Markets to the Rescue

Milton Friedman

This selection first appeared in the Wall Street Journal on 13 October 1998. Milton Friedman is a senior research fellow of the Hoover Institution at Stanford University and a recipient of the Nobel Prize in economics.

The air is rife with proposals to reform the International Monetary Fund, increase its funds, and create new international agencies to help guide global financial markets. Indeed, Congress and the Clinton administration spent much of the last week’s budget negotiations fine-tuning the details of the United States’ latest $18 billion IMF subvention package. Such talk is on a par with the advice to the inebriate that the cure for a hangover is the hair of the dog that bit him. As George Shultz, William Simon, and Walter Wriston wrote on this page in February: “The IMF is ineffective, unnecessary, and obsolete. We do not need another IMF. . . . Once the Asian crisis is over, we should abolish the one we have.” Centralized planning works no better on the global than on the national level.

The IMF was established at Bretton Woods in 1944 to serve one purpose and one purpose only: to supervise the operation of the system of fixed exchange rates also established at Bretton Woods. That system collapsed on 15 August 1971, when President Nixon, as part of a package of economic changes including wage and price ceilings, “closed the gold window”–that is, refused to continue the commitment the United States had undertaken at Bretton Woods to buy and sell gold at $35 an ounce. The IMF lost its only function and should have closed shop.

International Agencies

But few things are so permanent as government agencies, including international agencies. The IMF, sitting on a pile of funds, sought and found a new function: serving as an economic consulting agency to countries in trouble–an agency that was unusual in that it offered money instead of charging fees. It found plenty of clients, even though its advice was not always good and, even when good, was not always followed. However, its availability, and the funds it brought, encouraged country after country to continue with unwise and unsustainable policies longer than they otherwise would have or could have. Russia is the latest example. The end result has been more rather than less financial instability.

The Mexican crisis in 1994-95 produced a quantum jump in the scale of the IMF’s activity. Mexico, it is said, was “bailed out” by a $50 billion financial aid package from a consortium including the IMF, the United States, other countries, and other international agencies. In reality Mexico was not bailed out. Foreign entities–banks and other financial institutions–that had made dollar loans to Mexico that Mexico could not repay were bailed out. The internal recession that followed the bailout was deep and long; it left the ordinary Mexican citizen facing higher prices for goods and services with a sharply reduced income. That remains true today.

The Mexican bailout helped fuel the East Asian crisis that erupted two years later. It encouraged individuals and financial institutions to lend to and invest in the East Asian countries, drawn by high domestic interest rates and returns on investment, and reassured about currency risk by the belief that the IMF would bail them out if the unexpected happened and the exchange pegs broke. This effect has come to be called “moral hazard,” though I regard that as something of a libel. If someone offers you a gift, is it immoral for you to accept it? Similarly, it’s hard to blame private lenders for accepting the IMF’s implicit offer of insurance against currency risk. However, I do blame the IMF for offering the gift. And I blame the United States and other countries that are members of the IMF for allowing taxpayer money to be used to subsidize private banks and other financial institutions.

Seventy-five years ago, John Maynard Keynes pointed out that, “if the external price level is unstable, we cannot keep both our own price level and our exchanges stable. And we are compelled to choose.” When Keynes wrote, he could take free capital movement for granted. The introduction of exchange controls by Hjalmar Schacht in the 1930s converted Keynes’s dilemma into a trilemma. Of the three objectives–free capital movement, a fixed exchange rate, independent domestic monetary policy–any two, but not all three, are viable. We are compelled to choose.

The attempt by South Korea, Thailand, Malaysia, and Indonesia to have all three–with the encouragement of the IMF–has produced the external financial crisis that has pummeled those countries and spread concern around the world, just as similar attempts produced financial crises in Britain in 1967, in Chile in the early 1980s, in Mexico in 1995, and in many other cases.

Some economists, notably Paul Krugman and Joseph Stiglitz, have suggested resolving the trilemma by abandoning free capital movement, and Malaysia has followed that course. In my view, that is the worst possible choice. Emerging countries need external capital, and particularly the discipline and knowledge that comes with it, to make the best use of their capacities. Moreover, there is a long history demonstrating that exchange controls are porous and that the attempt to enforce them invariably leads to corruption and an extension of government controls, hardly the way to generate healthy growth.

Either of the other alternatives seems to me far superior. One is to fix the exchange rate by adopting a common or unified currency, as the states of the United States and Panama (whose economy is dollarized) have done and as the participants in the euro propose to do, or by establishing a currency board, as Hong Kong and Argentina have done. The key element of this alternative is that there is only one central bank for the countries using the same currency: the European Central Bank for the euro countries; the Federal Reserve for the other countries.

Hong Kong and Argentina have retained the option of terminating their currency boards, changing the fixed rate, or introducing central bank features, as the Hong Kong Monetary Authority has done in a limited way. As a result, they are not immune to infection from foreign exchange crises originating elsewhere. Nonetheless, currency boards have a good record of surviving such crises intact. Those options have not been retained by California or Panama and will not be retained by the countries that adopt the euro as their sole currency.

Proponents of fixed exchange rates often fail to recognize that a truly fixed rate is fundamentally different from a pegged one. If Argentina has a balance of payments deficit–if dollar receipts from abroad are less than payments due abroad–the quantity of currency (high-powered or base money) automatically goes down. That brings pressure on the economy to reduce foreign payments and increase foreign receipts. The economy cannot evade the discipline of external transactions; it must adjust. Under the pegged system, by contrast, when Thailand had a balance of payments deficit, the Bank of Thailand did not have to reduce the quantity of high-powered money. It could evade the discipline of external transactions, at least for a time, by drawing on its dollar reserves or borrowing dollars from abroad to finance the deficit.

Such a pegged exchange-rate regime is a ticking bomb. It is never easy to know whether a deficit is transitory and will soon be reversed or is a precursor to further deficits. The temptation is always to hope for the best and avoid any action that would tend to depress the domestic economy. Such a policy can smooth over minor and temporary problems, but it lets minor problems that are not transitory accumulate. When that happens, the minor adjustments in exchange rates that would have cleared up the initial problem will no longer suffice. It now takes a major change. Moreover, at this stage, the direction of any likely change is clear to everyone–in the case of Thailand, a devaluation. A speculator who sold the Thai baht short could at worst lose commissions and interest on his capital since the peg meant that he could cover his short at the same price at which he sold it if the baht was not devalued. In contrast, a devaluation would bring large profits.

Many of those responsible for the East Asia crises have been unable to resist the temptation to blame speculators for their problems. In fact, their policies gave speculators a nearly one-way bet, and by taking that bet, the speculators conferred not harm but benefits. Would Thailand have benefited from being able to continue its unsustainable policies longer?

Capital controls and unified currencies are two ways out of the trilemma. The remaining option is to let exchange rates be determined in the market predominantly on the basis of private transactions. In a pure form, clean floating, the central bank does not intervene in the market to affect the exchange rate, though it or the government may engage in exchange transactions in the course of its other activities. In practice, dirty floating is more common: The central bank intervenes from time to time to affect the exchange rate but does not announce in advance any specific value that it will seek to maintain. That is the regime currently followed by the United States, Britain, Japan, and many other countries.

Floating Rate

Under a floating rate, there cannot be and never has been a foreign exchange crisis, though there may well be internal crises, as in Japan. The reason is simple: Changes in exchange rates absorb the pressures that would otherwise lead to crises in a regime that tried to peg the exchange rate while maintaining domestic monetary independence. The foreign exchange crisis that affected South Korea, Thailand, Malaysia, and Indonesia did not spill over to New Zealand or Australia because those countries had floating exchange rates.

As between the alternatives of a truly fixed exchange rate and a floating exchange rate, which one is preferable depends on the specific characteristics of the country involved. In particular, much depends on whether a given country has a major trading partner with a good record for stable monetary policy, thus providing a desirable currency with which to be linked. However, so long as a country chooses and adheres to one of the two regimes, it will be spared foreign exchange crises and there will be no role for an international agency to supplement the market. Perhaps that is the reason why the IMF has implicitly favored pegged exchange rates.

The present crisis is not the result of market failure. Rather, it is the result of governments intervening in or seeking to supersede the market, both internally via loans, subsidies, or taxes and other handicaps and externally via the IMF, the World Bank, and other international agencies. We do not need more powerful government agencies spending still more of the taxpayers’ money, with limited or nonexistent accountability. That would simply be throwing good money after bad. We need government, both within the nations and internationally, to get out of the way and let the market work. The more that people spend or lend their own money, and the less they spend or lend taxpayer money, the better.

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