality just two options, and he is in no doubt that flexible exchange rates are by far preferable to further regulation and protectionism.

Friedman acknowledges that adjustment to a “shock” to the economy (for example a jump in oil prices) can happen via pricing. However, he states that prices are typically not fully flexible – in part due to various forms of government regulation – and that an adjustment of the exchange rate will therefore be much less painful.

Friedman illustrates this with the so-called Daylight-Saving-Time argument. According to Friedman, the argument in favour of flexible exchange rates is in many ways the same as that for summer time. Instead of changing the clocks to summer time, everyone could instead “just” change their behaviour: meet an hour later at work, change programme times on the TV, let buses and trains run an hour later, etc. The reason we do not do this is precisely because it is easier and more practical to put clocks an hour forward than to change everyone’s behaviour at the same time. It is the same with exchange rates, one can either change countless prices or change just one – the exchange rate.

According to Friedman, a further advantage of flexible exchange rates is that adjustments to economic shocks can be continual and gradual. This is in stark contrast to fixed exchange rates. Here, all adjustments have to take place via changes in prices and wages, and as prices and wages are sluggish movers, the adjustment process will be slow. This implies that the country will still at some point be forced to adjust its exchange rate (devalue or revalue), and these adjustments will typically be much greater than the continual adjustments that occur in a flexible exchange rate system, as imbalances will grow larger in a fixed exchange rate system than in a flexible exchange rate system.

Read on: Milton Friedman on exchange rate policy #3

See also my post: “Milton Friedman on Exchange rate policy #1”