TRIBUTES AND REMEMBRANCES:
The Practical Milton Friedman

By George P. Shultz

George P. Shultz

We all feel the profound influence of Milton Friedman. That influence comes from his writing and research, from his teaching, from his work with his wife Rose on Free to Choose (as a book and a documentary TV series), and, of course, from his impact on people with whom he had contact, directly and indirectly. Some of those people were formally labeled “students” and some others were fellow faculty members. I fell in the latter group, but I really belonged in the former. Milton was a great teacher, and I found his ideas to be of tremendous applicability when I worked in government, particularly as secretary of the Treasury. So this story revolves around Milton’s argumentation for flexible exchange rates and his wonderfully helpful—and little known—suggestions for a plan to get there from the sense of crisis that emerged after the United States closed the gold window in August 1971.

Milton saw this coming and wrote President-elect Nixon shortly before his inauguration in January 1969, saying that sooner or later the United States would be forced to close the gold window. Milton counseled that the president would be better off doing this as his own policy initiative rather than being faced with a need to close the window in a crisis. His advice was not followed. Pressures continued to build despite futile efforts inherited from the prior Johnson administration to shield the dollar from pressure through an interest equalization tax, a mandatory foreign direct investment program, and a parallel foreign credit restraint program. (Later, I took great pleasure in ending these programs.)

As the year 1971 unfolded, I was director of the Office of Management and Budget. I knew that the fiscal and monetary policies in place would bring down a worrying rate of increase in the consumer price index; in fact, small declines were evident during the year. Nevertheless, there was great unease, particularly in the business community, about the power of unions in big industries to gain major wage increases with consequent pressure for inflation.

Some of those people Milton influenced were formally labeled “students” and some were fellow faculty members. I fell in the latter group, but I really belonged in the former.

I remember a meeting of the Business Council in the spring of 1971 at which I argued for my “steady as you go” policy, and business leaders were calling for controls. Yes, you read it right. Mature businesspeople thought you could have wage controls without price controls. Congress enacted a statute that was, in essence, a dare, empowering the president to impose wage and price controls if he so wished. That put members of Congress in the position of saying, We’ve given the president the tools; if inflation goes up, it’s his fault.

Then John Connolly entered the scene as secretary of the Treasury. He was a charming, dynamic, handsome former governor of Texas, and he sensed the atmosphere of concern about inflation. Meanwhile, pressure mounted, with the likelihood that countries holding dollars would start coming to the Treasury to redeem them for gold at $35 an ounce. Connolly developed a plan that he sold to the president, and I remember meeting with the two of them in July 1971. The plan involved closing the gold window, imposing wage and price controls to counter the inflationary impact of a decline in the value of the dollar, and imposing a presumably temporary tariff on imports. I remember the president saying, “I’ve decided to do this after Labor Day. In the meantime, only the three of us know about this decision and none of us will talk.”

Events unfolded as Milton had predicted. By August 15, foreign holdings of dollars totaled more than three times our holdings of gold when valued at $35 an ounce. A run on the bank was about to start. I spent the following weekend with my family at our old vacation house in the Berkshires. My 12-year-old son Alex was something of a squirrel; he would make a few bucks by cutting the lawn and would never spend a dime. One afternoon, I was sitting on the porch and I could hear the radio in the background. Someone was speculating on the possible devaluation of the dollar. My son came to me and said, “Dad, I want my dollar to be worth more, not less, don’t I?” When I told this story to President Nixon, it scared him to death. I regretted having mentioned it because the story reinforced his determination to use wage and price controls.

There’s an old saying among economists that everybody loves to argue with Milton, particularly when he isn’t there.

I argued vigorously in favor of closing the gold window, as that would lead us away from a system of quasi-fixed exchange rates and toward flexible exchange rates. Milton had convinced me that such a system would be superior. I lost the battle on wage and price controls and on tariffs.

The wage and price controls, initially wildly popular, proved in the end to be as catastrophic as Milton and I and many others had predicted. A period of uncertainty and turmoil on the exchange-rate front ensued. Foreign policy considerations emerged, and the initial maneuvering was fierce. Henry Kissinger got an education in how some issues in economics have strategic implications. Again, against the urge to find the presumed order of a managed system, I lost the argument that the dollar should be allowed to find its own level.

The result of these stirrings was an effort to re-create a system of fixed exchange rates—a par value system—at different levels in what became known as the Smithsonian Agreement, a negotiating achievement for John Connolly. But the Smithsonian Agreement did not really settle anything for long because the agreed-on cross-rates could not reflect developments in the market. From my perch at the Office of Management and Budget, I kept asking Treasury what its plan was. The people there told me they had one, but that it was secret. Not long afterward, Connolly left and I became secretary of the Treasury, so I said, “OK, where’s the plan?” They didn’t have one.

Around that time, I had a long conversation with Milton. We could readily agree that the dollar should be allowed to float and that a system of flexible exchange rates should somehow be brought into being. Nevertheless, Milton and I both recognized how controversial that was. We looked for a plan that might bring the result we wanted, yet be reassuring. Milton produced a brilliant idea that would give us a system of flexible exchange rates in the clothing of a more familiar system of par values. I spent the summer working with my colleagues, Secretary of State Bill Rogers, Chairman of the Federal Reserve Arthur Burns, and Chairman of the Council of Economic Advisers Herb Stein. Paul Volcker, my under secretary for monetary policy, had the laboring oar. In the end, I succeeded in bringing this group to a consensus around a special kind of par value plan: changes in reserves would automatically produce changes in exchange rates. It was a symmetrical plan that would operate in countries that were losing as well as gaining reserves.

After my young son heard someone on the radio speculating on the possible devaluation of the dollar, he said, “Dad, I want my dollar to be worth more, not less, don’t I?” When I told this story to President Nixon, it scared him to death.

I then took what amounted to Milton’s plan to the president, who endorsed it. I encouraged him to present it to the upcoming meeting of the IMF and the World Bank, the annual get-together of the world financial community. Instead, he announced that his secretary of the Treasury would present the plan the following day. What a buildup! The world heaved a sigh of relief. Even when people argue with U.S. proposals, our leadership is essential for progress.

With the president’s permission, I introduced a plan that proved to be a productive way to work with key countries. One by one, I invited the finance ministers of Germany, France, Britain, and Japan to come to my office, take a look at the text of my speech, and give me their comments. This had never been done before. I made a few of their suggested changes, none of which altered the basic proposal. The effort, however, laid the foundation of personal confidence that served us well in the ensuing period. In fact, it resulted in the creation of the Group of Five, which subsequently became the Group of Seven with the addition of Canada and Italy.

Our idea was never adopted, but it was an excellent placeholder and gave me the platform from which to continue advocating a system of flexible exchange rates. The negotiating process came to a head in two climactic meetings in Paris in March 1973. The finance ministers agreed to refrain from intervention in exchange markets except in the case of an undefined situation of “disorderly markets.” Thus, the essence of a flexible exchange rate system came into being. That system—in an imperfect way, to be sure—is still in place today. And the sum of all this is that Milton’s ideas prevailed because they were in line with the pressures of the marketplace.

As I worked on these problems, I had confidence that what I was doing was right and I developed steel in my backbone through endless arguments with Arthur Burns and others. I attribute this in considerable part to Milton. We kept in touch, and he kept me focused on the key ideas.

There’s an old saying among economists that everybody loves to argue with Milton, particularly when he isn’t there. But the point is that his ideas, his convictions, and his arguments are always present, even when he is not.