Money Mischief_ Episodes in Monetary History - Milton Friedman [92]
The contrast between the behavior of Chile and that of Hong Kong is a somewhat blurred example of this phenomenon. The central bank of Chile understandably was unwilling or unable to undertake the drastic deflationary measures that would have been necessary to maintain the pegged rate of the peso in 1982. Similarly, Israel has had repeated devaluations since it pegged the shekel to the dollar in 1985 and to a basket of currencies in 1986. Hong Kong, on the other hand, had no such recourse after it unified its currency with the U.S. dollar in 1983. It adjusted to the further appreciation of its currency vis-a-vis non-U.S. currencies by permitting prices and wages to adjust. The example is blurred because most of the appreciation of the U.S. dollar occurred before Hong Kong unified its currency with the U.S. dollar.
Pegged exchange rates can be maintained for a time by governmentally arranged capital flows, by foreign exchange controls, or by restrictions on international trade. But there is ample evidence by now that these are at best temporary expedients and generally lead to the conversion of minor problems into major crises.
That was certainly the experience under Bretton Woods before 1971. Exchange rate changes were numerous and often massive. The system worked only so long as the United States followed a moderately noninflationary policy and remained passive with respect to capital movements and exchange controls imposed by other countries.
It has been equally true of the succession of monetary arrangements in the Common Market: the European Payments Union, the "snake," the current EMS. None of these arrangements has been able to avoid exchange crises and exchange rate changes, and several have simply broken down. The EMS has been working reasonably well because Germany has been willing to play the role that the United States played under Bretton Woods, of pursuing a moderately noninflationary policy and tolerating capital movements and foreign exchange controls imposed by other member countries. I suspect that EMS, too, will break down if Germany ever becomes unwilling to follow those policies, as it well may as a result of the unification of East and West Germany.
Many observers give the EMS credit for enabling its members, notably France, to reduce inflation in recent years. No doubt the French anti-inflationary policy did gain greater credibility from France's membership in the EMS, that is, from its tie to the relatively stable German mark. However, the decline in inflation was a worldwide phenomenon that was by no means limited to members of the EMS.
In my view, the explanation for the worldwide decline in inflation is linked to the end of Bretton Woods. That led to the adoption of a world monetary system that has no historical precedent. For the first time in the history of the world, so far as I know, all major currencies are pure fiat currencies—not as a temporary response to a crisis, as often occurred in the past in individual countries, but as a permanent system expected to last. The countries of the world have been sailing uncharted seas. It is understandable that in the first decade of that voyage all sorts of things might happen, and, in particular, a worldwide outburst of inflation did occur. That worldwide outburst of inflation discredited the simpleminded