Recent currency crises in Lebanon, Turkey, and Argentina have once again brought to the fore the question of the optimal exchange rate regime in an emerging country. Almost 70 years ago, Milton Friedman published “The case for flexible exchange rates” (Friedman 1953). In it he argued that a system of ‘pegged but adjustable’ parities was highly unstable and made a strong pitch for flexible exchange rates regimes. The paper, however, dealt exclusively with developed countries; it didn’t cover poor or middle-income nations. While today almost every advanced nation has a flexible interest rate regime similar to the one advocated by Friedman, most emerging countries continue to have ‘conventional peg’ (IMF 2019).
An important question to clarify is what Friedman’s views on currency and monetary regimes in developing countries were. In a 1973 Congressional testimony, Friedman said: “[w]hile I have long been in favor of a system of floating exchange rates for the major countries, I have never argued that that is necessarily also the best system for the developing countries.”
In a recent paper, I investigate the evolution of Friedman’s views on monetary and exchange rate regimes in poor and middle-income nations (Edwards 2020). More specifically, I analyse under what conditions he thought that flexible rates were the right system for developing countries, and when he thought that it was appropriate to have alternative regimes. Of course, for Friedman the exchange rate and monetary regimes were two sides of the same question. If a country opted for a strict monetary rule, it had to have a flexible exchange rate. Under a fixed exchange rate (and free capital mobility) the quantity of money was endogenous (Friedman 1948).
Milton Friedman in India: 1955 and 1963
In 1955, Milton Friedman traveled to India to advise the Nehru government. He prepared a short memorandum that covered, among other things, the exchange rate issue. At the time, foreign exchange was rationed and allocated in a discretionary fashion. Friedman wrote that there were only two ways to deal with external imbalances: “First, to inflate or deflate internally in response to a putative surplus or deficit in the balance of payments; second, to permit the exchange rate to fluctuate… [a method] that has been adopted by Canada with such conspicuous success” (Friedman 1955). He added that if a completely free float was ruled out (for political reasons), an auction system was a solid second-best solution. This would allow “purchasers to use it for anything they wish and in any currency area they wish.”
Friedman returned to India in 1965. This time he was particularly critical of the Bretton Woods’ pegged-but-adjustable regime. A mere devaluation, he stated, was not a solution in a country with chronic inflation. In a lecture delivered in Mumbai he said: “The temptation will be to change its [the rupee’s] value from its present level… and then try to hold it at the new fixed level. That would be another mistake. Even if the new exchange rates are correct when established, once you pegged them, there is no assurance that they will indefinitely remain correct” (Friedman 1968).
The ‘unified currency’ regime
In the early 1970s Milton Friedman’s views on currency regimes in emerging nations changed. From that point onward he believed that a flexible rate was a second-best solution. His preferred exchange rate arrangement was a currency board, or what he called a ‘unified currency’ regime. He spoke about it for the first time in 1972, when he delivered the Horowitz Lectures in Israel. These were published a year later as Money and Economic Development. This is Friedman’s only (major) work with the word “development’ in the title.
Halfway through the second Horowitz Lecture, Friedman explained in great detail what then became a key component in his views regarding currency and monetary regimes in developing countries (1973b). According to him, an alternative to a floating exchange rate – and almost always a preferred option – was a ‘unified currency’, or a regime where a poor country fixes its currency value irrevocably to that of an advanced nation. He pointed out that such a regime had served Hong Kong very well: “[Its] currency [is] closely linked to the British pound sterling. Through a Currency Board, printing paper currency requires the deposit of British currency in stated ratio”.
Friedman criticised, once more, the Bretton Woods system with its frequent and large devaluations. Further, he pointed out that in ‘pegged but adjustable’ regimes, when the exchange rate became out of line with its long run equilibrium value, most countries (including Israel and India) tended to adopt exchange controls, and, often, a very inefficient multiple exchange rate regime.
Friedman’s conclusion was simple and controversial: “I conclude that the only way to refrain from using inflation as a method of taxation is to avoid having a central bank” (1973). He then added: “The reason why I regard a floating rate as a second best for such a [developing] country is because it leaves a much larger scope for government intervention.”
During the Horowitz Lectures, Friedman also addressed the crawling peg. He thought that a system of ‘mini devaluations’ was a good pragmatic solution for an emerging country. He said: “The Brazilian [crawling peg] system is certainly an improvement over a system in which you keep the exchange rate pegged for long stretches of time… The Brazilian system seems to me better than no attempt to change exchange rates but less good than an exchange rate that changes more rapidly” (1973).
Exchange rates as nominal anchors: Chile and Israel
During the 1970s and 1980s, a number of countries relied on fixed exchange rates as a way of controlling very rapid inflation. Two of the best-known cases were Chile and Israel. What made these experiences interesting was their different outcomes: while Chile ended up in a major crisis in 1982, Israel was successful in stabilising the economy.
In 1994, Friedman published an article comparing both experiences. Friedman begins by pointing out that there was an element of luck: immediately after Chile fixed the exchange rate with respect to the US dollar in 1979, external conditions soured. The dollar strengthened in global markets, and the terms of trade turned against Chile. In contrast, when Israel fixed the value of the shekel in 1985, external shocks were favourable (a drop in the price of oil and a weakening of the dollar). An important difference between the two cases was that Israel devalued the shekel by 20% before fixing it relative to the dollar. By doing this, it built a ‘cushion’ for real appreciation to take place without generating overvaluation. Chile instead fixed the exchange rate rigidly at a time when the peso was already overvalued (in 1979). Further, while Israel instituted income policies that included a temporary wages and prices freeze, Chile put in place a backward-looking wage indexation system that, with declining inflation, resulted in automatic increases in real wages. Finally, Israel pegged the exchange rate to the US dollar as a temporary measure aimed at guiding expectations in the short run. After a few months the shekel was devalued “at irregular intervals to offset the difference between the roughly 20% inflation in Israel and the lower inflation in its trading partners” (Friedman 1994). Chile instead announced that the fixed rate would remain indefinitely, even in light of obvious overvaluation, and even if it still left the devaluation option open.
Towards the end of this article Friedman wrote: “The central bank of Chile was, understandably, unwilling or unable to undertake the drastic deflationary measures that would have been necessary to maintain the pegged rate of the peso in 1982” (1994). In his 1998 memoirs, he wrote: “I have consistently taken the position that a county like Chile with a central bank should let its currency float. The alternative is to abolish the central bank and unify its currency with that of its major trading partner” (Friedman 1998).
Friedman’s long-term influence on exchange rate regimes
Friedman’s views on exchange rate and monetary regimes were extremely influential in the advanced nations. In contrast, Friedman’s ideas have been much less influential among developing countries. In 2018, only 24 developing nations – most of them tiny islands – had what Friedman called a “unified currency regime”. According to the IMF (2019), in 2018 the most popular regime among emerging countries continued to be a conventional peg.
There are a number of possible explanations for the lack of unified currency regimes among developing nations. Perhaps the most important one is the absence of modern successful experiences that serve as examples of best practices. The failure of Argentina’s experiment with a currency board (between 1991 and 2001) generated great skepticism regarding the merits of super fixed regimes (Bluestein 2006, Edwards 2010). Many of the causes behind the collapse of the Argentine experiment were related to issues raised by Milton Friedman throughout the years. For example, in spite of implementing a currency board, the central bank was not abolished. Starting in 1995, it began to relax its operational rules, and credit was created with a reduced backing of hard currency. Fiscal policy was pro-cyclical, and deficits, mostly driven by provincial profligacy, grew significantly over time. In addition, wages were not flexible enough as to allow for relative price adjustments (or internal devaluation) when it was needed. After ten years of a fixed exchange rate at one peso per US dollar, the parity was abandoned in early 2002. By 2003, Argentina’s economy was in disarray and the reputation of monetary regimes based on unified currencies and currency boards suffered a severe blow.
Blustein, P (2006), And the Money Kept Rolling In (and Out) Wall Street, the IMF, and the Bankrupting of Argentina, Public Affairs.
Edwards, S (2010), Left Behind, University of Chicago Press
Edwards, S (2020), “Milton Friedman and Exchange rates in Emerging Countries,” NBER Working Paper 27975.
Friedman, M (1948a), “A monetary and fiscal framework for economic stability”, American Economic Review XXXVIII.
Friedman, M (1953), “The Case for Flexible Exchange Rates”, in M Friedman (ed), Essays in Positive Economics, University of Chicago Press, pp. 157-203.
Friedman, M (1955 ), “The India Memorandum”, in S Roy and W E James (eds) Foundations of India’s Political Economy: Towards an Agenda for the 1990s, Sage Publications.
Friedman, M (1963 ), “Inflation: Causes and Consequences” in M Friedman, “The Council for Economic Education, Asia, Bombay”, reprinted Dollars and deficits: inflation, monetary policy and the balance of payments, Prentice-Hall.
Friedman, M (1973a), Money and Economic Development: The Horowitz Lectures of 1972, Praeger Publishers.
Friedman, M (1973b), “Statement and Testimony”, in US Congress, Joint Economic Committee, Hearings before Subcommittee on International Economics, How Well are Fluctuating Exchange Rates Working?, pp. 114-120.
Friedman, M (1992), “Chile and Israel: Identical policies – Opposite outcomes”, in M Friedman (ed) Money Mischief: Episodes in Monetary History, Harcourt Brace Jovnovich.
Friedman, M and R D Friedman (1998) Two Lucky People. Memoirs, The University of Chicago Press.
IMF (2019) Annual report on exchange arrangements and exchange restrictions 2018, Washington DC.