Managed currency without definite, stable, legislative rules is one of the most dangerous forms of "planning." A free enterprise economy can function only within a legal framework of rules; and no part of that framework is more important than the rules which define the monetary system. In the past those rules have been empty and inadequate; but there is no tolerable solution to be found in resort to the wisdom (if "authorities." No liberal can contemplate with equanimity the prospect of an economy in which every investment and business venture is largely a speculation in the future actions of the Federal Reserve Board.
Henry C. Simons (1935: 558)
The institutional arrangements that constitute the global monetary system have long occupied center stage of discussions in international economics. For many years, the discussions focused on the choice of exchange rate regime, especially the relative merits of fixed and floating exchange rates. Beginning in the 1980s, however, the focus of the discussions shifted from arrangements among countries to the appropriate framework for national monetary policies. With the widespread acceptance of monetary rules by the majority of the profession, the debate has shifted to the evaluation of alternate rules--most notably, the comparison between those that involve a fixed exchange rate regime and those that involve only domestic goals. Our objective is to contribute to this debate.
We pivot our discussion around the work of Milton Friedman, whose views on the viability of alternative exchange rate regimes and on national monetary rules in many ways presaged modern thinking on these issues. In common with much of modern thinking, Friedman favored a combination of flexible exchange rates and a domestic monetary ride. As we will demonstrate, two key factors underpinned Friedman's views. First, in common with John Taylor (2017), Friedman believed that this particular combination would deliver superior economic performance, helping to avoid the major policy mistakes of the past produced by fixed exchange rate regimes cum discretionary monetary policies. Second, Friedman also thought that the combination of flexible exchange rates and a domestic monetary rule was more consistent with democratic principles than a regime based on fixed exchange rates and discretionary monetary policy. (1)
The remainder of this article is structured as follows. First, we provide an overview of the three major international fixed exchange rate systems that existed in the 20th century: the classical gold standard (1880-1913), the interwar gold exchange standard (1924-1936), and the Bretton Woods System (1944-1973). We show that Friedman concluded that the classical gold standard, whatever its virtues--and Friedman thought that its virtues had been exaggerated by its adherents--would not be sustainable in the world of the mid-20th century and after. The circumstances that rendered the gold standard unsustainable, he believed, also applied to other fixed exchange rate arrangements. Next, we discuss Friedman's views on flexible exchange rates and the reasons underpinning his advocacy of a domestic monetary policy rule. We then consider the case for a Taylor rule.
Fixed Exchange Rate Regimes
The basic case for fixed exchange rates is that fixed rates eliminate exchange rate uncertainty, which is alleged to impede international trade and investment. (2) Monetary historians have argued that the exchange rate stability of the period of the classical gold standard helped create a global trade boom and increased investors' confidence in faraway places, giving rise to unprecedented levels of capital exports (Gallarotti 1995, Morys 2014).
Classical Gold Standard, 1880-1913
The classical gold standard was a rules-based monetary policy regime. The basic rule for each monetary authority was the commitment to convert its domestic (paper) currency into a fixed quantity of gold at a fixed nominal price. This rule required the subordination of domestic policy considerations to the external, fixed gold price, constraint.
Under the gold standard, if a country faced a balance-of-payments deficit--for example, capital account inflows that were not sufficient to finance a current account deficit--it needed an adjustment mechanism to reverse the resulting outflow of gold (O'Rourke and Taylor 2013: 172). The gold standard mechanism was essentially automatic. It included a reduction of the domestic money supply--because the money stock was tied directly to the quantity of domestic gold holdings--and the consequent reduction of prices of domestic goods and services relative to those of foreign goods and services. The resulting depreciation of the real exchange rate would help restore external balance.
Modern monetary historians, citing the durability of the system, have a benign view of the workings of the classical gold standard, at least for the countries at the system's core (3) (Eichengreen 1992, O'Rourke and Taylor 2013, Bordo and Schenk 2017). Friedman's view was more nuanced. He believed that if an automatic gold standard were feasible, "It would provide an excellent solution to the liberal's dilemma: a stable monetary framework without the danger of the irresponsible exercise of monetary powers" (Friedman 1962a: 40-41). Nevertheless, he noted that "even during the so-called great days of the gold standard in the nineteenth century, when the Bank of England was supposedly running the gold standard skilfully ... it was a highly managed system" (p. 42). Underlying this circumstance was the fact that, historically, an automatic commodity system always tended to develop toward a mixed system, containing, in addition to the monetary commodity, fiduciary elements, such as bank notes and deposits, and government notes: "And once fiduciary elements have been introduced, it has proved difficult to avoid government control over them" (p. 41). For example, Friedman estimated that gold coins and gold certificates constituted only 10-20 percent of the money stock in the United States during the late 19th century (p. 42).
Friedman's assessment of the performance of the gold standard in die United States was as follows: "In retrospect, the system may seem to us to have worked reasonably well. To Americans of the time, it clearly did not" (p. 42). As an example, he pointed out that the "agitation" to monetize silver in the 1880s and 1890s, culminating in William Jennings Bryan's "Cross-of-Gold" speech during the 1896 presidential election "was one sign of dissatisfaction. In turn, the agitation was largely responsible for the [economically] depressed years of the early-1890s.... [The agitation] led to a flight from the dollar and a capital outflow that forced deflation at home" (pp. 42-43).
More importantly, Friedman did not believe that the gold standard, even if fully automatic, would be viable in the world of the mid 20th century and after. To the extent that the gold standard operated as intended, it did so because of special circumstances. First, the late 19th and early 20th centuries made up a world in which "the countries of the Western world placed much heavier emphasis on freedom from government interference at home ... than on domestic stability; thus they were willing to allow domestic economic policy to be dominated by the requirements of fixed exchange rates" (Friedman 1953: 166-67). Second, wages and prices were relatively flexible during the gold standard period (pp. 172-73). As a result, the adjustment toward balance-of-payment equilibrium could take place with relatively minor effects on domestic output and employment.
The world of the mid-20th century, Friedman observed, was very different from that of the gold standard period. The Great Depression of 1929 to 1933 encouraged the view that a capitalist economy is inherently unstable and that it is the government's responsibility to stabilize the economy. (4) As a result, the role of government in economic affairs expanded greatly, and the pursuit of full employment became the overriding goal of economic policy. The...