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 a gold standard, 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 national 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.
Keith Weiner is the founder DiamondWare, a VoIP software company, and is a PhD student at Antal Fekete’s New Austrian School of Economics in Munich. He is now a trader and market analyst in precious metals and commodities.
© 2012 Keith Weiner.
/* If a significant component of the assets are composed of US dollars, and the US dollar falls, the central bank’s balance sheet deteriorates. */
Yes, but only if the Central bank holds just US dollars on its assets side of the balance sheet. What if a central bank holds gold on its assets and marks its gold reserves to market every quarter?
Then if dollar is devalued, their gold asset portion grows while the dollar assets deteriorate.
Source: FOFOA
Which central banks have more gold than dollars?
Correct Jesse, I agree
But that will increase the value of the currency in question to the point that its trade balance will deteriorate to the point that the country’s business leaders will go rampant and demand some kind of action. This is happening presently in Switzerland where the Swiss National Bank (SNB) fixed a minimum rate against the EURO of 1.20. A most dangerous strategy by the SNB in my opinion, especially considering the dire state the EU is presently in.
Quote from Jesse_Fan: “Then if dollar is devalued, their gold asset portion grows while the dollar assets deteriorate.”
And that also happens to every person who is using dollars, only not all at the same time. The central bank and the state and their cronies benefit first, while those little people at the end of the line pay the price. What happens when the people at the end of the line figure out that they should just use gold and hang the paper money?
It’s all a con game to try and make something out of nothing, but sooner or later, the bill comes due. People that refuse to recognise this are simply deluding themselves, or part of the con game.
Interesting piece, Mr Weiner, but I would like to ax you about this quote.. “Many have noted that the currencies do not “float”; they sink at differing rates,”
What are they sinking against? In light of the absent of a gold standard (which I clearly support – script redeemable in PMs) what other mechanization could be used to value world currency today?
To me, Uncle Milton’s arguments appear quite logical, as the American Dollar has been on a thirty year decline…Furthermore, are not tradeable scripts subject to the venerable laws of supply and demand?
“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.”
As the US Dollar declines, would not the Central Bank demand more of them as compensation?
If your paragraph is true, Mr Weiner, how would you address this? Would the new medium of exchange become gold?
Could not the Central Banks holdings in Au decline, as well as it’s own fiat money?
Hans: they are are sinking against gold, yes.
If Friedman’s arguments are logical, then the US trade deficit would have reverted to zero a long time ago.
If one tries to understand the value of a currency in terms of so called “supply and demand” then one would expect the US dollar would have collapsed a long time ago. The US dollar has the greatest supply–by far–of any paper currency. I think marginal utility and the key concept of “stocks to flows” is the proper lens through which to look at the dollar.
How can anyone just demand more of something, simply because its value has declined? Do you demand more money in your bank account when the value of the dollar falls? I don’t understand the question.
Absent the coercion of law, a market process selected gold as the most marketable commodity. People who produce less marketable goods trade them for gold. Thus gold came to be used as the medium of exchange, i.e. of indirect trade. The maker of shoes does not have to worry about the problem that the maker of food may not need shoes today, when the shoe maker is hungry.
Yes, Mr Weiner, you are correct that most if not all world currency are indeed “sinking” against Au, but what would be the results if gold was deprecating and not appreciating? Furthermore, are we not comparing apples to pears? There remains the question, as to whether a gold standard would produce better economic results or even eliminate inflation..
I personally suspect, the world would still suffer from economic ebb and flows even on a gold standard, as a natural course of events…
If one compares the world’s currency (US Dollar) to others, then there are numerous examples of appreciating fiat currencies…
Since America’s largest import item is oil and that it is traded and paid for in US Dollars, explains why America has not been able to balance it’s trade deficit…As the US Dollar declines in value, the oil merchant demands a greater payment for their product..Remove goo from the trade deficit ledger and America moves to a surplus…
There is a rather simple counter measure for a declining currency, the deliver of goods simply increase their prices as a necessary compensation…
Keith, you would certain agree, that a floating exchange rate is superior to that of a fix one.
I did forget to add, Mr Weiner, that I suspect that most or all currency declined against a basket of food and base metal commodities…
I guess the exchange rate has failed after!!
all….