by Dae Woong Kang and Ashoka Mody
Appeared originally at Voxeu.org 13 July 2015
In 1997, Milton Friedman warned that when politics clashes with economics, the outcome is not a pretty one. This column reviews some of criticisms and weaknesses of the European macroeconomic system, taking a historic look at the decades leading up to the creation of the euro. The clash Friedman warned about is manifest now in Greece. The economic logic for dealing with Greece is clear, but politics continue to defy economics.
Flexible exchange rates in the aftermath of the Great Depression
Up until the Great Depression of the 1930s, the predominant view was that national currencies should be exchanged at fixed rates. The expectation was that the rate would not be changed unless there was a compelling reason to do so. The success of the gold standard between 1870 and 1913 had deepened the faith in fixed rates. During those years, the world's major economies had maintained a commitment to exchanging their currencies for a fixed amount of gold and, for much of the time, the world economy prospered. But the gold standard proved completely unworkable after 1913, and was, by Barry Eichengreen's influential account, a major contributor to the severity of the Great Depression (Eichengreen 1992a). Fixed exchange rates, the Harvard economist Gottfried von Haberler later commented, became “a casualty of the Great Depression” (Habeler 1976, p.17).
That triggered a revolution in international macroeconomic thinking. In the 1940s, a new phrase, ‘flexible exchange rates', appeared in intellectual discourse (Figure 1). Strikingly, Germans were the pioneers in discussing flexible exchange rates (‘flexible Wechselkurs' or ‘schwankender Wechselkurs') while the French showed the least interest (‘taux de change flexible' or ‘taux de change flottant').
Figure 1. The usage of the phrase ‘flexible exchange rate' in German, English, and French books
Note: The graph was created using the Google Books Ngram Viewer (https://books.google.com/ngrams/info). It reports the frequency with which the phrase flexible exchange rate is mentioned in the books scanned by Google; ‘flexible Wechselkurs' was used for German books and ‘taux de change flexible' for French books. The English variation ‘floating exchange rate', the German variation ‘schwankender Wechselkurs' and the French variation ‘taux de change flottant' yielded similar trends.
The immediate post-World War II monetary system was fashioned at that intellectual cusp. In July 1944, when policymakers met at Bretton Woods, New Hampshire, it was still hard to break free from the fixed exchange rate mind set. But in deference to reality, the new system allowed countries to ‘adjust' their fixed rates under international supervision. To authorise these changes – and to oversee the world's exchange rate policies – the IMF was created.
The system was short-lived. With capital criss-crossing the world in ever larger volumes, the fixed rates were continuously tested. In 1953, the University of Chicago economist and later Nobel Laureate Milton Friedman proposed the more widespread use of flexible exchange rates (Friedman 1953). As Figure 1 shows, the usage of the phrase ‘flexible exchange rates' accelerated, once again in Germany.
