Making Change

Money Mischief.
by Milton Friedman.
Harcourt Brace Jovanovich. 274 pp. $19.95.

Milton Friedman’s latest book comes at a pivotal moment. Around the globe, monetary systems are being fundamentally restructured. The European Community is moving toward a single currency, expending considerable political capital to achieve that goal. Third-world and post-Communist governments from Argentina to Ukraine are experimenting with a diverse array of reforms.

Yet Money Mischief, subtitled “Episodes in Monetary History,” is at least as concerned with the past as with the present. Much of the book deals with events of the late 19th and early 20th centuries. For instance, Friedman examines the Coinage Act of 1873, which placed the U.S. dollar on a gold standard and effectively denied a monetary role to silver. Analyzing the consequences of that move, he explores what might have occurred if different policies had been followed. This leads to a broader discussion of the relative virtues of monometallism, in which a currency is linked to either gold or silver, and bimetallism, in which the money is backed by both. Friedman also looks at the significance of the development, late in the last century, of a new technique for extracting gold from low-grade ore. Moving forward several decades, he speculates about the effects of the silver-purchase program initiated by the Roosevelt administration in the early 1930’s.

As the book proceeds into more recent monetary history, Friedman compares Chile’s establishment of a fixed exchange rate in the late 1970’s with Israel’s adoption of a similar policy in the mid-1980’s. Drawing on a range of examples, he defends his well-known thesis that excessive monetary growth is the crucial factor underlying inflation. The final chapter offers, in broad strokes, a picture of the world’s present monetary situation.

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The links between Friedman’s discussion of historical events and his analysis of current developments are rather tenuous. The reader who expects to find present-day relevance in the lengthy discussion of bi- versus monometallism, for example, is bound to be disappointed; Friedman himself acknowledges that the issue is primarily of historical interest. Moreover, the pace of current monetary change is such that various late developments—the December 1991 Maastricht summit on a unified European currency, Russia’s grappling with the issue of a convertible ruble, Argentina’s attempt to fight inflation by linking its currency to the dollar—receive little or no discussion. Money Mischief is thus limited as a guide to current policy issues. But as a meditation on the twists and turns of the past, it has much to offer.

The role of chance in monetary history, and the propensity of government actions to yield unintended consequences, are themes common to many of the episodes Friedman recounts. Thus, Money Mischief retells the story, familiar from Friedman’s earlier work, of how China was affected by the U.S. government’s purchases of silver—purchases undertaken by President Franklin D. Roosevelt as a political sop to influential Senators from silver-producing states.

In Friedman’s telling, the resulting boost in silver prices led to a general price deflation in China, a nation which, in the early 1930’s, was the only populous country still on a silver standard. This hastened the Nationalist government’s abandonment of the standard and rendered China more vulnerable to the hyperinflation that resulted from the need to finance the war against Japan and the civil war against the Communists. Friedman convincingly argues that the U.S. silver purchases contributed, at least modestly, to Chiang Kai-shek’s downfall—an outcome well beyond the imagining of Roosevelt and other American politicians who wanted to “do something for silver.” Indeed, insofar as Asia entered into American calculations, it was assumed that China would benefit from higher silver prices.

Friedman’s comparison of Chile and Israel also emphasizes the element of unpredictability. These two nations followed essentially the same policy, that of establishing a fixed exchange rate or “pegging” the local currency to the U.S. dollar. In each case, the purpose was to curtail inflation. Yet the respective actions, taken some six years apart, had drastically different outcomes, due to circumstances well beyond the control of policy-makers in either country.

Chile had the misfortune of establishing a fixed exchange rate in 1979, just prior to the dollar’s sharp appreciation against other major currencies. The Chilean peso thus rose against other currencies in tandem with the dollar, damaging the country’s exports. Meanwhile, the price of copper, Chile’s major export, was declining in world markets, while the price of oil, which Chile imports, was rising. The result was a deep recession, one that would have been far less severe had the peso been allowed to depreciate against the dollar. In 1982, the currency peg was abandoned.

By contrast, Israel’s pegging of the shekel to the dollar occurred in the mid-1980’s, just as the dollar was beginning to descend against major currencies. At this time, furthermore, oil prices were in decline. The fixed dollar-shekel rate was kept in place for only thirteen months (after which the shekel was pegged to a basket of currencies), but during that time, it helped bring inflation down from an annual rate of about 500 percent into the low double digits. Without causing a recession, Israel’s currency peg helped create a degree of price stability that lasts to this day.

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The issue of pegged exchange rates has taken on increasing importance in the past several years. The European Monetary System (EMS) is essentially an arrangement of flexible pegs, in which national currencies are constrained in the extent to which they can fluctuate against one another. Friedman is an opponent of such currency pegs, believing they represent an unstable middle ground between floating exchange rates and unified currencies (either of which he sees as preferable). In Money Mischief, he takes several swipes at the EMS.

Some of this criticism is well-founded. Friedman notes, for example, that pegged exchange-rate systems often come under stress from the divergent domestic agendas of individual nations’ central banks. Certainly, such strains were seen in the EMS over the past year, as European central banks were torn between their currency commitments (which required that interest rates be high enough to attract investment) and the need to stabilize domestic economies (which required lower interest rates, to spur economic growth). Friedman also has a point in questioning the extent to which the EMS can be credited with the lower inflation which member countries have enjoyed in recent years; after all, inflation has declined in many non-EMS countries as well.

In one respect, however, Friedman’s skepticism toward the EMS is unconvincing. It is unrealistic, he writes, to expect a system of pegged exchange rates to lead to a unified currency. Such a prospect he describes as an “utter mirage,” since it would require the elimination or integration of redundant central banks, a politically tricky endeavor. Yet with the Maastricht summit of December 1991, it has become clear that this outcome is now a realistic possibility. For better or worse, most members of the European Community have demonstrated considerable determination to establish a unified currency by the end of the decade.

The single-currency plan may be criticized on various grounds; Friedman himself wrote an op-ed piece in the Wall Street Journal shortly after Maastricht, wondering whether it would not be better to let market forces, rather than government policy, establish an eventual unified currency. But Money Mischief‘s casual dismissal of European monetary union as far-fetched is now out of date.

The next several years will be a fascinating time for observers of monetary systems. There is much to be learned, not only from the European project but also from smaller-scale monetary experiments around the world. One looks forward to further comments from Milton Friedman.

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