The Compensated dollar and monetary policy in small open economies

It is Christmas time and I am spending time with the family so it is really not the time for blogging, but just a little note about something I have on my mind – Irving Fisher’s Compensated dollar plan and how it might be useful in today’s world – especially for small open economies.

I am really writing on a couple of other blog posts at the moment that I will return to in the coming days and weeks, but Irving Fisher is hard to let go of. First of all I need to finalise my small series on modern US monetary history through the lens of Quasi-Real Indexing and then I am working on a post on bubbles (that might in fact turn into a numbers of posts). So stay tuned for these posts.

Back to the Compensated dollar plan. I have always been rather skeptical about fixed exchange rate regimes even though I acknowledge that they have worked well in some countries and at certain times. My dislike of fixed exchange rates originally led me to think that then one should advocate floating exchange rates and I certainly still think that a free floating exchange rate regime is much preferable to a fixed exchange rate regime for a country like the US. However, the present crisis have made me think twice about floating exchange rates – not because I think floating exchange rates have done any harm in this crisis. Countries like Sweden, Australia, Canada, Poland and Turkey have all benefitted a great deal from having floating exchange rates in this crisis. However, exchange rates are really the true price of money (or rather the relative price of monies). Unlike the interest rate which is certainly NOT – contrary to popular believe – the price of money. Therefore, if we want to change the price of money then the most direct way to do that is through the exchange rate.

As a consequence I also come to think that variations of Fisher’s proposal could be an idea for small open economies – especially as these countries typically have less developed financial markets and due to financial innovation – in especially Emerging Markets – have a hard time controlling the domestic money supply. Furthermore, a key advantage of using the exchange rate to conduct monetary policy is that there is no “lower zero bound” on the exchange rate as is the case with interest rates and the central bank can effectively “circumvent” the financial sector in the conduct of monetary policy – something which is likely to be an advantage when there is a financial crisis.

The Compensated dollar plan 

But lets first start out by revisiting Fisher’s compensated dollar plan. Irving Fisher first suggested the compensated dollar plan in 1911 in his book The Purchasing Power of Money. The idea is that the dollar (Fisher had a US perspective) should be fixed to the price of gold, but the price should be adjustable to ensure a stable level of purchasing power for the dollar (zero inflation). Fisher starts out by defining a price index (equal to what we today we call a consumer price index) at 100. Then Fisher defines the target for the central bank as 100 for this index – so if the index increases above 100 then monetary policy should be tightened – and vis-a-vis if the index drops. This is achieved by a proportional adjustment of  the US rate vis-a-vis the the gold prices. So it the consumer price index increase from 100 to 101 the central bank intervenes to strengthen the dollar by 1% against gold. Ideally – and in my view also most likely – this system will ensure stable consumer prices and likely provide significant nominal stability.

Irving Fisher campaigned unsuccessfully for his proposals for years and despite the fact that is was widely discussed it was not really given a chance anywhere. However, Sweden in the 1930s implemented a quasi-compensated dollar plan and as a result was able to stabilize Swedish consumer prices in the 1930s. This undoubtedly was the key reason why Sweden came so well through the Great Depression. I am very certain that had the US had a variation of the compensated dollar plan in place in 2008-9 then the crisis in the global economy wold have been much smaller.

Three reservations about the Compensated dollar plan

There is no doubt that the Compensated dollar plan fits well into Market Monetarist thinking. It uses market prices (the exchange rate and gold prices) in the conduct of monetary policy rather than a monetary aggregate, it is strictly ruled based and it ensures a strong nominal anchor.

From a Market Monetarists perspective I, however, have three reservations about the idea.

First, the plan is basically a price level targeting plan (with zero inflation) rather than a plan to target nominal spending/income (NGDP targeting). This is clearly preferable to inflation targeting, but nonetheless fails to differentiate between supply and demand inflation and as such still risk leading to misallocation and potential bubbles. This is especially relevant for Emerging Markets, which undergoes significant structural changes and therefore continuously is “hit” by a number of minor and larger supply shocks.

Second, the plan is based on a backward-looking target rather than on a forward-looking target – where is the price level today rather than where is the price level tomorrow? In stable times this is not a major problem, but in a time of shocks to the economy and the financial system this might become a problem. How big this problem is in reality is hard to say.

Finally third, the fact that the plan uses only one commodity price as an “anchor” might become a problem. As Robert Hall among other have argued it would be preferable to use a basket of commodities as an anchor instead and he has suggest the so-called ANCAP standard where the anchor is a basket of Ammonium Nitrate, Copper, Aluminum and Plywood.

Exchange rate based NGDP targeting for small-open economies

If we take this reservations into account we get to a proposal for an exchange rate based NGDP target regime which I believe would be particularly suiting for small open economies and Emerging Markets. I have in an earlier post spelled out the proposal – so I am repeating myself here, but I think the idea is worth it.

My suggestion is that it the the small open economy (SOE) announces that it will peg a growth path for NGDP (or maybe for nominal wages as data might be faster available than NGDP data) of for example 5% a year and it sets the index at 100 at the day of the introduction of the new monetary regime. Instead of targeting the gold price it could choose to either to “peg” the currency against a basket of other currencies – for example the 3-4 main trading partners of the country – or against a basket of commodities (I would prefer the CRB index which is pretty closely correlated with global NGDP growth).

Thereafter the central bank should every month announce a monthly rate of depreciation/appreciation of the currency against the anchor for the coming 24-36 month in the same way as most central banks today announces interest rate decisions. The target of course would be to “hit” the NGDP target path within a certain period. The rule could be fully automatic or there could be allowed for some discretion within the overall framework. Instead of using historical NGDP the central bank naturally should use some forecast for NGDP (for example market consensus or the central bank’s own forecast).

It could be done, but will anybody dare?

Central bankers are conservative people and they don’t go around and change their monetary policy set-up on a daily basis. Nonetheless it might be time for central banks around the world to reconsider their current set-up as monetary policy far from having been successfully in recent years. I believe Irving Fisher’s Compensated dollar plan is an excellent place to start and I have provided a (simple) proposal for how small-open economies might implement it.

Exchange rate based NGDP targeting for small-open economies

The debate about NGDP targeting is mostly focused on US monetary policy and the focus of most of the Market Monetarist bloggers is on the US economy and on US monetary policy. That is not in anyway surprising, but this is of little help to policy makers in small-open economies and I have long argued that Market Monetarists also need to address the issue of monetary policy in small-open economies.

In my view NGDP level targeting is exactly as relevant to small-open economies as for the US or the euro zone. However, it terms of the implementation of NGDP level targeting in small open economies that might be easier said than done.

A major problem for small-open economies is that their financial markets typically are less developed than for example the US financial markets and equally important exchange rates moves is having a much bigger impact on the overall economic performance – and especially on the short-term volatility in prices, inflation and NGDP. I therefore think that there is scope for thinking about what I would call exchange rate based NGDP targeting in small open economies.

What I suggest here is something that needs a lot more theoretical and empirical work, but overall my idea is to combine Irving Fisher’s compensated dollar plan (CDP) with NGDP level targeting.

Fisher’s idea was to stabilise the price level by devaluing or revaluing the currency dependent on whether the actual price level was higher or lower than the targeted price level. Hence, if the price level was 1% below the target price level in period t-1 then the currency should devalued by 1% in period t. The Swedish central bank operated a scheme similar to this quite successfully in the 1930s. In Fisher’s scheme the “reference currency” was the dollar versus gold prices. In my scheme it would clearly be a possibility to “manage” the currency against some commodity price like gold prices or a basket of commodity prices (for example the CRB index). Alternatively the currency of the small open economy could be managed vis-à-vis a basket of currencies reflecting for example a trade-weighted basket of currencies.

Unlike Fisher’s scheme the central bank’s target would not be the price level, but rather a NGDP path level and unlike the CDP it should be a forward – and not a backward – looking scheme. Hence, the central bank could for example once every quarter announce an appreciation/depreciation path for the currency over the coming 2-3 years. So if NGDP was lower than the target level then the central bank would announce a “lower” (weaker) path for the currency than otherwise would have been the case.

For Emerging Markets where productivity growth typical is higher than in developed markets the so-called Balassa-Samuelson effect would say that the real effective exchange rate of the Emerging Market economy should gradually appreciate, but if NGDP where to fall below the target level then the central bank would choose to “slowdown” the future path for the exchange rate appreciation relative to the trend rate of appreciation.

I believe that exchange rate based NGDP level targeting could provide a worthwhile alternative to floating exchange (with inflation or NGDP targeting) or rigid pegged exchange rate policies. That said, my idea need to be examined much closer and it would be interesting to see how the rule would perform in standard macroeconomic models under different assumptions.

Finally it should be noted that the there are some clear similarities to a number for the proposal for NGDP growth targeting Bennett McCallum has suggested over the years.

Repeating a (not so) crazy idea – or if Chuck Norris was ECB chief

Recently I in a post came up with what I described as a crazy idea – that might in fact not be so crazy.

My suggestion was based on what I termed the Chuck Norris effect of monetary policy – that a central banks can ease monetary policy without printing money if it has a credible target. The Swiss central bank’s (SNB) actions to introduce a one-sided peg for the Swiss franc against the euro have demonstrated the power of the Chuck Norris effect.

The SNB has said it will maintain the peg until deflationary pressures in the Swiss economy disappears. The interesting thing is that the markets now on its own is doing the lifting so when the latest Swiss consumer prices data showed that we in fact now have deflation in Switzerland the franc weakened against the euro because market participants increased their bets that the SNB would devalue the franc further.

In recent days the euro crisis has escalated dramatically and it is pretty clear that what we are seeing in the European markets is having a deflationary impact not only on the European economy, but also on the global economy. Hence, monetary easing from the major central banks of the world seems warranted so why do the ECB not just do what the SNB has done? For that matter why does the Federal Reserve, the Bank of England and the Bank of Japan not follow suit? The “crazy” idea would be a devaluation of euro, dollar, pound and yen not against each other but against commodity prices. If the four major central banks (I am leaving out the People’s Bank of China here) tomorrow announced that their four currencies had been devalued 15% against the CRB commodity index then I am pretty sure that global stock markets would increase sharply and the positive effects in global macro data would likely very fast be visible.

The four central banks should further announce that they would maintain the one-sided new “peg” for their currencies against CRB until the nominal GDP level of all for countries/regions have returned to pre-crisis trend levels around 10-15% above the present levels and that they would devalue further if NGDP again showed signs of contracting. They would also announce that the policies of pegging against CRB would be suspended once NGDP had returned to the pre-crisis trend levels.

If they did that do you think we would still talk about a euro crisis in two months’ time?

PS this idea is a variation of Irving Fisher’s compensated dollar plan and it is similar to the scheme that got Sweden fast and well out of the Great Depression. See Don Patinkin excellent paper on “Irving Fisher and His Compensated Dollar Plan” and Claes Berg’s and Lars Jonung’s paper on Swedish monetary policy in 1930s.

PPS this it not really my idea, but rather a variation of an idea one of my colleagues came up with – he is not an economist so that is maybe why he is able to think out of the box.

PPPS I real life I am not really a big supporter of coordinated monetary action and I think it has mostly backfired when central banks have tried to manipulate exchange rates. However, the purpose of this idea is really not to manipulate FX rates per se, but rather to ease global monetary conditions and the devaluation against CRB is really only method to increase money velocity.

Milton Friedman on exchange rate policy #6

Gold standard?

The last remnants of the global gold standard system died when the Bretton Woods agreement collapsed in 1971, but the notion of a global currency system based on a gold standard occasionally pops up in both general and academic debates, especially in the USA.

Friedman was never any great proponent of the gold standard or other goods-based currency systems. He sees a gold standard system as neither possible nor desirable in a today’s world: undesirable because its reintroduction would imply enormous costs in connection with purchasing gold, and not possible because the “mythology” that surrounded the gold standard in the nineteenth century no longer exists. In the nineteenth century everyone expected changes in the money supply to be determined by developments in the price of gold, and that money and gold were close substitutes. Today, we expect the central bank – not gold – to ensure the value of our money. A reintroduction of the gold standard would require a shift in this perception.

In the nineteenth century the gold standard ensured low (or more correctly no) inflation for long periods of time. On the other hand, prices fluctuated considerably from year to year as gold production rose and fell. According to Friedman this was possible because the goods and labour markets were much more flexible at that time than now. Any attempt to reintroduce the gold standard now would result in exactly the same negative outcomes as a fixed exchange rate policy.

Despite the global gold standard having been abandoned many years ago, most central banks continue to own large amounts of gold. Friedman’s view is that one should fully acknowledge the end of the gold standard system and auction off the gold reserves of the central banks.

This concludes my little series on Milton Friedman’s view on FX policy. See the other posts here:

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 #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.

“Chinese Silver Standard Economy and the 1929 Great Depression”

Only two major countries – China and Spain – were not on the Gold Standard at the onset of the Great Depression in 1929. As a consequence both countries avoided the most negative consequences of the Great Depression. That is a forcefully demonstration of how the “wrong” exchange rate regimes can mean disaster, but also a reminder of Milton Friedman’s dictum never to underestimate the importance of luck.

I have recently found this interesting paper by

Cheng-chung Lai and Joshua Jr-shiang Gau on the “Chinese Silver Standard Economy  and the 1929 Great Depression”. Here is the abstract for you:

“It is often said that the silver standard had insulated the Chinese economy from the Great Depression that prevailed in the gold standard countries during the 1929-35 period. Using econometric testing and counterfactual simulations, we show that if China had been on the gold standard (or on the gold-exchange standard), the balance of trade of this semi-closed economy would have been ameliorated, but the general price level would have declined significantly. Due to limited statistics, two important factors (the GDP and industrial production level) are not included in the analysis, but the general argument that the silver standard was a lifeboat to the Chinese economy remains defensible.”

If anybody has knowledge of research on Spanish monetary policy during the Great Depression I would be very interested hearing from you (

PS Today I have received Douglas Irwin’s latest book “Trade Policy Disaster: Lessons From the 1930s” in the mail. I look forward to reading it and sharing the conclusions with my readers. But I already know a bit about the conclusion: Countries that stayed longer on the Gold Standard were more protectionist than countries with more flexible exchange rate regimes. This fits with Milton Friedman’s views – see here and here.

Milton Friedman on Exchange rate policy #2

“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”

Friedman vs Mundell revisited

The euro crisis continues, but the issues are not new. Already back in 2001 two of the most influential monetary economists ever debated the euro issue – and the question of fixed versus floating exchange rates. Milton Friedman represented the euro sceptic view, while Robert Mundell represented the pro euro view.

Both Milton Friedman and Robert Mundell have done fantastically insightful research on currency issues. Most notably Friedman already in 1950 presented “The Case for Flexible Exchange Rates”, while Mundell founded the theoretical foundation for the euro in “A theory of Optimum Currency Areas” in 1961.

The 2001 debate was originally printed in the Canadian magazine “OPTIONS POLITIQUES”. The article is available online. It is a real gem and I am still puzzled why the debate between these two giants of monetary theory has been so underreported.

I will not go through the entire debate, but let me just quote Milton Friedman:

“Will the euro contribute to political unity? Only, I believe, if it is economically successful; otherwise, it is more likely to engender political strife than political unity… Ireland requires at the moment a very different monetary policy than, say, Spain or Portugal. A flexible exchange rate would enable each of them to have the appropriate monetary policy. With a unified currency, they cannot. The alternative adjustment mechanisms are changes in internal prices and wages, movement of people and of capital. These are severely limited by differences in culture and by extensive government regulations, differing from country to country. If the residual flexibility is enough, or if the existence of the euro induces a major increase in flexibility, the euro will prosper. If not, as I fear is likely to be the case, over time, as the members of the euro experience a flow of asynchronous shocks, economic difficulties will emerge. Different governments will be subject to very different political pressures and these are bound to create political conflict, from which the European Central Bank cannot escape.”

Friedman died at an age of 94 in 2006. The euro outlived Friedman, but will it also outlive Robert Mundell?

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