Friedman vs Mundell

OPTIONS POLITIQUESMAI 2001

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ONE WORLD, ONE MONEY?

Creation of the euro, among other devel-opments, has increasingly focused atten-tion on the question of fixed exchangerates versus flexible exchange rates. Evenin Canada, seminars and conferenceshave been held exploring the subject.Would a global move toward fixedexchange rates, including currency blocs,be a good idea or not?

Milton Friedman: Discussion of thisissue requires replacing the dichotomyfixed or flexible by a trichotomy: 1. hard fixed (e.g., members of Euro,Panama, Argentine currency board);2. pegged by a national central bank(e.g., Bretton Woods, China currently);3. flexible (e.g., US, Canada, Britain,Japan, Euro currency union).

By now, there is widespread agree-ment that a global move to pegged rateregimes would be a bad idea. Everycurrency crisis has been connectedwith pegged rates. That was true mostrecently for the Mexican and EastAsian crisis, before that for the 1992and 1993 common market crises. Bycontrast, no country with a flexiblerate has ever experienced a foreignexchange crisis, though there may wellbe an internal crisis as in Japan.

The reasons why a peggedexchange rate is a ticking bomb arewell known. A central bank control-

ling a currency that comes underdownward pressure does not have toalter domestic monetary policy. It candraw upon reserves of foreign currencyor borrow foreign currency to meet theexcess demand for foreign currency.However, that recourse is limited bythe amount of foreign exchangereserves and borrowing capacity. It isnever easy to know whether a deficit istransitory and will soon be reversed oris a precursor to further deficits. Thetemptation is always to hope for thebest, and avoid any actions that woulddepress the domestic economy. Such apolicy can smooth over minor andtemporary problems, but lets minorproblems that are not transitory accu-mulate. When that happens the minoradjustments in exchange rates thatwould have cleared up the initial prob-lem will no longer suffice. It now takesa major change. Moreover, the direc-tion of that change is clear, offeringclose to a one-way bet to currencyspeculators, who perform the usefulfunction of forcing the central bank toaccept the inevitable sooner ratherthan later.

A hard fixed rate is a very differ-ent thing. My own view has long beenthat for a small country, to quote froma lecture that I gave in 1972, “the bestpolicy would be to eschew the rev-enue from money creation, to unifyits currency with the currency of alarge, relatively stable developed

country with which it has close eco-nomic relations, and to impose nobarriers to the movement of money orprices, wages, and interest rates. Sucha policy requires not having a centralbank.” [Milton Friedman, Money andEconomic Development, (Praeger,1973),p.59] Panama exemplifies this policy,which has since come to be called“dollarization.” A currency board is aslightly less rigid version of a hardfixed rate than dollarization. A furthermovement in this direction, creatingperhaps a number of currency blocsconsisting of a major country and anumber of much smaller countrieswith close economic ties to the majorcountry, may well occur and be agood thing.

The one really new development isthe euro, a transnational central bankissuing a common currency for itsmembers. There is no historical prece-dent for such an arrangement. Itinvolves each country’s giving up powerover its internal monetary policy to anentity not under its political control.Such a system has economic advantagesand disadvantages, but I believe that itsreal Achilles heel will prove to be politi-cal; that a system under which the polit-ical and currency boundaries do notmatch is bound to prove unstable. Inany event, I do not believe the euro willbe imitated until it has a chance todemonstrate its viability.

Robert Mundell: First of all, let me say

Robert Mundell and Milton Friedman debate thevirtues—or not—of fixed exchange rates, gold, and a world currency.

Robert Mundell et Milton Friedman débattent des vertus—ou des vices—des taux de change fixes, de l’étalon or et d’une monnaie mondiale.

1. Exchange rates:Fixed or flexible?

POLICY OPTIONSMAY 2001

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One world, one money?

that I feel honored to debate these issueswith Milton Friedman, a great econo-mist and from whom I have learned agreat deal over the past few decades.

Although there are real differencesbetween our positions on alternativeroutes to monetary stability, I am alsoconvinced that an important part ofthe differences reduce to linguisticproblems.

I can illustrate this by the use ofthe term “fixed” exchange rates. I usethe term “fixed exchange rates” tomean a process in which the centralbank fixes the price of foreignexchange (or gold, but that is not rel-evant in the current context) and letsthe money supply move in a direc-tion that keeps the balance of pay-ments in equilibrium. There is awhole spectrum of possibilitiesunderneath this term:

1. A common currency area. This isthe apotheosis of fixed exchange rates.The BC dollar, the Ontario dollar andthe Quebec dollar are the same curren-cies, the Canadian dollar. Settlementbetween regions, provinces andmunicipalities is automatic. If there isan excess supply of money in oneprovince combined with a correspon-ding excess demand for goods, theexcess money leaves that province (abalance of payments deficit) and thatcompletes the adjustment process. Thesame adjustment process appliesbetween New York and California orbetween different Federal Reserve dis-tricts. This fits Friedman’s category of“unified.”

2. A “dollarized” area. A good exam-ple is Panama. When a peninsula jut-ting out from the Republic of Columbiaseparated from it to become Panama in1904, the new republic signed a treatywith the United States committingitself not to create a paper currency.Panama’s own currency, the balboa, is acoin equivalent to the US dollar, butmost transactions are in US paper dol-lars; the balboa is “hard-fixed” to thedollar. With this system, Panama hashad the most stable currency in LatinAmerica, getting in effect the US infla-tion rate throughout the 20th century.

Other examples include San Marino,which uses the Italian lira, Monaco,which uses the French franc, andAndorra, which uses both the Frenchfranc and the Spanish peseta.

Similar arrangements exist in thesmall republics carved out of SouthAfrica, using the latter’s currency, therand. This also fits Friedman’s categoryof “unified.” Recent examples includeMontenegro (using the DM-to-become-the-euro) and Ecuador (usingthe dollar).

3. A monetary union. Belgium andLuxembourg have had a monetaryunion since the inter-war period.Luxembourg francs circulate side-by-side with Belgian francs but monetarypolicy is conducted by the dominant

partner, Belgium. Luxembourg’s role iscompletely passive; lacking a currencyto manipulate, Luxembourg has thelowest public debt—almost none—inthe European Union. A similar exam-ple is the Scottish pound which forcenturies since the Treaty of Union cir-culated side-by-side with the Britishpound. This fits Friedman’s category of“hard fixed.”

4. A currency board system. Underthis arrangement, a country has itsown currency, but it is completelybacked by a foreign currency to whichit is rigidly fixed. The money supplymoves in exactly the same way as ifthe country used the foreign currencyto which it is fixed. This fitsFriedman’s category of “hard fixed.”

Most currency board systems inthe real world differ in some respects

from each other and may not meetexactly all the qualifications. HongKong’s system is a good example (atleast until 1997, when the governmentestablished the Hong Kong MonetaryAuthority and threatened to introducediscretion into monetary policy).Argentina has had a partial currencyboard since 1991. Estonia (from 1992),Lithuania (from 1994), Bulgaria (from1997) and Bosnia and Herzegovina(from 1997) are other examples.

An interesting variant on the cur-rency board system is provided by theexample of the 13 CFA franc countriesin West and Equatorial Africa that wereformally French colonies. They hadcurrency board arrangements, theexchange rates on which, with respectto the French franc, were underwrittenor guaranteed by the French treasury.They altered the system somewhatwith a large devaluation in 1994, butthey are now fixed to the euro throughthe French franc.

5. Fixed rates. A looser form of fixedexchange rate system in which the mon-etary authority exercises some discretionwith respect to the use of domestic mon-etary operations but nevertheless allowsthe adjustment mechanism to work. Adeficit in the balance of paymentsrequires sales of foreign exchangereserves to keep the currency fromdepreciating, and this sale automaticallyreduces the money base of the financialsystem, setting in motion a decline inexpenditure that shifts demand awayfrom imports and exportable goods andcorrects the deficit. An analogousprocess occurs in the opposite directionto eliminate a surplus.

Recent examples of this kind offixed exchange rate system includeAustria and the Benelux countrieswhich, over most of the 1980s and1990s, kept their currencies crediblyfixed against the DM. Before 1971,under the Bretton Woods arrange-ments, the major countries, with thesingle exception of Canada, practicedthis system. Germany, Japan, Italyand Mexico, for example, were able tokeep fixed exchange rates in equilibri-um for most of the period between

Friedman [The euro’s] realAchilles heel will prove to bepolitical; that a system underwhich the political andcurrency boundaries do notmatch is bound to proveunstable. In any event, I donot believe the euro will beimitated until it has a chanceto demonstrate its viability.


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Milton Friedman et Robert Mundell

1950 and 1970. The gold standardsystem that prevailed before the FirstWorld War was precisely such a sys-tem with a considerable amount ofdiscretion on the part of centralbanks, but not enough to undermineconfidence in the parities.

6. Pegged exchange rates. The dis-tinction between fixed and peggedrates that I find useful refers to theadjustment mechanism. Under a fixedrate system, the adjustment mecha-nism is allowed to work and is per-ceived by the market to be allowed towork. Whereas under “pegged” rates or“adjustable peg” arrangements, thecentral bank pegs the exchange ratebut does not give any priority to main-taining equilibrium in the balance ofpayments. There is no real commit-ment of policy to maintaining the par-ity and it makes the currency a sittingduck for speculators.

Some countries that have peggedrates engage in sterilization operations.The Bank of England, for example,automatically buys government bondswhenever it sells foreign exchange toprevent the latter transaction fromreducing the reserves of the bankingsystem, and, conversely, it sells govern-ment bonds when it buys foreignexchange. This practice might havemade sense when it began in 1931, afterBritain went off gold and set up itsexchange equalization fund to manageits new floating arrangements, but theBank of England kept the system even

after Britain had returned to a fixed—ormore correctly, pegged—system. As aconsequence, Britain faced periodic bal-ance-of-payments crises over most ofthe post-war period.

I do not count “pegged butadjustable” rates among the categoryof fixed rates. But when economistsattack fixed rates they nearly alwaysfocus their attention on “peggedrates.” I have never nor ever wouldadvocate a general system of “pegged”rates. Pegged rate systems always breakdown. Monetary authorities may, as atemporary expedient, find peggedrates useful as a tactical weapon oversome phase of the business cycle, but itcannot and should not be elevatedinto a general system.

Where do Friedman and I differ inthis category? I can happily accept histerms “unified” or “hard fixed” for thefirst four arrangements outlinedabove, and we have no important dis-agreement on “pegged rates,” exceptpossibly their usefulness as a tempo-rary expedient. But there may be a realdifference between us in connectionwith the fifth category, which I callsimply “fixed rates” without excludingfrom that category unified or hardfixed. I believe that larger countriescan have a hard fix without establish-ing a currency board system or mone-tary union, and I would say that theBretton Woods arrangements provedthat, as did the gold standard in thepast, and as did the experience ofAustria and the Netherlands in theexchange rate mechanism of theEuropean Monetary System.

There are something like 178 cur-rencies in the world. A vast number ofthese smaller currencies have beenfloating and unstable. Most of thesmaller countries that have economiclinks to the dollar or euro areas wouldbe better off fixing their currencies inhard-fix fashion to one or the otherareas. But there are several countriesthat could also benefit from the stabil-ity that fixed rates can provide withoutgoing to the full extent of dollarizationor euroization or adopting a currencyboard. There are other routes to credi-

bility than currency boards.Milton Friedman: I appreciate Bob

Mundell’s kind comments. We havebeen friends for more than threedecades, during which I have benefitedgreatly from his writings and manydiscussions, as I am benefiting fromthis one.

Bob and I have no disagreementon the theory of international tradeand finance, as evident by my com-plete agreement with his taxonomy ofalternative exchange arrangements.We share and strongly support theview that policies about trade andfinance should have as their objectivethe maximum possible free trade ingoods and services and free movementof capital. We also agree that mainte-nance of a relatively stable price levelof final goods and services will gener-ally promote that objective.

In view of my answer to the firstquestion, I shall interpret the meaningof “fixed” as “hard fixed” or “unified.”The economic factors that country Ashould consider in deciding whetherto unify its currency with that of coun-try B are:

1. How extensive is trade between Aand B? The more extensive the tradethe larger the gain from the unifiedcurrency in the form of savings intransaction costs, and the smaller thecost from unnecessary adjustment tomonetary changes in B.

However, this item is not as simpleas it may appear. The adoption of aunified currency may have a major

Mundell I have never norever would advocate ageneral system of “pegged”rates. Pegged rate systemsalways break down.Monetary authorities may,as a temporary expedient,find pegged rates useful asa tactical weapon over somephase of the business cycle,but it cannot and shouldnot be elevated into ageneral system.

Friedman Bob and I have no disagreement on thetheory of internationaltrade and finance ... We share and stronglysupport the view thatpolicies about trade andfinance should have as theirobjective the maximumpossible free trade in goodsand services and freemovement of capital.


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effect on the amount of trade betweenA and B.

2. How flexible are wages and pricesin A?

3. How mobile are workers within Aand between A and B?

4. How mobile is capital within Aand between A and B? The more flexibleare wages and prices, the more mobileare workers and capital, the easier itwill be for country A to adapt to fac-tors that under a flexible rate wouldlead to changes in the exchange rate,usually described as asynchronousshocks that affect A and B differently.

5. An inevitably political question:How good is monetary policy in A; in B;and how good is it likely to be? In prac-tice, this is often the most importantquestion. Experience suggests that in asmall developing country an inde-pendent internal monetary policy islikely to be highly unstable, with occa-sional episodes of high inflation. Thereis every reason to believe that the mon-etary policy of the US, or Germany,now the euro, or Britain, howeverflawed from the large country’s ownpoint of view, will provide much morestability than the small country willproduce by itself. This has probablybeen the major factor that has ledcountries to consider or to adopt a cur-rency board or dollarization.

6. Another inevitably political ques-tion: What is the political relationbetween A and B? To cite two examples:

● Hong Kong, where items 1, 2,3 and 4 are all favorable to a unifiedcurrency with the US dollar. Item 5 isnot, since Hong Kong could have beencounted on to have as good a mone-tary policy as the US, whose past mon-etary policy leaves, to put it mildly,much to be desired. In practice, HongKong’s currency board has been highlysuccessful, despite a severe attack dur-ing the East Asian crisis.

● Argentina, where item 5 wasclearly the major reason for the adop-tion of a currency board tying theArgentine currency to the US dollar.Items 2, 3 and 4 are much lessfavourable than in Hong Kong. Limitedflexibility and mobility are likely to

subject the Argentine currency board torepeated tests. The resultant uncertain-ty and its effect on interest rates has ledArgentina to consider replacing the cur-rency board with dollarization.

Robert Mundell: The choicebetween fixed and flexible exchangerates is an oxymoron. The alternativesare incomparable. A fixed exchangerate system is a monetary rule. A flexi-ble exchange rate is the absence of thatparticular monetary rule and is consis-tent with price stability or anything atall, including hyperinflation. The realchoice is between a fixed exchangerate monetary rule and alternativemonetary rules such as inflation tar-geting or monetary targeting.

The choice between the threemonetary rules depends on several fac-tors, including the actual and desiredrate of inflation. Assuming a countrywants monetary stability, but is in astate of high inflation, it should adopta monetary rule because the high infla-tion rate is almost certainly due toexcess growth of the reserve base ofthe money supply (usually fiscaldeficits that have to be financed by thecentral banks).

At lower rates of inflation, saybelow 15-20 per cent per annum, it isbetter to shift to inflation targeting,which, at lower inflation rates is betterfor fine tuning because it is less sus-ceptible to variations in the moneymultiplier and income velocity, eventhough its implementation dependson forecasts of inflation to takeaccount of monetary lags.

At rates of inflation below, say,five per cent, a fixed exchange rate canbe the best monetary rule (but not, ofcourse, for all countries). Equilibriumunder fixed exchange rates means thatthe country’s money supply is directedby its balance of payments. When thebalance is in surplus, the money sup-ply expands and that increases expen-diture on goods and securities and thatcorrects its surplus. When the balanceof payments is in deficit, the moneysupply contracts and that decreasesexpenditure on goods and serves andcorrects its deficit. The country will

then get the inflation rate of the cur-rency area it is joining. This is howAustria and the Benelux countriesmaintained their equilibrium in theDM zone in the 1980s and 1990s, andit is how monetary policy works in theeuro zone.

A fixed exchange rate monetaryrule is not appropriate for all countriesat the present time. Big countries can-not fix to little countries. The UnitedStates, at present the world’s largestcurrency area, has no viable alterna-tive to inflation targeting. But a fixedexchange rate with the dollar is aviable alternative for countries likeCanada or Mexico and other LatinAmerican countries, and a fixedexchange rate with the euro is a viablealternative for several countries inCentral and Eastern Europe andAfrica.

A currency board system is a spe-cial case of a viable fixed exchange ratesystem. Under a pure currency boardsystem a country fixes its currency to aforeign currency, and purchases andsales of the foreign currency are auto-matically reflected in changes of themonetary base.

The choice of system thereforedepends on the current rate of infla-tion, the position of a country (is itnear a large and stable neighbour?)and its willingness to share the infla-tion rate of that area.

Mundell A fixed exchangerate monetary rule is notappropriate for all countriesat the present time ... But a fixed exchange ratewith the dollar is a viablealternative for countries likeCanada or Mexico and otherLatin American countries,and a fixed exchange ratewith the euro is a viablealternative for severalcountries in Central andEastern Europe and Africa.


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because they would participate in a cur-rency area that had global dimensions.Also, Canadians would have a stable pur-chasing power over a continental basketof goods and securities instead of themuch smaller local Canadian basket.

Another consideration for fixing isthe quality of monetary policy. TheUnited States has had some ups anddowns in the quality of its monetarypolicy, but by and large it has beensuperior to that of its North Americanneighbors. This greater stability isreflected in the exchange rates. InMexico, the peso was worth 8 cents formore than 22 years between 1954 and

1976. After Mexico abandoned its fixedexchange rate system in 1976, it lost itsmonetary stability, and suffered fromdebt and currency crises, from which ithas not even to this day recovered.

Canada had a dismal experiencewith floating exchange rates in the1950s and far from insulating itselffrom the US business cycle it duplicatedit with recessions in 1954 and 1957 andstagnation after that. The governmentthen decided to “talk the Canadian dol-lar down” from its high perch andimmediately got itself embroiled in thecurrency crisis of 1962, after which itkept the Canadian dollar fixed atUS92.5 cents. In 1970, however,Canada went back to floating and inthe 1970s the dollar was as high as

US$1.07. But the late 1970s saw toomuch inflation and the late 1980s toomuch deflation, and the end result wasthat the Canadian dollar is now hardlytwo-thirds of a US dollar. Over the longrun the United States has had a morestable monetary policy than Canada.

I have no important objections tothe factors Friedman includes on hislist. The more closely countries areintegrated, the more adjustment willbe facilitated. But the overriding crite-rion of a workable currency area is thatmember countries agree on the targetrate of inflation and are willing toaccept the arrangements for fixingexchange rates and deciding upon themonetary policy that will bring thecommon target rate of inflation about.

Milton Friedman: Where Bob and Isometimes disagree is about the bestway to achieve the objective that wejointly seek. Such disagreement reflectsdivergent judgements about (a) theempirical importance of shocks affect-ing different entities differentially; (b)the efficiency of present mechanismsother than exchange rate changes foradjusting to those shocks; (c) perhapsthe importance of such mechanisms;and (d) the political consequences of amonetary area that is not coterminouswith a political entity.

Bob’s comments on Canada’sexperience with floating exchangerates since 1970 offer an excellentexample of items (a), (b) and (c). Hewrites: “In 1970, however, Canadawent back to floating and in the 1970sthe dollar was as high as US$1.07. Butthe late 1970s saw too much inflationand the late 1980s too much deflation,and the end result was that theCanadian dollar is now hardly two-thirds of a US dollar.”

Over the 30 years from 1970 to2000, Canadian inflation has averagedabout 0.5 per cent a year higher thanUS inflation. That accounts for some-what more than half of the decline inthe Canadian dollar relative to the USdollar in the past 30 years. The impor-tant point for present purposes is theremaining nearly half of the decline inthe Canadian dollar.

Mundell Countries with aunified currency systemtrade a great deal morewith one another and areable to exploit the gainsfrom trade and thereforehave a higher standard ofliving. If Canada had thesame currency as the UnitedStates and a genuine freetrade area, Canadians wouldhave as high or higher astandard of living as theaverage American.

Robert Mundell: I would answer thequestion “What are the main econom-ic considerations whether a countryshould have fixed or flexible exchangerates?” differently.

Some countries don’t have anoption. The United States can’t fix itsdollar! To what would it fix? Big coun-tries can’t fix to little countries andexpect to get any stability out of it.

Smaller countries have an option.Canada has a GDP about 1/12 that ofthe United States, considerably smallerthan the GDP of California. IfCalifornia were a separate country, itwould elbow Canada out of the G-7.But if California were a separate coun-try, it couldn’t do better than to usethe US dollar, or, if it wanted to haveits own currency to nourish its feelingsof self-importance, it would be bestadvised to fix the Californian dollar tothe US dollar. Countries with a unifiedcurrency system trade a great dealmore with one another and are able toexploit the gains from trade and there-fore have a higher standard of living.

If Canada had the same currencyas the United States and a genuine freetrade area, Canadians would have ashigh or higher a standard of living asthe average American.

Two countries can have a com-mon currency or maintain fixedexchange rates, however, only if theyare willing to accept a common rate ofinflation. If inflation preferences dif-fer, they should have separate curren-cies and flexible exchange rates.

Other things equal—includinginflation rates—large currency areas aremore stable and more resistant toshocks than small currency areas. In amonetary union or fixed exchange ratearrangement between a large and asmall country, most of the gain goes tothe small country.

If for example, Canada and theUnited States fixed exchange ratesbetween their two dollars, Canadianswould gain much more than Americans

2. The C-dollar:Fix or float?


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That reflected different forcesaffecting the Canadian than the USeconomy. If the Canadian dollar hadbeen rigidly tied to the US dollar, thosedifferences would have requiredCanada to deflate relative to theUnited States, with unfortunate conse-quences for Canada that would havestrained, to put it mildly, the traderelations between the two countries,and have put strong pressure onCanada to devalue or float. In myopinion, Canada was better served bya flexible rate in those 30 years than itwould have been by a fixed rate.

I do not agree with Bob’s com-ment that “Over the long run theUnited States has had a more stablemonetary policy than Canada.” Ibelieve the reverse is true, certainly inthe 1930s, but also since 1970.

Robert Mundell: By a “better mone-tary policy” I mean less inflation, andMilton’s own data, that Canadianinflation has averaged 0.5 per cent ayear higher than the US confirms thatstatement.

But the situation is much worsefor Canada, because, in the later1970s, when the United States wasmoving into an inflationary period ofthree years of back-to-back two-digitinflation (1979-81), Canada wasallowing its dollar to depreciate, andthen, after the US had got, withReaganomics, its inflation rate downto four per cent, the Bank of Canadaannounced, in early 1987, a policy ofzero inflation, and this policy wasaccepted, or at least condoned by theCanadian government. But the Bankof Canada had no idea of what a zero-inflation equilibrium in Canadawould mean at a time when the UShad four per cent inflation, or if it did,its spokesmen never let the market orthe government know their ideas.Assuming equal growth rates inCanada and the US, an inflation dif-ferential of four per cent would meanthat Canadian wage rates would haveto rise by four percentage points lessthan US wages. It also meant thatCanadian bonds would have to yieldfour percentage points less than US

bonds, despite the fact that through-out Canadian history, Canadian yieldshave had to be higher, not lower, thanUS yields. The Canadian dollar thensoared from about US73 cents to overUS91 cents in 1990, only to begin itslong descent in the 1990s to a lowpoint (so far) of US62 cents. The epi-logue is that the Conservative Party,which presided over the fiasco, whichalmost broke up Canada, were all butwiped out in the next elections. Neversince the Federal Reserve let itself getdragged into the Great Depression inthe early 1930s has a central bankdone so much harm to its people!

There were two mistakes here.One was in the wisdom of the choiceof a goal of zero inflation at a timewhen its great neighbor to the southhad four per cent inflation. The prob-lem is expectations. Canadians andAmericans frequently listen to thesame television programs andCanadian and American predictionsget mixed up. Because there was noserious dialogue about the implicationof its policy between the Bank ofCanada and the Canadian public,expectations were not correctly adjust-ed and the Canadian economy took abath, with higher, not lower interestrates, and much higher, two-digitunemployment at a time when USunemployment was getting down

below five per cent. By and large, theCanadian public has never understoodthis episode in its history, and thenewly-formed Free Trade Area unfairlygot much of the blame.

I think Canada had a worse mon-etary policy than the United Statesover the past three decades because 1.its average inflation rate was higher, asMilton agrees; 2. Canadian monetarypolicy was more inflationary than theUS at a time when the latter was tooinflationary; and 3. Canadian mone-tary policy was more disinflationarythan the US at a time when the US hadbrought its inflation close to its con-sensus equilibrium. Only in the pastfew years could we say that Canadianpolicy was as good or better thanAmerican.

Had Canada fixed its dollar in the1970s at parity with the US dollar itwould have had less inflation than itdid in the 1970s and much less unem-ployment than it had in the 1980s —and it still would have had a viableConservative Party!”

Milton Friedman: I confess that Bobhas made a good case that I gave toomuch credit to Canada when I linked itsmonetary policy after 1970 with its poli-cy in the 1930s, when it clearly did havea better monetary policy than the US.

Combining Bob’s story aboutCanadian monetary policy with myown knowledge of US monetary policy,both countries had poor monetary poli-cies from 1970 to the late 1980s, andboth have had much better policythereafter. My main point, however,remains. The history of US monetarypolicy since the establishment of theFed has many more periods of poorthan of good policy. If I were aCanadian, I would not regard thatrecord as an adequate basis for commit-ting the country to US monetary poli-cy—dollarization with no escape hatch.

Part of the difficulty here and else-where is in the meaning of price sta-bility. The prices that are relevant toCanada are not necessarily the same asthose that are relevant to the UnitedStates, given the different compositionof both consumption and production.

Friedman If [over the last 30years] the Canadian dollarhad been rigidly tied to theUS dollar, those differenceswould have requiredCanada to deflate relative tothe United States, withunfortunate consequencesfor Canada that would havestrained, to put it mildly,the trade relations betweenthe two countries, and haveput strong pressure onCanada to devalue or float.


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The desirable monetary policy has asits objective stability of different priceindexes.

Robert Mundell: I don’t agree.Imagine for a moment that Canadaand the United States had a commoncurrency. They still have a quite differ-ent production mix, but quite a similarconsumption mix. Why wouldn’tCanadians want price stability over aNorth American basket rather thanjust the basket of products producedby BC, Alberta, Saskatchewan, etc.? Avery important concern is the value ofinvestments for social security, andhere, I think, the broadest possible bas-ket is best. Or suppose that BC had aseparate currency. Why would BritishColumbians want stability of theirincomes over a narrow BC basket, incontrast to a national basket or, better,a continental basket?”

Milton Friedman: There is no sim-ple answer to the definition of theprice level that it is desirable to stabi-lize. This is an issue that has beendebated for many decades. Should it bethe price level of the goods and servic-es that people on the average con-sume? Or that the economy produces?Or of the factors of productionemployed by the economy? Or of laborservices alone? There are advantagesand disadvantages to each. Whicheveris chosen, the index should be for theeconomic and political entity that isdoing the stabilizing.

Bob sets up a straw man when heasks “Why wouldn’t Canadians want

price stability over a North Americanbasket rather than just the basket ofproducts produced by BC, Alberta,Saskatchewan, etc.?” He is comparinga consumption index with a produc-tion index. If the index to be stabilizedis the consumption price level, it willinclude goods imported from abroad,weighted by their importance in localconsumption. That weight will not bethe same as the weight of those goodsin the US index. In addition, the pricemay not be the same, whether becauseof transportation costs or local tariffsor other reasons. In any case, the localweight and price are the ones relevantto the local consumer. Similarly, oneshould compare a production indexfor Canada with a production indexfor the US, not a consumption indexwith a production index.

Robert Mundell: The advent of the eurohas demonstrated to one and all howsuccessful a well-planned fixedexchange rate zone can be. After the 11currencies of the zone were locked tothe euro and to each other, even beforethe euro has been issued as a paper cur-rency or a coin, speculative capitalmovements between the lira and themark, the franc and the peseta, and allthe other currencies became a thing ofthe past. It ended uncertainty overexchange rates and destabilizing capi-tal movements. The 11 countries of theeuro zone are now getting a bettermonetary policy than they ever hadbefore. The creation of the euro zonetherefore suggests a viable approach tothe formation of other currency areaswhen prospective members can agreeon a common inflation rate and acoordinated monetary policy.

It is important at the outset, how-ever, to make a distinction between asingle-currency monetary union thatinvolves each country scrapping itsown currency, and a multiple-currencymonetary union, where the nation-states retain their own currency. The

former, which is the objective of theeuro-zone countries, involves a steptoward political integration that goesmuch beyond the latter approach.

Milton Friedman: My differencewith Bob which reflects what I earlierlabelled (d) is exemplified by my pes-simism and his optimism about theeuro. We agree that the euro has no his-torical precedent. I believe we alsoagree that its attainment was driven bypolitical, not economic, considera-tions, by the belief that it would con-tribute to greater political integration—the much heralded United States ofEurope—that would in turn renderimpossible the kind of wars whichEurope has suffered so much. Ifachieved, political integration wouldrender the monetary and political areascoterminous, the historical norm.

Will the euro contribute to politi-cal unity? Only, I believe, if it is eco-nomically successful; otherwise, it ismore likely to engender political strifethan political unity. And here, Ibelieve, is where Bob and I differ most.Ireland requires at the moment a verydifferent monetary policy than, say,Spain or Portugal. A flexible exchangerate would enable each of them to havethe appropriate monetary policy. Witha unified currency, they cannot. Thealternative adjustment mechanisms arechanges in internal prices and wages,movement of people and of capital.These are severely limited by differ-ences in culture and by extensive gov-ernment regulations, differing fromcountry to country. If the residual flex-ibility is enough, or if the existence ofthe euro induces a major increase inflexibility, the euro will prosper. If not,as I fear is likely to be the case, overtime, as the members of the euro expe-rience a flow of asynchronous shocks,economic difficulties will emerge.Different governments will be subjectto very different political pressures andthese are bound to create political con-flict, from which the European CentralBank cannot escape.

Robert Mundell: My own view aboutthe politics of the euro is that it willprovide a catalyst for increased political

Mundell After the elevencurrencies of the[euro] zonewere locked to the euro andto each other, even beforethe euro has been issued as a paper currency or acoin, speculative capitalmovements between the lira and the mark, the francand the peseta, and all theother currencies became athing of the past.

3. The euro revolution


17


integration in Europe, which, after twocenturies of a Franco-German rivalrythat has periodically engulfed theentire world, is highly desirable.Increased political integration wouldalso enhance Europe’s voice on theworld political stage and allow Europeto share some of the leadership role andburden of the United States. In my viewthere are few, if any, risks associatedwith an increased power position ofEurope in world affairs.

I do agree with Milton that thepolitical benefits will bear fruit only ifthe euro is also an economic success.But on economic grounds alone Ibelieve the case for the euro is over-whelming. The 11 countries of theeuro area have now a common capitalmarket instead of 11 different markets.The locking of exchange rates hascompletely eliminated speculativecapital movements within the euroarea and put the hedge funds out ofbusiness in that sector. No one woulddream of imposing “Tobin taxes” oncurrency transactions within the euroarea. The fixed exchange rate route tocurrency integration has been an out-standing success.

I also believe that every country inthe euro area is now getting a bettermoney than they had before. First ofall, the size of the euro area is vastlylarger than the size of any of the

national currency areas, and thataffords to each country a better insula-tion against shocks. The gains in thisrespect vary in inverse proportion tothe size of the country. The currenciesof small countries can get blown out ofthe water by speculative attacks.Germany may gain less proportionate-ly than the smaller countries, but theGermans now have, or will have whenthe transition is complete, a currencythat is three times larger than the markarea alone.

The biggest issue between Miltonand myself lies in the quality of themonetary policy. I believe that everycountry in Europe is getting a bettermonetary policy than it had before.This is, I think, obvious for countrieslike Italy, Spain and Portugal, which,before the euro area was formed, hadinterest rates several percentage pointsabove German rates. The convergenceof interest rates has brought greatgains to the capital markets and to thereduction of the interest burden of thepublic debt.

Milton Friedman: Two final com-ments. First, given that the euro hasbeen established, I hope that I amwrong and Bob is right that it willinduce its members to introduceenough freedom in internal prices andwages and encourage enough mobilityto prove my fears unjustified. It is inthe interest of Europe and Americathat it succeed. Second, flexible ratesare not a guarantee of sensible internalmonetary policy. A country can havebad internal monetary policy withfixed rates or with flexible rates. Whatflexible rates do is to make it possiblefor a country to have a good internalmonetary policy, regardless of the poli-cies followed by other countries.

Robert Mundell: I agree with bothMilton’s last comments, although Iwould put the conclusions a little dif-ferently. We both agree on the impor-tance of price flexibility. Exchange ratechanges can never be a substitute forthe vast number of changes in individ-ual prices that have to be made in anefficient market. But the possibility ofexchange rate changes has neverthe-

less deflected the attention of policymakers from the vastly more impor-tant subject of flexibility in all individ-ual markets. I believe that flexibility ofindividual prices will be fostered bythe euro area and that, with exchangerate changes ruled out, policy makerswill increasingly turn to deregulationand fewer controls.

I agree that a country is better offwith a national monetary policy if themonetary policy is likely to be betterthan that in the rest of the world, as itcould be if the rest of the world isunstable. Short of a monetary unionwith the euro and yen areas, theUnited States has no real alternativeto inflation targeting and a flexibleexchange rate.

But apart from the United States,most if not all countries would benefitfrom being part of a larger currencyarea, for reasons of economies of scale,cushioning against shocks, and a bettermonetary policy. Most of the 175-oddcurrencies in the world should be classi-fied as “junk” currencies, sources ofinstability rather than anchors of stabil-ity. Europe has been the pioneer in theprocess of forming a larger currencyarea, and I believe it is an example thatwill be increasingly imitated in the restof the world. It is even possible that theprocess could lead to a reformation ofthe international monetary system, aresult that would have the promise ofoptimizing the efficiency of our worldtrade and payments mechanism.

Friedman If the existence ofthe euro induces a majorincrease in flexibility, theeuro will prosper. If not, as Ifear is likely to be the case,over time, as the membersof the euro experience a flow of asynchronousshocks, economic difficultieswill emerge. Differentgovernments will be subject to very differentpolitical pressures and these are bound to createpolitical conflict.

Friedman Flexible rates arenot a guarantee of sensibleinternal monetary policy. A country can have badinternal monetary policywith fixed rates or withflexible rates. What flexiblerates do is to make itpossible for a country tohave a good internalmonetary policy, regardlessof the policies followed by other countries.


18


Could we consider a question of RobertMundell’s: “Does Ireland need a separatemonetary policy?” Why is Ireland betteroff as part of the euro zone, in view oflabour mobility, language and other polit-ical obstacles to economic adjustmentmentioned by Prof. Friedman?

Robert Mundell: There is, to besure, a widely-held view that everycountry needs a different monetarypolicy, and that a one-size-fits-all mon-etary policy won’t be efficient.Suppose, for example, that one coun-try, say Ireland, grows more rapidlythan another country. Does this meanthat Ireland should have a higherinterest rate in order to prevent infla-tion? I don’t believe that’s true at all.

Suppose for a moment we shift theexample to California within the UScurrency area. Suppose Californiagrows more rapidly than other stateswhile the Federal Reserve keeps mone-tary policy adjusted to maintain pricestability (zero to two per cent infla-tion) within the United States as awhole. More rapid growth inCalifornia just means that more of thenew money created by the Fed willfind its way into that state rather thaninto the slower-growing states. Interestrates in California should stay exactlyat the same level as they are in the restof the US monetary union.

Does this mean that California’sprice level has to move differentlythan the price levels in the otherstates? If all states measured inflationby an index of prices of a commonbasket of goods, inflation rates in thelong run would have to be the same.But the more rapid growth inCalifornia might put up the prices ofsome California-specific factors, likelabour, that may cause California’sprice index to rise more rapidly thanelsewhere. Money wages in Californiamight rise faster than elsewhere andthis would mean a rise in real wagerates expressed in terms of the com-

mon US basket. But why shouldn’tCalifornian workers participate in thegrowth and why should that be con-sidered inflation?

Ireland’s case is not basically dif-ferent. With more rapid growth inIreland than in the rest of the euroarea, wage rates grow more rapidlythan elsewhere and prices of non-trad-ed goods may rise relative to goods inthe rest of the euro area. Such changesin relative prices are frequently neces-sary, but they should never be con-fused with inflation, which is a mone-tary phenomenon.

Higher growth in a common cur-rency area does not, in fact, alwayslead to more rapid increases in theprice level. The effect on the pricelevel depends on the sector in whichproductivity growth takes place, giv-

ing rise to the need for changes in rel-ative prices. If the productivity growthis primarily in the (internationally-)traded goods industries, the prices ofthese goods have to fall relative to theprices of traded goods, and with fixedexchange rates, the prices of domesticgoods have to rise. If, on the otherhand, the productivity growth takesplace in the domestic goods indus-tries, the prices of domestic goodshave to fall.

It is true that an independentmonetary policy with a flexibleexchange rate could lead to apprecia-

tion of the Irish punt in the formercase, and depreciation in the lattercase, and that these exchange ratechanges would ameliorate the pricepressures. But there are severe limita-tions on this alternative:

1. Ireland’s real exchange rate mayhave to appreciate or depreciate by, sayfour per cent a year during the periodof high growth, but the flexibleexchange rate would not produce asmooth and steady appreciation.Volatility might make the punt fluctu-ate by several percentage points upand down more than is necessary, andthis unproductive volatility would leadto overshooting that would introducenew and spurious inflationary devel-opments. Expectations factors wouldlead to sympathetic overshooting ofinterest rates and false pricing.

2. Economic models, such as thetwo-sector model applied here, give adistorted and over-simplified picture ofthe real world. Instead of “traded” and“domestic” goods, there are dozens ofsuch types, each of which have differ-ent productivity experiences. Duringgrowth, some industries grow rapidly,others more slowly and some may evendecline as comparative advantages arelost. The dozens of necessary industry-specific price adjustments cannot beduplicated by the single variable of theexchange rate. With the punt tied tothe euro, Ireland can import the scarci-ty relationships of the vast euro area,without filtering these relationshipsthrough a fluctuating and volatileexchange rate.

3. The admittedly-higher infla-tion experienced by a fast-growingcountry within the euro area is miti-gated by the fact that inflationarypressures there will be recorded in theinflation rate of the euro area as awhole, and thus, other things equal,lead to a tighter monetary policy inthe whole area. (This argument ismore important the larger is theweight of the growing country’s goodsin the price indexes of the euro area,and would not therefore be of muchrelevance in the case of a low-weightcountry like Ireland.)

Mundell Most of the 175-odd currencies in the worldshould be classified as“junk” currencies, sources of instability rather thananchors of stability. Europe has been thepioneer in the process offorming a larger currencyarea, and I believe it is anexample that will beincreasingly imitated in the rest of the world.

4. Has fixing hurt theIrish economy?


19


4. Countries in the euro area haveto accept inflation differentials inso-far as the consumer price indexes onwhich they are based refer to differentbaskets of goods and services. In thesame way, New York, Louisiana andCalifornia can have different infla-tion rates. But what is relevant forpolicy purposes is the common infla-tion measure of the euro area, the so-called Harmonized Index ofConsumer Prices (HICP), produced byEurostat, the statistical arm of theEuropean Commission, that tries tomeasure a common basket of goods.The HICP index for Ireland will showless inflation than Ireland’s nationalindex of consumer prices, largelybecause of the rapid growth of Irishwages.

5. The increase in the inflationrate in Ireland has been due entirelyand perhaps not mainly to differentialproductivity growth. The fall of theeuro by 25-30 per cent must bear alarge share of the blame, Ireland,being on the northwest fringe ofEurope, having a much larger pass-through effect, by which the lowereuro affects Irish prices earlier, and toa larger degree, than the other mem-bers of the euro area.

6. It is not at all clear to me thatIrish workers and property ownerswould prefer to experience their high-er real incomes in the form of anappreciation of the punt rather thanan increase in prices denominated inpunts and euros. My guess is that theIrish workers like the rapid rises inwages and property values, and thatthe main complaints about the processcome from euro-skeptics!

7. By giving up its link to the euro,Ireland would lose its direct link to thenow vast euro-area capital market.

8. Foreign investment would shunIreland because it no longer wouldhave the same currency as theContinent. Producers’ profits could bewiped out by sudden and unpre-dictable exchange rate changes. TheUK example shows that the volatilepound in the past year has inducedseveral Japanese car makers to with-

draw their operations from the UK. 9. Ireland, a small country, would

find that the real burden of its taxationmoves up and down with a volatileexchange rate.

10. Ireland, for hundreds of years abackwater colony with a per capitaincome less than half that of the U.K.,has now outstripped it and that greatsuccess has been due primarily to a. entry into the EU; b. low tax ratesthat make foreign investment attrac-tive; and c. certainty about its mone-tary policy and exchange rate withother EMU members.

More rapid growth in a countryis not, in my view, a good argumentfor an independent monetary policy,nor, in practice, is the argumentabout asymmetrical shocks. Specificshocks and individual growth experi-

ences are inevitable in a world ofchange, but the exchange rate isalmost never the best form of adjust-ment. The exchange rate is a mone-tary variable that can change theprice level or inflation rate but can-not offset the effects of shocks due tochanges in the terms of trade, disas-ters like earthquakes, or large move-ments of population.

Milton Friedman: Consumer pricesin Ireland are currently rising atbetween 15 per cent and 20 per centper annum—more rapidly than in

other members of the euro becauseIreland’s rapid growth is generating abalance of payments surplus that isadding to its money supply. Wagesmust rise that rapidly just to keep pacewith inflation. They are rising morerapidly still because real wages are ris-ing as well. The rise in nominal wagesto offset inflation is pure noise thatestablishes misleading expectations inboth the wage recipients and theemployers. Adjustment to the currentrapid rise in productivity and theinevitable subsequent tapering offwould be easier if consumer priceswere stabler and the punt was appreci-ating relative to other currencies. Thatis what could be happening if Irelandhad its own currency and monetarypolicy.

To put this point in a very differ-ent way, Ireland’s membership in theeuro forces it to use some of its scarceinternal capital (the counterpart to itsbalance of payments surplus) to pur-chase additional euros. The additionaleuros that finance the higher con-sumer price level do not serve any pro-ductive function. On the contrary,they simply introduce irrelevant noise.If Ireland had its own monetary policy,the capital used to purchase additionaleuros would be available for internalinvestment.

What about Bob’s point thatcountries like Italy, Spain andPortugal gain from the convergenceof interest rates? They do, at least inthe first instance. But there is no freelunch. The extra capital that flowsinto those countries comes from acommon capital pool, which meansthat other countries will have to pay aslightly higher interest rate.Moreover, the interest rates that con-verge are the risk-free rates. Differentcountries will still pay different rates,depending on their credit quality. Themembers of the euro have acceptedrestrictions on their fiscal policy, butit remains to be seen whether theywill be honored, and if they are nothonored, whether the monetary com-munity can enforce them. Those testsare yet to come.

Friedman Adjustment to the current rapid rise inproductivity [in Ireland] and the inevitablesubsequent tapering offwould be easier if consumer prices werestabler and the punt wasappreciating relative toother currencies. That is what could behappening if Ireland had its own currency andmonetary policy.


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The Bretton Woods system of fixedexchange rates, created in 1944, wasdesigned to bring stability to currencymarkets. Major currencies were fixed tothe US dollar, which meant that othercountries essentially adopted US inflationrates. The system broke down in the early1970s. You have differing ideas about thesystem’s successes and failures.

Milton Friedman: Another exampleof a similar difference in judgement iswith respect to Bob’s comment, “Ibelieve that larger countries can have ahard fix without establishing a curren-cy board system or monetary union,and I would say that the BrettonWoods arrangements proved that.”Hardly. There were repeated revalua-tions and devaluations under theBretton Woods arrangement, and anumber of severe international crisesinvolving “larger countries.” HadBretton Woods behaved as well as Bobsuggests, it never would have collapsedas it did in the early 1970s.

Robert Mundell: I agree that theBretton Woods arrangements were notperfect, in large part because countriesdid not follow the rules of adjustment.The important reserve countries likeBritain and the United States automat-ically sterilized reserve losses, throw-

ing the burden of adjustment ontoother countries. But what was wrongwith the experience of large countrieslike Germany and Japan with fixedexchange rates coupled with a mone-tary policy that kept their balances ofpayments in equilibrium? Over thisperiod, which included Japan’s “sud-den economic rise” between 1955 andthe 1970s, Japan had the longest peri-od of two-digit growth in its or anyother country’s history.

Germany had its own “Erhard”miracle. Smaller countries like Italy,Austria and Mexico that had fixedexchange rates lasting over 20 years,enjoyed rapid growth, high employ-ment and the same price stability asthe United States. The period from1950 to 1970 was a great period in thehistory of most of Western Europeand Japan. The United States, encum-bered with punitive tax rates inherit-ed from the war, was less fortunate,yet even so, the period 1950 to 1973was better than the decade that fol-lowed it, despite the Korean andVietnam Wars.

Some countries did get into trou-ble. Countries that did not obey therules of a fixed exchange rate systemhad problems. Britain disobeyed therules with its automatic sterilization ofany change in reserves and its inter-mittent flirting with Keynesian poli-cies. Dozens of developing countries

had problems because they tried to usethe inflation tax as an instrument forfinancing economic development.Countries that break the economiclaws required for stability should anddid have problems. France had bigproblems in the 1950s, but after 1958got its balance-of-payments mecha-nism working again under the influ-ence of Jacques Rueff, General deGaulle’s economic adviser.

The Bretton Woods Arrangementsdid break down. But why? There weretwo main reasons. One was that theprice of gold, set by PresidentRoosevelt at $35 per ounce in 1934,had become obsolete, after the infla-tions of the Second World War, theKorean War and the Vietnam War. Allother prices had more than doubledand gold had become undervalued,creating speculation in its favour thatled to vast withdrawals by foreign cen-tral banks. For political reasons—thetwo biggest producers were SouthAfrica, with its noxious policy ofapartheid, and the Soviet Union, theenemy of the West in the Cold War,along with the fact that US credibilitywas at stake—the US rejected theBretton Woods solution provided forin the IMF Articles of Agreement, name-ly a universal reduction in the parvalue of currencies, putting up theprice of gold. So, after losing morethan half of its post-war gold stock,

THE CHICAGO SCHOOL IN THE 1960s

Rudi Dornbusch

Chicago in the 60s, no doubt, offeredone of the great times in economics;maybe Keynes was the center of a greatmoment in economics, but the time wehad in Chicago is hard to match. RobertMundell and Milton Friedman were verymuch at the centre of it, as were GeorgeStigler, Harry G. Johnson, Al Harbergerand more. There was the “oral tradi-tion” and there were the “workshops,”the formidable feeling for students andfaculty alike of a revolution in the mak-

ing. The great issue of the day was justhow the economy works and what rolegovernment must play, if any, and whatrole monetary policy must definitely notbe allowed to play. This is when Keynesdied—actually he was long dead bythen but his powerful ideas were fullythere and had just animated the greatKennedy-Johnson expansion—and theresulting inflation. Monetarism wasborn in the midst, and in reaction, tothe wave of inflation of the time. Thiswas when “Chicago Boys” were made, aderogatory term at the time but rather abrand name by now. Note Mexico’snew finance minister, Francisco Gil Diaz,another Chicago boy trained just in

those special years in the late 60s.Chicago economics was built on

two pillars: price theory and monetarytheory. Price theory was about resourceallocation, how markets work, how gov-ernment for good reasons (patronage orcapture by business interests) misallo-cates resources to create rents for them-selves or their clientele, how competi-tion tends to be the rule, how ultimate-ly all and everything revolves aroundincentives and economic responses,from crime and love to corruption andtrade restrictions. In Chicago, complexproblems had simple answers—easy tounderstand wrong answers, the ene-mies would say. >>

5. Why Bretton Woods failed


21


when important countries asked toconvert dollars into gold, the UnitedStates said no, and the gold windowwas closed.

The closing of the gold windowdid not have to break up the system.The other countries could have con-tinued to fix their currencies to thedollar. But there was a basic differencebetween the United States and Europeover the common rate of inflation.Partly to ease the financing of theVietnam War, the United States want-ed—and imposed on the rest of theworld—a higher rate of inflation thanwas optimal for Europe. It was a hardchoice for Europe: the EconomicCommunity had, since the HagueSummit in 1969, already set out on itspath to monetary union. Going on toflexible exchange rates would sacrificethe valuable convergence with oneanother their economies had achievedaround the fixed dollar. But, in theend, the countries floated, partlybecause they thought (mistakenly) itwould teach the US a lesson.

The breakdown of the BrettonWoods arrangements was thereforecaused by 1. the undervaluation of thegold anchor; and 2. a differencebetween the inflation objectives of theUnited States and Europe. But thebreakdown was by no means neces-sary. Had the US followed a tighterpolicy, not allowing its inflation rate

to increase in the late 1960s and early1970s, or if Europe had been willing toaccept a somewhat higher rate of infla-tion (but not nearly as high as theyhad after they floated!), the systemcould have been held together.

Beneath all this was a simmeringdispute between Europe and theUnited States, based on French resent-ment against the asymmetrical dollarsystem and the Vietnam War, the infla-tion tax involved in holding excessdollar reserves, and a power struggle inwhich Europe was trying to free itselffrom its “quasi-colonial” status withrespect to the United States.

Milton Friedman: In response to mybrief comment on Bretton Woods, BobMundell granted that “Some countriesdid get into trouble” and that “TheBretton Woods Arrangements didbreak down.” However, he ends upsaying, “Had the US followed a tighterpolicy, not allowing its inflation rateto increase in the late 1960s and early1970s, or if Europe had been willing toaccept a somewhat higher rate of infla-tion (but not nearly as high as theyhad after they floated!), the systemcould have been held together.”

His comment reminds me ofGottfried Haberler’s famous responseto a similar “if” statement: “If my aunthad wheels, she would be a bus.” Anyproposed policy—or past policy—mustbe judged in terms of how it will in

fact operate, not how it might operateunder ideal conditions. Bob’s excellentanalysis of the breakdown of BrettonWoods shows that the factors that ledto its demise were not accidentaldefects in the policies followed by thevarious countries, but important polit-ical and economic forces.

More important, the countriesacted in the way they did, a way thatproved fatal to Bretton Woods, in partbecause of the incentives BrettonWoods itself established. For example,take Bob comments, “Some countriesdid get into trouble. Countries that didnot obey the rules of a fixed exchangerate system had problems. Britain dis-obeyed the rules with its automaticsterilization of any change in reservesand its intermittent flirting withKeynesian policies. Dozens of develop-ing countries had problems because

The second pillar of the oral tradi-tion was monetary theory, a formidablysophisticated and deep excursion inwhy there is money, how it works andhow it can be destroyed. Anyone whosat through Friedman’s lecturesemerged with an altogether profoundrespect for the proposition that tinker-ing with the quality of money is pro-foundly destructive of economic lifeand, indeed, society. This is where peo-ple learnt that stable prices promotelong horizons, that monetary instabilitypromotes economic misallocation.

Even though the ideology waspatently free market economcs, politicswas really not to be seen. I might be

contradicted by those who note thatduring the 1968 campus riots, thedepartment continued lectures as if theoutside world had not stopped. Iremember vividly demonstrators enter-ing Friedman’s class only to be told thatthey were interfering with the freedomand choice to learn; moreover, not hav-ing registered they were not even freeto stay quietly. In hindsight amazingly,the protesters left and our insular cliquewent on experiencing the quantity the-ory of money.

Beyond the classes, with a formida-bly competitive and merciless decima-tion of class size, one proceeded to the“workshops” where the real action was.

Here students and faculty presentedtheir work in progress and submitted tothe unrelenting bombardment of theworkshop members. Yes, there weredouble standards; there was some kind-ness to students who made their firstattempts; there was no mercy at allamong the faculty; there was absolutelyno mercy for junior professors who wereplain beaten up. If they survived, therewas nothing more to shock them orthrow them off course.

Mundell and Friedman could nothave been more different. They contin-ue to be revered by their students butwith starkly different memories. Miltonone remembers for his >>

Mundell Had the USfollowed a tighter policy,not allowing its inflationrate to increase in the late1960s and early 1970s, or if Europe had been willingto accept a somewhathigher rate of inflation ...the system could have been held together.


22


they tried to use the inflation tax as aninstrument for financing economicdevelopment.” Agreed, but thesecountries were induced to behave asthey did because under a fixedexchange rate system, a country thatoverexpands can benefit by imposingcosts on the other members of the sys-tem. The initial gain to a country,developing or developed, fromexpanding its money supply is greaterif other countries in the system willaccept its currency, at least for a time,at an unchanging rate. Postponing theevil day is a strong incentive to anembattled politician. Bretton Woodscarried within it the seeds of its owndestruction.

I have long argued that a major

advantage of flexible exchange rates isthat they mean that a country willbear fully the benefits and the costs ofits own monetary policies. A mistakein monetary policy will not directlyaffect its trading partners—though, ofcourse, it will affect them indirectly asit reduces the attractiveness of the ini-tial country as a trading partner orlocus of investment. This feature isimportant economically, but it is alsoimportant politically, since it reducesthe occasion for political conflict.

Bob and my disagreement aboutthe euro is identical with our disagree-ment about Bretton Woods. The euroencompasses 11 politically independ-ent countries, differing in culture,resources and economic development,and subject to divergent influences.There are bound to develop amongthem differences about appropriatemonetary, fiscal and other policies.Flexible exchange rates offered a wayof adjusting to such differencesthrough the market without politicalconflict. The euro closes that possibili-ty. Bob is confident that other adjust-ment mechanisms will rapidly devel-op—greater internal flexibility inprices, regulations, and the like. I hopehe is right, but I fear he may not be. Ifhe turns out not to be, the euro willgenerate more political conflict, notpolitical unity.

At various times, both of you haveexpressed views on gold (or some othercommodity base) as a national or globalcurrency standard. What are your currentviews?

Robert Mundell: The gold and silverstandards of the past were means bywhich countries could share a com-mon currency (or metallic backing fora currency) without political integra-tion. The silver, gold and bimetallicstandards gave the world a kind ofmonetary unity even though theEuropean empires were frequently atloggerheads with one another. And itkept inflation within bounds, com-pletely in contrast with the paper cur-rency inflations of the 20th century.

Silver was gradually eased out ofthe system (for not very good reasons!)in the 1870s and gold became thedominant monetary metal. Whatkilled the gold standard? Charles Rist,the French economist and centralbanker, once said that “democracykilled the gold standard.” He meant bythis that democracy led to drasticallyinflated expectations of what govern-ment could do for people and led toincreased government spending andbudget deficits that often had to be

Friedman [Bob’s] commentreminds me of GottfriedHaberler’s famous responseto a similar “if” statement:“If my aunt had wheels, shewould be a bus.” Anyproposed policy—or pastpolicy—must be judged in terms of how it will infact operate, not how itmight operate under ideal conditions.

unbelievably baggy brown suits (fromEast Germany I surmise), his incisiveuncompromising mind and a sweetsmile going along with “what you reallymean to say ...” Bob Mundell, by con-trast favored a continental appearanceand demeanor, his Canadian back-ground notwithstanding. His mindlooked for paradigms and always it wasabout upstaging received wisdom, chal-lenging dogma, being the enfant terriblethat he still is. Friedman’s workshop wasmolded on his own principles of rulesand responsibilities, no exceptions.Everybody present had to present apaper, no spectators. Everybody had toread the paper ahead of time (i.e. therewas a paper) and discussion would pro-

ceed page by page. Friedman ruled, therest mostly trembled or slurped the bib-lical pronouncement. The internationalworkshop of Mundell and HarryJohnson was quite the opposite; oftenthere were no papers and even whenthere was something, Mundell’s tenden-cy for going off course to his latest ideaseasily penetrated; order was discour-aged, speculation was at a premium.Harry Johnson would carve little animalsfrom wood and occasionally pronounce,Mundell was unstoppable and Socratic.He never, never in the time I saw him inChicago answered any question otherthan with another question. He alwaysheld that what was already on paperwas too stale to look at or talk about,

what was just in the making was thechallenge. That was not easy for thepaper presenter. Mchael Mussa, proba-bly the most brilliant of the group andtoday chief economist at the IMF, cameclose to strangling Mundell (at least inhis mind). What did it do for us? Themost extraordinary learning experience,questioning established truth, learningto think through a proposition, gettinga view of the economy in our head withwhich to think on our feet.

Mundell and Friedman ran very dif-ferent schools. For Friedman open econ-omy was a short topic: flexibleexchange rates—fully flexible—and freetrade. What else was there to say? ForMundell it was, rightly, hard to >>

6. The Gold Standard


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financed by money creation. This wasan important insight, but I believe itdoes not put the finger on anotherproblem.

The other problem was thechange in the power configuration ofcountries. The gold standard was adecentralized monetary system thatcould work as long as it was not con-trolled by a single power. But with thecreation of the Federal Reserve Systemin 1913, a central bank for the econo-my that was already before the FirstWorld War several times larger thanany other economy, the future of thegold standard became dependent onthe policies of the Federal ReserveSystem. The United States killed thegold standard. I wrote about this inmore detail in my Nobel Prize Lecturepublished in the American EconomicReview in June, 2000 [available athttp://www.columbia.edu/~ram15/nobelLecture.html].

How can gold be used in the cur-rent system? If it were stable or couldbe made stable against commodities, itwould once again make a fine univer-sal unit of account and means of pay-ment for the world economy. But I amskeptical that governments wouldwant to reinstate a gold standard orthat they would not screw it up if itwere reinstated. So I would as an alter-native prefer that it became a non-gov-

ernmental unit of account and meansof payment for ordinary transactionsand the Internet. It would then serveas a check on inflationary govern-ments.

Milton Friedman: My views remainthose I expressed in 1962 in Capitalismand Freedom: “My conclusion is that anautomatic commodity standard is nei-ther a feasible nor a desirable solutionto the problem of establishing mone-tary arrangements for a free society. Itis not desirable because it wouldinvolve a large cost in the form ofresources used to produce the mone-tary commodity. It is not feasiblebecause the mythology and beliefsrequired to make it effective do notexist.” (p. 42)

In the 19th century, when gold orsilver standards or bimetallic standardswere common, governments werespending about 10 per cent of thenational income and exerting littlecontrol over the economy. The publictook for granted that gold or silver wasthe “real” money and were willing toaccept the costs of adjusting to inflowsor outflows of gold. The gold standardproduced long term relative stability inprices at the cost of a great deal ofshort term instability.

Whatever may be the verdict onthe gold standard for that period, thesituation is very different today.

Governments are spending 40 per centor more of the national income andare intervening extensively in theeconomy. The public now takes it forgranted that a central bank, not anamount of gold, is responsible for thequantity of money. No major countrywould tolerate the discipline of a real,effective gold standard.

For the United States, I have longbelieved that the policies of govern-ment storage of wheat and gold areequally illogical, and that the govern-ment should get out of the storagebusiness for both and for other com-modities as well. For gold, I have pro-posed that the government commititself to auctioning off one-fifth of itsstock in each of the next five years.

Mundell I am skeptical thatgovernments would want toreinstate a gold standard orthat they would not screw itup if it were reinstated. So I would as an alternativeprefer that it became a non-governmental unit of account and means of payment for ordinarytransactions and theInternet.

understand how Friedman could talkabout monetary policy in a closed econ-omy as if there were such a thing. As timewent on and the world moved to flexiblerates, Mundell increasingly favored fixedraes, monetary areas, a world money. Healways kew that fashions move in a circleso now his view is back to full chic.

Every so often there was a gladiatorevent, a workshop where for some rea-son faculty from different areas gottogether and got at each other. Mundellvs. Friedman were special events.Friedman obviously admired the sheercreativity of Mundell but would not lethim get by, sparks would fly. Mundellrecognized Friedman as an icon butunderstood that he could play the bad

boy with success. I remember theunspeakable from Mundell: “Milton, thetrouble with you is you lack commonsense”. Both won the argument, wecould not choose. But even so, each hadtheir cohort and the cohort would imi-tate the master in style and speech andmannerisms. It must have been peculiarfor anyone looking in, maybe that iswhy it was called the Chicago School.

And then there was the day whenMundell presented to a full-full househis new theory of the policy mix—mon-etary policy for price stability, fiscal poli-cy for supply-side growth. Suffice it tosay that this a very noisy afternoon.

In the Italian city of Siena thoseborn inside the city walls think them-

selves the true Sienese, born sulle pietre,unlike those from the surroundings,born sulla terra. Much the same goes forChicago economists; having vaguelyright-wing tendencies does not makefor not having been there and beingpart of a great experience. These wereformidable years for economics, theyhave changed the way our professiontoday thinks about money and theworld economy. Two Nobel laureateslater, with independent central banks,flexible exchange rates, low inflationand “new economics” what was donethere has helped change the world.

Rudi Dornbusch is Ford InternationalProfessor of Economics at MIT.


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You are both so close—but. The core dif-ferences, it seems, may be ultimatelypolitical rather than economic. Assumingsome form of price stability, the issue iswhether a country has political policies inplace—regarding capital markets, labour,taxation and regulatory regimes—thatwill allow it to adapt to economic changeand shocks. The Mundell view is that, inthe final analysis, countries must andultimately will see the benefits of adopt-ing internal market-based policy reformunder a fixed currency regime. TheFriedman view is that, for deep internalpolitical reasons, individual countriescannot be counted on to adhere to properinternal market policies, and so need flex-ible exchange rates to absorb the shocksof economic change.

Under the Mundell view, then, thelogical objective would be a global econo-my under one world currency. Under theFriedman view, the logical objectivewould be a global currency system basedon competing national currencies.

But the reasons are political ratherthan economic. Would you agree? Andwhere do you think this issue will bepolitically and economically in, say, 20years?

Milton Friedman: I do not agreethat the differences between Bob andme are primarily political. We differ inour judgement about the politicaleffects of the Euro, but that is not themain source of our disagreementabout floating versus hard-fixed ratesworldwide.

Hard-fixed rates reduce transac-tion costs of international trade andfinance and thereby facilitate interna-tional trade and investment. However.a country that enters into a hard-fixedrate bears an economic cost. The costis discarding a means—a flexibleexchange rate—of adjusting to exter-nal forces that impinge on it different-ly than on the other country or coun-tries whose currency it shares.Adjusting to such external forces witha hard-fixed rate requires adjustments

in many individual prices and wagesthat could be avoided if it couldchange the exchange rate. As I wrotenearly 50 years ago (1953), “If internalprices were as flexible as exchangerates, it would make little economicdifference whether adjustments werebrought about by changes inexchange rates or by equivalentchanges in internal prices. But thatcondition is clearly not fulfilled. Theexchange rate is potentially flexible inthe absence of administrative actionto freeze it. At least in the modernworld, internal prices are highlyinflexible [and , if anything, havebecome more so since that was writ-ten]. ... The inflexibility of prices ...

means a distortion of adjustments inresponse to changes in external condi-tions. The adjustments take the formprimarily of price changes in somesectors, primarily of output changes inothers ...

“The argument for flexibleexchange rates is, strange to say, verynearly identical with the argument fordaylight savings time. Isn’t it absurdto change the clock in summer whenexactly the same result could beachieved by having each individualchange his habits? All that is requiredis that everyone decide to come to hisoffice an hour earlier, have lunch anhour earlier, etc. But obviously, it ismuch simpler to change the clock thatguides all than to have each individ-ual change his pattern of reaction tothe clock, even though all want to doso. The situation is exactly the same in

the exchange market. It is far simplerto allow one price to change, namelythe price of foreign exchange, than torely upon changes in the multitude ofprices that together constitute theinternal price structure.” Bob and Iagree, I believe, on this abstract state-ment of benefits and costs of hard-fixed rates. Where we disagree is onthe actual magnitude of the benefitsand costs.

I suspect that we differ mostabout cost rather than benefit.“Assuming some form of price stabili-ty” begs a key issue. Rough price sta-bility in the euro as a whole hasmeant 15 to 20 per cent inflation inconsumer prices in Ireland. Stableprices in Ireland would have requireda 15 to 20 per cent appreciation of anindependent Irish Punt vis-a-vis theeuro. The hard-fix has insteadrequired extensive nominal priceadjustments in addition to the adjust-ments in relative prices called for byIreland’s rapid development. Thosenominal price adjustments havetaken place promptly in some cases,been overdone in others, been longdelayed in still others, and so on ininfinite variety. The result has beenunnecessary distortions in physicalmagnitudes.

History shows that “some form ofprice stability” cannot be taken forgranted. The periods that can be sodescribed, even for the major nationsof the world, are few and far between.We happen to be in a good patch now,but it has lasted not much more thana decade, and came only after theadoption of flexible rates by the majorcountries. How does a country thathard-fixes its currency to that ofanother country get any assurance ofprice stability in the country to whichit hitches, let alone of price stabilityrelevant to itself?

For example, In June, 1979 Chilepegged its currency to the US dollar,with every intention of maintaining ahard-fix. In the prior three years,Chile had succeeded in cutting infla-tion sharply. By linking to the US dol-lar it hoped to cement the gains that

Friedman A country thatenters into a hard-fixed ratebears an economic cost Thecost is discarding a means—a flexible exchange rate—ofadjusting to external forcesthat impinge on itdifferently than on theother country or countrieswhose currency it shares.

7. A world currency?


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had already been made and to facili-tate further reduction. Unfortunatelyfor Chile, not long after it fixed theexchange rate, the United Statesadopted a severely restrictive mone-tary policy in order to stem the infla-tion of the 1970s. The US inflationpeaked in 1980 and then deceleratedsharply. The change in policy wasaccompanied by a major appreciationin the foreign exchange value of theUS dollar. The result for Chile was dis-astrous. Chile was thrown into amajor recession, from which itemerged only after it floated the pesoin August 1982. Chile paid a heavyprice for substituting US monetarypolicy for its own.

Finally, I believe that 20 yearsfrom now, as now, there will be a vari-ety of independent currencies in theworld linked by flexible exchangerates. Whether more or fewer willprobably depend on how successfulthe euro proves to be. But it also maydepend on a major wild card that wehave not considered at all: theInternet and the emergence of one ormore varieties of E-money.

Robert Mundell: It would be diffi-cult to sum up in a few words thebasic differences between Milton andmyself on the issue of fixed and flexi-ble exchange rates. But it is too facileto say that they are political. I see dif-ferences between us concerning: 1.the mechanism and ease of adjust-

ment between regions with a commoncurrency, or between countries with(hard) fixed exchange rates; 2. theeffectiveness of the exchange rate as acushion against internal or externalshocks; and 3. the relevance andimportance of the size configurationof countries in the world.

Rather than focusing entirely onthe differences between Milton andmyself, I would like to emphasize, inthe short space available, some gener-al points:

1. The exchange rate is not aneffective cushion against real shocks.For example, a change in the terms oftrade (e.g., a rise in the price of oil), aloss of export markets or a technolog-ical change cannot be offset byexchange rate changes. At its best, aflexible exchange rate can insulate acountry against foreign inflation ordeflation.

2. Exchange rate flexibility is nosubstitute for price flexibility. Efficientmarkets require thousands of flexibleprices and the exchange rate providesonly one price. Moreover, theexchange rate is no help for individualregions within a single country.

4. The time zone analogy is aseductive half-truth. If wages andprices get out of line, it is argued, it iseasier to accept the fait accompli andrestore international competitivenessby changing the exchange rate than itis to lower wages and prices, just as itis easier to shift to daylight-savingtime than it is to make people adjusttheir habits by an hour. But the analo-gy has a fatal flaw. The change in theexchange rate will introduce expecta-tions of future changes and set inmotion further wage and price move-ments that start the country down theslippery slope of inflation. The physi-cal universe is very different: Settingthe clocks back does not change theposition of the sun!

5. Devaluation is not a good toolfor increasing employment. The argu-ment depends on money illusion andstarts a country down the slipperyslope of monetary instability.Devaluation raises the price level and

lowers real wages, potentially increas-ing demand for labor. But if unionsdemand compensation for priceincreases, as they will if they have nomoney illusion, or apply an automaticcost-of-living adjustment, or haveanticipated the devaluation and raisedwages in advance, real wage rateswould be unchanged and the policyfails. Even in the best of circum-stances, the adjustment works by rais-ing prices and undermining monetarystability.

6. Currency areas (zones of fixedexchange rates or common currencies)result in common rates of inflationdefined in terms of a common basketof goods, modified only slightly forchanges in the prices of domesticgoods when one area grows at a differ-ent pace than the other areas. The UScurrency area has roughly the sameinflation rate in all parts of the coun-try, and so does (or will when theadjustment process is complete) theeuro area. Exceptional growth in onearea can give rise to increases in nom-inal (and real) wages as well asincreases in land prices but this neces-sary real adjustment, which is current-ly taking place in Ireland, should notbe identified with inflation.

7. Countries seeking to reducetheir inflation rate by monetary restric-tion should not neglect exchange ratepolicy. Tight money typically leads tocapital inflows and an overvalued cur-rency that builds up a “one-wayoption” for speculators that leadsinevitably to a major crisis when theovervaluation has to be corrected. The

Mundell Exchange rateflexibility is no substitutefor price flexibility. Efficientmarkets require thousandsof flexible prices and theexchange rate provides only one price. Moreover,the exchange rate is no help for individual regionswithin a single country.

Friedman History showsthat ... price stability cannotbe taken for granted. The periods that can be sodescribed, even for themajor nations of the world,are few and far between.We happen to be in a goodpatch now, but it has lastednot much more than adecade, and came only after the adoption offlexible rates by the major countries.


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longer the process goes on the moreovervalued the currency and the high-er interest rates have to be. Canada gotinto this difficulty in 1988-92, andMexico seems to be heading in thatdirection today.

8. A large currency area is a bettercushion against shocks than a smallcurrency area, just as a large lake canabsorb the impact of a meteor betterthan a small pond. The euro (assum-ing sound monetary policy), will be amuch more stable currency area thanany of its component national curren-cies. Similarly, at equal inflation rates,the US dollar is a more effective cur-rency than the Canadian dollar or theMexican peso, and a North Americanmonetary union, whether based onthe US dollar or a new unit (such asHerbert Grubel’s plan for an “amero”),would be a more stable unit than anyof the national currencies alone. Onthis argument, the ideal currency areawould be one comprising the entireworld.

9. Adjustment between regions ofa common-currency area is painlessand apparently effortless because itstarts to take place as soon as a prob-lem arises and it is implementedsmoothly and efficiently until adjust-ment has been completed. Exactly thesame ease of adjustment is possiblebetween areas with firmly-fixedexchange rates. If, for example,Canada formed a monetary unionwith the United States, or dollarized,or fixed its dollar firmly and irrevoca-bly to the US dollar, the two countries

would share the same inflation rateand adjustment between Canada andthe United States would be just aseasy as it is between California orPuerto Rico or Panama and theUnited States

10. Trade between areas with acommon currency or a firmly-fixedexchange rate is higher than thatbetween areas separated by flexibleexchange rates because exchange rateuncertainty imposes a cost of trademuch like a tariff. If the fifty states ofthe United States had separate curren-cies connected by flexible exchangerates, the real income of the UnitedStates would plummet. By the sametoken, if Canada and the United Statesshared a stable common currency oran irrevocably fixed exchange rate,Canada’s real income would soar, clos-ing a large part of the gap between thetwo countries’ GDP per capita.

11. When a country firmly fixesits currency to a large and stable mon-etary leader (such as the dollar or euroareas) it gets a rudder for its monetarypolicy, a stable rate of inflation, anddiscipline for its fiscal policy (budgetdeficits are anathema to fixedexchange rates). In addition it gets thebonus of being a member of a largecurrency area that is a better cushionagainst shocks.

12. The inefficiency of flexiblerates is underlined by the volatility ofexchange rates between the threelargest currency areas. The dollar, euroand yen areas have each achieved sta-bility of their price levels, but havebeen subject to extreme volatility,largely due to currency speculationthat exceeds $1.5 trillion a day! Thisextreme volatility has prompted callsfor “Tobin taxes” to reduce the crasswaste associated with all this unneces-sary hedge-fund activity. But theEuropeans have pointed the way to amuch better alternative, eliminatingexchange rate volatility altogether byfixing exchange rates. Since the lock-ing of the eleven euro area currencies,speculative capital movements havecompletely disappeared!

There is no need for sweeping

exchange rate changes between areasthat have the same degree of price sta-bility, and a monetary union of the“G-3” would have the merit of pro-ducing both what Keynes called inter-nal balance (price stability) and exter-nal balance (exchange rate stability),at the same time.

13. Fluctuations in the yen-dollarand euro-dollar rates pose grave prob-lems for the smaller currency areasand constitute the major source ofinstability in the international mone-tary system. The appreciation of thedollar against the yen between April1995 and June 1998 was largelyresponsible for the so-called “Asiancrisis,” and fluctuations in the euro-dollar rate have helped to underminethe stability of the transition coun-tries. A monetary union of the G-3countries, while appearing to be along shot, could be an anchor aroundwhich stable international monetarysystem could be rebuilt.

14. The viability of a world offlexible exchange rates depends criti-cally on the size configuration ofcountries in the world. There are now178 members of the InternationalMonetary Fund. If these countrieswere all the same size, flexible rateswould have resulted in monetarychaos. In such a case the need for auniversal unit of account—whethergold or an IMF currency—would beobvious. What saved the system fromchaos was that the dollar, the curren-cy of the superpower, filled the vacu-

Mundell Exchange rateuncertainty imposes a costof trade much like a tariff ...If Canada and the UnitedStates shared a stablecommon currency or anirrevocably fixed exchangerate, Canada’s real incomewould soar, closing a largepart of the gap between the two countries’ GDP per capita.

Photo courtesy National Post

Milton Friedman


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um and could take on the functions ofinternational unit of account andmedium of exchange.

15. Despite the success of the USeconomy as motor for the world econ-omy in the past two decades—spurredon as it was by the supply-side tax rev-olution in the 1980s, and the IT revo-lution of the 1990s—the dollar’s roleas stand-in for a world currency weak-ens the long-run financial position ofthe United States. Since floating beganin the early 1970s, the United Stateshas moved from being the world’slargest creditor to the world’s largestdebtor. The US net debtor position,currently increasing at the rate ofmore than $400 billion a year (theamount of the US current accountdeficit), will eventually underminethe dollar and its usefulness as a worldcurrency. The euro may be able to takeup the slack in the intermediate run,but in the long run, there is no viablealternative to a world currency.

16. Without exception, all thegreat classical economists favoredfixed exchange rates anchored togold, and abhorred the idea of incon-vertible currencies and flexibleexchange rates. Their great worry wasthat paper currencies, unchecked byconvertibility, would lead to deficitfinance and inflationary monetarypolicies, a worry that well proved tobe justified a century later.

The idea of flexible exchangerates was championed by economistsfrom Britain and the United States,the monetary leaders, respectively, ofthe 19th and 20th centuries. I amthinking here of Keynes (who was onboth sides of the question) and JamesMeade in Britain, and Irving Fisherand of course Milton Friedman in theUnited States. But it was one thing forthe large anchor economies to haveflexible exchange rates and quite a dif-ferent thing for the smallereconomies, for whom a world of flex-ible exchange rates was equivalent tochaos. The United States can afford toneglect its exchange rate, but anyother economy, including the euroarea, does so at its own peril.

17. I think Milton and I agreethat most of the smaller developingcountries are better off with curren-cies firmly anchored to a stable largecountry. Because that way they willget a better monetary policy and con-nections to the capital market of thelarge country. Milton believes, how-ever, that the large countries are bet-ter off with inflation targeting, whileI believe they also are better off withfirmly fixed exchange rates if anagreement between them could bereached. Milton is skeptical of thepossibility of agreement betweenlarge countries on exchange rateswhile I think that self-interest willdrive countries eventually to a moreefficient cooperative solution.

18. My approach is more interna-tionalist than Milton’s. I reject as eco-nomically wasteful a system of 178national currencies floating againstone another. I would prefer to seefixed exchange rates between thethree dominant currency areas and touse a fixed dollar-euro-yen unit as aplatform from which to launch, underthe auspices of the Board of Governorsof the International Monetary Fund, aworld currency.

19. The idea of a world currency isby no means a new idea. A world cur-rency of some sort has indeed existedfor most of the past 2,500 years. Twothousand years ago, in the age ofCaesar Augustus, it was the Romanaureus. A thousand years ago it wasthe gold bezant. A hundred years agoit was the gold sovereign. Less thanthirty years ago it was the 1944 golddollar. The world has been without auniversal currency for only a tiny frac-tion of its history.

In the run-up to the BrettonWoods conference in 1944, both theBritish and American plans for post-war international monetary arrange-ments contained provisions for aworld currency. The British plan,largely written by Keynes, proposed“bancor” as the name for the worldcurrency; the American plan, largelywritten by Harry Dexter White, pro-posed “unitas” as the world currency.

But as negotiations proceeded, theAmericans dropped the idea of a worldcurrency and refused to discuss thematter further. The Americans wereafraid that the world currency wouldcompete with or detract from the dol-lar. It is ironic because it could havesaved the dollar. This failure to createa world currency at Bretton Woodswas one of the reasons the BrettonWoods fixed-exchange rate systembroke down.

A few economists have recentlyrecognized the merits of and need fora world currency. Whether that can beachieved or not in the near future willdepend on politics as well as econom-ics. But it is nevertheless a project thatwould restore a needed coherence tothe international monetary system,give the International Monetary Funda function that would help it to pro-mote stability, and be a catalyst forinternational harmony. As PaulVolcker has put it, “A global economyneeds a global currency.”

Milton Friedman: I have longbelieved, to paraphrase Clemenceau’sfamous remark about war, that moneyis far too serious to be left to centralbankers. Is it tolerable in a democracyto have so much power concentratedin a body free from any kind of direct,effective political control? On thosegrounds, national central banks,whether called independent or not,

Mundell A world currency ofsome sort has existed formost of the past 2,500years. Two thousand yearsago, in the age of CaesarAugustus, it was the Romanaureus... A hundred yearsago it was the goldsovereign. Less than thirtyyears ago it was the 1944gold dollar. The world hasbeen without a universalcurrency for only a tinyfraction of its history.


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are always subject to ultimate politi-cal control. That is the fundamentalreason why the monetary area hashistorically been coterminous withthe political area. The euro is uniquein its multi-country character. Ibelieve that is a basic flaw, and is like-ly sooner or later to convert econom-ic differences into unresolvable polit-ical differences.

Bob views the prospect of a singleworld money with enthusiasm. I viewit as a monstrosity—on a par with myreaction to world government, forthat is what a common currencyamounts to for one aspect of econom-ic activity. As a citizen of the UnitedStates, I find it bad enough that wehave developed monetary arrange-ments under which so much powerhas been vested in a small group ofunelected individuals, subject onlyindirectly to political control. I find itfar worse to vest so much power inindividuals chosen by internationalnegotiation, individuals who are notaccountable in any meaningful way atthe ballot box.

Gold was able to serve as a pseudoworld money in the 19th and early20th century precisely because it wasimpersonal and not subject to thecontrol of a political authority. It was

a commodity purchased and sold inthe market whose rate of exchangewith other goods and services wasdetermined by demand and supply.Individual nations chose to fix theprice of gold in terms of their nation-al currencies. However, each nationretained the right to separate itsnational currency from gold and mostnations found the occasional need todo so. The euro—and Bob’s idea of aworld money—involves discardingthat possibility. The dream of a UnitedStates of Europe underlies the accept-ance of that limitation for the mem-bers of the euro. However unlikely tobecome reality, it is at least an under-standable dream, given the culturallinks among the European countries.If it were ever achieved, it wouldrestore the coincidence of the mone-tary and political areas.

There is no similar possibility on aworld scale. The gold standard, in itshey-day, did not eliminate the conflictbetween external stability of exchangerates and internal stability of pricelevel. Exchange rates were stable forlong periods, but those periods werecharacterized by much internal eco-nomic instability in prices and eco-nomic activity. The post-war period offlexible exchange rates has displayedmuch more instability of exchangerates, but that has been consistentwith—indeed, I would say, has con-tributed to—rapid growth in worldtrade, free flow of capital investment,and far greater internal economic sta-bility than before World War I orbetween the two wars.

More than 150 years ago, JohnStuart Mill wrote “There cannot ... bea more insignificant thing, in theeconomy of a society, than money;except in the character of a con-trivance for sparing time and labour. Itis a machine for doing quickly andcommodiously, what would be done,though less quickly and commodious-ly, without it: and like many otherkinds of machinery, it only causes adistinct and independent influence ofits own when it gets out of order.”

Competition has a role to play in

money as in other areas. Multiple cur-rency areas provide competition andthe opportunity for experimentation.The euro is an example of the benefitsof competition. It enables us toobserve, on a less than world scale,how a multi-country managed curren-cy will operate. Surely, Bob is some-what premature in declaring it a suc-cess before it is even fully operational.Let us see how it works before rushinginto any broader arrangements.

Robert Mundell Milton attributedto me a view I have never had andhave, on the contrary, explicitlyrejected. He said I favoured a singleworld currency. Emphasis on the “sin-gle.” I have never said that, and couldnot say that. In fact, I have writtenelsewhere that a single world curren-cy would be unstable; it would breakup. I myself could have writtenMilton’s attack on a single worldpaper currency run by internationalbureaucrats!

I am afraid people don’t under-stand the distinction between a paral-lel currency and a single currency.Back in Italy now, I told my wife,Valerie, that I would have to write aresponse to Milton’s last comment onthe grounds that he attributed to me abelief in a single world currency,whereas I have advocated a world cur-rency. Her comment sums up mydilemma: “What’s the difference?”

A single world paper currency iseven worse than Milton said. If therewere such a thing, every country


Friedman I have longbelieved, to paraphraseClemenceau’s famousremark about war, thatmoney is far too serious tobe left to central bankers. Is it tolerable in ademocracy to have so muchpower concentrated in abody free from any kind ofdirect, effective politicalcontrol?

Photo courtesy National Post

Robert Mundell


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would want to gain seigniorage byproducing its own national currency,or have its banks do the same. This iswhat happened in the twilight of thegold standard. In 1900, there wereonly 21 central banks. Now we haveabout 190. The central bank move-ment started when, as a result of infla-tionary war policies, gold becameunstable. The US price level was at 100in 1914, 200 in 1920 and 140 in 1921,and gold and the dollar were corre-spondingly unstable. Countries in therest of the world then thought theycould do better with central bankmanagement, and we had a rash ofnew central banks pushed on LatinAmerica by Edwin Kemmerer ofPrinceton University. The end resultof the central bank movement wasthat paper currencies replaced gold,and most central banks becameinstruments of permanent inflation.

If you created a world paper cur-rency, central banks would have anincentive to replace the world curren-cy with national paper, to gainseigniorage and power. It would there-fore break up, unless it could beimposed with drastic prohibitions onthe creation of national currencies.This would be incompatible with sov-ereignty or democracy. In otherwords, a single world currency wouldonly work in an imperium or a mone-tary dictatorship.

The British and American plans atBretton Woods proposed a world cur-rency, but not a single world currency.In my 1968 “Plan for a WorldCurrency,” I proposed a world curren-cy, but not a single world currency. Inmy ideal system, there would be aworld currency but countries woulduse their home currency for domesticpurposes.

So we agree on the impossibilityor undesirability of a world currency.But I am not sanguine at all thatMilton will be in any more agreementwith me on my non-single-currencyplan!

Just as it is good to have a worldlanguage in which everyone can con-verse, so it is useful to have a world

currency for international transac-tions. But I would never propose abol-ishing all national languages in favourof esperanto or English, nor would Ipropose scrapping all national curren-cies in favour of the dollar or worldcurrency.

My ideal and equilibrium solutionwould be a world currency (but not asingle world currency) in which eachcountry would produce its own unitthat exchanges at par with the worldunit. We could call it the internation-al dollar or, to avoid the parochialnational connotation, the intor, acontraction of “international” and theFrench word for gold. Everythingwould be priced in terms of intors,and a committee—in my view, say, aG3 open market committee designat-ed by the Board of Governors of theInternational Monetary Fund—woulddetermine how many intors producedeach year would be consistent withprice stability. Every country wouldfix its currency to the intor followingcurrency-board system principles.Ideally, countries would redefine theirnational units so that, for example,one Canadian intor (an intor with thehead of the Queen or a maple leaf onit) was equal to one intor. Both intorsand Canadian intors would be allowedto circulate in Canada, and the pro-portion of the Canadian paper-dollardemand that is supplied by Canadianintors (canintors?) would be no morethan 75 per cent. The loss of seignior-age would therefore not be much, andin any case, Canada would get a rebatefrom the international institution.

Such a world currency would notbe obligatory, but a voluntary choice.Maintaining convertibility wouldrequire monetary and fiscal discipline.Countries that could not cut themuster might well decide to opt outand suffer the consequences of higherinterest rates and monetary instabili-ty. Others that wanted a tighter mon-etary policy and a lower rate of infla-tion (e.g., Switzerland, Japan?) mightdecide to go on floating, as mightCanada, where the Canadian dollar islooked upon as a badge of independ-

ence. But for the bulk of the world, itwould be a great step forward.

Now comes the issue of gold.Milton has argued strongly that theUnited States should auction off itsgold supplies. Other economists haverecommended the IMF auction off itsgold and give away the proceeds topoor countries. But I have always beenopposed to this.

From the US point of view, itmakes sense, in my mind, to keepsome reserves against contingencies,in a crisis. Gold is by far the most con-venient reserve to hold, it is thecheapest commodity to store (relativeto its value) and it gives the US a stakein the disposition of gold in the futureinternational monetary system. But ifother Americans felt the same wayand wanted to get rid of the 250 mil-lion ounces of gold now held by theUnited States, it would provide a goodopening for a reform of the interna-tional monetary system.

The unwanted gold could betransferred to an international author-ity in exchange for deposits of, orpaper notes of, intors. The rest of theworld could go on the intor standard,and the United States would have astock of intors (about US$75-billionworth, pricing gold at US$300 anounce) that it could hold or invest inother things. The acquisition of one-quarter of the world’s monetary gold


Mundell Just as it is good tohave a world language inwhich everyone canconverse, so it is useful tohave a world currency forinternational transactions.But I would never proposeabolishing all nationallanguages in favour ofesperanto or English, norwould I propose scrappingall national currencies infavour of the dollar or world currency.


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to back the international currencywould be a great booster of confidencein the intor, and at the same timerelieve the United States of its burdenin holding so much gold.

Milton could make the same casefor the European Union. It now holds

more than 400 million ounces of gold.Unlike Americans, however,Europeans have identified gold withpower, and would be reluctant toscrap their gold for fear that power toinfluence the international monetarysystem would decline. Nevertheless,most Europeans think the EuropeanSystem of Central Banks holds toomuch gold, and it might easily be pos-sible to pry another 100 millionounces from the coffers of the centralbanks.

For the rest of it, the InternationalCentral Bank (ICB) would exchangeintors for convertible currencies, partof which it could invest in Treasurybills or bonds to provide the incometo cover the expenses of running the

central bank. Unlike the IMF, which iscluttered with reserves of inconvert-ible currencies, the ICB and the intorwould be entirely backed by gold andthe best currencies in the world.

All this sounds unrealistic now,but I see an externality out there thatis bound to be filled one way oranother, and I myself think this is themost efficient way to exploit it, con-sistent with the political realities ofthe world as we know it.

Gold will no longer be at the cen-tre of the system as it was before 1914,but I am convinced it has a role toserve in the new century. It can buildconfidence in international exchangethat does not exist in the case ofnational paper currencies.


Mundell A world currencywould not be obligatory,but a voluntary choice ...Countries that could not cutthe muster might welldecide to opt out and sufferthe consequences of higherinterest rates and monetary instability.

Taxpayers by income group

Taxes paid by income group

The hardy few

Source: David Perry, Canadian Tax Highlights.

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Friedman vs Mundell