Subject: Krugman vs. Friedman Date: 13 Oct 1998 21:29:08 GMT From: susupply@aol.com (SUSUPPLY) Organization: AOL http://www.aol.com Newsgroups: sci.econ In a fascinating and instructive coincidence both Milton Friedman and Paul Krugman weigh in today on the IMF and the Asian financial situation. Friedman on page A22 of today’s Wall Street Journal, Krugman in two pieces on his web page. The three articles demonstrate something that I have posted before on this newsgroup: That the disagreements among economists are, both greatly exaggerated, and about things other than they superficially appear to be. I recommend reading all the articles, but for those who can’t, here are some dueling excerpts: Krugman ("THE ETERNAL TRIANGLE"): "the problem of choosing an international monetary regime could be summarized as the effort to achieve Adjustment, Confidence, and Liquidity. Exactly what these terms mean is somewhat in the eye of the beholder; but my version goes as follows. Adjustment means the ability to pursue macroeconomic stabilization policies - to fight the business cycle. Confidence means the ability to protect exchange rates from destabilizing speculation, including currency crises. Liquidity basically means short-term capital mobility, both to finance trade and to allow temporary trade imbalances. "So what is the dilemma of international financial architecture? It is that, essentially because of the threat of currency speculation, you can't get everything you want. More specifically, insisting on having any one of the three desired attributes in an international regime forces the abandonment of one of the others. As a result, there is a limited menu of possible regimes - and each item on that menu is unsatisfactory in some important way. Friedman ("Markets to the Rescue"): "Seventy-five years ago, John Maynard Keynes pointed out that ‘if the external price level is unstable, we cannot keep both our own price level and our exchanges stable. And we are compelled to choose.’ When Keynes wrote, he could take free capital movement for granted. The introduction of exchange controls by Hjalmar Schacht in the 1930s converted Keynes's dilemma into a trilemma. Of the three objectives--free capital movement, a fixed exchange rate, independent domestic monetary policy--any two, but not all three, are viable. We are compelled to choose." Krugman: "But this means that these countries face a cruel choice: since they must choose confidence, that is, a stable exchange rate, they must either give up on stabilization policy - turning the clock back to pre-Keynesian fatalism - or try to restrict capital movement, with all the costs that entails. [snip] "But of course at this point officials and those who want to stay close to them will not, indeed cannot, think about it. They cannot say bluntly that countries must give up on stabilization, that only a handful of First World central banks are allowed to have policies. Nor are they prepared to turn their backs on a generation of denouncing the evils of currency and capital controls. "Hence the strangely enervated tone of discussion. The current situation is unacceptable, and everyone knows that something has to give; but the policy ideas that the community of respectable opinion can allow itself to discuss are at best marginal, at worst irrelevant." Friedman: "The attempt by South Korea, Thailand, Malaysia and Indonesia to have all three--with the encouragement of the IMF--has produced the external financial crisis that has pummeled those countries and spread concern around the world, just as similar attempts produced financial crises in Britain in 1967, in Chile in the early 1980s, in Mexico in 1995 and in many other cases." Krugman: "This...led me to consider the possibility that the least bad option may lie on the other side of the triangle. Everybody knows how bad capital controls are for economic efficiency. But these costs must be compared with the alternatives. For example, Brazil's efforts to maintain both liquidity and confidence will probably lead to near-zero growth this year, something like -3 percent next year, in an economy that needs something like 5 percent growth to keep unemployment from rising. Think about it." Friedman: "Some economists, notably Paul Krugman and Joseph Stiglitz, have suggested resolving the trilemma by abandoning free capital movement, and Malaysia has followed that course. In my view, that is the worst possible choice. Emerging countries need external capital, and particularly the discipline and knowledge that comes with it, to make the best use of their capacities. Moreover, there is a long history demonstrating that exchange controls are porous and that the attempt to enforce them invariably leads to corruption and an extension of government controls, hardly the way to generate healthy growth. "Either of the other alternatives seems to me far superior. One is to fix the exchange rate, by adopting a common or unified currency, as the states of the U.S. and Panama (whose economy is dollarized) have done and as the participants in the Euro propose to do, or by establishing a currency board, as Hong Kong and Argentina have done. The key element of this alternative is that there is only one central bank for the countries using the same currency: the European Central Bank for the Euro countries; the Federal Reserve for the other countries. "Hong Kong and Argentina have retained the option of terminating their currency boards, changing the fixed rate, or introducing central bank features, as the Hong Kong Monetary Authority has done in a limited way. As a result, they are not immune to infection from foreign-exchange crises originating elsewhere. Nonetheless, currency boards have a good record of surviving such crises intact. Those options have not been retained by California or Panama, and will not be retained by the countries that adopt the Euro as their sole currency." Krugman: "Confidence: Suppose that a country decides that it simply cannot accept an unstable currency, driven up and down by swings of investor sentiment (or, in the modern world, by the winding and unwinding of hedge fund positions). This means that it must either peg its exchange rate, or at least manage it strongly. But if it also tries to maintain liquidity - by allowing unrestricted flows of capital - then it will be subject to severe speculative attacks whenever the market suspects that stabilization concerns will lead to a devaluation. So a choice must be made. Either the country credibly forswears any future exchange rate adjustment - by adopting a currency board, or starting off down the road to monetary union - or it must restrict capital movement." Friedman: "Proponents of fixed exchange rates often fail to recognize that a truly fixed rate is fundamentally different from a pegged one. If Argentina has a balance of payments deficit--if dollar receipts from abroad are less than payments due abroad--the quantity of currency (high-powered or base money) automatically goes down. That brings pressure on the economy to reduce foreign payments and increase foreign receipts. The economy cannot evade the discipline of external transactions; it must adjust. Under the pegged system, by contrast, when Thailand had a balance of payments deficit, the Bank of Thailand did not have to reduce the quantity of high-powered money. It could evade the discipline of external transactions, at least for a time, by drawing on its dollar reserves or borrowing dollars from abroad to finance the deficit. "Such a pegged exchange rate regime is a ticking bomb. It is never easy to know whether a deficit is transitory and will soon be reversed or is a precursor to further deficits. The temptation is always to hope for the best, and avoid any action that would tend to depress the domestic economy. Such a policy can smooth over minor and temporary problems, but it lets minor problems that are not transitory accumulate. When that happens, the minor adjustments in exchange rates that would have cleared up the initial problem will no longer suffice. It now takes a major change. Moreover, at this stage, the direction of any likely change is clear to everyone--in the case of Thailand, a devaluation. A speculator who sold the Thai baht short could at worst lose commissions and interest on his capital since the peg meant that he could cover his short at the same price at which he sold it if the baht was not devalued. On the other hand, a devaluation would bring large profits." Well, that’s just a taste. I probably haven’t done justice to either man’s position, so I encourage interested readers to see for themselves. Patrick Hi, This all reminds me of debates between scientists: Linus Pauling or Carl Sagan vs Edward Teller etc. They all agree on the basic scientific principles, but use them to support opposite public policies. Or how various Christians use the same sources to reach opposite conclusions. ,,,,,,, _______________ooo___(_O O_)___ooo_______________ (_) jim blair (jeblair@facstaff.wisc.edu) Madison Wisconsin USA. This message was brought to you using biodegradable binary bits, and 100% recycled bandwidth.