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Professor Milton Friedman Interview
Professor Milton Friedman
Interviewed by Radio Australia
17 July 1998
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Professor Milton Friedman received the 1976 Nobel Prize
for Economic Science. He has been a senior research
fellow at the Hoover Institution, Stanford, California,
since 1977 and is Paul Snowden Russell Distinguished
Service Professor Emeritus of Economics at the University
of Chicago.
Radio Australia:
Professor Friedman, may I first ask you what you
think was the main impact of the Keynesian
orthodoxy on public policy which, basically since
the Great Depression, tended to influence economic
policy makers around the world?
Professor Friedman:
It certainly did, although the effect was
primarily, I'd say, after World War II. Keynes's
book, after all, came out in 1936 and only three
years elapsed after that before the world was at
war. So the main effect was after the war and the
effect was very extensive, there's no question
about that, and it still exists. The effect was to
encourage politicians to do what politicians love
to do: spend money and not raise taxes. The
Keynesian theory; not as Keynes himself necessarily
presented it, but as it was interpreted in the
intellectual community, the media and the political
community; said that if you have high unemployment,
the way to solve that is to cut taxes, increase
government spending and create a government
deficit.
The government could have created the deficit
entirely by cutting taxes and not increasing
spending, but if you're sitting in the House of
Commons in London or in your counterpart in
Canberra or in Washington, obviously the thing
you'd like to do is increase spending. So the major
effect of the Keynesian orthodoxy in the post war
period was to encourage an expansion in government
spending as a fraction of income and to contribute
to the inflation of the 1970s, not because of the
spending, but because of the loose monetary
policies that went along with it.
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RA:
Well, why do you think that Keynesian economics has
gone out of favour when, as you've said, it tended
to be the major theoretical paradigm in the post
war period?
Professor Friedman:
It went out of fashion to some extent, but I think
it's much too strong a statement to say that it's
out of fashion. It is no longer accepted in the
academic community in its original, more rigid
form. But in terms of the effect on policy, it's
still very strong. For example, Washington is
currently advising Japan to get out of its trouble
(and Japan is in deep trouble).
What is Washington's advice? Fiscal stimulus; spend
more; cut tax. It's bad advice. Japan has
introduced fiscal stimulus five times in the past
seven or eight years and each time it's been a
failure and that's not a surprise. Fiscal stimulus
is not stimulating in and of itself, in my opinion.
I think the Keynesian view is wrong on that issue.
Fiscal stimulus has generally been accompanied by
monetary expansion and then monetary expansion has
been stimulating. However, in the Japanese
experiments of the last five or seven years, fiscal
stimulus has been accompanied by a restrictive
monetary policy rather than an expansive monetary
policy and the result has been that you've had
continued recession or depression. If the Keynesian
orthodoxy were out of fashion, Washington would be
giving Japan very different advice. It would be
saying to Japan: 'Well, maybe it's a good idea for
you to cut taxes in order to increase incentives,
but there is no need for the government to increase
spending, that's a bad thing to do. What you should
do is encourage a more expansive monetary policy.'
So I think it's much too strong to say that
Keynesian orthodoxy is out of fashion.
RA:
Well, quite clearly, Professor Friedman, you do
believe still that monetarism is relevant for the
economic conditions and the challenges that are
facing us today. Could you perhaps expand on that
and explain to a lot of our listeners who have no
training in economics what the basic tenets of
monetarism are and why they are still relevant
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today?
Professor Friedman:
I would be very glad to do that. In the first
place, the reason Keynesian orthodoxy came so much
into favour was because of a widespread
misinterpretation of the Great Depression. The
contraction from 1929 to 1933 in the United States
and on to 1936 in France ‐ and different dates in
different countries around the world ‐ was without
question the most severe economic difficulty that
the United States had ever experienced. It was
widely interpreted as showing that monetary policy
couldn't work. It was interpreted that way, of
course, because all of the central bankers kept
saying that they were following easy money policies
and that the economy was declining in spite of, and
not because of their actions.
But when Anna Schwartz and I examined the history
of that period in detail, we found that the
situation was very different. In the United States
from 1929 to 1933, the quantity of money declined
by a third. Similarly in Britain, it declined till
1931, when Britain went off the gold standard. In
France, the reason the contraction kept on until
1936 was because France insisted on staying on the
gold standard and kept the money supply declining.
To go back to the United States, at all times from
1929 and 1933, the Federal Reserve had the power
and ability to have prevented the decline in the
quantity of money and to have increased the
quantity of money at any desired rate.
So in our opinion, the Great Depression was not a
sign of the failure of monetary policy or a result
of the failure of the market system as was widely
interpreted. It was instead a consequence of a very
serious government failure, in particular a failure
in the monetary authorities to do what they'd
initially been set up to do. When the Federal
Reserve Act was passed in 1913, its major purpose
was to prevent 'banking panics' as they were
called, temporary crises that had occurred in the
United States in 1907 and during earlier periods.
What it did was to preside over the worst banking
panic in the history of the United States. Not only
did the quantity of money go down by a third, but
about a third of the banks failed and in the Spring
of 1933, the Federal Reserve System, which had been
set up to prevent banking panics, closed its doors
itself and stopped operating.
That's a disgraceful performance and was the reason
why, on the one hand, the role of monetary policy
was denigrated for a while, but on the other hand,
why the demonstration that monetary policy had
played a major negative role in producing the Great
Depression promoted a revival of interest in
monetary policy.
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RA:
Professor Friedman, can I just take you up on this
point about the central banks, or at least some
central banks? Some of them don't seem to believe
that they can target the money supply through the
money base to control the inflation rate and
instead seem to have primarily targeted interest
rates. Do you think that has occurred, at least in
some central banks around the world and what are
its implications for monetary policy?
Professor Friedman:
That is a question not of basic principle, but of
technique. When they so‐called 'target the interest
rate', what they're doing is controlling the money
supply via the interest rate. The interest rate is
only an intermediary instrument. There's only one
thing that all of the central banks control and
that is the base, their own liability, and they can
control that in various ways. They can control it
directly by open market operations, buying and
selling government securities or other assets, for
example, buying and selling gold, or they can
control it indirectly by altering the rate at which
banks lend to one another.
The central banks cannot control interest rates.
That's a mistake. They can control a particular
rate, such as the Federal Funds rate, if they want
to, but they can't control interest rates. If
central banks could control interest rates, you
never would have had interest rates at 10‐15% in
the late 1970s. If they could control interest
rates, would Brazil now be having interest rates in
the 20‐30% range? What central banks can control is
a base and one way they can control the base is via
manipulating a particular interest rate, such as a
Federal Funds rate, the overnight rate at which
banks lend to one another. But they use that
control to control what happens to the quantity of
money. There is no disagreement. No central banker
today would disagree with the proposition that
inflation is primarily a monetary phenomenon. Not
one of them will disagree that every inflation has
been accompanied by a rapid increase in the
quantity of money and every deflation by a decline
in the quantity of money. I believe that this
argument about interest rates versus the base
really takes you off the main track.
RA:
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Thank you very much. I think people will be very
interested to hear your comments there. Can we move
to something else which perhaps isn't getting a
very good press among ordinary members of the
community and that's the floating exchange rates? A
lot of citizens ‐ not to mention a lot of
politicians ‐ around the world, particularly in
Malaysia, have expressed concerns about the
apparent uncertainties that come with floating
exchange rates. As we've seen, that's been
exacerbated in the recent Asian financial crisis.
In your view can any case be made for a return to
the fixed exchange rate regime?
Professor Friedman:
Which fixed exchange rate regime do you want to
return to? Do you want to return to the gold
standard of the 19th Century? Do you want to return
to the pseudo‐fixed exchange rate of Bretton Woods?
What fixed exchange rate do you want to return to?
RA:
Well, could you perhaps explain how the system of
fixed exchange rates worked as it was before we saw
the floating of the exchange rate?
Professor Friedman:
Yes, there's really a great confusion about the
meaning of fixed exchange rates, as my comments
have just illustrated. There are, in fact, three
fundamental ways in which a country can order its
exchange rates. It can have a truly fixed exchange
rate, which means that it eliminates its central
bank, and adopts a policy such as pegging its
currency to gold. It will buy and sell gold at a
fixed rate or it can establish a currency board, as
Hong Kong has done in your part of the world. Hong
Kong does not have a central bank; it has fixed its
exchange rate to the US dollar. In effect, it says,
we will let the Federal Reserve make our monetary
policy. Hong Kong is, as it were, a designated
thirteenth Federal Reserve district.
The United States has a fixed exchange rate between
the different states. California uses the same
dollar as New York. Australia has a fixed exchange
rate between its different states. Both New South
Wales and Victoria use the Australian dollar.
Now, in the same way, Panama uses the US dollar,
although it calls it by a different name. Hong Kong
says that 7.8 Hong Kong dollars equals one US
dollar and they use the US dollar, fundamentally,
as their currency. The reason they do it through a
currency board instead of through direct
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dollarisation, is very clear. In the first place,
it enables them to get what economists call
'seigniorage.' When the Federal Reserve Board
issues dollars, essentially it's borrowing money at
a zero interest rate. People who hold those dollars
are, in effect, lending resources to the US
government and therefore the US government is
benefiting by the interest that could be earned on
those funds. That's what's called 'seigniorage,' in
fact, it's called 'seigniorage' because it refers
to the benefit the seignior or the lord got from
issuing money or from stamping his picture on
coins.
If Hong Kong were literally to use the US dollar
and not print any of its own [money], the US would
get the seigniorage from the currency that was
printed. By establishing a currency board in which
they say 7.8 Hong Kong dollars equals one US dollar
and conducting the currency board so that for every
7.8 Hong Kong dollars in existence in Hong Kong it
holds at least one US dollar, it can invest those
US dollars in government bonds and other assets and
earn interest on them and so Hong Kong gets the
seigniorage instead of the United States. That's
why you have a currency board instead of straight
dollarisation. But that is a truly fixed exchange
rate.
The second way of arranging the exchange system is
the way that Thailand, Korea and so on adopted
before the crash last year. [This involved] a
pegged exchange rate in which they said, 'we are
going to instruct the central bank to act in such a
way as to keep the local currency exchanging for
the US dollar at a fixed rate'. Now they didn't
have to peg to the US dollar, they could have
pegged to the Yen and indeed they would have been
much better off if they had done so. They could
also have pegged to the German Mark. Indeed, some
countries have pegged to a combination of
currencies, through a mixture of the Mark and the
dollar, for example.
That's a fundamentally different arrangement,
because it involves keeping a Central Bank and it's
an arrangement that's a recipe for trouble. This is
what happened in East Asia. The Central Bank
followed internal monetary policies that were not
consistent with keeping the exchange rate at the
designated peg and sooner or later there was a
collapse.
Whenever you have a pegged exchange rate system
like that, it has a tendency to let small problems
accumulate into big ones and then to create a
crisis. This is true, I may say, not only among
small countries like Thailand or Korea. Several
times in the 1950s and 1960s, Great Britain had
similar exchange crises arising from exactly the
same thing. It was trying to peg its currency, at
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that time under Bretton Woods, to the US dollar,
and its Central Bank was behaving in a way that was
not consistent with that. So, lo and behold, you
had an exchange crisis and a devaluation. The same
thing happened in 1992 and 1993, when you had the
crisis in the European common market and when
Britain and Italy both broke away because their
pegged exchange rates were not consistent with what
their central banks were doing.
The third method of having an exchange rate system
is to have a floating exchange rate. Now, a
floating exchange rate is one in which the
government does not intervene in the exchange rate
market but allows the market to set its own values.
[Here you find] one very interesting historical
phenomenon. No nation that has had a floating
exchange rate has ever had external currency crisis
in international finance. Why is it that the East
Asian crisis hasn't affected New Zealand, close
neighbour to Australia? It hasn't affected New
Zealand, because New Zealand has a truly floating
exchange rate. Has it affected Australia? I don't
know the details about Australia. But Australia has
a quasi‐floating exchange rate and that has
insulated it.
RA:
So, in short, do you think that some people are
perhaps drawing the wrong lessons from the Asian
economic troubles?
Professor Friedman:
They are drawing the wrong lessons. The lesson for
Asia is; if you have a central bank, have a
floating exchange rate; if you want to have a fixed
exchange rate, abolish your central bank and adopt
a currency board instead. Either extreme; a fixed
exchange rate through a currency board, but no
central bank, or a central bank plus truly floating
exchange rates; either of those is a tenable
arrangement. But a pegged exchange rate with a
central bank is a recipe for trouble.
RA:
Perhaps could we move to another common perception
or misconception about the price of the dollar?
Many ordinary people seem to think that it's the
screen jockeys, as I think they've become known,
who hang on the news from around the world. It's
those (some people would say economically
illiterate) screen jockeys who determine exchange
rates at the moment. Could you perhaps explain, as
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an economist, who actually does the determining of
the exchange rates in this flexible rate regime?
Professor Friedman:
Well, in a day‐to‐day term, the speculators, whom
you are describing, can have some influence. But
let me ask a very simple question: You are a
speculator. How can you make money and how can you
lose money? You can only make money if you buy a
product, whatever it is ‐ maybe a currency, maybe
wheat and maybe something else ‐ at a relatively
low price and sell it at a higher price than you
buy it at. There's no other way to make money.
If you buy at a relatively low price, you're making
that price higher than it otherwise would be. If
you're selling at a relatively high price, you're
making that price lower than it otherwise will be.
If speculators make money, on the whole ‐ there are
some rare theoretical exceptions ‐ but, on the
whole, they make the market more stable, not less
stable.
However, when you have the kind of pegged exchange
rate situation we were talking about, there's an
invitation for speculators, because they're given a
one way ride. They can't lose because the
government is a counter‐party and what happens is
that speculators can make money because the
government is going to lose money. The government,
in effect, is following a policy which is not
tenable. It's following an internal monetary policy
which is not consistent with the exchange rates
they're trying to pay. And yet, they try to peg it.
This process gives speculators a one‐way option.
However, in floating exchange rate markets,
speculators can only make money if they help to
stabilise a market, not if they make it more
unstable. Over anything but the shortest period, a
month or two months or three months, the exchange
rates and the flexible exchange rate system are
determined by two fundamental forces: one is trade
‐ imports, exports and the comparative advantage of
the country in question in respect to exports ‐ and
the second is capital movements.
If a country is an attractive place for foreigners
to invest their funds, then that country will have
a relatively high exchange rate. If it's an
unattractive place, it will have a relatively low
exchange rate. Those are the fundamentals that
determine the exchange rate in a floating exchange
rate system. Let me emphasise that there's nothing
special about exchange rates. If Australia tries to
peg the price of wool ‐ let's say wool is a major
product of Australia ‐ and if it sets the price too
high, it'll have the same effects as if the
exchange rate is set at too high a rate. If it sets
it too high, then there will be a surplus of people
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trying to sell wool and a shortage of people trying
to buy wool. If it sets it too low, it'll be the
other way around. And the government can maintain
the price only if it is willing to accumulate
stocks of wool in the one case or to provide wool
from inventories in the other. Everything I've just
said about wool applies just as well to the Thai
baht.
RA:
Could we now look more broadly at how governments
around the world are coping with the economic
challenges of the last couple of decades? We've
seen the floating of exchange rates, and before
that, the floating of the dollar. Would you say
that governments today are more receptive to the
arguments and policies that you set out in your
book 'Capitalism and Freedom', which I think you
published back in 1962? Do you think that's the
case and how do you explain that?
Professor Friedman:
Well, in the first place, you have to distinguish
between rhetoric and practice. There's no doubt
that the rhetoric comes closer to what I was
talking about in 'Capitalism and Freedom', but part
of the reason it does that is because practice has
gone further away. I shouldn't speak about
Australia because I don't know enough about it. But
the United States, Great Britain, Germany, France,
almost every major country I know anything about,
has a bigger government, larger government
spending, more intrusive government and more rules
and regulations than they had in 1962 when
'Capitalism and Freedom' was published and I
bemoaned at the time the fact that government was
too big and too intrusive! The practice has gone
the other way, but rhetoric has changed. The reason
it's changed is because the public at large has
learned a lesson that governments of that kind are
very expensive, impose very high taxes and are very
inefficient. The actual results of policies are
almost always the opposite of the intended results
of policies. A government which claims that it's
going to cut unemployment, generally ends up having
higher unemployment than one that keeps quiet about
it.
Governments have also been proclaiming for years
that they are going to eliminate poverty and in
fact, welfare systems in the United States and
Britain and elsewhere have not been effective in
achieving their objectives. So the public
themselves have gotten rather fed up with
excessively large and intrusive government. In
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Britain, Margaret Thatcher first was elected
because of this widening view and helped to
dramatise it. In the United States a couple of
years later, Ronald Reagan was elected because the
public had come to agree with his views. He had
expressed the same views 20 years earlier, but he
could not have been elected President 20 years
earlier. Margaret Thatcher could not have been
Prime Minister 20 years earlier in Britain.
What's happened is that, on the one hand,
governments have become bigger and more intrusive,
while on the other, the public at large has
experienced the adverse results of that. The result
is that there is pressure on governments everywhere
to become smaller and less intrusive.
Moreover, when you talk about the world in the last
20 or 30 years, there have been a number of
important forces that have led the rhetoric for
change, the most important of which was the
collapse of the Soviet Union and the tearing down
of the Berlin Wall. That was a major event and
altered the public and intellectual conception. Up
until that point, there was widespread belief in
the intellectual community that collectivism,
central planning and central direction was a
viable, possible way to organise a modern economy.
The collapse of the Soviet Union and in particular,
the discovery that places like East Germany, which
had been thought to be fairly efficient, were much
worse than they'd ever been estimated to be,
shattered that belief.
The Soviet experience was much worse than experts
in the West had thought. That discovery had a
tremendous impact both on the intellectual
community and on the public at large. I think that
is the most important single factor explaining why
the rhetoric is so very different than it was
earlier.
The fascinating thing to me is that the past 20 or
30 years have been very good years around the world
on the whole. We're talking about very severe
crises in East Asia, but remember, those crises,
with the possible exception of Indonesia, only
reduced by a small amount the gains that had been
made in the previous ten years. After all, those
countries all had very rapid real growth. The same
thing has happened in Singapore, Hong Kong, Taiwan
and New Zealand. China has been transformed in the
past 20 years. So that if you look at it from a
broad point of view, the developments over the past
20 years have been very positive and have been all
produced not by government policy, but by the
forces of private enterprise, foreign investment,
foreign technology and opening up of trade. An
increase in trade and the revolution in technology
‐ those have been the forces that have created the
rapid advances of the past 20 years for much of the
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world.
Now there are some exceptions. Russia is obviously
a basket case. But aside from Russia ‐ well, maybe
North Korea is another example ‐ it's hard to find
any place in the world which is worse off now than
it was 30 years ago.
RA:
Thank you very much. Before we sign off, could I
just take the opportunity to ask you what you think
the prospects are for the attempts in Europe to
create a common currency area? Are you optimistic
about their success?
Professor Friedman:
: I think it's a big gamble and I'm not optimistic.
Unfortunately, the Common Market does not have the
features that are required for a common currency
area. A common currency area is a very good thing
under some circumstances, but not necessarily under
others. The United States is a common currency
area. Australia is also a common currency area. The
characteristics that make Australia and the United
States favourable for a common currency are that
the populations all speak the same language or some
approximation to it; there's free movement of
people from one part of the country to the other
part, so there's considerable mobility; and there's
a good deal of flexibility in prices and to some
extent in wages. Finally, there's a central
government which is large relative to the local
state governments so that if some special
circumstances affect one part of the country
adversely, there will be flows of funds from the
centre which will tend to offset that.
If you look at the situation in the Common Market,
it has none of those features. You have countries
with people all of whom speak different languages.
There's very little mobility of people from one
part of the Common Market to another. The local
governments are very large compared to the central
government in Brussels. Prices and wages are
subject to all sorts of restrictions and control.
The exchange rates between different currencies
provided a mechanism for adjusting to shocks and
economic events which affected different countries
differently. In establishing the common currency
area, the Euro, the separate countries are
essentially throwing away this adjustment
mechanism. What will substitute for it?
Perhaps they will be lucky. It may be that events,
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as they turn out in the next 10 or 20 years, will
be common to all the countries; there will be no
shocks, no economic developments that affect the
different parts of the Euro area asymmetrically. In
that case, they'll get along fine and perhaps the
separate countries will gradually loosen up their
arrangements, get rid of some of their restrictions
and open up so that they're more adaptable, more
flexible.
On the other hand, the more likely possibility is
that there will be asymmetric shocks hitting the
different countries. That will mean that the only
adjustment mechanism they have to meet that with is
fiscal and unemployment: pressure on wages,
pressure on prices. They have no way out. With a
currency board, there is always the ultimate
alternative that you can break the currency board.
Hong Kong can dismantle its currency board tomorrow
if it wants to. It doesn't want to and I don't
think it will. But it could. But with the Euro,
there is no escape mechanism.
Suppose things go badly and Italy is in trouble,
how does Italy get out of the Euro system? It no
longer has a lira after whatever it is ‐ 2000 or
2001 ‐ so it's a very big gamble. I wish the Euro
area well; it will be in the self‐interest of
Australia and the United States that the Euro area
be successful. But I'm very much concerned that
there's a lot of uncertainty in prospect.
RA:
Thank you very much Professor Friedman.
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