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October 26, 2012

He Saw It Coming

Many years ago, the great economist warned against euro euphoria and other economic train wrecks. As usual, he was right. By Robert Leeson.


The Milton Friedman archive illustrates the power of subversive ideas when promoted by a determined genius who was commonly regarded as “the best debater in a profession that loves to debate.” For the last three decades of his life, Friedman was a senior research fellow at the Hoover Institution. It is fitting that all his published essays (two-thirds of which were not on his list of publications) plus some of his correspondence will shortly become accessible via the Hoover website.

Those who “surf” the Friedman collections will discover a revolutionary with an uncanny ability to detect subterranean forces that others had not seen or had discounted. They will also encounter one of the most generous and engaging letter-writers in the history of public policy. The reason for Friedman’s prescience was simple: he understood his opponents’ arguments better than they did themselves. He could sniff humbug and self-deception at a hundred paces: any subsequent shoot-out at high noon was almost a foregone conclusion.

Two episodes best illustrate the confrontations between Friedman and the collective delusions of his age: the Bretton Woods system of fixed exchange rates (1944–73) and the dream of a common European currency (1979–) which culminated with the euro (1999).

BRETTON WOODS

In the 1960s and early 1970s, Friedman out-debated those who promoted fixed exchange rates. Those who administered the crisis-prone Bretton Woods system considered a variety of reforms—but firmly and unanimously discarded at the outset the one Friedmanite reform that was subsequently implemented: flexible exchange rates.

Friedman perceptively observed that the debate over flexible exchange rates pitted private sector bankers with “unlimited faith in the ability of government bureaucrats” against academics with faith in private market outcomes. He found in his opponents only “bland faith” and a determination to avoid reality by discussing “a glittering gold man with only an occasional side glance at the reality it conceals. . . . I rubbed my eyes as I read all of this.” His opponents were setting up “a straw man, a scarecrow of shreds and patches to frighten children with.”

Simply put, Milton Friedman understood his opponents’ arguments better than they did themselves.

In a 1967 debate with Robert Roosa (a leading member of the Bretton Woods establishment), Friedman deferred to his opponent’s superior knowledge about day-to-day market operations but was incredulous when Roosa denied that a market in foreign exchange would actually exist without central authorities fixing rates. Roosa predicted that traders would not wish to be “crushed between the pressures generated by central bank giants in a free-for-all. . . . I am not trying to confront Professor Friedman with an organized strike of my fellow traders in the foreign exchange markets of the world . . . [but] there would surely . . . be no little recruiting problem in getting the trading desks capably manned for the launching of his system.”

Friedman interrupted: “Do you deny that the market will set a price?”

Roosa: “I deny that an actual market will exist.”

Friedman: “You deny that a market will exist in exchange?”

Roosa: “I do, yes.”

The Bretton Woods system broke down in 1971, and in 1973 was replaced by the system that its policemen believed could not exist.

Milton and Rose Friedman
Milton and Rose Friedman, lifelong partners, embrace in October 2006, just two months before Milton Friedman died. Rose Friedman was said to be the only person to best her husband in a debate.

Friedman jangled the nerves of those who patched up Bretton Woods. He mocked the “veterans” who undertook the “herculean” labor of restraining market forces, and sarcastically referred to the “grave problems” and “frantic scurrying of high government officials from capital to capital. . . . One of the major sources of the opposition to floating exchange rates [is that] the people engaged in these activities are important people and they are all persuaded that they are engaged in important activities.” With flexible exchange rates, the international jetsetters who “man the emergency phones . . . could be released to do some truly productive work.”

THE EURO

Henry Kissinger is reported to have said, “When I want to consult with Europe, what number do I call?” After the Second World War, Europe created a free-trade community to reap the economic benefits and also to reduce the risk of another war. Political aspirations were tacked on: a single foreign policy to rival the voice of America. A single currency appeared to be the logical extension of a single telephone number—but Friedman saw the defective logic that underpinned the “irrational exuberance” of euro euphoria.

After 1945, the Germans became the “good Europeans.” Friedman played a role in this healing: in 1950 he was special representative attached to the Organization for European Economic Cooperation (later superseded by the Organization for Economic Cooperation and Development).

Immediate post-Nazi Germany left its mark on the Friedmans. Those members of Rose Friedman’s family who had not left their homeland “all died in the Holocaust. We have never learned where or how,” she said. As Milton worked to rebuild Europe, Rose apprehensively guarded their two children: “Of course I knew there were no Nazis in the park, but somehow there was always in my subconsciousness those terrible stories about what happened to Jewish children during the Nazi era. That trip to Germany haunted me for many years.”

Milton wrote to Don Patinkin: “on coming into Germany, Rose and I had a tremendous feeling of revulsion, the hatred of years came to the surface [and] we saw a Nazi in every German face. That softened a bit but did not disappear in a few days.”

In 1999 the euro was launched, and the Canadian economist Robert Mundell was awarded the Nobel Prize in Economic Sciences “for his analysis of monetary and fiscal policy under different exchange rate regimes and his analysis of optimum currency areas.” The Nobel press release went on to say, “Mundell’s research has had such a far-reaching and lasting impact because it combines formal—but still accessible—analysis, intuitive interpretation, and results with immediate policy applications. Above all, Mundell chose his problems with uncommon—almost prophetic—accuracy in terms of predicting the future development of international monetary arrangements and capital markets. . . . At a given point in time, academic achievements might appear rather esoteric; not long afterwards, however, they may take on great practical importance. Mundell’s analysis has also attracted attention in connection with the common European currency.”

The following year, in a debate with Milton Friedman, Mundell proclaimed that “the advent of the euro has demonstrated to one and all how successful a well-planned fixed exchange rate zone can be . . . a viable approach to the formation of other currency areas when prospective members can agree on a common inflation rate and a coordinated monetary policy.” Mundell extrapolated from political benefits (eliminating centuries of Franco-German rivalry, enhancing Europe’s voice and status on “the world political stage”) to economics: “On economic grounds alone I believe the case for the euro is overwhelming. . . . The locking of exchange rates has completely eliminated speculative capital movements within the euro area and put the hedge funds out of business in that sector. No one would dream of imposing ‘Tobin taxes’ on currency transactions within the euro area. The fixed exchange rate route to currency integration has been an outstanding success.”

Milton Friedman would not live to see the strains as the euro crisis unfolded: the revival of the political extremes with dubious attachments to democracy (including neo-Nazis) and the proposed remedy of a Tobin tax on financial transactions advocated by both German chancellor Angela Merkel and French president Nicolas Sarkozy. Nevertheless, in that debate Friedman punctured euro euphoria with the reminder that a pegged exchange rate was “a ticking bomb.”

“It involves each country’s giving up power over its internal monetary policy to an entity not under its political control,” he argued. “The real Achilles’ heel [for the euro] will prove to be political: that a system under which the political and currency boundaries do not match is bound to prove unstable.” Friedman illustrated this by reference to Canada and the United States: adding a common currency to a free trade arrangement would have led to worse outcomes.

Referring to Portugal, Ireland, and Spain (three of the five countries later to be dubbed PIIGS during the euro crisis), Friedman predicted that “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.”

He punctured euro euphoria with the reminder that a pegged exchange rate was “a ticking bomb.”

Friedman feared that “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.” The crucial unknown was whether the advertised restrictions on national fiscal policy “will be honored, and if they are not honored, whether the monetary community can enforce them. Those tests are yet to come.”

Twelve years later—and six years after his death—Milton Friedman’s predictive power has returned to haunt those whose economic analysis is blinded by prejudice and wishful thinking.


Robert Leeson was a W. Glenn Campbell and Rita Ricardo-Campbell National Fellow for 2006–2007 at the Hoover Institution.


Special to the Hoover Digest.