Friedman on FX Regimes

This article appeared in the April 2007 issue of Globe Asia.
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With the passing of MiltonFriedman last November,we lost one of the greatchampions of free markets.Friedman's obituaries andcommentaries on his life'swork and enormous influence have invariablymentioned his advocacy of floating exchangerates, leaving the impression that he always favoredfloating rates. This was not the case.

For Friedman, there were three distincttypes of exchange-rate regimes: floating, fixed,and pegged (see accompanying table), each withdifferent characteristics and different results.

Although floating and fixed rates appeardissimilar, they are members of the samefree-market family. Both operate without exchangecontrols and are free-market mechanismsfor balance-of-payments adjustments.With a floating rate, a central bank sets amonetary policy but has no exchange-ratepolicy—the exchange rate is on autopilot.In consequence, the monetary base is determineddomestically by a central bank. Witha fixed rate, there are two possibilities: eithera currency board sets the exchange rate, buthas no monetary policy—the money supplyis on autopilot—or a country is "dollarized"and uses a foreign currency as its own. Inconsequence, under a fixed-rate regime, acountry's monetary base is determined by thebalance of payments, moving in a one-to-onecorrespondence with changes in its foreignreserves. With both of these free-market,exchange-rate mechanisms, there cannot beconflicts between monetary and exchangeratepolicies, and balance-of-payments crisescannot rear their ugly heads. Indeed, underfloating- and fixed-rate regimes, market forcesact to automatically rebalance financial flowsand avert balance-of-payments crises.

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Fixed and pegged rates appear to be thesame. However, they are fundamentally different:pegged-rate systems often employexchange controls and are not free-marketmechanisms for international balance-of-paymentsadjustments. Pegged rates require acentral bank to manage both the exchange rateand monetary policy. With a pegged rate, themonetary base contains both domestic and foreign components. Unlike floating and fixed rates, pegged ratesinvariably result in conflicts between monetary and exchange-ratepolicies. For example, when capital inflows become "excessive" undera pegged system, a central bank often attempts to sterilize theensuing increase in the foreign component of the monetary base byselling bonds, reducing the domestic component of the base. Andwhen outflows become "excessive," a central bank attempts to offsetthe decrease in the foreign component of the base by buying bonds,increasing the domestic component of the monetary base. Balanceof-payments crises erupt as a central bank begins to offset more andmore of the reduction in the foreign component of the monetarybase with domestically created base money. When this occurs, it isonly a matter of time before currency speculators spot the contradictionsbetween exchange-rate and monetary policies (as they didin the Asian financial crisis of 1997-98) and force a devaluation orthe imposition of exchange controls.

There was more to Friedman than floating exchange rates, muchmore. His exchange-rate trichotomy makes this clear. As a matterof principle, Friedman favored both floating and fixed rates. Capitalflows freely, without controls, under these two free-market regimes.Friedman always rejected the pegged exchange-rate regime.

Friedman's actions—and he was a man of action—also demonstratethat his arsenal contained more than floating rates. In 1992,I co-authored a book, Monetary Reform for a Free Estonia, whichcarries the following dust jacket endorsement by Friedman: "A currencyboard such as that proposed by Hanke, Jonung and Schuleris an excellent system for a country in Estonia's position." Withinsix months, Estonia had dumped the Russian ruble and its currencyboard was exchanging kroon at a fixed rate of eight per Germanmark (subsequently 15.65 per euro). Since then, Estonia's GDP percapita has increased tenfold, a spectacular performance.

During the Asian crisis of 1997-98, Friedman again enteredthe fray. As former President Suharto's advisor, I proposed thatthe rupiah be fixed to the dollar via a currency board. Shortlythereafter, The Far Eastern Economic Review published "The Sayingsof Chairman Milton." His thoughts on a currency board forIndonesia were: "If the Indonesians would live by the discipline,it could be a good thing. What else can they do?" Well, theycould be forced by a U.S.-IMF lead phalanx to abandon the currencyboard idea, which is just what happened—with disastrouseconomic results.

Where did Friedman stand with regard to the world's showcasefree-market economy? He favored Hong Kong's fixed exchangerate: "The experience of Hong Kong clearly indicates that a particularcountry like Hong Kong does not need a central bank. Indeed ithas been very fortunate that it has not had one. The currency boardsystem that was introduced in 1983 has worked very well for HKand I believe it is desirable that it be continued."Contrary to popular belief, Milton Friedman favored bothfloating and fixed exchange rate regimes.