Milton Friedman and the Euro.

• Author: Martino, Antonio
• Position: Report

Milton Friedman did not like the euro. In early 1999 I wrote to him mentioning my daughter Erika's thesis and, in a letter dated March 127 1999, he wrote back:

Erika's thesis on "The Euro and the Dollar" is one of the subjects I have been maintaining a real interest in. As you know, I am very negative about the euro and I am very doubtful about how it will work out. However, I am less pessimistic about it now than I was earlier simply because I never expected that the various countries would display the kind of discipline that was required in order to qualify for the euro. The convergence in inflation rates, interest rates, and so on was greater and more rapid than I would have expected. I believe that the monetary-fiscal constitution adopted with the introduction of the European single currency is consistent with Friedman's intellectual legacy. Let me explain.

The ideas of Milton Friedman on money have been so largely spread and absorbed that it may appear trite to repeat them once again. But, since there still is a lot of misunderstanding on the issue, I may be forgiven for giving a summarized version of them.

Discretion versus Rules

In the field of money and public budgets, the market-liberal view, which stresses the need for impartial roles and constraints on the discretionary powers of government, has been contrasted with the Keynesian one, which viewed money and the public budget as instruments of short-run discretionary policy. (1)

For the better part of the last 50 years, the Keynesian view has been prevalent: only the accurate manipulations of monetary aggregates and especially of the public budget by the authorities in charge of economic policy could prevent the instability, the cyclical Fluctuations, and the crises that were typical of a capitalist system. It was up to economic policy--the enlightened action of government officials--to remedy the deficiencies of a market economy, and prevent stagnation, recession, and mass unemployment.

Today, the traditional liberal wisdom is vindicated: a growing number of economists support the need to take monetary policy decisions away from the discretion of monetary authorities, and entrust money to a monetary constitution, a set of impartial rules, aimed at providing that framework of stability without which markets cannot efficiently operate. Similar considerations apply to fiscal policy: a decreasing number of economists today believe that full employment, price stability, and economic growth can be achieved by the expert manipulation of budget deficits, while more and more economists of all persuasions have finally come to accept the need for a fiscal constitution--a set of rules making it impossible for governments to borrow their countries into bankruptcy.

The Keynesian ideas that inflation was the unavoidable price of economic growth, that there was a stable tradeoff between inflation and unemployment, that it was possible to reduce interest rates through monetary expansion, and that the time horizon for monetary policy decisions had to be dictated by the needs of short-term stabilization policies have 'all succumbed to the empirical evidence and the theoretical analyses of the last 30 years.

There is no evidence that economic growth inevitably involves price inflation. On the contrary, there are good reasons to believe that monetary instability hinders long-term projects and makes economic growth more difficult, as evidenced by the experience of a number of" Latin American countries.

The idea of a stable tradeoff between inflation and unemployment is thoroughly discredited: an unexpected acceleration of inflation may temporarily reduce unemployment below its "natural rate," but this effect is short-lived. Only an accelerating inflation could keep unemployment below its "natural rate," but even that unappetizing possibility is dubious. (2)

Manipulation of monetary aggregates can influence interest rates only temporarily: as soon as inflationary expectations catch up with reality, the Keynesian "liquidity effect" is replaced by the "Fisher effect," which will more than offset the initial impact of the unexpected change in monetary policy (Thornton 1988). Nominal interest rates tend to be higher, not lower, when monetary policy is loose.

As for stabilization policies, it is now largely (though certainly not unanimously) agreed that our insufficient knowledge, unreliable short-ran macroeconomic forecasts, and variable time lags in the impact of monetary policy decisions, make it likely that policies aimed at stabilizing the economy in the short run may end up being pro-cyclical rather than anti-cyclical. Attempts at "fine-tuning" the economy often result in additional, avoidable instability. Consequently, "Monetarists ... favor stable policy roles that reduce variability and uncertainty for private decisionmakers. They argue that government serves the economy best by enhancing stability and acting predictably, not by trying to engineer carefully timed changes in policy actions which are frequently destabilizing" (Meltzer 1991: 31). (3) In a sense, the monetary-fiscal constitution embedded in the euro reflects the change in the...