The Euro – A Fiscal Strangulation Mechanism (but mostly for monetary reasons)

In my earlier post The Euro – A Fatal Conceit I argued that had the euro not be introduced and had we instead had freely floating exchange rates then “European taxpayers would (not) have had to pour billions of euros into bailing out Southern European and Eastern European government”. Said in another way had we not had the euro then there would not have been a European “debt crisis” or at least it would have been significantly smaller.

A simple way of illustrating this is to have a look at the debt development in the euro countries (and the countries pegged to the euro) and comparing that with the debt development in the European countries with floating exchange rates.

I use the same countries as in my previous post – The Euro – A Monetary Strangulation Mechanism. 21 euro countries (and countries pegged to the euro) and 10 countries with more or less floating exchange rates.

The graph below shows the development in (median) gross public debt (% of GDP) in the two groups of countries. (All countries are hence equally weighted).

debt change 2007 20014 floaters peggers

The picture is very clear – while both the floaters and the euro countries saw their public debt ratios increase sharply on the back of the 2008 shock (albeit less extremely for the floaters than for the euro countries) – from 2011 there is a very clear difference in the debt development.

Hence, from 2011 the floaters have seen as seen a gradual decline in gross public debt (as share of GDP), while the euro countries (and the peggers) have seen a steep increase in public indebtedness.

So while the floaters have seen their public debt increase by just above 10% of GDP from 2007 to 2014 the euro countries have seen a rise in public debt of more than 25% of GDP!

The graph below shows the individual breakdown of the data.

Publ debt green red

Again the picture is very clear – the euro countries (and the euro peggers) have had significantly more negative debt dynamics than the European floaters. Even if we disregard the PIIGS countries then the euro countries are on average doing a lot worse than the floaters in terms of public debt dynamics .

The euro countries are trying harder, but are succeeding less

One could of course argue that the difference in debt development simply reflects that some countries are just less prudent than other. However, the graph below shows that this is not a very good explanation.

Fiscal tightening

The graph shows the annual change in the fiscal stance (measured as the annual change in IMF’s estimate for the structural public balance as share of GDP). Positive (negative) values are a fiscal easing (tightening).

A few interesting conclusions emerge. First of all overall both euro countries and floaters seem to have had rather pro-cyclical fiscal policies – hence, both groups of countries eased fiscal policy in the ‘good years’ (2005-2009), but tightened the fiscal stance in the ‘bad years’ (2010-14.)

Second, it is notable that the fiscal stance of the euro countries and the floaters is highly correlated and is of a similar magnitude.

So even if the fiscal stance has an impact on growth in both groups of countries it seems a bit far-fetched to in general attribute the difference in real GDP growth between the two groups of countries to difference in the fiscal stance. That said, it seems like overall the euro countries and peggers have had a slightly more austere fiscal stance than the floaters after 2010. (Some – like Greece of course have seen a massive tightening of fiscal policy.)

This of course makes it even more paradoxical that the euro countries have had a significantly more negative debt dynamics than the floaters.

It is not a debt crisis – it is an NGDP crisis  

So we can conclude that the reason that the euro countries’ debt dynamics are a lot worse than the floaters is not because of less fiscal austerity, but rather the problem seems to be one of lacking growth in the euro countries. The graph below illustrates that.

NGDP debt

The graph plots the debt dynamics against the growth of nominal GDP from 2007 to 2014 for all 31 countries (both euro countries and the floaters).

The graph clearly shows that the countries, which have seen a sharp drop in nominal GDP such as Ireland and Greece have also seen the steepest increasing the public debt ratios. In fact Greece is nearly exactly on the estimated regression line, which implies that Greece has done exactly as good or bad as would be expected given the steep drop in Greek NGDP. This leaves basically no room for a ‘fiscal irresponsibility’ explanation for the rise in Greek public debt after 2007.

This of course nearly follows by definition – as we define the debt ratio as nominal public debt divided by nominal GDP. So when the denominator (nominal GDP) drops it follows by definition that the (debt) ratio increases. Furthermore, we also know that public sector expenditure (such as unemployment benefits) and tax revenues tend to be rather sensitive to changes in nominal GDP growth.

As a consequence we can conclude that the so-called ‘Europe debt crisis’ really is not about lack of fiscal austerity, but rather a result of too little nominal GDP growth.

And who controls NGDP growth? Well, overall NGDP growth in the euro zone is essentially under the full control of the ECB (remember MV=PY). This means that too tight monetary policy will lead to too weak NGDP growth, which in turn will cause an increase in public debt ratios.

In that regard it is worth noticing that it is hardly a coincidence that the ECB’s two unfortunate rate hikes in 2011 also caused a sharp slowdown in NGDP growth in certain euro zone countries, which in turn caused a sharp rise in public debt ratios as the first graph of this post clearly shows.

Consequently it would not be totally incorrect to claim that Jean-Claude Trichet as ECB-chief in 2011 played a major role in dramatically escalating the European debt crisis.

Had he not hiked interest rates in 2011 and instead pursued a policy of quantitative easing to get NGDP growth back on track then it seems a lot less likely that we would have seen the sharp increase in public debt ratios we have seen since 2011.

Of course that is not the whole story as the ECB does only control overall euro zone NGDP growth, but not the NGDP growth of individual euro zone countries. Rather the relative NGDP growth performance within the euro is determined by other factors such as particularly the initial external imbalances (the current account situation) when the shocks hit in 2008 (Lehman Brothers’ collapse) and 2011 (Trichet’s hikes.)

Hence, if a country like Greece with a large current account deficit is hit by a “funding shock” as in 2008 and 2011 then the country will have to have an internal devaluation (lower prices and lower wage growth) and the only way to achieve that is essentially through a deep recession.

However, that is not the case for countries with a floating exchange rate as a floating exchange country with a large current account deficit does not have to go through a recession to restore competitiveness – it just has to see a depreciation of its currency as Turkey as seen since 2008-9.

Concluding, the negative debt dynamics in the euro zone since 2008 are essentially the result of two things. 1) The misguided rate hikes in 2011 and 2) the lack of ability for countries with large current account deficits to see a nominal exchange rate depreciation.

The Euro is Fiscal Strangulation Mechanism, but for monetary reasons 

We can therefore conclude that the euro indeed has been a Fiscal Strangulation Mechanism as fiscal austerity has not been enough to stabilize the overall debt dynamics in a numbers of euro zone countries.

However, this is only the case because the ECB has first of all failed to offset the fiscal austerity by maintaining nominal stability (hitting its own inflation target) and second because countries, which initially had large current account deficits like Greece and Spain have not – contrary to the floaters – been able to restore competitiveness (and domestic demand) through a depreciation of their currencies as they essentially are “pegged” within the euro zone.

PS I have excluded Croatia from the data set as it is unclear whether to describe the Croatian kuna as a dirty float or a dirty peg. Whether or not Croatia is included in the sample does not change the conclusions.

Update: My friend Nicolas Goetzmann pointed out the Trichet ECB also hiked interest rates in 2008 and hence dramatically misjudged the situation. I fully agree with that, but my point in this post is not necessarily to discuss that episode, but rather to discuss the fiscal implications of the ECB’s failures and the problem of the euro itself.


If you want to hear me speak about these topics or other related topics don’t hesitate to contact my speaker agency Specialist Speakers – e-mail: or


Friedman, Schuler and Hanke on exchange rates – a minor and friendly disagreement

Before Arthur Laffer got me very upset on Monday I had read an excellent piece by Kurt Schuler on about Milton Friedman’s position on floating exchange rates versus fixed exchange rates.

Kurt kindly refers to my post on differences between the Swedish and Danish exchange regimes in which I argue that even though Milton Friedman as a general rule prefered floating exchange rates to fixed exchange rates he did not argue that floating exchange rates was always preferable to pegged exchange rates.

Kurt’s comments at length on the same topic and forcefully makes the case that Friedman is not the floating exchange rate proponent that he is sometimes made up to be. Kurt also notes that Steve Hanke a couple of years ago made a similar point. By complete coincidence Steve had actually a couple of days ago sent me his article on the topic (not knowing that I actually had just read it recently and wanted to do a post on it).

Both Kurt and Steve are proponents of currency boards – and I certainly think currency boards under some circumstances have some merit – so it is not surprising they both stress Friedman’s “open-mindeness” on fixed exchange rates. And there is absolutely nothing wrong in arguing that Friedman was pragmatic on the exchange rate issue rather than dogmatic. That said, I think that both Kurt and Steve “overdo” it a bit.

I certainly think that Friedman’s first choice on exchange rate regime was floating exchange rates. In fact I think he even preffered “dirty floats” and “managed floats” to pegged exchange rates. When I recently reread his memories (“Two Lucky People”) I noted how often he writes about how he advised governments and central bank officials around the world to implement a floating exchange rate regime.

In “Two Lucky People” (page 221) Friedman quotes from his book “Money Mischief”:

“…making me far more skeptical that a system of freely floating exchange rates is politically feasible. Central banks will meddle – always, of corse, with the best of intentions. Nevertheless, even dirty floating exchange rates seem to me preferable to pegged rates, though not necessarily to a unified currency”

I think this quote pretty well illustrates Friedman’s general position: Floating exchange rates is the first choice, but under some circumstances pegged exchange rates or currency unions (an “unified currency”) is preferable.

On this issue I find myself closer to Friedman than to Kurt’s and Steve’s view. Kurt and Steve are both long time advocates of currency boards and hence tend to believe that fixed exchange rates regimes are preferable to floating exchange rates. To me this is not a theoretical discussion, but rather an empirical and practical position.

Finally, lately I have lashed out at some US free market oriented economists who I think have been intellectually dishonest for partisan reasons. Kurt and Steve are certainly not examples of this and contrary to many of the “partisan economists” Kurt and Steve have great knowledge of monetary theory and history. In that regard I am happy to recommend to my readers to read Steve’s recent piece on global monetary policy. See here and here. You should not be surprised to find that Steve’s position is that the main problem today is too tight rather than too easy monetary policy – particularly in the euro zone.

PS I should of course note that Kurt is a Free Banking advocate so he ideally prefers Free Banking rather anything else. I have no disagreement with Kurt on this issue.

PPS Phew… it was much nicer to write this post than my recent “anger posts”.


Related post:
Schuler on money demand – and a bit of Lithuanian memories…

Boom, bust and bubbles

Recently it has gotten quite a bit of attention that some investors believe that there is a bubble in the Chinese property market and we will be heading for a bust soon and the fact that I recently visited Dubai have made me think of how to explain bubbles and if there is such a thing as bubbles in the first bubbles.

I must say I have some experience with bubbles. In 2006 I co-authoured a paper on the Icelandic economy where we forecasted a bust of the Icelandic bubble – I don’t think we called it a bubble, but it was pretty clear that that is what we meant it was. And in 2007 I co-authored a number of papers calling a bust to the bubbles in certain Central and Eastern European economies – most notably the Baltic economies. While I am proud to have gotten it right – both Iceland and the Baltic States went through major economic and financial crisis – I nonetheless still feel that I am not entire sure why I got it right. I am the first to admit that there certainly quite a bit of luck involved (never underestimate the importance of luck). Things could easily have gone much different. However, I do not doubt that the fact that monetary conditions were excessive loose played a key role both in the case of Iceland and in the Baltic States. I have since come to realise that moral hazard among investors undoubtedly played a key role in these bubbles. But most of all my conclusion is that the formation of bubbles is a complicated process where a number of factors play together to lead to bubbles. At the core of these “accidents”, however, is a chain of monetary policy mistakes.

What is bubbles? And do they really exist? 

If one follows the financial media one would nearly on a daily basis hear about “bubbles” in that and that market. Hence, financial journalists clearly have a tendency to see bubbles everywhere – and so do some economists especially those of us who work in the financial sector where “airtime” is important. However, the fact is that what really could be considered as bubbles are quite rare. The fact that all the bubble-thinkers can mention the South Sea bubble or the Dutch Tulip bubble of 1637 that happened hundreds years ago is a pretty good illustration of this. If bubbles really were this common then we would have hundreds of cases to study. We don’t have that. That to me this indicates that bubbles do not form easily – they are rare and form as a consequence of a complicated process of random events that play together in a complicated unpredictable process.

I think in general that it is wrong to see any increase in assets prices that is later corrected as a bubble. Obviously investors make mistakes. We after all live in an uncertain world. Mistakes are not bubbles. We can only talk about bubbles if most investors make the same mistakes at the same time.

Economists do not have a commonly accepted description of what a bubble is and this is probably again because bubbles are so relatively rare. But let me try to give a definitions. I my view bubbles are significant economic wide misallocation of labour and capital that last for a certain period and then is followed by an unwinding of this misallocation (we could also call this boom-bust). In that sense communist Soviet Union was a major bubble. That also illustrates that distortion of  relative prices is at the centre of the description and formation of bubbles.

Below I will try to sketch a monetary based theory of bubbles – and here the word sketch is important because I am not actually sure that there really can be formulated a theory of bubbles as they are “outliers” rather than the norm in free market economies.

The starting point – good things happen

In my view the starting point for the formation of bubbles actually is that something good happens. Most examples of “bubbles” (or quasi-bubbles) we can find with economic wide impact have been in Emerging Markets. A good example is the boom in the South East Asian economies in the early 1990s or the boom in Southern Europe and Central and Eastern European during the 2000s. All these economies saw significant structural reforms combined with some kind of monetary stabilisation, but also later on boom-bust.

Take for example Latvia that became independent in 1991 after the collapse of the Soviet Union. After independence Latvia underwent serious structural reforms and the transformation from planned economy to a free market economy happened relatively fast. This lead to a massively positive supply shock. Furthermore, a quasi-currency board was implemented early on. The positive supply shock (which played out over years) and the monetary stabilisation through the currency board regime brought inflation down and (initially) under control. So the starting point for what later became a massive misallocation of resources started out with a lot of good things happening.

Monetary policy and “relative inflation”

As the stabilisation and reform phase plays out the initial problems start to emerge. The problem is that the monetary policies that initially were stabilising soon becomes destabilising and here the distinction between “demand inflation” and “supply inflation” is key (See my discussion decomposion demand and supply inflation here). Often countries in Emerging Markets with underdeveloped financial markets will choose to fix their currency to more stable country’s currency – for example the US dollar or in the old days the D-mark – but a policy of inflation targeting has also in recent years been popular.

These policies often succeed in bringing nominal stability to begin with, but because the central bank directly or indirectly target headline inflation monetary policy is eased when positive supply shocks help curb inflationary pressures. What emerges is what Austrian economists has termed “relative inflation” – while headline inflation remains “under control” demand inflation (the inflation created by monetary policy) increases while supply inflation drops or even turn into supply deflation. This is a consequence of either a fixed exchange rate policy or an inflation targeting policy where headline inflation rather than demand inflation is targeted.

My view on relative inflation has to a very large extent been influenced by George Selgin’s work – see for example George’s excellent little book “Less than zero” for a discussion of relative inflation. I think, however, that I am slightly less concerned about the dangers of relative inflation than Selgin is and I would probably stress that relative inflation alone can not explain bubbles. It is a key ingredient in the formation of bubbles, but rarely the only ingredient.

Some – George Selgin for example (see here) – would argue that there was a significant rise in relatively inflation in the US prior to 2008. I am somewhat skeptical about this as I can not find it in my own decompostion of the inflation data and NGDP did not really increase above it’s 5-5.5% trend in the period just prior to 2008. However, a better candidate for rising relative inflation having played a role in the formation of a bubble in my view is the IT-bubble in the late 1990s that finally bursted in 2001, but I am even skeptical about this. For a good discussion of this see David Beckworth innovative Ph.D. dissertation from 2003.

There are, however, much more obvious candidates. While the I do not necessarily think US monetary policy was excessively loose in terms of the US economy it might have been too loose for everybody else and the dollar’s role as a international reserve currency might very well have exported loose monetary policy to other countries. That probably – combined with policy mistakes in Europe and easy Chinese monetary policy – lead to excessive loose monetary conditions globally which added to excessive risk taking globally (including in the US).

The Latvian bubble – an illustration of the dangers of relative inflation

I have already mentioned the cases of Iceland and the Baltic States. These examples are pretty clear examples of excessive easy monetary conditions leading to boom-bust. The graph below shows my decompostion of Latvian inflation based on a Quasi-Real Price Index for Latvia.

It is very clear from the graph that Latvia demand inflation starts to pick up significantly around 2004, but headline inflation is to some extent contained by the fact that supply deflation becomes more and more clear. It is no coincidence that this happens around 2004 as that was the year Latvia joined the EU and opened its markets further to foreign competition and investments – the positive impact on the economy is visible in the form of supply deflation. However, due to Latvia’s fixed exchange rate policy the positive supply shock did not lead to a stronger currency, but rather to an increase in demand inflation. This undoubtedly was a clear reason for the extreme misallocation of capital and labour in the Latvian economy in 2005-8.

The fact that headline inflation was kept down by a positive supply shock probably help “confuse” investors and policy makers alike and it was only when the positive supply shock started to ease off in 2006-7 that investors got alarmed.

Hence, here a Selginian explanation for the boom-bust seems to be a lot more obvious than for the US.

The role of Moral Hazard – policy makers as “cheerleaders of the boom”

To me it is pretty clear that relative inflation will have to be at the centre of a monetary theory of bubbles. However, I don’t think that relative inflation alone can explain bubbles like the one we saw in the Latvia. A very important reason for this is the fact that it took so relatively long for investors to acknowledge that something wrong in the Latvian economy. Why did they not recognise it earlier? I think that moral hazard played a role. Investors full well understood that there was a serious problem with strongly rising demand inflation and misallocation of capital and labour, but at the same time it was clear that Latvia seemed to be on the direct track to euro adoption within a relatively few years (yes, that was the clear expectation in 2005-6). As a result investors bet that if something would go wrong then Latvia would probably be bailed out by the EU and/or the Nordic governments and this is in fact what happened. Hence, investors with rational expectations rightly expected a bailout of Latvia if the worst-case scenario played out.
The Latvian case is certainly not unique. Robert Hetzel has made a forcefull argument in his excellent paper “Should Increased Regulation of Bank Risk Taking Come from Regulators or from the Market?” that moral hazard played a key role in the Asian crisis. Here is Hetzel:

“In early 1995, the Treasury with the Exchange Stabilization Fund, the Fed with swap accounts, and the IMF had bailed out international investors holding Mexican Tesobonos (Mexican government debt denominated in dollars) who were fleeing a Mexico rendered unstable by political turmoil. That bailout created the assumption that the United States would intervene to prevent financial collapse in its strategic allies. Russia was included as “too nuclear” to fail. Subsequently, large banks increased dramatically their short-term lending to Indonesia, Malaysia, Thailand and South Korea. The Asia crisis emerged when the overvalued, pegged exchange rates of these countries collapsed revealing an insolvent banking system. Because of the size of the insolvencies as a fraction of the affected countries GDP, the prevailing TBTF assumption that Asian countries would bail out their banking systems suddenly disappeared.”

I would further add that I think policy makers often act as “cheerleaders of the boom” in the sense that they would dismiss warnings from analysts and market participants that something is wrong in the economy and often they are being supported by international institutions like the IMF. This clearly “helps” investors (and households) becoming more rationally ignorant or even rationally irrational about the “obvious” risks (See Bryan Caplan’s discussion of rational ignorance and rational irrationality here.)

Policy recommendation: Introduce NGDP level targeting

Yes, yes we might as well get out our hammer and say that the best way to avoid bubbles is to target the NGDP level. So why is that? Well, as I argued above a key ingredient in the creation of bubbles was relative inflation – that demand inflation rose without headline inflation increasing. With NGDP level targeting the central bank will indirectly target a level for demand prices – what I have called a Quasi-Real Price Index (QRPI). This clearly would reduce the risk of misallocation due to confusion of demand and supply shocks.

It is often argued that central banks should in some way target asset prices to avoid bubbles. The major problem with this is that it assumes that the central bank can spot bubbles that market participants fail to spot. This is further ironic as it is exactly the central banks’ overly loose monetary policy which is likely at the core of the formation of bubbles. Further, if the central bank targets the NGDP level then the potential negative impact on money velocity of potential bubbles bursting will be counteracted by an increase in the money supply and hence any negative macroeconomic impact of the bubble bursting will be limited. Hence, it makes much more sense for central banks to significantly reduce the risk of bubbles by targeting the NGDP level than to trying to prick the bubbles.NGDP targeting reduces the risk of bubbles and also reduces the destabilising impact when the bubbles bursts.

Finally it goes without saying that moral hazard should be avoided, but here the solutions seems to be much harder to find and most likely involve fundamental institutional (some would argue constitutional) reforms.

But lets not worry too much about bubbles

As I stated above the bubbles are in reality rather rare and there is therefore in general no reason to worry too much about bubbles. That I think particularly is the case at the moment where overly tight monetary policy rather overly loose monetary policy. Furthermore, contrary to what some have argued the introduction – which effective in the present situation would equate monetary easing in for example the US or the euro zone – does not increase the risk of bubbles, but rather it reduces the risk of future bubbles significantly. That said, there is no doubt that the kind of bailouts that we have see of certain European governments and banks have increased the risk of moral hazard and that is certainly problematic. But again if monetary policy had follow a NGDP rule in the US and Europe the crisis would have been significantly smaller in the first place and bailouts would therefore not have been “necessary”.


PS I started out mentioning the possible bursting of the Chinese property bubble. I have no plans to write on that topic at the moment, but have a look at two rather scary comments from Patrick Chovanec:

“China Data, Part 1A: More on Property Downturn”
“Foreign Affairs: China’s Real Estate Crash”



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.

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