Milton Friedman was a proponent of so-called “floating” exchange rates between the various irredeemable paper currencies that he promoted as the proper monetary system. Many have noted that the currencies do not “float”; they sink at differing rates, sometimes one is sinking faster and then another. This article focuses on something else.
Under gold, a nation or an individual cannot sustain a deficit forever. A deficit is when one consumes more than one produces. One has a negative cash flow, and eventually one runs out of money. The economy of a household or a nation is therefore subject to discipline—sooner or later.
Friedman asserted that floating exchange rates would impose the same kind of forces on a nation to balance its exports and imports. He claimed that if a nation ran a deficit, that this would cause its currency to fall in value relative to the other currencies. And this drop would tend to reverse the deficits as the country would find it expensive to import and buyers would find its goods cheap to import.
Friedman was wrong.
To see why, one must look at the concept known to economists as “Terms of Trade”. This phrase refers to the quantity of goods that can be purchased with the proceeds of the goods exported. For example, country X uses the xyz currency. It exports xyz1000 worth of goods and it can thereby pay for xyz1000 worth of imports. But what happens if the xyz drops relative to the currency’s of X’s trading partners, because X is running a trade deficit?
The country exports the same goods as before, but they are now worth less on the export market. So X can pay for fewer goods than before. Buying the same amount of goods will result in a larger deficit.
At this point, one may be tempted to say “Ahah, Friedman was right!” But remember, we are not talking about a gold standard. We are talking about an irredeemable paper money system. Money is borrowed into existence. Looking at the trade deficit from the perspective of Terms of Trade, we see that trade deficits lead to budget deficits, which leads to a falling currency, which leads to increased trade deficits. It is not a negative feedback loop, which is self-limited and self-correcting. It is a positive feedback loop.
There is no particular limit to this vicious cycle until the country in question accumulates so much debt that buyers refuse to come to its bond auctions. And this is not a correction or a reversal of the trend; it is the utter destruction of the currency and the wealth of the people who are forced to use it.
And, of course, Friedman had to be aware that America was likely to be biggest trade deficit runner in the world. Its currency, the dollar, was (and is) the world’s reserve currency. That means that every central bank in the world held dollars as the asset, and pyramided credit in their own currencies on top of the dollars.
What would happen if the dollar weakened because the US was importing real goods and exporting paper dollars? The US would simply import the same goods next year and export even more paper dollars to compensate for the drop in the dollar!
Friedman would have also been aware of the economist Robert Triffin, who wrote in the early 1960’s about a problem that became known as Triffin’s Dilemma. In essence, the issue is that the world needs to expand credit to grow and so has demand for more US dollars. But this can only occur if the US runs a perpetual trade deficit, which would weaken the US dollar.
To the central banks that hold dollars as the reserve asset, this is deadly. Like any bank, a central bank has assets and liabilities. If a significant component of the assets are composed of US dollars, and the US dollar falls, the central bank’s balance sheet deteriorates. The liabilities side, of course, is the central bank’s own currency. So the asset is falling and the liability is not. This is a dangerous situation and unsustainable.
And to blithely propose this as a system is to propose open theft. Why should any country agree to allow the US to dissipate its savings, defaulting on the US dollar obligations in slow motion, a few percent per year as Friedman proposed?
The scheme of floating exchange rates of irredeemable paper currencies is therefore dishonest as well as unworkable. Today, some 40 years after the plunge into the worldwide regime of irredeemable paper currencies, it’s starting to matter.