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Floating Dollar, Milton Friedman's Contraption

Economics / Inflation Mar 20, 2011 - 05:14 AM GMT

By: Gary_North


Best Financial Markets Analysis ArticleOn March 12, David Stockman gave a lecture at the Mises Institute in Alabama. I was in attendance. It was a rousing speech, filled with funny one-liners. It reminded me of Patch Adams' listing of euphemisms for death in the hospital room of the guy with terminal cancer. It got us all laughing.

The speech had four important points. First, the Treasury-Federal Reserve bailout in October 2008 was not necessary to save the financial markets. It was necessary to save three or four finance companies that had cooked their books and were facing exposure, meaning write-downs.

Second, the crisis took place because of Nixon's decision on August 15, 1971, to cease honoring the good-as-gold guarantee of the 1944 Bretton Woods agreement. He "closed the gold window." While Stockman did not mention what prompted this, we gold standard dinosaurs remember: Nixon refused to insist that the Federal Reserve System cease inflating, which it was doing in order to stimulate the economy and get it out of a two-year recession. He admitted publicly that he was now a Keynesian, and the FED's Arthur Burns funded this transition.

Third, the idea behind this decision to close the gold window was what Stockman called Milton Friedman's contraption: a two-part reform to float the dollar and abolish the last traces of the gold standard.

Fourth, the Asians are running mercantilist economies. They are inflating their domestic monetary bases in order to buy Treasury debt in a plan to keep their currencies from rising, which would otherwise reduce exports. They will not be able to follow this program much longer, he said. Labor costs are rising.

The text of his speech is here.


Milton Friedman believed in the free market most of the time. The trouble was, whenever he approached the coercive monopoly known as civil government, he came up with logical solutions based on the idea that civil government can be made more efficient by adopting pseudo-market arrangements. He came up with ideas justifying the imposition of the Federal withholding tax in 1943. That was going to be a temporary wartime tax, the public was assured. He believed the government could collect far more revenue through withholding. He was correct. This made government far more efficient than ever before at extracting wealth.

He promoted the idea of educational vouchers issued by local governments and based on taxes extracted from the public. He did not consider the obvious fact that the courts would make this the wedge by which the state would take over private education. He and I debated this in 1993.

Most of all, he promoted the idea that storing gold in government vaults to back the currency is wasteful. It wastes gold. It wastes storage space. It wastes armed guards. So, to make monetary policy more efficient, the Federal Reserve should increase money – he never said which M – by 2% to 5% per annum. He wanted central-bank-controlled fiat money.

The only critics from the fringes of academia were the Austrian School economists. We knew that an efficient government is a dangerous government. We also knew that a central bank that does not face an outflow of gold in response to its policies of monetary inflation will inflate far more than would be allowed in any gold-related economy.

I responded to this argument, which had been picked up by The Wall Street Journal, back in 1969.

Hans Sennholz responded on many occasions. So did Murray Rothbard. But we were not taken seriously. We were not part of the mainstream. Academic economists had long since abandoned any support of a gold coin standard. They did not all support Friedman's idea of a restrained Federal Reserve. In fact, very few of them supported it. They wanted flexibility. They still do.

Once Nixon closed the gold window, there was no turning back. The monetary base grew, all of the various Ms grew, prices rose, bubbles grew and blew, and the Federal debt rose to today's gigantic, unsustainable level – unsustainable apart from mass inflation followed by hyperinflation.

The abolition of a currency convertible on demand into gold was only one part of Dr. Friedman's contraption. The other part was his suggestion of floating exchange rates. This deserves special consideration.


If currency A is redeemable on demand at 35 A's for one ounce of gold, and currency B is redeemable at 70 B's per ounce of gold, they will trade at a fixed rate of two B's for one A. No one establishes a price control that mandates this. No one needs to. Here's why.

If the central bank of nation A starts cranking up the money machine, currency A will decline in price. Gold will start creeping up to 36 A's. At that point – or before – speculators will start buying currency A and cashing the units in for gold at 35 units. Then they will take the gold and buy 36 A's. Then they take 35 A's to nation A's treasury and demand an ounce of gold. They pocket the extra A. Over time, they will have 35 A's. They will then cash them in for another ounce of gold.

Transaction by transaction, the gold will flow out of nation A's treasury. Either the treasury will run out of gold, or else it will stop redeeming gold at 35 A's per ounce. It may even cease all gold redemptions.

Currency A will fall in relation to currency B. After all, you can buy an ounce of gold for 70 B's. Anyone who thinks he can buy 35 A's and then sell them for 70 B's, so as to make a run on B's treasury, will find that all of his competitors have figured out the same move. The price of B's in relation to A's will rise. That ends the fixed exchange. The fixed exchange ends because nation A quits redeeming its currency at 35 A's per ounce of gold.

There was a fixed exchange rate before A's central bank began buying debt with fiat money. This rate was not set by law. It was set by the free market. The legal convertibility of A into gold at 35 A's per ounce, plus the legal convertibility of B's at 70 B's per ounce, set the rate of exchange.

This was not a price control of currency A vs. currency B. It was a pair of price controls: currency and gold at 35 A's per ounce (fixed by domestic law), and currency B and gold at 70 B's per ounce (fixed by domestic law). The second relationship was by definition-law. The rate of exchange was set by each nation's central bank.

Any deviation from that fixed definition would cause feedback. If the price of gold was set too high, the central bank would be flooded with gold: "glut." If the price were set too low, the central bank would experience a run: "shortage." Either condition would force the bank to make changes: either changes in monetary policy or changes in the official definition of the currency-currency exchange rate.

The fixed rate of exchange, currency A vs. currency B, was a market rate of exchange. It did not change, because each nation honored its respective contract regarding convertibility into gold at a fixed price.


The 1944 Bretton Woods agreement was a contraption. It was a "new, improved" contraption whose original design was the gold-exchange standard, which came into existence in 1922 at the Genoa Conference. At that conference, governments agreed to establish a "new, improved" gold standard. Rather than re-establishing full gold coin convertibility domestically, which would transfer authority over monetary policy to the people, they came to an agreement. They would hold interest-bearing debt certificates issued by the United States or Great Britain instead of holding gold.

Britain went back onto the gold standard in 1925, but at the pre-War rate of exchange, as if mass inflation had not taken place. This was Churchill's decision as Chancellor of the Exchequer. This would soon force Britain either to sell gold or shrink the money supply. The government wanted to do neither. So, Montagu Norman, the head of the Bank of England, persuaded his very, very close friend Benjamin Strong, the head of the New York Federal Reserve, to persuade the Federal Reserve to pump up the U.S. money supply, so as to avoid a run on the Bank of England's gold. This Strong did until he died in 1928. Then the FED reversed course late 1928. It ceased inflating. That popped the stock market bubble.

The IMF created a system of fixed exchange rates. These were not based on gold convertibility. These were price controls. The IMF enforced these fixed rates, though not very well. From time to time, some nation devalued, i.e., refused to supply foreign exchange at the fixed rate. The IMF had no sanctions to impose. So, the system lurched along from devaluation to devaluation.

Only the United States sold gold at $35 per ounce to governments and central banks. But this could not go on. Gold flowed out. After 1964, France kept demanding payment in gold. The Federal Reserve kept inflating.


Friedman easily took apart the idea of fixed exchange rates. Fixed exchange rates are a form of price control. Friedman was a good enough economist to know that price controls produce shortages. The artificially undervalued currency goes out of circulation. The overvalued currency produces gluts. There will be runs on central banks.

Domestic purchasers of foreign goods say to the central bank: "Sell us the artificially undervalued foreign currency at the official price." The central bank runs out of foreign currencies. Trade collapses. There is then a devaluation. The official prices of the foreign currencies are raised to new fixed exchange rates.

It was easy for Friedman to expose this as ridiculous. "Just float the currencies," he said. "Let the free market set their prices." This was good advice. Price controls do not work as promoted. They always produce gluts or shortages.

But then Friedman recommended his old favorite: pure fiat currencies. He said that these can be managed rationally by means of a fixed rule governing a predictable expansion of money. "Turn it over to the Federal Reserve. All will be well if the Federal Reserve does not tamper with the rate of growth." As John Wayne said in The Searchers: "That'll be the day."

Nixon adopted Friedman's contraption. First, there would be no more convertibility of gold for foreign official government agencies.

For a little less than two years, there were universal price controls on American goods. These controls led to shortages and a disruption of international trade. The dollar was not officially floated until December 1973.

When the price controls came off, prices rose. In 1975, Gerald Ford launched the WIN plan: Whip Inflation Now. The recession of 1975 did exactly that. Then came the worst monetary inflation in American peacetime history: 1976-80. Gold and silver soared.

Friedman's contraption clearly was not working. Floating exchange rates were not the problem. The abolition of the gold exchange standard was the problem.

Friedman's contraption has engulfed the whole world in monetary inflation, bubbles, and busts.


Stockman blames floating exchange rates and the abolition of the gold standard.

That the demise of the gold standard should have been as destructive of fiscal discipline as it was of monetary probity can hardly be gainsaid. Under the ancient regime of fixed exchange rates and currency convertibility, fiscal deficits without tears were simply not sustainable – no matter what errant economic doctrines lawmakers got into their heads.

Back then, the machinery of honest money could be relied upon to trump bad policy. Thus, if budget deficits were monetized by the central bank, this weakened the currency and caused a damaging external drain on monetary reserves; and if deficits were financed out of savings, interest rates were pushed up – thereby crowding out private domestic investment.

This is an accurate assessment of what happened. But the anchor to this was not the fixed exchange rate system, because the IMF had no real authority to enforce them. The anchor was the promise of the United States to sell gold at $35 an ounce. When the chain was cut, and the U.S. kept its gold, the international currency system was cut adrift. The anchor resides in the vault of the New York Federal Reserve Bank.

In the good old days, there was pain, Stockman observed. "Politicians did not have to be deeply schooled in Bastiat's parable of the seen and the unseen. The bitter fruits of chronic deficit finance were all too visible and immediate." This ended in 1971.

During the four decades since the gold window was closed, the rules of the fiscal game have been profoundly altered. Specifically, under Professor Friedman's contraption of floating paper money, foreigners may accumulate dollar claims or exchange them for other paper monies.

But there can never be a drain on U.S. monetary reserves because dollar claims are not convertible. This infernal engine of fiat dollars, therefore, has had numerous lamentable consequences but among the worst is that it has facilitated open-ended monetization of the U.S. government debt.

The government is running a $1.6 trillion deficit. Nothing can be done politically to stop this. We are on a runaway train. The main brakes were removed in 1971. The only brake now is that of the bond vigilantes, but the Federal Reserve is the buyer of bonds today, along with Asian central banks. Stockman observed that "the Fed's QE2 bond purchases have been so massive that it is literally buying Treasury paper in the secondary market almost as fast as new bonds are being issued."

Is all this Friedman's fault? Stockman lets him off the hook, to some extent.

By contrast, under the contraption that Professor Friedman inspired, trade account imbalances are never settled. They just grow and grow and grow – until one day they become the object of fruitless jabbering at a photo-op society called G-20.

In all fairness, Professor Friedman did not envision a world of rampant dirty floating. Indeed, it would have taken a powerful imagination to foresee four decades ago that China would accumulate $3 trillion of foreign currency claims or more than 50% of GDP, and then insist over a period of years and decades that it did not manipulate its exchange rate!

My response: it was all Friedman's fault, intellectually speaking. When an economist recommends a policy, he also recommends its effects. Friedman failed to see what Austrian School economists had predicted: the unleashing of fiat money, and manipulated rates – dirty floating. Dirty floating is all there is in a world run by government-licensed central banks without gold coin convertibility. But for our saying this, decade after decade, the economics profession has marginalized us.


Milton Friedman was always too clever by half. He advised governments to get more efficient, and they did so. They used his advice to expand their power and expand their reach into our wallets.

We told him so. He did not listen. His followers did not listen. Today, they all sit mute at the side of the road, mumbling about potentially excessive deficits and potentially excessive price inflation, but generally approving of the Federal Reserve.

The problem is the original contraption: (1) government's monopolistic control over money and (2) central banking as such. Here, Friedman was supportive of government.

The problem was not floating exchange rates or the breakdown of Bretton Woods in 1971. Those were the inevitable results of Bretton Woods, as Henry Hazlitt warned in the late 1940s, and was fired by the New York Times for saying so. You can read what he predicted.

The problem was not even the Genoa Conference of 1922, the contraption designed to solve the inflation that came as a result of the suspension of redemption in the second half of 1914, when World War I broke out.

The problem was the mass confiscation of the people's gold in 1914: first by commercial banks, then by the central banks.

Milton Friedman's contraption was just one more ill-fated attempt to deal with the results of the original confiscation. It was one more case of his outlook: "The government was right to confiscate the gold and end the gold standard. That was an efficient way to fight a war, just as withholding taxes are efficient, and vouchers are efficient."

Milton Friedman spent his career defending the efficiency of the free market. But, on the really big issues, he sold his peers on the efficiency and good will of government politicians and bureaucrats. "Trust them to be efficient."

The Austrians said the same thing, but added, following Forrest Gump's mother, "Efficiency is as efficiency does." The state gets more efficient only in order to tyrannize people on a cost-effective basis.

Milton Friedman's contraption was the unchecked welfare-warfare state: unchecked by annual taxation without withholding and unchecked by the gold standard.

If that's efficiency, include me out.

Gary North [send him mail ] is the author of Mises on Money . Visit . He is also the author of a free 20-volume series, An Economic Commentary on the Bible .

© 2011 Copyright Gary North / - All Rights Reserved
Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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