Money Mischief_ Episodes in Monetary History - Milton Friedman [94]
Some four decades ago (in 1950), I spent some months as a consultant to the U.S. Marshall Plan agency, analyzing the plan for the Schuman Coal and Steel Community, the precursor to the Common Market. I concluded then that true economic unification in Europe, defined as a single relatively free market, was possible only in conjunction with a system of freely floating exchange rates. (I ruled out a unified currency on political grounds, if memory serves.)
Experience since then has only strengthened my confidence in that conclusion, while also making me far more skeptical that a system of freely floating exchange rates is politically feasible. Central banks will meddle—always, of course, with the best of intentions. Nonetheless›, even dirty floating exchange rates seem to me preferable to pegged rates, though not necessarily to a unified currency.
CHAPTER 10
Monetary Policy in a Fiat World
We saw in chapter 2 that a world monetary system has emerged that has no historical precedent: a system in which every major currency in the world is, directly or indirectly, on an irredeemable paper money standard—directly, if the exchange rate of the currency is flexible though possibly manipulated; indirectly, if the currency is unified with another fiat-based currency (for example, since 1983, the Hong Kong dollar). The ultimate consequences of this development are shrouded in uncertainty.
The system has emerged by bits and pieces since World War I. From then until 1971, much of the world was effectively on a dollar standard, while the United States, though ostensibly on a gold standard (except for a brief interval in 1933–34), actually was on a fiat standard combined with a government program for pegging the price of gold. The Bretton Woods agreement in the main simply ratified that situation, despite the lip service it paid to the role of gold and its provisions for changes in exchange rates.
In the United States, the gradual change in the monetary role of gold was marked by two major milestones: (1) prohibition of the private ownership of gold in 1933 and (2) the elimination of gold reserve requirements for Federal Reserve deposits in 1965 and Federal Reserve notes in 1968. President Nixon's closing of the gold window in 1971, which removed both the formal link between gold and the dollar and the pretense that the United States was on a gold standard, simply set the seal on an ongoing process. Stocks of gold listed on the books of central banks are a relic of a bygone era, though a slim possibility remains that at some future date they will again become more than that. The 1974 removal of the prohibition against private ownership of gold in the United States was, somewhat paradoxically, a tribute to the end of gold's monetary role.
President Nixon's action was precipitated by an inflationary surge in the United States in the 1960s. In turn, the end of the arrangements entered into at Bretton Woods helped to produce a continuation and acceleration of inflation during the 1970s, in both the United States and much of the rest of the world.
Irregular and highly variable inflation has stimulated interest in monetary reform. Inflation brought into sharp focus the poor performance of the monetary authorities, reinforcing and giving greater credence to the conclusions about prior policy that various scholars had reached (including Anna Schwartz and me in our Monetary History).
In addition, inflation in the United States produced a rise in nominal interest rates that converted the government's control, via Regulation Q, of the interest rates that banks could pay from a minor to a serious impediment to the effective clearing of credit markets. One response was the invention of money-market mutual funds as a way to enable small savers to benefit from high market interest rates. The money-market funds proved an entering wedge to financial innovation that forced the prompt relaxation and subsequent abandonment of control over the interest rates that banks could pay, as well as the loosening of