The case against a dollar policy.

• Author: Brittan, Samuel

Milton Friedman's classic "The Case for Flexible Exchange Rates" was published in 1953, but its inception dates back to 1950 when the author was a consultant to the U.S. Economic Cooperation Administration that was responsible for implementing the Marshall Plan. At that time, it was taken for granted that the Western nations were committed to a system of fixed exchange rates, except for periodic adjustments to new parities. Little did he know that in 1952 the British Treasury had proposed in a very pessimistic vein and as a result of gloomy and wrongheaded forebodings--that sterling should move to a floating rate.

The plan, known as "Robot," was defeated in the British Cabinet. The country had to wait until 1972 to move to floating and another 20 years--after it was forced out of the European Exchange Rate Mechanism--to learn how to operate economic policy under such a system. Internationally the big shift to floating dates to the early 1970s, between President Nixon's suspension of gold convertibility in 1971 and the collapse of the Smithsonian attempt to rebuild a fixed exchange rate system in 1973.

The fixed rate system broke down because of the inherent tensions between the goals of free multilateral trade, national freedom to determine monetary policy, and fixed exchange rates. It is fortunate that a fixed exchange rate regime was the element that gave way in the end. The main force for change was as usual the pressure of events. Insofar as there was an intellectual influence it was the coming together of a coalition of "sound money" economists who wanted to be free to run stable domestic policies and "expansionists" who wanted to experiment with a more rapid increase in domestic nominal demand.

A newcomer to the Friedman essay would have to read it backwards: in other words as an argument for keeping the present system and not moving back toward currency pegs or some hybrid such as target zones. The fundamental analysis, however, is unaffected. It is still true that there are only four ways in which pressures on international payments can be met: (1) counterbalancing changes in currency reserves, (2) adjustments in the internal level of prices and incomes, (3) direct controls over foreign exchange transactions, and (4) exchange rate adjustments. The heart of the argument is that the first three methods are either unworkable beyond certain limits, or harmful, or a mixture of both.

The one counterargument that Friedman told me privately that he found most difficult to answer was that a flexible exchange rate might remove a barrier to inflationary policies by governments that then believed that they were following advanced thinking. Indeed in the 1970s it looked as if this fear was vindicated. But as time went on inflationary policies became unfashionable through the demonstration that they were counterproductive in practice and did not promote growth and employment, but only that ugly condition known as stagflation. Since the late 1980s flexible exchange rates have been increasingly used as a safety valve to allow each monetary authority to pursue the goal of noninflationary growth in its own way.

Stability

When Friedman's essay appeared most of the controversy was over the contention that floating rates would prove stable. Indeed Friedman had to contend with another school of thought that agreed with him on the advantages of more exchange rate flexibility, but believed that exchange rate changes should be determined by governments at discrete intervals on the best available econometric evidence. This is something that many policymakers and economists still in their hearts believe.

How stable have flexible rates proved to be in practice? It is like the old question of how long is a piece of string? The case that floating rates would be stable was vastly oversold at least by European exponents of the system. It is fair to say that few of them anticipated the extent of overshooting and undershooting that developed.

Any judgment would have to set up as a counterfactual what might have happened if there had been discontinuous lump sum adjustments of the kind advocated by those who wanted a revived Bretton Woods. Any such study would also have to make a judgment on the likely feedback from this alternative exchange rate regime on monetary and trade policies and numerous other variables. As far as I know, no such study has been attempted and I suspect that the results would depend on the beliefs of those who organized it.

Optimal Currency Areas

The biggest omission from the Friedman essay was any discussion of the areas between which currencies should be allowed to float. The nearest he got to it was in discussing noncommittally whether the sterling area should break up or float as a unit against the rest of the world. There has of course been a huge, and in my view inconclusive, subsequent literature on optimal currency areas.

My own hunch, mainly derived from events in Europe, is that an optimal currency area in practice is one where nominal labor costs are subject to much the same forces. Optimists on the euro believed that its very existence would make for such harmonization. But so far events have not worked out that way. Germany, after a long delay and many years of unnecessary stagnation, is at long last adjusting its labor costs to the euro exchange rate--in Friedman's terminology getting up earlier in the morning as a substitute for daylight saving time. Italy however has not made such adjustments and is experiencing all the drawbacks of an overvalued currency without the safety valve of devaluation.

The Changing Problem

There is a more prosaic difference between the time when Friedman wrote his essay and the present. The background to his writing was the balance-of-payments problems of many European countries, by which was meant current account deficits and ways of dealing with the downward currency pressures to which they gave rise. There is some discussion in the Friedman essay of surplus countries; but the big new development has been the combination of large current account deficits with relatively high exchange rates made possible by inward...