Milton Friedman was right on the value of having your own currency

30 August, 2012 at 10:41 | Posted in Economics | 3 Comments

Countries that have joined the Europen Monetary Union have not only lost their capacity to issue debt in a currency over which they are their own masters. They have also lost the possibility of using their own instruments of economic policy in the form of interest rates and exhange rates.

Because of this they have also almost no other possibility of getting their costs in line than through “internal devaluation” by burdensome austerity measures. Measures that have driven the economies of Greece, Spain, Italy, Ireland and Portugal to the brink of disaster.

Since the countries of the euro area do not have their own currencies they cannot deal with crisis in a proper way. Had these countries had their own currencies they could have devalued their currencies and much more easily been able to restore their competitiveness and adjust to the shock of the financial crises of 2008.

Being “sort of” Keynesian, yours truly don’t often find the occasion to approvingly quote Milton Friedman. But on this issue I have no problem:

If internal prices were as flexible as exchange rates, it would make little economic difference whether adjustments were brought about by changes in exchange rates or equivalent changes in internal prices. But this condition is clearly not fulfilled. The exchange rate is potentially flexible in the absence of administrative action to freeze it.
At least in the modern world, internal prices are highly inflexible. They are more flexible upward that downward, but even on the upswing all prices are not equally flexible. The inflexibility of prices, or different degrees of flexibility, means a distortion of adjustments in response to changes in external conditions. The adjustment taes the form primarily of price changes in some sectors, primarily of output changes in others.

Wage rates tend to be among the less flexible prices. In consequence, an incipient deficit that is countered by a policy of permitting or forcing prices to decline is likely to produce unemployment rather than, or in addition to, wage decreases. The consequent decline in real income reduces domestic demand for foreign goods and thus demand for foreign currency with which to purchase these goods. In this way it offsets the incipient deficit. But this is clearly a highly efficient method of adjusting to external changes. If the external changes are deep-seated and persistent, the unemployment produces steady downward pressure on prices and wages, and the adjustment will not have been completed until the deflation has run its sorry course.

The argument for a flexible exchange rate is, strange to say, very nearly identical with the argument for daylight savings time. Isn’t it absurd to change the clock in summer when exactly the same result could be achieved by having each individual change his habits? All that is required is that everyone decide to come to his office an hour earlier, have lunch an hour earlier, etc. But obviously it is much simpler to change the clock that guides all than to have each individual separately change his pattern of reaction to the clock, even though all want to do so. The situation is exactly the same in the exchange market. It is far simpler to allow one price to change, namely, the price of foreign exchange, than to rely upon changes in the multitude of prices that together constitute the internal price structure.

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3 Comments »

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  1. First, you are aware that “internal devaluations” are very different from “austerity measures”?

    Second, I am very surprised to see how you accept an argument relating to price and wage rigidities. I thought that a central message of Keyne’s GT was that both prices and wages are indeed very flexible! (in fact, I think it’s only mainstream economists that believe that price rigidities create a link between nominal and real variables)

    • 1) Yes
      2) I’ve explained this to you before.
      To Keynes there would be disequilibrating forces at work EVEN IF wages were not rigid (which they as a rule ARE).
      What’s so difficult for you to understand in this?

    • Yes pontus, Keynes assumed prices and wages were flexible for the purpose of conveying that sticky wages/prices were not the cause of unemployment.


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