Free‐market versus managed regimes. For Friedman, there are three distinct types of exchange‐rate regimes: floating, fixed, and pegged—each with different characteristics and different results (Table 1). Indeed, in his response to the opening question posed in an eight‐part debate on exchange rates with Robert Mundell, Friedman insisted that the dichotomy (floating or fixed) be replaced by a trichotomy (floating, fixed, or pegged).1 What Friedman meant by these terms differs from the meanings they are often given, and to understand Friedman’s thinking, one must understand the differences.
In Friedman’s sense, strictly fixed and floating rates are regimes in which the monetary authority is aiming for only one target at a time. Although floating and fixed rates appear dissimilar, they are members of the same freemarket family. Both operate without exchange controls and are free‐market mechanisms for balance‐of‐payment adjustments.
With a floating rate, a central bank sets a monetary policy but has no exchange‐rate policy—the exchange rate is on autopilot. In consequence, the monetary base is determined domestically by a central bank. With a fixed rate, or what Friedman often referred to as a unified currency, there are two possibilities: either a currency board sets the exchange rate, but has no monetary policy—the money supply is on autopilot—or a country is “dollarized” and uses a foreign currency as its own. In consequence, under a fixed‐rate regime, a country’s monetary base is determined by the balance of payments, moving in a one‐to‐one correspondence with changes in its foreign reserves.
With both of these free‐market exchange‐ rate mechanisms, there cannot be conflicts between monetary and exchange‐rate policies and balance‐ofpayments crises cannot rear their ugly heads. Floating‐ and fixed‐rate regimes are inherently equilibrium systems in which market forces act to automatically rebalance financial flows and avert balance‐of‐payments crises.
Friedman’s Foreign‐Exchange Trichotomy
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Pegged rates. Most economists use “fixed” and “pegged” as interchangeable or nearly interchangeable terms for exchange rates. Friedman, however, saw them as “superficially similar but basically very different exchange‐rate arrangements.“2 For him, pegged‐rate systems are those where the monetary authorities are aiming for more than one target at a time. They often employ exchange controls and are not free‐market mechanisms for international balance‐ of‐payments adjustments. Pegged exchange rates are inherently disequilibrium systems, lacking an automatic response mechanism to produce balance‐ of‐payments adjustments. Pegged rates require a central bank to manage both the exchange rate and monetary policy. With a pegged rate, the monetary base contains both domestic and foreign components.
Unlike floating and fixed rates, pegged rates invariably result in conflicts between monetary and exchange rate policies. For example, when capital inflows become “excessive” under a pegged system, a central bank often attempts to sterilize the ensuing increase in the foreign component of the monetary base by selling bonds, reducing the domestic component of the base. And when outflows become “excessive,” a central bank attempts to offset the decrease in the foreign component of the base by buying bonds, increasing the domestic component of the base.
Balance‐of‐payments crises erupt as a central bank begins to offset more and more of the reduction in the foreign component of the monetary base with domestically created base money. When this occurs, it is only a matter of time before currency speculators spot the contradictions between exchange‐rate and monetary policies (as they did in the Asian financial crisis of 1997–98) and force a devaluation, the imposition of exchange controls, or both.
When Friedman first distinguished among fixed, pegged, and floating rates, fluctuating exchange rates were rare, and in fact the International Monetary Fund discouraged them. By the 1990s, many countries were practicing what is often termed managed floating, in which the monetary authority does not promise to maintain any particular level of the exchange rate, but intervenes from time to time to influence the rate. Despite having a fluctuating rate, managed floating falls under what Friedman termed pegged exchange rates, because the monetary authority is aiming at more than one target at a time. Perhaps today it would be better to use the term “intermediate” to describe the gamut of arrangements between a Friedman‐style fix and a Friedmanstyle float. What Friedman meant by a floating rate is what is now usually called a clean float, to distinguish it from a managed float.3
An advocate of both fixed and floating rates. Contrary to what most people think, Friedman was not simply an advocate of floating exchange rates. His exchange rate trichotomy makes this clear. As a matter of principle, Friedman favored both floating and fixed rates, and rejected pegged rates as “worse than either extreme.“4
Friedman, however, laid great stress on the fact that a fixed exchange rate administered by a central bank is dangerous. There is always the potential for a central bank to engage in discretionary monetary policy and to break the one‐to‐one link between changes in foreign reserves and changes in the money supply.
For example, after Argentina passed its Convertibility Law in April 1991, Friedman insisted that Argentina’s central bank was the Achilles’ heel of convertibility. He didn’t trust the central bank. Even though the system worked perfectly well for years, Friedman thought that the central bank would eventually adopt a discretionary monetary policy and convertibility would get into trouble. He was later proved right: Argentina’s central bank simultaneously attempted to maintain a rigid exchange rate and engaged in an active monetary policy. This culminated in a balance‐of‐payments crisis, exchange restrictions, the end of convertibility, and a peso devaluation in January 2002.5
Friedman’s first and most famous foray into the exchange‐rate debate was as much an attack on exchange controls and a case for free trade as anything else. He originally wrote “The Case for Flexible Exchange Rates“6 as a memorandum in 1950, when he served as a consultant to the U.S. agency administering the Marshall Plan. At the time European countries were imposing a plethora of controls on cross‐border flows of trade and capital. Friedman opposed these restrictions. He concluded that adopting floating exchange rates across Europe would remove the need for exchange controls and other distortionary policies that impeded economic freedom.
It is important to stress that economic freedom was also a primary motivator for Friedman’s advocacy of unified currency regimes for developing countries. He concluded: