Happy Birthday, Milton Friedman, The European Crisis Is Your Latest Vindication

The discussion between these two brilliant men was sponsored by The Institute for Research on PublicPolicy in May of 2001. If you have the time, read it over.  You’ll end up knowing more about currency economics than anybody has a right to, and you’ll learn more than anybody in any position of power in international finance knows about things like currency unions and fixed and flexible and pegged and unpegged (and gradations between) exchange rates . But the real clash was between the genius who thought up the Euro and the genius who was skeptical of it.

 

Friedman nailed it right at the beginning:

 

“There is no historical precedent for such an arrangement. It involves each country’s giving up power over its internal monetary policy to an entity not under its political control. Such a system has economic advantages and disadvantages, but I believe that its real Achilles heel will prove to be political; that a system under which the political and currency boundaries do not match is bound to prove unstable.”

 

In other words, when the accountability for creating money is separated from the accountability for spending money, chaos results.

 

Mundell argued that the Euro and similar schemes which he hoped would be imitated around the world were worth it because they would lead to a higher standard of living:

 

“Countries with a unified currency system trade a great deal more with one another and are able to exploit the gains from trade and therefore have a higher standard of living.”

 

But Friedman argued that, in fact, the Euro would not be economically successful because Europe lacked sufficient economic freedom:

 

“A flexible exchange rate would enable each of them to have the appropriate monetary policy. With a unified currency, they cannot. The alternative adjustment mechanisms are changes in internal prices and wages, movement of people and of capital. These are severely limited by differences in culture and by extensive government regulations, differing from country to country. If the residual flexibility is enough, or if the existence of the euro induces a major increase in flexibility, the euro will prosper. If not, as I fear is likely to be the case, over time, as the members of the euro experience a flow of asynchronous shocks, economic difficulties will emerge. Different governments will be subject to very different political pressures and these are bound to create political conflict, from which the European Central Bank cannot escape.”

 

As we’ve seen a thousand times since this debate in 2001, as the economic case for the Euro weakens, advocates fall back on national security arguments. Mundell argues that the Euro is a bringer of peace:

 

“My own view about the politics of the euro is that it will provide a catalyst for increased political integration in Europe, which, after two centuries of a Franco-German rivalry that has periodically engulfed the entire world, is highly desirable. Increased political integration would also enhance Europe’s voice on the world political stage and allow Europe to share some of the leadership role and burden of the United States. In my view there are few, if any, risks associated with an increased power position of Europe in world affairs.”

 

Friedman argues that instead, a unified currency in an environment of low economic freedom and competing political agendas will be a bringer of strife:

 

“My difference with Bob which reflects what I earlier labelled (d) is exemplified by my pessimism and his optimism about the euro. We agree that the euro has no historical precedent. I believe we also agree that its attainment was driven by political, not economic, considerations, by the belief that it would contribute to greater political integration —the much heralded United States of Europe—that would in turn render impossible the kind of wars which Europe has suffered so much. If achieved, political integration would render the monetary and political areas coterminous, the historical norm. Will the euro contribute to political unity? Only, I believe, if it is economically successful; otherwise, it is more likely to engender political strife than political unity.”

 

Now, I have a great deal of respect for Dr. Mundell. He’s been kind enough to allow me to interview him, and I’ve learned a lot from him. He is required reading around here. And he’s right about a lot of things, even in cases where Friedman was wrong. But in this case Friedman was able to foresee with far greater accuracy the future course of the European monetary union than its intellectual father. I suspect that Dr. Mundell’s political idealism got the better of him in this case.