Friedman On Pegging

I’ve got the book*, but I’m too lazy to type it all out, so I’m quoting Friedman’s thoughts on this from my friend Lar’s post (excerpt):

Milton Friedman on exchange rates #4

...Despite Milton Friedman typically – and rightly – being labelled as the standard bearer for floating exchange rates, he often stresses that the choice is not easy, and he has repeatedly emphasised that countries have achieved both good and bad results with fixed and floating exchange rates. He points out for example that in 1985 Israel successfully implemented a fixed exchange rate policy against the dollar that helped cut inflation without causing any negative long-term economic repercussions.

By way of contrast, Chile implemented a fixed exchange rate policy against the dollar in 1976. Results were good for the first year following the implementation. However, when US monetary policy was seriously tightened between 1980 and 1982, causing the dollar to surge, monetary policy in Chile also had to be tightened: Chile suffered a serious economic setback, and in 1982 it abandoned its fixed exchange rate policy.

Friedman used the two cases above to underline that identical exchange rate policies can lead to different results. The outcome of the fixed exchange rate policy depends on how “lucky” one is with regard to the monetary policy in the country whose currency one has fixed to. Israel was lucky to introduce a fixed exchange rate policy at a time when monetary policy was relatively accommodative in the USA, while Chile was unlucky to fix just before US monetary policy had to be vigorously tightened. Or as Friedman says:

“Never underestimate the role of luck in the fate of individuals or of nations.”[2]

Here’s another article quoting from the same source (excerpt):

Money Mischief, by Milton Friedman

...Friedman’s comparison of Chile and Israel also emphasizes the element of unpredictability. These two nations followed essentially the same policy, that of establishing a fixed exchange rate or “pegging” the local currency to the U.S. dollar. In each case, the purpose was to curtail inflation. Yet the respective actions, taken some six years apart, had drastically different outcomes, due to circumstances well beyond the control of policy-makers in either country.

Chile had the misfortune of establishing a fixed exchange rate in 1979, just prior to the dollar’s sharp appreciation against other major currencies. The Chilean peso thus rose against other currencies in tandem with the dollar, damaging the country’s exports. Meanwhile, the price of copper, Chile’s major export, was declining in world markets, while the price of oil, which Chile imports, was rising. The result was a deep recession, one that would have been far less severe had the peso been allowed to depreciate against the dollar. In 1982, the currency peg was abandoned.

By contrast, Israel’s pegging of the shekel to the dollar occurred in the mid-1980’s, just as the dollar was beginning to descend against major currencies. At this time, furthermore, oil prices were in decline. The fixed dollar-shekel rate was kept in place for only thirteen months (after which the shekel was pegged to a basket of currencies), but during that time, it helped bring inflation down from an annual rate of about 500 percent into the low double digits. Without causing a recession, Israel’s currency peg helped create a degree of price stability that lasts to this day...

What’s the Fed going to be doing soon?

That’s right, raising interest rates and tightening monetary policy.

What does that make the idea of pegging the Ringgit to the USD right now?

Beyond dumb, and somewhere between dumber and dumbest.

Technical Notes:

* “Money Mischief: Episodes in Monetary History”