The most important lesson to emerge from the crisis in the eurozone has very little to do with fiscal policy. The eurozone crisis is just the latest case study in the dangers of fixed exchange rate regimes. Fixed exchange rates have arguably caused more economic and social misery than almost any other economic institution in recent decades. Yet much of the analysis of developments in the eurozone misses this fundamental point.
The idea of a market-determined exchange rate was almost unthinkable to policymakers in the 1950s, but not to Milton Friedman. In his 1953 essay The Case for Flexible Exchange Rates, Friedman pulled no punches. He argued that the Bretton Woods system of fixed exchange rates and its bagman, the International Monetary Fund, were ‘the major mistake made in post-war international economic policy.’ Correcting that mistake was nothing less than ‘absolutely essential’ to the ‘economic integration of the free world through multilateral trade.’ Friedman’s essay was to prove as consequential as it was novel.
Friedman noted that a common exchange rate required not only a central monetary and fiscal authority, but also the absence of restrictions on movements of goods, people and capital. The danger of common currencies and fixed exchange rate regimes was that governments would sacrifice these freedoms in order to defend the exchange rate.
The main advantage of a flexible exchange rate is that it allows a single, market-determined price to carry much of the burden of adjustment to a wide-range of internal and external macroeconomic shocks. Under a common currency and fixed exchange rate regimes, internal prices and incomes have to adjust instead. The exchange rate regime becomes the tail that wags the economy.
Friedman maintained that the argument for a flexible exchange rate was ‘very nearly identical with the argument for daylight saving time.’ It is easier to change the notional time shown by the clock than each individual’s pattern of reaction to the clock. Similarly, it is better to allow the market to adjust the exchange rate than to require adjustment in the myriad of domestic prices.
In 1969, a group of liberal economists including Friedman held a conference in Brgenstock, Switzerland to advocate the adoption of floating exchange rates. They were motivated by concern that the increasingly troubled Bretton Woods system of fixed exchange rates would continue to undermine the prospects for global free trade. They issued a communiqu calling for a shift to floating exchange rates and published the conference proceedings in 1970.
The conference was exceptionally timely. The Bretton Woods system collapsed from 1971 and the Brgenstock papers provided the intellectual basis for a new system of floating exchange rates and a new era of free trade and globalisation.
Politicians in most countries only reluctantly gave up their control of the exchange rate. Australia was typical in requiring a balance of payments crisis to force politicians’ hand in 1983. While floating the Australian dollar is now portrayed as a heroic act of policy bravery, this is to make a political virtue out of what had become an economic necessity. Australia was simply following an international trend.
From the beginning, the euro project was an act of willful ignorance in relation to the pitfalls of a common currency in the absence of political and economic integration. The microeconomic benefits of a common currency are small relative to the enormous macroeconomic risks.
But the euro project was never about economics. Politicians saw the euro as a way of furthering the project of political integration. This was to put the cart before the horse. A common currency is a product and not a cause of economic and political integration. Rather than promoting peaceful integration, the euro is tearing Europe apart.
The eurozone crisis is unlike most other crises in that it was perfectly foreseeable. The same liberal economists who identified the flaws in fixed exchange rate regimes were quick to foresee the problems with European monetary integration.
For his part, Friedman gave the euro project no more than 10-15 years. Had the fiscal rules that were meant to underpin the euro from the outset been rigorously enforced, the euro may not have even outlived Friedman, who died in 2006.
Harvard economist Martin Feldstein warned in 1997 that ‘if EMU does come into existence… it will change the political character of Europe in ways that could lead to conflicts in Europe and confrontations with the United States… the adverse economic effects of a single currency on unemployment and inflation would outweigh any gains from facilitating trade and capital flows among the EMU members.’
Much analysis of the euro crisis assumes that the problem is how to keep the eurozone together. The real policy problem is how to bring the flawed euro project to an end.
Dr Stephen Kirchner is a Research Fellow at the Centre for Independent Studies and a Senior Lecturer in Economics at the University of Technology Sydney Business School.