Beware the Funny Money

Friday, July 30, 1999

“The odds are against it!” laughed Milton Friedman, Nobel economics laureate and senior research fellow at the Hoover Institution, when we ended an interview (Hoover Digest, 1998, no. 2) by saying we’d see him again in 2002.

Hopefully not—Friedman, 86, has important things to say about what’s wrong and what’s right with the world’s economy. We jumped the gun, and dropped by his San Francisco apartment just before Friedman and Rose, his wife of sixty-one years, jetted off to Hong Kong for a Pacific cruise.

BRIMELOW Popular wisdom: Inflation is dead, and the thing to worry about is the next recession.

FRIEDMAN I see no sign of recession. I do see some possibility of more inflation. I think the Federal Reserve has been too expansionary, although there are some signs that’s tapering off.

We’re in a period like the 1960s, when no one paid any attention to the money supply. Then we got inflation. By the 1980s everyone was obsessed with the money supply. Now they’re forgetting again. And it will turn around and surprise them.

I hasten to add that commentators didn’t see any signs of most past recessions, either. I don’t think recessions come out of any inevitable internal process within the economy but from unexpected shocks. Part of the reason we’ve been doing so well in the last two or three years is that East Asia has done so badly. That has had the effect of lowering the cost of imports and making the United States a good place to invest. Well, East Asia is going to turn around. It may be the recovery of East Asia, not the opposite, that causes us problems.

Japan has the capacity to make a tremendous recovery. There’s nothing to prevent Japan, a year or two from now, from being in a boom. And Japan’s recovery could destabilize the U.S. economy by raising global interest rates.

BRIMELOW They do seem to be accepting your recommendation, espoused in our last talk, that they should print money.

FRIEDMAN Who knows? You hear so many contradictory stories about Japan. The mechanism of recovery is monetary expansion plus reform of their banking system. In the short run, nothing other than monetary expansion [will work]—that plus a reduction in the misdirected fiscal stimuli. Japan is wasting its capital assets by building public structures that have a negative rate of return.

BRIMELOW Essentially, this East Asian problem has been caused by governments mucking about with exchange rates?

FRIEDMAN Entirely, entirely. Note—no government in East Asia, or anywhere else, that had a floating exchange rate has had a foreign exchange crisis. Everybody refers to the problems of Indonesia, Malaysia, Korea. Nobody pays any attention to the fact that other countries in that area, like New Zealand and Australia, have been doing fine. And Japan has serious internal problems, but it doesn’t have a foreign exchange crisis.

The IMF deserves a great deal of the blame for the East Asian crisis. It was the existence of the IMF, and the perception, stimulated greatly by the Mexican episode, that the IMF would bail out foreign lenders, that played a large part in the excessive flow of funds to East Asia.

And the IMF also played an important part in those countries’ adopting pegged exchange rates. There are only three types of exchange rate regimes. Really fixed, unified exchange rates—Hong Kong, Argentina, Panama versus the U.S. dollar. Really flexible exchange rates—New Zealand, Australia, Japan. Pegged exchange rates—Thailand, Indonesia, Malaysia before the East Asian breakdown.

Now, in a world of truly fixed exchange rates, there’s nothing for the International Monetary Fund to do. The market handles things.

It’s not an accident, therefore, that the IMF has tended to favor pegged exchange rate regimes. And those pegged exchange rate regimes cause the trouble. If there had been no IMF, there’d have been no East Asian crisis.

BRIMELOW People say, look, the Mexican bailout was successful, the [U.S.] Treasury got its money back.

FRIEDMAN Mexico was a success? Ask the people in Mexico. Don’t ask the people at Morgan Guaranty. It was a success for the people who had loaned money to Mexico. But Mexican national product and average income are lower than they were ten years ago. Mexico has had a terrific recession. Mexico drained the internal economy to pay back these external debts. I don’t think the Mexican bailout was a success. I think it was a terrible failure.

So far as the United States is concerned, one of the most important reforms is to get rid of the Exchange Stabilization Fund. It’s sort of an innocuous agency—nobody knows very much about it—originally established in 1934 and financed by the paper gains on raising the price of gold, designed to stabilize foreign exchange markets. But it essentially enables the Treasury to make foreign policy.

BRIMELOW That’s how they bailed Mexico out.

FRIEDMAN Yeah, sure. Congress wouldn’t approve. But the president was able to do it on his own because of the Exchange Stabilization Fund.

BRIMELOW In Canada there’s a flurry of interest in going wholly onto the U.S. dollar. [Some economists are promoting] dollarization for countries like Argentina.

FRIEDMAN If I were an Argentinean, I’d be opposed! It means Argentina accepts U.S. monetary policy. It’s the same as the euro. Argentina would deny itself monetary tools. If U.S. monetary policy continues to be good, probably it’s desirable. On the other hand, can you count on that? Go back to 1981–82, when the U.S. dollar doubled. Chile, which was tied to the U.S. dollar, was thrown into a very deep depression. It took years to recover.

BRIMELOW The problem is not simply that the U.S. monetary authorities make mistakes but that their conditions are so different. How integrated are the Argentinean and American economies?

FRIEDMAN Not particularly. There’s a much better case for Canada.

As an economic matter, it makes sense. I’m not sure it makes sense as a political matter. Currency is a very important symbol of sovereignty. And it seems to me a nation, if it’s going to stay a nation, needs as many symbols of sovereignty as it can possibly have.

BRIMELOW What are the implications of dollarization for U.S. monetary policy?

FRIEDMAN A country like Argentina, trivial. Canada would be more serious. Now if you take my view of proper monetary policy, which is to get rid of the central bank and have a fixed rate of growth of high-powered money, then it doesn’t matter how many countries you have attached to it. The same thing would happen to all of them. But that’s not realistic. You’re going to have a central bank.

BRIMELOW Oh, really?

FRIEDMAN Yeah, I’m afraid so! [Laughs.] And the central bank is going to exercise discretionary policy because bureaucrats want to be important. So you have to look not only at the reports from the twelve Federal Reserve districts but also from the Bank of Canada and the Bank of Argentina. I’m not sure how you would fit those together, especially since you have no political responsibility for those countries.

Note—no government in East Asia, or anywhere else, that had a floating exchange rate has had a foreign exchange crisis. Japan has serious internal problems, but it doesn’t have a foreign exchange crisis.

BRIMELOW When we first talked in December 1988 you said that liberalism—in the American sense of big government—was dead. But it is taking a long time to lie down. Federal spending as a fraction of the economy is down from its peacetime peaks. But the federal tax take has never been higher.

FRIEDMAN Partly, government involvement has shifted from economic to social: pollution, aid to the disabled, and so on, combined with deregulation of airlines, telecommunications. Impressed by the latter, many people underestimate the importance of the former.

It’s incredible to me that the high-tech companies have been so shortsighted as to invite the government to pursue the Microsoft case. Aside from their legal costs, they’re going to end up with government regulations that will do far more harm to their bottom line than Microsoft could.

Beyond that, if there’s any empirical observation that is well founded, it’s that government will spend all the money that it collects—plus as much more as it can get away with.

This is a period of so-called surpluses—so-called because they’re being balanced by an increase in the unfunded debt of the government, with respect to Social Security, Medicare, and so on. But that’s enough, so far as government is concerned. We see all this pressure to spend the so-called surplus. I think that, unless we have major tax cuts that get rid of the surplus, the experience of having government spending decline as a fraction of income will very shortly disappear. If you expect tax receipts to grow more rapidly than the economy, then I think that government spending will catch up.

I believe that experience itself is a result of the accident of a Democratic president and a Republican House and Senate. As a result, while there’s no shortage of laws passed, there are no major programs. There’s been a gridlock. And that’s a good thing!

However, I think there is another phenomenon on the horizon that will be effective in keeping government spending and taxes in check. And that’s the Internet.


FRIEDMAN The states are losing millions of dollars of taxes on Internet sales. If they start to collect taxes, there’s nothing to prevent these sales being done in Bermuda or China or anywhere else in the world where the tax is lower. What’s missing at the moment is e-cash. But it’ll come. There’ll be a way in which you can transfer money to me without my knowing where it comes from, or your knowing where it goes to. How is the government going to collect taxes on it?

BRIMELOW They’ll think of something.

FRIEDMAN The people who operate on the Internet will be cleverer. Governments will not be able to succeed, just as they haven’t prevented tax evasion now.

BRIMELOW Now, what we’re talking about here is tax evasion, not just avoidance, but evasion. It requires a population that’s absolutely unwilling to comply with the law.

FRIEDMAN [Laughs.] What do you have?

BRIMELOW Well, actually the tax system does depend on people being relatively honest.

FRIEDMAN People are relatively honest. But it has eroded. The biggest erosion I’ve ever observed was in the case of Britain. I remember their attitude toward foreign exchange regulation at the end of World War II: As a matter of principle, even if they thought they wouldn’t get caught, they would abide by it. But today, the British are no more law obedient in respect to taxes than the Americans or anybody else.

As people’s stake in government goes down, they don’t want to pay taxes. Without withholding, it would be utterly impossible to collect the amount of taxes we do now.

BRIMELOW But isn’t there an issue of moral hazard if the population is forced into illegality? It raises the question of political legitimacy.

FRIEDMAN Well, for many years the only reason Italy did so well was the black market. brimelow But Italy is not a paragon of political stability. friedman No, it’s not. No, what I’m trying to say is that the Internet will force governments to become smaller. They’ll try to adapt by enforcing tax laws. But they will more fundamentally adapt by becoming smaller.

Peter Brimelow

James Glassman and Kevin Hassett of the American Enterprise Institute say that the Dow is too cheap at 11,000 because the risk premium for stocks—the extra return you get from holding them rather than bonds—is going to go away. That’s because the market is finally recognizing that stocks are not really riskier than bonds over the long term. It all sounds reminiscent of Yale professor Irving Fisher saying, in the autumn of 1929, that stocks were reaching a “permanently high plateau.”

Here are Friedman’s thoughts on risk premiums, irrational exuberance, and Internet stocks:

“Glassman and Hassett have a valid point, but they carry it too far. As it happens, one of Fisher’s explanations was identical: a lower-risk premium. And for the same reason: Bonds in the 1920s had been a much poorer and less stable investment than stocks; and we had learned how to maintain stable prices.

“Fisher’s exposition was extensive and sophisticated, and this was only one of sixteen points he made. He obviously did not think the Fed would behave as stupidly as it did [in contracting the money supply during the Depression].

“Glassman and Hassett are also overoptimistic about the future stability of the price level and the economy. I find it hard to justify what I take to be the market expectation of inflation for the next thirty years. If we look at the thirty-year security and compare the yield on that, which is now about 5.5 percent, with a long-term real interest rate, which is about 3 to 4 percent, we get an estimate that over the next thirty years inflation is going to be in the neighborhood of 1.5 to 2.0 percent.

“That’s extremely optimistic. Inflation is always in the wings because it’s the most tempting way for governments to raise money. I do not believe another Great Depression is in our foreseeable future. But greater inflation surely is.

“And even if all that is wrong, a phenomenon—the risk premium—that has been present for over a century is not going to disappear so fast.”

If you are going to be in the market anyway, should you own a fund that tries to beat it?

“It makes a great deal of sense for individuals to buy an index fund,” says Friedman. “It gives them diversification. On the other hand, if all owners of equities used index funds, there would be nothing to decide the prices of anything. It’s the people who don’t use index funds who are essentially setting the relative prices of different stocks. Now, the question I’m asking is: As you’ve got more equities being invested through index funds, what has been happening?

“You would think that the prices of the equities included in the index fund would go up relative to the equities that are not and that therefore there ought to be a market for a fund which uses only equities that are not in any index, because they ought to have the advantage that they have less of a markup.”

Interesting theory. If you want to try it out, sell your Vanguard Index 500 fund and buy the unpopular Extended Market Portfolio, which tracks the Wilshire index of 4,500 stocks that are not in the S&P 500 index.

Those web stocks are the most puzzling of all. Friedman: “—worth more than Barnes & Noble, with all its stores? It’s a bubble—part of the Internet bubble. But I thought that two years ago!”