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Friedman on flexible exchange rates

Lars Christensen’s blog The Market Monetarist, which I make sure to read regularly, used the recent centenary of Milton Friedman’s birth to discuss Friedman’s views on exchange rates. The standard view of Friedman was that he was an advocate of flexible exchange rates, pure and simple. I think this view is based on an incomplete reading of Friedman, as Steve Hanke argued several years ago. (Anna Schwartz told Hanke she disagreed strongly with his interpretation of Friedman, but I think it's the only way to view Friedman's pronouncements on exchange rates as consistent over the years.)

Friedman wrote his most frequently cited essay on exchange rates, “The Case for Flexible Exchange Rates,” as a proposal for a quick way for Western European countries to eliminate the exchange controls that they had established before World War II and that persisted in the early 1950s. Exchange controls hindered trade. Flexible exchange rates could allow countries to remove their exchange controls quickly, Friedman thought, thereby improving opportunities for international trade and the wealth created by the international division of labor.

In the same essay, though, Friedman also discussed the sterling area, a zone of rigid exchange rates with the pound sterling. He wrote, “In principle there is no objection to a mixed system of fixed exchange rates within the sterling area and freely flexible rates between sterling and other countries, provided that the fixed rates within the sterling area can be maintained without trade restrictions.” At the time, the sterling area included most of Britain's colonies and protectorates as well as India, Pakistan, Australia, and New Zealand. It therefore extended over a considerable portion of the globe. Friedman likewise showed no objection to, or even praised, fixed exchange rates on a number of other occasions, cited in Hanke’s article.

The key to reconciling Friedman’s apparently contradictory positions is to understand that clean fixed and clean floating exchange rates, though differing in their degree of nominal rigidity, are similar in that both give market forces free rein. Under a clean fixed exchange rate, the nominal exchange rate is fixed and market forces determine the nominal monetary base. Under a clean floating exchange rate, the nominal monetary base is in the short term fixed (or perhaps a better word would be "set") and market forces determine the nominal exchange rate. Under intermediate arrangements where the monetary authority intervenes in the foreign exchange market to influence the nominal exchange rate and the nominal monetary base simultaneously, market forces do not have free rein and market adjustment is to some extent frustrated.

The overall impression Friedman's statements on exchange rates leave is that he considered flexible exchange rates to be the system most desirable and most politically sustainable for large and medium-size economies that were politically independent and able to keep inflation relatively low. In his policy advice, which took account of the particular circumstances of various countries, he did not, however, advocate flexible exchange rates across the board, nor were the cases where he thought fixed exchange rates would work acceptably mere unimportant exceptions.

  • Paul Marks

    A "fixed exchange rate" can work (indeed is automatic) if different countries are using the same money – or if they have common money supply policies over a long period of time.

    For example (in a different world), if the British "Pound" represented one ounce of gold and the Australian "Pound" (I know perfectly well that the Australian currency is called a "Dollar" and that neither the British or Australian currency actually represent anything now) represented half an ounce of gold.

    The exchange rate between the British Pound and Australian Pound would be two Australian Pounds to one British Pound.

    An attempt to "fix" the exchange rate of the British Pound to the Australian Pound at two Austalian Pounds for one British Pounds would, therefor, work and an attempt to "fix" the exchange rate at any other level would NOT work.

    To give a practical example, the exchange rate of the British Pound and the American Dollar was a known level before the First World War – as both were defined in terms of a specific amount of gold.

    Both currencies were taken off gold durin the First World War and inflated, BUT the the British currency was inflated MORE than the American currency was.

    Therefore the attempt to back to the old exchange rate in 1925 was proplematic (to put it mildly).

    Benjamin Strong (of the New York Fed) followed a policy of inflation (by "inflation" I am talking about his policy of encouraging the increse of the credit money supply of Dollars, not some "price level" stuff) in order to support the ARTIFICIAL exchange rate of the Pound (to support his friend M. Norman of the Bank of England).

    An alternative policy would have been to ACCEPT REALITY and to admit that the Pound was worth less (in terms of the Dollar) in 1925 than it had been before the Pound was inflated. I.E. to accept that OBJECTIVE REALITY (in the end) determins the exchange rate.

    If this had been done – then a stable exchange rate could have been established and kept to, as long as neither the United States or Britain engaged in a policy of inflation (again "inflation" defined as an increase in the money supply).

    This even holds true in the case of pure FIAT currencies.

    Let us say that two currencies had an exchange rate of one for two – and had done so for a long time.

    The exchange rate could be "fixed" at that level – and the fixing would hold, as long as neither country changed policy.

    If both countries kept their money supply frozen then (in normal circumstances) the exchange rate would remain the same.

    It would even remain the same if both countries INCREASED the money supply – as long as they agreed to alwsys do so AT THE SAME RATE.

    For example, if two countries increase their money supply at 10% per year (year in, year out – for ever) then this need have no effect on their exchange rate.

    Of course, in the above, I have largely left out banker antics (i.e. lending out "money" that was never really saved – creating a credit money bubble that must inevitablly end in a bust), although this was the sort of "increase in the money supply" that Benjamin Strong pushed in the United States in the late 1920s.

    For when one says "the Federal Reserve created the depression" one must be clear what one means by that.

    Does one mean that the Fed was not active enough in trying to PRESERVE the credit bubble (the expanded credit money supply) after the crash of 1929?

    That is what (for example) the present Federal Reserve Chairman (Ben the bubble man) means by "the Federal Reserve followed the wrong policy".

    Or does one mean that the Federal Reserve was wrong to CREATE THE CREDIT BUBBLE "BOOM" of the late 1920s? The credit bubble that inevitablly led to the crash.

    Which is what a free market person would mean by "the Federal Reserve followed the wrong policy" or "the Federal reserve created the depression".

    Although it should be noted that it was the REACTION of Herbert "The Forgotten Progressive" Hoover to the depression (particularly his efforts to prevent wages falling – as he was a victim of the "demand" fallacy) that turned the depression into the GREAT Depression.

  • VangelV

    I think that the best way to understand the contradictory positions is to admit that Friedman was not as good on the subject of money and interest rates as he is said to be and that his position was not nearly as in favour of free markets as many people claim. I use the Friedman videos to educate my kids on a number of subjects because he was very good on them. But when it comes to money I have to conclude that he has been found inadequate and that we must turn to better thinkers on the subject.