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I was in Chicago on November 17 to address the MBA
class of 2007 at the University of Chicago Graduate School of Business. I had
a prepared address on Milton Friedman’s monetary theories concerning the
adjustment mechanism of foreign trade under the floating exchange rate
system. Before I could deliver it the announcement came that Friedman had
died the previous day in San Francisco at the age of 94. Newspapers carried
long obituaries calling him the man “who has changed economics, policy,
and markets” and
“made free markets popular again”. My address was sharply
critical of the Nobel laureate Chicago economist. It would have been a
dissonant chord in the cacophony of eulogies, so I decided to deliver an
extempore address instead. However, I did not tear up my script. A dollar
crisis was brewing. As I see it, Friedman has sowed the wind and the world is
going the reap the whirlwind. Soon. When it does, I may want to publish my
critique of Friedman’s monetary theories.
Here it is.
Keynes and Friedman
Mr. Humphries, Graduating Class, Honored
Guests, Ladies and Gentlemen:
You may call me reckless for daring to come here,
the shrine of monetarism, to preach the anti-monetarist gospel. I must confess
that I do it with some diffidence, given the enormous prestige of the father
of monetarism.
Along with John Maynard Keynes (1883-1947) Milton Friedman was the enfant terrible
of twentieth-century economics. Thirty-five years apart, the two of them were
the great wreckers of the gold standard. George Schultz, a friend of
Friedman’s who served in the Nixon administration, says that in 1968
Friedman wrote a letter to president-elect Nixon suggesting that upon
inauguration he should unilaterally take the United States off the gold
standard (or whatever was left of it after president F. D. Roosevelt had
wrecked it, on advice from Keynes, 35 years earlier in 1933).
In 1933 Keynes set out to persuade Roosevelt to
default on the domestic gold obligations of the United States. He prevailed.
In 1968 Friedman set out to persuade Nixon to default on the international
gold obligations of the United States. He did not prevail. Not immediately,
anyway. Thus the glory for dealing the coup de grâce
to the gold standard eluded him.
Demonetization of gold was not the only option
available to Nixon. He could have also devalued the dollar in terms of gold.
As is known, Mises was in favor
of the latter. A new official gold price of $70 per oz, amounting to a 50
percent devaluation, was the figure being bandied about.
Friedman’s unsolicited advice to Nixon tells
us something about the character of the man. Rather than initiating a
high-level debate among monetary economists on the disastrous monetary
policies of the US government that has led to the 1968 crisis, Friedman
preferred to work behind the scenes on his plan to plunge the nation headlong
into irredeemable currency. He was determined to make the dollar an
out-and-out fiat money, the worst type of currency known to man.
Friedman knew that people would be hooked on fiat
money once it has been inflicted on them. Here is a quotation from monetary
scientist Walter E. Spahr [1], the Head of
Department of Economics at New York University from 1927 to 1956.
"The majority, when given a taste of it,
embrace irredeemable currency. The arguments offered in its defense are many and various, and constitute a sad
commentary on human intelligence and character. The dilemma whether to give
it up is much like that of the drug addict whether to give up dope. Even if
he wanted to heed the advice of his understanding and experienced physician,
often he will decide not to kick the habit. The run-of-the-mill speeches and
articles on ‘inflation’ in this country provide a typical example
of the majority reaction: they either evade the issue in ignoring that
inflation is caused by fiat money, or they distort pertinent evidence, or
they preach virtue where there is none, or they utilize currently popular
platitudes, or they treat superficiality as though it should be accepted as
wisdom. Rarely does one see a statement that an irredeemable currency is
preferable accompanied by an attempt to give reasons for such an untenable
belief.”
Friedman’s is such a statement.
“A nation in due course pays severely for the
use of irredeemable currency. The United States is in a position analogous to
that of a drug addict administering a law liked by all other fellow drug
addicts.”
In this case the ‘understanding’
physician, Friedman, urges the addict to carry on with substance abuse.
Irredeemable currency is massive fraud
The following quotation is also from Walter E. Spahr [2].
“Irredeemable currency means either fiscal or
moral bankruptcy, or both. We are morally bankrupt now in so far as our monetary
system is concerned. Both the U.S. government and the Federal Reserve have
demonstrated that they wish to be free of pressure that people may put on
them if our currency were redeemable. They are satisfied to hide behind
irredeemable I.O.U.’s. Although a private citizen can expect
imprisonment if he issues irredeemable bills of credit, our government and
Federal Reserve banks have adopted as defensible a standard of morality that
is not tolerated among honest people. They exercise power arbitrarily while
refusing to accept the corresponding responsibility.”
Friedman has never addressed the question of
morality in issuing obligations that one has neither the means nor the
intention to meet — as demonstrated by the check-kiting scheme between
the U.S. Treasury and the Federal Reserve.
“A nation is in serious trouble when that
state of affairs exists. The federal spending orgy since 1933, the
depreciation in the purchasing power of our dollar, the mounting federal
debt, the centralization of power in Washington, D.C., the steady march into
the Death Valley of socialism, these are some of the manifestations of what
tends to happen when a government steals the people’s purse, having
drugged them with the poison of irredeemable bills of credit.”
This was written in 1958. Much happened since that would have
surpassed even the worst fears of the author had he lived to see it,
including the dismantling of America’s once flourishing industries.
“Irredeemable currency is a massive fraud on
the people. It is the chief and common means by which governments put
shackles on free men.“
In spite of all his free-market rhetoric, this point
was lost on Friedman.
“A government loses its moral standing among
men of integrity when it employs irredeemable I.O.U.’s. The regime of
irredeemable currency is a monument to the dishonor
of governments.”
And, one might add, to the dishonor
of advisors urging the government to carry on this abuse of power, in
defiance of the Constitution.
“Irredeemable currency tends to expand and
grow, and to carry abusers to their destruction. It is a potent contributor
to international economic disintegration.”
To this day Friedman could not see the signs of
disintegration, be it the accelerating increase of the money supply, or the Babeldom of foreign exchange derivatives trading at the
rate of $ 500 trillion per annum, and rising exponentially, when the
combined GNP’s of all the nations on earth is a paltry $ 40 trillion
per annum.
"Irredeemable currency is a cesspool in which
economic disease and human conflict are spawned. It is a wrecker of people,
of families, and of nations. It is a road to the despotism of
dictatorship.”
It was, in Russia in 1917; in Germany in 1933; in China
in 1949, to mention but three outstanding examples. Does Friedman really
believe that it cannot happen here?
In most cases irredeemable currency led to war or
civil war. Does Friedman really believe that it won’t this time?
“Irredeemable currency is a symptom of a great
national sickness. It
‘engages all the hidden forces of economic law on the side of
destruction which not one man in a million is able to diagnose’
(according to Keynes, writing in 1919).”
Apparently, nor is Friedman the one in a million.
“What
is the meaning of a gold standard and a redeemable currency? It represents
integrity. It insures the people’s control over the government’s
use of the public purse. It is the best guarantee against the socialization
of a nation. It enables a people to keep the government and banks in check.
It prevents currency expansion from getting ever farther out of bounds until
it becomes worthless. It tends to force standards of honesty on government
and bank officials. It is the symbol of a free society and an honorable government. It is a necessary prerequisite to
economic health. It is the first economic bulwark of free men.”
It is a great tragedy of our age that Friedman, the
self-styled defender of the freedom of the individual and the free market,
could not see this. Nor could he see the wisdom of Thomas Jefferson’s
warning: “If the American people ever allow bankers to control the
issuance of currency, first by inflation and then by deflation, corporations
growing up around them will deprive people of all their prosperity until
their children wake up homeless on the land that their fathers have gained
for them.
Floating or sinking?
In the 1950's Friedman concocted his pseudo-theory
purporting to show how the floating system of foreign exchange rates would
provide an automatic adjustment mechanism to balance the external accounts of
trading nations. By implication, a gold standard was not a prerequisite of
bringing about equilibrium in foreign trade. To say that Friedman is not a
friend of the gold standard is an understatement. He maintains that it is a
“price-fixing scheme” and as such a gold standard is anathema to
the free market.
A monetary scientist should know better. Friedman
puts the cart before the horse. A gold standard does not fix the price of
gold any more than the tail wags the dog. What happens is that, once gold is
in circulation, it is the price of
bonds and notes that governments and banks are all too anxious to
stabilize in terms of the gold coin of the realm. If they can, gold gives
their obligations unmatched respectability. If they can’t, then
well-informed people will make their own conclusion about the quality of
their paper.
According to Friedman’s theory, under freely
floating foreign exchanges a country in deficit would experience a loss in
the exchange value of its national currency vis-à-vis a country
in surplus which would, in turn, experience a gain. The former would be a
more attractive market to buy from and less attractive to sell in. It could
now export more and import less. The latter would be a less attractive market
to buy from and more attractive to sell in. It would now export less and
import more. The resulting changes in the export-import cocktail would
restore trade balance. This is supposed to work as an automatic adjustment
mechanism balancing foreign trade through the system of variable exchange
rates.
This is an inept rationalization of the misfortune
to have abandoned sound money. To say, as Friedman does, that debasement of
the currency is a legitimate means of eliminating trade deficits, when
carried ad absurdum, is saying that the worst currency is the best and
the best the worst. Friedman’s theory was actually put to into practice
by Nixon. The result judged from thirty-five years’ of perspective was
an unmitigated disaster. The monetary, financial, and economic stature of the
United States is in shambles, thanks to Friedman’s floating dollar. As
a matter of fact, the euphemism ‘floating’ should be interpreted
as ‘sinking’. It was the sinking dollar that has turned the
country from the greatest creditor into the greatest debtor the world ever
knew. The dollar used to be a monetary giant, the envy of the rest of the
world. Now, it is a dwarf treated with contempt abroad. And the worst is
still to come. We are facing a credit collapse.
Floating did not solve problems that the United
States was facing in 1968. It made them worse. The devaluation and the
deliberate debasement of the dollar did not make American exporters stronger.
It made them weaker. The weak dollar was a huge bonanza for the foreign
competitors of America. They were able to buy more imported goods per unit of
exports. By contrast, Americans were able to buy less. The deficit was
financed by an unprecedented debt-pyramid spinning out of control. The terms
of trade for America has deteriorated to such an extent that it necessitated
the wholesale dismantling of once prosperous American industries. It is not
just the foreign purchasing power of the dollar that is on skid row. So is
its domestic purchasing power, official doctoring of statistics
notwithstanding. The widely fluctuating value of U.S. Treasury bonds is a
butt of some very unkind jokes by foreigners. True, the American people still
appear to be well off. But this prosperity is resting on “thin
ice” in the words of former Federal Reserve Board Chairman Paul A.
Volcker.
What caused the great Depression?
In their “Monetary History” published in
1963 Friedman and Anna Schwartz blamed the Great Depression of the 1930's on
the ‘Great Contraction’ of the money supply in the United States
during the period 1929 to 1933. This is where Friedman went wrong. He
mixed up cause and effect. In reality the contraction of the money supply was
the effect of the Great Depression, not its cause. Businessmen declined to
borrow in spite of the extraordinarily low interest rate available, because
they could not see any profitable business opportunities around. The Federal
Reserve can print all the dollars bills it wants; what’s the use if there
are no takers? The idea of putting crisp Federal Reserve notes into
circulation through helicopter-drop, attributed to Friedman by Bernanke, is
puerile. There is no synthetic substitute for the enterprising spirit of
businessmen in search of entrepreneurial profits. You can’t push dollar
bills down the throat of lethargic businessmen.
The real cause of the Great Depression eluded
Friedman, as it did Keynes before him. It was found by the German economist Heinrich
Rittershausen who in looking for it went farther
back in history than any other economist.
Unnoticed by Friedman and Schwartz, 1909 was a
milestone in the history of money. That year, in preparation for the coming
war, France and Germany decided to concentrate monetary gold in government
coffers. They stopped paying civil servants in gold coin. To make this
legally possible the notes of the Bank of France and the Reichsbank
were made legal tender. Most people did not even notice the subtle change.
Gold coins stayed in circulation for another five years. It was not the
disappearance of gold coins from circulation that heralded the destruction of
the world’s monetary system. It was the making of bank notes
irredeemable, even if they circulated side-by-side with gold coins for the
time being. There was an early warning sign: the fact that finance and
treasury bills were ‘crowding out’ real bills from the portfolio
of central banks in consequence of the French and German governments’
decision to make bank notes legal tender. Thus did the clearing system of the
international gold standard fall victim to sabotage. It took twenty years
before the chickens of 1909 came home to roost.
Well, come home they did with a vengeance. However,
by 1929 the memory of the 1909 sabotage faded. No one suspected that a causal
connection existed between the two events: making the bank notes legal tender
and the wholesale destruction of jobs twenty years later. Permit me to
elaborate.
Real Bills Doctrine
Friedman calls himself a ‘monetarist’,
meaning that he is a devotee of the Quantity Theory of Money. Like all
quantity theorists, he is a sworn enemy of Adam Smith’s Real Bills
Doctrine. He has never understood completely the market in real bills as it
existed before World War I, the function of which was to serve as the clearing
system for the international gold standard.
When the victorious powers dictated their peace
terms after the cessation of hostilities, they intentionally disallowed the
international bill market to resume its former functions. They wanted foreign
trade to follow a political rather than an economic agenda, in this case, to
keep their former adversaries on short leash. At the same time, they wanted
to retain the outward trappings of a gold standard. They failed to realize
that sooner or later the gold standard would seize up without the support of
its clearing system, the bill market. Worse still, they failed to see that
world trade would contract severely as a consequence. Worst of all they were
too obtuse to understand that the elimination of the bill market would be
followed, albeit with some lag, by a horrendous and intractable unemployment
problem confronting the entire world. This was correctly foreseen and
predicted by Rittershausen in 1930. See [3] and
[4].
Had the victors allowed the market in real bills to
resume its proper functions after the signing of peace treaties, world trade
would have recovered quickly and the international gold standard would have
continued to hold sway over the world. On advice from upright economists
sensible governments would have realized that legal tender laws were
thoroughly bad and would have removed them from the books. The charters of
central banks barring finance and treasury bills from the portfolio could not
have been violated with impunity. In that milieu there would have been no
great depression. World trade wouldn’t have vanished. The horrendous
word-wide unemployment would have never occurred.
Destruction of the wage fund
The fact of the matter is that prior to World War I
wages of the majority of workers, namely all those engaged in the consumer
goods sector, were financed by the international bill market. This is a point
that eluded not only Milton Friedman but Ludwig von Mises
as well. They missed the fact that the consumer was the ultimate paymaster and
he would pay on the dot, provided that he had access to gold. It was his gold
coin with which all wages were paid under the gold standard cum real
bills. Tampering with the bill market, the clearing house of the gold
standard, had an inevitable, if delayed, deleterious effect on employment.
Payment of wages is due long before the final sale
of merchandise to the ultimate gold-paying consumer. In some cases the
employer paying wages may have to wait as long as three months before he can collect
his share of the proceeds from the sale of merchandise. Thus, then, there is
the problem of financing wage payments. Unless this problem is solved
satisfactorily, mass unemployment will ensue. The wage fund cannot be
financed out of savings. Under the gold standard it was financed through the
spontaneous circulation of real bills.
Whenever certain goods were in urgent demand, their
movement through the channels of production and distribution was financed by
self-liquidating credit. This also included all wages payable to workers
handling consumer goods that were moving along on their way to the final
consumer through the ‘assembly line’, as it were. The credit was
liquidated out of the proceeds of the sale: the gold coin given up by the
ultimate consumer when he removed the merchandise from the market. The system
worked admirably well. Bills drawn on the retailer would circulate
spontaneously. Real bills enjoyed ephemeral monetary privileges, which
treasury bills and finance bills did not. Producers could buy supplies
against this credit, and they could discount these bills at the bank to get
gold coins with which to pay wages. Bills were the most liquid form of
earning assets in existence. The competition of banks for them was keen.
It is no exaggeration to say that the discovery of
the spontaneous circulation of self-liquidating credit is one of the great
achievements of the human intellect, on a par with the discovery of indirect
exchange. Without it the great economic progress in the Modern Age would be
unthinkable.
After World War I the victorious powers, led by
blind hatred for the vanquished, wanted to make foreign trade bilateral
instead of multilateral. Exports and imports were made subject to political
rather than economic considerations so that the victors could discriminate
against their former adversaries. In this effort they unintentionally ruined
the natural system of financing production and payment of wages. They
dissipated the wage fund. They blocked
the spontaneous circulation of self-liquidating credit in the world,
the only safe and sound source from which wage payments could be financed. In
doing so not only did they deal a mortal blow to the gold standard but,
inadvertently; they brought upon the world the curse of massive and persistent
unemployment.
This problem has been haunting the world ever since.
There is still no satisfactory way of financing the wage fund of workers in
the consumer goods sector in the absence of a gold standard cum real
bills. There is no way bills could circulate under the regime of irredeemable
currency. Not because real bills are anathema to Friedman; but because the
idea of a real bill maturing into paper money is preposterous. A real bill is
a future good. It must be maturing into a present good such as
the gold coin in order to be able to circulate. It would just not circulate
if it matured into another future good such as a bank note, redeemable or
not.
The wage fund couldn’t be financed out of
savings. Apart from the problem that saving takes time, the sums involved are
far too large. The idea that the working class can save the funds out of
which it can pay wages to itself is no less preposterous than the idea that
soldiers in the field can lift themselves up by their own bootstraps.
The only alternative to a gold standard cum
real bills is the regime of irredeemable currency. But then the government
has to assume the responsibility for paying the handouts of the welfare
state: it has to pay workers for not working, and farmers for not farming. Tertium non datur:
there is no third alternative. The regime of irredeemable currency and the
so-called welfare state are Siamese twins. Here, in a nutshell, is Friedman
on the horns of a dilemma. He likes irredeemable currency while he dislikes
the welfare state. But if you like irredeemable currency, then you had better
like its corollary, the welfare state as well. Nor does the problem end
there, since fiat money cannot be a permanent arrangement of society. Unless
it is stabilized by returning to a gold standard, it will collapse after
having caused a lot of mischief in the economy, as convincingly demonstrated
by monetary theory and history.
Optimal rate of increasing the stock of money
Of course, Friedman says he has a panacea in mind
for all the economic ills of the world. Just entrust the issuance of
high-powered money at a steady optimal rate to the Federal Reserve. He was
jubilant when his mentor Arthur Burns was named as chairman of the Federal
Reserve Board. If anybody, he could do it! He could put the tenets of
monetarism into practice. Well, he didn’t. Neither could other chairmen,
Bernanke’s ‘apology’ on Friedman’s 90th
birthday notwithstanding. Central bankers consider Friedman’s
prescriptions “impractical” and they have said so. Friedman retaliated
by quipping that “even a clever horse can thrash out grain at a steady
rate, so why can’t the dummies at the Fed?” There is neither
inflation nor deflation in the never-never land of Friedman.
The idea that there is an ‘optimal rate’
of increasing the stock of money, and it could be determined scientifically,
is chimerical. Creditors would challenge the ‘optimal rate’
saying it is too high; debtors would fight it saying it is too low. The
federal government, being the greatest debtor of them all, would apply
pressure on the Fed in support of the latter.
If the power to increase the money supply is
delegated to an agency dressed in scientific garb, then this agency is a
front behind which impostors hell-bent to usurp unlimited power under false pretenses hide. No matter how you look at it, the power
to issue the currency is unlimited power. Unlimited power means
unlimited corruption.
Mene Tekel Upharsin
In so far as Friedman has any coherent theory of
money at all, it is the tenet that, even though the creation of wealth must
be trusted to private hands and to the free play of the market, the creation
of money must not — notwithstanding the monetary provisions of the U.S.
Constitution. Money creation must be put squarely into the hands of the
government — never mind the Constitution which is, after all,
‘just a piece of paper’ (with apologies to George W. Bush).
Naturally, the U.S. government and the Federal
Reserve were all too eager to embrace unlimited power assigned to them by
Friedman, in spite of the fact that this power was not
‘enumerated’ in, nay, it was explicitly denied by the
Constitution of the United States. Friedman’s defense
of a floating currency is pseudo-scientific claptrap, modernistic stuff
designed to impress the mind untrained in monetary science (as opposed to
‘dismal monetary science’). The unfortunate part is that
permanent damage has been inflicted to the social science faculties of our
colleges and universities where so many have abandoned true science for the
dismal kind, in pursuit of the scent of money.
When Friedman’s monetary theory is put on a
scale against the U.S. Constitution, the verdict is: Mene
tekel upharsin (you
have been weighed and found wanting). Why the theory in the citation for
Nobel Prize not was worth to merit a constitutional amendment is an
interesting story. The credentials of Friedman were not strong enough to
withstand public furor that would erupt if the
paper dollar, hardly worth one constitutional gold cent, was supposed to be
carved into the stone of the U.S. Constitution. The powers-that-be
don’t want to rock the boat. It is too risky. ‘Let the sleeping
dog lie’. Policy-makers could not muster the necessary moral courage to
initiate a constitutional amendment. They would rather live with the odium of
running a blatantly unconstitutional monetary regime. Be that as it may, the
next dollar crisis will force the issue.
In “Two Lucky People”, written together
with his wife Rose, Friedman said: “We do not influence the course of
events by persuading people that we are right when we make what they regard
as radical proposals. Rather, we exert influence by keeping options available
when something has to be done at a time of crisis”.
Well, Mr. Friedman, crisis is knocking on our door
right now. It is a dollar crisis dwarfing that of 1968, or any monetary
crisis in all the history of money. Do you mean to say that the option to
rehabilitate the gold standard cum real
bills is open still?
Antal E. Fekete
References
[1] The
Real Culprit, by Walter E. Spahr, Monetary
Notes, July 1, 1959.
[2] The
Debate Is Not Over, by Walter E. Spahr, U.S.A.,
May 9, 1958.
[3] Arbeitslosigkeit und Kapitalbildung,
by Heinrich Rittershausen, Jena: Fischer, 1930
[4] Unemployment: Human Sacrifice on
the Altar of Mammon, by
Antal E. Fekete, September 30, 2005
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