At the Hebrew University of Jerusalem

From The Collected Works of Milton Friedman, compiled and edited by Robert Leeson and Charles G. Palm.

“Flexible Exchange Rates For Israel” by Milton Friedman Lecture, Hebrew University of Jerusalem, 5 July 1977

CHAIRMAN, Professor Giora Hanoch: Ladies and gentlemen, on behalf of the Department of Economics I would like to greet the great scholar and our warm friend for a long time, Professor Milton Friedman. The usual chairman will say that Friedman does not need an introduction, and then go on to introduce him. I will try not to do that. We all are Professor Friedman’s students: those who had the privilege to study under him directly as well as those who studied his scholarly writing and have seen him in his previous visits here and elsewhere.

This evening he’s going to talk about the subject of flexible exchange rates for Israel. As you all know, it is a great pleasure and stimulus to disagree with Professor Friedman. Even if we disagree, it’s always a great pleasure to hear him about any topic. I think he chose this particular topic tonight as an example . . . We all know what is his stand on flexible rates and abolition of controls on foreign exchange. And I’m sure he will go tonight beyond that and try to tell us more specifically how to do it, and not only why to do it. Professor Friedman has been a friend of the Hebrew University and of the Israeli economy for a long time. I remember, I missed his first visit in Israel. I was in Chicago when he visited here. He came back and told me all about the Israeli economy.

So I’m sure by now, after his recent one-day visit here, he can tell us all many things which we ourselves do not know. I would add only that what I learned most from Professor Friedman— who is always very confident, a great believer of what he preaches and what he says—and his analyses is to put a question mark on all these other statements that we tend to take as given and self-evident. After listening to his side, we always, if we don’t completely agree, at least put the question mark. So I hope that this discussion tonight will help to put some question marks around topics related to foreign exchange control and flexible or non-flexible exchange rates which have been so much in recent political news as well.

MILTON FRIEDMAN: Thank you. You know it’s the custom in most academic institutions that before an individual acquires a doctorate, he has to give a public lecture. In the Hebrew University of Jerusalem, you naturally do things in a different way. You first give a man a doctorate and then he has to give a public lecture.

I’m glad that you will not be able to determine the appropriateness of the doctorate that I received yesterday on the basis of what I say today. I am very happy indeed to be an alumnus of this University. I had felt a member of it for many years, both because of my appearances here, but even more because of the steady stream of students from Israel—many from the Hebrew University—whom we have had at the University of Chicago. They have consistently been among the ablest, most effective and most active of our students, and I hope the flow continues. I chose the topic about flexible exchange rates for Israel not because I’m going to tell you how to do it—despite Giora’s leading introduction—but because the topic is suddenly lively here. Moreover, you suddenly have a fresh opportunity to do something about it.

From The Collected Works of Milton Friedman, compiled and edited by Robert Leeson and Charles G. Palm.

It therefore seemed to me that it might be appropriate to consider not the general case for flexible exchange rates, but the special case for flexible exchange rates in the particular circumstances of Israel—not those of the year 1977, but more generally because I believe that the circumstances of Israel have been especially suited for many years to the introduction of flexible exchange rates. Indeed, much of what I shall say today, I have said before here in Israel, particularly in 1972, when I had the great honor of delivering the David Horowitz Lecture in Israel.

With respect to flexible exchange rates in general, there is an enormous contrast, as you are all well aware, between the situation when I first began to write on the subject, and the situation as it is now. I was first led to write on the subject of flexible exchange rates in 1950. That was twenty-seven years ago, before many of you in this room had seen the light of day. At that time, we were in the immediate postwar period of the Bretton Woods Agreement. It was taken for granted around the world that the only appropriate regime was rigidly fixed exchange rates among countries. The idea of flexible exchange rates was a heresy that received little attention. A historical accident led me to look into the question. I spent a few months in Paris with the U.S. Marshall Plan agency and I was asked to look into the economics of the so-called Shuman Plan for an “Iron and Steel” community, what later developed into the Common Market. I became persuaded that a common market would never be a viable economic entity, unless the countries of the Common Market introduced flexible exchange rates among themselves. That was what led me to write the essay which I later published under the title of The Case for Flexible Exchange Rates.

As you all know, there is no longer any question whether exchange rates should be flexible. They are. That is the existing system. The fixed rate system broke down, as it inevitably had to. Its final demise came in 1973, after several preliminary demises. Since then, essentially all the countries of the world have adopted a flexible exchange rate system. The only question that remains is the form that flexibility should take. The Israeli experience is an exaggerated version of what has happened around the rest of the world. Israel, as you will recall, started with an exchange rate of $3.00 to the Israeli pound—you have now progressed very greatly so that you now have 9.5 pounds to the U.S. dollar. (9.47! I was just rounding off to the nearest half. Because after all I don’t want this talk to be very dated and next week it will be something else.)

If you look at the way the changes have taken place, you will see the gradual transition that has been taking place—not only in Israel but throughout the world.

Originally, the system was one of temporarily fixed exchange rates subject to wide changes from time to time. The pattern for Israel was that every once in a while, when you couldn’t hold the official exchange rate any longer, you had a big devaluation. Of course, in between, Israel didn’t really have a fixed exchange rate. In between, you had a multiple exchange rate system, which concealed devaluations of one form or another. It is not possible for any country, least of all for Israel, to disregard completely market forces and to keep the price of your currency different from the price that the market dictates. But to some extent you can conceal what’s happening, and that’s what Israel did. It concealed devaluation in the form of subsidies to exports and restrictions on imports. You still do that to a very large extent. I was told today that there are sixty-three effective exchange rates in Israel and someone else said that that was a gross understatement, that there are literally thousands of exchange rates, which I well believe. And then you moved from occasional massive changes in the official rate to so-called “creeping

From The Collected Works of Milton Friedman, compiled and edited by Robert Leeson and Charles G. Palm.

devaluation” at fixed stated times, and then to “creeping devaluation,” at unstated times. And sooner or later, and the only question is how soon, you will move to unstated devaluations at unstated times, by adopting essentially a freely floating exchange rate.

Change has occurred not only in Israel but throughout the world. I was very much impressed by the change in the world attitude as reflected in two meetings that I happened to attend three years apart of the so-called “International Monetary Conference.” The first one that I attended was held in Copenhagen, I believe in 1969, at the late stages of the fixed exchange rate regime. The then Secretary of the International Monetary Fund gave the usual speech, the essence of which was that the only possible system was fixed exchange rates. He blasted the idea of flexible or floating exchange rates as a dangerous heresy that had to be extirpated from humankind if the world was going to last.

Three years later, I attended a meeting of the same group in Montreal, Canada, in 1972, some nine months after President Nixon had opened the new era by closing the U.S. gold window. The then Secretary General of the International Monetary Fund’s speech was very different. Everybody, he said, knows that the only possible system of exchange rates is a flexible exchange rate system.

What the IMF did reminded me of an old story of a great teacher of mine. Frank Knight, whom many here who studied at the University of Chicago knew and revered, used to tell the story of a breed of ducks that fly in the sky. They fly in a “V”, with a leader in front. Every once in a while, Knight said, the ducks would veer off in a different direction than their leader; the leader would keep going until he looked around and saw that nobody was behind him; then he’d run around to get in front of them.

That was exactly what the IMF was doing. The IMF is in a very delicate position, because the elimination of fixed exchange rates destroyed its reason for existence. Ever since, the IMF has been an agency in search of a function. After all, no civil servant likes to give up a job, especially a nice cushy job in an international agency—which is protected against inflation, protected against income taxes and has all sorts of fringe benefits. The same sort of thing is happening here in Israel. Here too, of course, the major obstacles to a sensible policy are the vested interests both of civil servants, who administer exchange controls and control exchange rates, and who obviously want to find a function for themselves, and, on the other side, of business interests, who have been receiving, or believe they have been receiving special treatment in the form of subsidies for exports or especially favorable terms on which they can acquire foreign exchange. As in so many of these cases, there is an unholy coalition between the civil servants, on the one hand, and the business groups, on the other, to maintain a system which temporarily benefits both, but which ultimately hurts the country and themselves as well.

In talking about Israel, I shall have to repeat much of what I said here in 1972. My only excuse for doing that is that after all there is only one truth. So if what I said in ‘72 is right, and if the fundamental conditions in Israel in this respect have not changed, which I believe they have not, that truth is still relevant.

My recipe for Israel in ‘72 was, and still is today, complete and immediate freeing of the exchange rate, complete and immediate elimination of all exchange controls, all foreign

From The Collected Works of Milton Friedman, compiled and edited by Robert Leeson and Charles G. Palm.

exchange controls. Giora said how to do it. That’s very easy. You simply publish in the newspaper that, beginning tomorrow, everybody is free to do what he wants with his money; he can take Israeli pounds and buy dollars, if he can find somebody who will sell them to him; if he has some dollars, he can buy Israeli pounds if he wants to or spend them on anything else. So far as the exchange rate is concerned, that will be determined openly and aboveboard in Lillianblum Street in Tel Aviv, instead of, as now, being determined there covertly. And the Bank of Israel can give up the pretense that it is determining exchange rates. That’s very easy to do. The subsidies that are associated with the exchange rate system are more sophisticated and more complicated. There are two different kinds of changes in economic policy—those in which it is desirable to move to the final stage gradually, in order to give people time to adjust, and those in which it is desirable to go to the final stage at once. As you know, there is always an aphorism on both sides of the issue. If you believe that a particular change should be made gradually, then you tell people, “Haste makes waste.” If you believe that this should be made all at once, you say, “It makes no sense to cut a dog’s tail off by inches.”

There are different circumstances for different things. In my opinion, exchange control and the fixing of exchange rates is best done away with immediately. If you try to make that change slowly, the effect is to produce speculative activity that makes it difficult to know what is happening and what the appropriate exchange rate to move to is. On the other hand, subsidization of exports, tariffs or their equivalent on imports, that is, a variety of concealed devaluations, are best done away with gradually. The reason is that you have induced people to invest funds, to make commitments, in the expectation that these subsidies or these restrictions on imports would be there. It is therefore desirable to give people time to make the adjustments that are called for, to unwind their commitments in an orderly fashion.

However, it is essential that gradually not be interpreted to mean not moving. There is a strong tendency for everybody to interpret “Oh, let’s be gradual” as meaning one-tenth of 1 percent for the next thousand years. What I mean by gradually is accompanying the immediate elimination of all exchange controls and of all fixed rates by a phasing out over a period of two or three years of the subsidization of exports and restrictions on imports. Needless to say, I cannot specify that in precise detail—you people can do that better than I, though I suspect that nobody knows in full about all such matters. It has probably become so complicated a story by this time, that it would take an army of people to ferret out all of the various forms of subsidy and of restrictions.

In the climate that has existed in this country and in other countries, a recommendation of this kind appears somewhat radical. You will ask, “What other countries around the world have a similar system today, of no exchange control and of no restrictions whatsoever on the price of foreign exchange?” At the moment, the United States and Hong Kong are the only two economies that I know of that fully conform to this pattern. The U.S. today, I am delighted to say, has no exchange controls and has no policy of trying to peg or fix the rate of exchange of the U.S. dollar versus other countries. So far as I know, Hong Kong has no such restrictions and no such exchange controls.

West Germany is very close to the same position, although it is not entirely there. But after all, we should not be time bound, we should have a broader historical perspective. With our generally parochial attitude, we tend to forget that the present situation is very recent, that for most of human history there have been no restrictions on foreign exchange, and there have been

From The Collected Works of Milton Friedman, compiled and edited by Robert Leeson and Charles G. Palm.

no fixed prices for foreign exchange. Indeed, and it is particularly appropriate in Israel to call this to your attention, foreign exchange control in its present form was only recently brought to its current shape of perfection. We can date very precisely when that occurred and who was responsible. Today’s form of foreign exchange control was perfected in 1934, by Hjalmar Schacht, the German central banker, for the explicit purpose of despoiling the Jews of Germany. It has always seemed to me something of a scandal and a disgrace that the Jews of Israel should have adopted the policies of Hjalmar Schacht to despoil the Jews of Israel.

I recognize that, however emotionally disturbing, that’s far from a conclusive argument. Even your worst enemies may invent something that turns out to be useful and good. I would never suggest that because the Germans might have invented, let us say, a particular mechanical instrument for a bad purpose that Israel should refuse to use it. However, while not a decisive argument, the origins of the present forms of exchange control should give you ground for questioning whether this device is really so natural and so necessary. After all, human history dates back some thousands of years before 1934, and the notion that somehow all the rest of human history is atypical and the period from 1934 to date is typical is very questionable.

Let me leave that emotional issue and go to the basic question: What are the arguments in the present situation of Israel for and against such a program of complete decontrol and complete freedom of exchange rates? The first argument for such a system is that in its essence that’s what you have now. Whom are you kidding? You have an enormous expertise in this country about how to get around government foreign exchange controls. There was a recent, much publicized incident that I suspect is far from unique. Indeed, I suspect that Diogenes might have almost as much trouble finding an Israeli who doesn’t have a foreign bank account, as he had finding an honest man.

So the first argument is that you might as well do openly and above-board what is now done with tremendous waste, and with tremendous disruption, in a concealed and indirect fashion. It is dubious that your foreign exchange controls have prevented capital from being held outside the country. Indeed the opposite is almost surely true: there is very likely more capital held abroad by the residents of Israel today than would have been held if Israel had had a free exchange rate and no controls all along.

If I am an Israeli resident, and happen to get some dollars, there is now every reason for me to keep it in the form of dollars. I can always turn it into pounds later on, but under present controls, if I once turn it into pounds, I may have to pay a substantial price to reverse the process. Your present system therefore encourages the holding of foreign assets by Israeli residents.

The second argument for complete decontrol and free exchange rates is that it permits the abolition of the multiple exchange rates and the arbitrary subsidies and restrictions that are spread throughout your economy, and that waste your substantial capital. There is no great virtue in exports as such. On the contrary, exports are a cost. The gain to a country from international trade comes from what it imports, not what it exports. Yet, so long as you have a system of fixed exchange rates, or even of temporarily fixed or governmentally controlled exchange rates, it looks as if there is some virtue to encouraging exports. I have read proposals in many countries, not only in Israel, for export-led growth. I believe those proposals are foolish. I believe that it is undesirable to distinguish in that way between foreign and domestic activity. What a country

From The Collected Works of Milton Friedman, compiled and edited by Robert Leeson and Charles G. Palm.

wants to do is to use all of its resources as efficiently as it can. If you can get goods more cheaply by exporting and then buying them abroad than you can by producing them at home, then you should do so. If you can get them more cheaply at home, you should do so. The pressure for export-led growth simply reflects the general protectionist tendency in most countries.

The fallacy in export-led growth becomes apparent if you generalize it. I was very much struck by this feature when I read recently a proposal by a British group for export-led growth in Britain. What happens if every country in the world seeks to get export-led growth? How do you add it up? After all, the books of the world must balance. Total exports must equal total imports, allowing, as the economists will immediately tell you, for capital movements, grants, etc. I hear much talk in Israel about Israel’s having a balance of payments problem. Israel has no balance of payments problem.

That’s nonsense. Israel may have an exchange rate problem, a problem of establishing a system which yields the right exchange rate. Israel undoubtedly has the universal problem of being poorer than it would like to be. But Israel has no balance of payments problem. On the contrary, Israel is in the fortunate position of having some export goods that are in very great demand.

To illustrate from my own case: I send dollars to Israel every year. I send them through contributions to the United Jewish Appeal. Why do I send dollars to Israel? Because I am buying something. After all, I’m not sending dollars to Israel without getting something in return. You are exporting a service to me that is part of a major export industry that yields you revenue in your balance of payments. That export industry is the industry of providing Jews like me around the world with a sense of satisfaction at the existence of a National Homeland, a feeling of pleasure of being able to contribute their mite to the growth of that National Homeland. There is nothing wrong with calling that an export industry—that’s what it is. It’s a very desirable export industry, and we all appreciate it. And you in return appreciate us. So you can see that it satisfies Adam Smith’s basic requirement: a good transaction is one in which both parties benefit.

In addition, you have a more recent, and I hope more transitory, export industry—of providing the United States government with an ally that is willing to provide its own troops. That’s a fairly rare export industry as well. The result is that the U.S. government is willing to buy your services in the form of providing you with military assistance. You are able persistently to have a deficit in what you record as your balance of payments, because you do not count these external sources of funds as proceeds from exports. I cannot conceive of anything that would be sillier than for Israel to try to eliminate that kind of a deficit. The real problem that you have is not the balance of payments but rather that you are wasting, on a large scale, much of the income which you derive from abroad. Instead of using that income to support productive investment, you are throwing it down the drain by giving it away in the form of subsidies for capital development, in the form of directed loans, and in other ways. That is simply wasting an important resource.

I am told by everybody here, for example, that Israel has a system of providing capital development loans to industry at an interest rate that only recently was raised to the figure of 19 percent. In a year in which inflation was 38 percent, that means that you have been encouraging people to lose 20 percent a year. Don’t misunderstand me. The people who have been acquiring those loans have not necessarily been profiting from them. They have simply been given an

From The Collected Works of Milton Friedman, compiled and edited by Robert Leeson and Charles G. Palm.

incentive to engage in investments that lose 20 percent a year. Is that a sensible thing for a country to do?

This unjustifiable subsidy program is only peripherally related to the so-called “balance of payments” problem. It is important in that connection because one of the justifications which is often given for throwing money down the drain in this way is to support exports. That is not a valid argument, as I have already suggested. If your receipts from abroad are not adequate to pay for the imports that are demanded at the existing exchange rates, the right solution is for the exchange rate to change. You do not need any subsidies to exports, or any restrictions on imports, other than that that are automatically produced by the right exchange rate, freely determined in the market.

The subsidies to exports and the restrictions on imports as I said before are simply concealed devaluations. A major advantage of setting the Israeli pound free and of eliminating exchange controls would be to encourage the elimination of multiple exchange rates and of these silly subsidies.

A third argument for such a reform is one that, though present all along, I have not before suggested. It has been impressed on me only recently because of the disappearance of Beirut as an international financial center. Israel has in principle many of the requirements for replacing Beirut as an international financial center. It has one major defect, of course; Arab countries would not use it openly. Don’t be misled. If Israel were able to establish an effective international financial center, lots of Arab money would come, but under cover, not openly and aboveboard. As a result, most large international banks, because of the fear of Arab displeasure, would be very unwilling to set up branches in Israel so that Israel cannot possibly replace Beirut. But, for a moment, put aside the problem of the Arabs, and look at the great advantages that Israel has as an international financial center. There is no country in the world that per capita has a larger pool of accumulated financial talent. You have a two thousand year-old inherited capital in this area. Why should you waste it, as you now do, on the off-setting actions of groups of civil servants, on the one side, who construct more and more complicated regulations, and of the citizens, on the other side, who construct more and more complicated devices for evading the regulations? Is it not a shame to waste an inherited resource of such great potential productivity in that way? Suppose, instead, that you could establish an enclave in which you had free capital movement, no restrictions on foreign exchange transactions by residents or non-residents, a free market in exchange. Might you not develop Israel as a great international financial center?

You have done so in a small way now. As I understand it, non-residents are essentially free of control with respect to foreign exchange transactions, and Israeli banks are free to offer deposits denominated in foreign currency to non-residents and to selected residents who have an official permit. This base could develop into an extremely important source of a new export industry for Israel. In order for this to occur, however, I believe you must go beyond foreign exchange controls and foreign exchange rates to banking regulations. There is no country in the world that I know of that has a more complicated set of banking regulations than Israel. And these regulations are completely counter-productive. You could promote Israel’s productivity and efficiency and, simultaneously, equity by eliminating the whole system of directed loans, by greatly simplifying the requirements of banks, freeing banking competition, and allowing banks to operate effectively. If you really did this effectively, you might even provide a bull market for

From The Collected Works of Milton Friedman, compiled and edited by Robert Leeson and Charles G. Palm.

the ingenious and knowledgeable civil servants who would then be redundant. They, too, have developed expertise in this process.

So much for the arguments in favor of the policy that I propose. What are the arguments against it?

The one argument I hear over and over and over again, that I have heard over the years and that has not changed over the years, is that Israel is a nation at war, that it has been at war for the whole of its existence, and that a nation at war cannot take chances of being deprived of foreign exchange. It is argued that when the war heats up, everybody in the country will try to get his capital out, and that this would cause chaos and disruption, and prevent the country from getting the military goods which it needs. I submit to you that that argument is precisely upside down. The situation of Israel is one in which the persistence of war, and the occasional war scares and periods of active fighting are an argument for, not against, eliminating exchange controls and eliminating controls over the exchange rate. Why?

In the first place, because of one fact I’ve already cited. So far as the government’s need is for foreign exchange to purchase military goods, it gets those funds in the form of foreign exchange. It doesn’t have to sell pounds in order to get dollars. Your government has been on the other side of the market. It has been a net seller of dollars, not a net buyer. Therefore your government cannot lose from this point of view. Most of the foreign currency in dollars coming from the major export industries to which I’ve already referred accrue directly to the government.

Suppose for a moment—to take an extreme case—that at the time of an emergency the free market exchange rate went very far down. That would be a great opportunity for the government to get many Israeli pounds by selling few U.S. dollars. It would benefit not lose. Next, consider the problem of the so-called “capital outflow.” Let us suppose you have a war scare, and people want to get capital out. How do they get capital out? Does somebody pick up a factory and put it on a boat and ship it out? Obviously not. People have a misleading notion. They believe that the way you send capital out is to pack up stacks of Israeli pound notes and put them on a ship and send them out. If people would only send capital out in that way, that would really solve your inflation problem overnight. Unfortunately, that is not the way people send capital out. If I have capital in Israel in the form of a building or a factory or in some other physical form, the only way I can send capital out is by selling that capital for Israeli pounds and then using the Israeli pounds to buy dollars.

Let us suppose that there is a war scare. Who sells and who buys? In order for some people to get capital out, other people have to buy their property. A moment’s reflection shows that the people who are trying to sell are the people who have little confidence in Israel. Who are the people who are willing to buy? The people who have much confidence in Israel. So, if you have any such war scare, if you have any attempt to get capital out, under a free exchange rate system, what happens in effect is a transfer of capital from weak hands to strong hands. Is that a bad thing for Israel?

With a fixed exchange rate the situation is altogether different—and that is, I suggest, the source of the misunderstanding of this issue. If the government is supporting the exchange rate, then the weak get their capital out at the expense of the strong, because what then happens is that, in the

From The Collected Works of Milton Friedman, compiled and edited by Robert Leeson and Charles G. Palm.

process of supporting the exchange rate, the government provides the foreign exchange which enables the weak to get their capital out. But if you have a free exchange rate, you are fully protected. In the first place, the domestic prices of property would tend to go down, which would shift domestic property from weak to strong hands. Internationally, any great attempt to convert Israeli pounds into dollars or marks would drive down the exchange rate against the pound, and the people who tried to get their money out would lose and the people who bought their pounds would gain. It is only if you peg the exchange rate, as you have done in the past, that the capital flight represents a loss to the country.

This argument can be extended. People will say, that’s all very well about capital, but what about trade flows? What about the effect of a depreciation of the exchange rate on the terms of trade? Imports will cost more. Exports will yield less.

That would be a real problem if you faced a situation of a long war, of four or five years duration, in which you had to try to maintain a flow of foreign exchange receipts. Fortunately, or unfortunately, that is not likely to be Israel’s problem. Any emergency, as in the past, is likely to be relatively brief. As a result, temporary gyrations in the exchange rate will not have any significant effects in the time interval in question on the flows of trade. More important, with few exceptions, Israel has no monopoly or monopsony position. It has no monopoly position as a seller, it has no monopsonistic position as a purchaser. It is selling goods for foreign currencies and buying goods for foreign currencies in a world market. This is really a footnote for the technical economist, not for the general public. But it means that Israel’s terms of trade in goods are not affected by what happens to the pound value of foreign currencies. The main point is that, in Israel’s particular situation, you have no problem of this kind. The possibility of an occasional war threat is a further argument for a free exchange rate and the elimination of exchange controls.

Finally, it may be said that if Israel really were to follow this policy, and were to have the courage of its convictions and remove all controls on exchange transactions tomorrow, who knows what would happen for the next five days? The answer is, nobody knows. You might have temporary gyrations. It might be that the exchange rate would go from 9.5 to 15 or to 5—I don’t know. I’m not about to predict where the exchange rate will go. If I thought I could predict exchange rates, I might be in favor of controlling them.

But one thing is sure, in my opinion. These perturbations would be relatively brief, they would not last long. The exchange rate would settle down very rapidly, if only because you now have effectively a free market for the largest part of your exchange transactions. Any fears that somehow or other there would be a terrific attempted flow of capital out immediately are false, because, again, all of this proceeds on the fiction that the present restrictions are effective. Of course, not everybody who seriously wanted to get money abroad has been able to do so. Unfortunately, foreign exchange regulations always hurt the small people. Foreign exchange controls and similar measures are always defended on grounds of equity. But that’s all window dressing. Almost always and almost everywhere, such measures hurt the small man who isn’t in a position to get around them. They have little or no effect, or actually help, people with much resources, who are in a position to get around them. The market protects the small man far more effectively than any bureaucrat.

From The Collected Works of Milton Friedman, compiled and edited by Robert Leeson and Charles G. Palm.

So far as the big sums of money are concerned, I would not be surprised if freeing exchange transactions would produce an inflow of capital. If you really abolished overnight your foreign exchange controls, if overnight you allowed the exchange rate to go free, and if you could establish confidence that the policy would be maintained, the package would surely attract capital not repel it. The final requirement, establishing confidence in the continuance of freedom, is the hardest. There would be only one effective way to do that: eliminate and disband the agencies now charged with enforcing controls and manipulating exchange rates. In principle, that is the right thing to do—but you won’t do it. And I recognize that I would be spitting in the wind to suggest that you should.

But even if you don’t establish full confidence that the policy will be retained, many people might be induced to bring capital into this country from the outset. And over a period of time, the promotion of international financial transactions would almost surely produce an inflow of capital into the country not an outflow. So I would not be at all surprised to see the true exchange rate of the Israeli pound appreciate rather than depreciate, if you were to follow such policies.

Again, I don’t mean to predict that it will happen, because as I say prediction is very unreliable in this area.

I have tried to cover the ground as effectively as I can. I want to leave as much time as I can for you people to object, to see what holes you can find in my argument, and to present reasons for continuing your present unwise policy.

Thank you.

Discussion

SPEAKER: Any questions from the audience? Maybe I should break the ice and start. Yes?

SPEAKER: (Question—unintelligible) (Statement?)

MILTON FRIEDMAN: I agree with you. But that problem you have regardless of the system. That problem is not affected by what system you have. Suppose tomorrow that were cut off with your present system, how would you meet it? Let’s not confuse the issue. That is really a separate problem.

SPEAKER: (Unintelligible)

FRIEDMAN: Let’s go to your first point. How can it be that the exchange rate would go to 24 instead of its present 11? If that is the case, how is the present 11 being maintained? Changing the exchange rate regime, to openly floating instead of concealed floating exchange rates, will not change the proceeds from your exports, in dollars, in marks. It will not change the dollar or the mark cost of your imports. If, in fact, the equilibrium exchange rate under a floating regime is 24, what’s maintaining your present system? Are you really arguing that somehow or other you have effective enough restraints on control, so that you are maintaining an exchange rate that is twice as high as the equilibrium exchange rate?

From The Collected Works of Milton Friedman, compiled and edited by Robert Leeson and Charles G. Palm.

Let’s learn from the experiences of other countries. Many countries around the world have tried to maintain exchange rates other than those that are consistent with the market. Japan is the most recent example. Japan tried to maintain an overvalued yen. It has been unable to do so. It has finally had to give ground. But by how much? It took tremendous efforts on Japan’s part to maintain roughly a 10 percent overvaluation of the yen. And Japan couldn’t do it. How is Israel able to maintain a 100 percent overvaluation? Is it really true that Israel is somehow able to do what Japan could not do, what Germany could not do, what Britain cannot do, what the U.S. cannot do? What is it that enables Israel to do it?

SPEAKER: (Unintelligible)

FRIEDMAN: On the contrary, you have already borne that burden. You are now spending all the dollars that you have available. You’re buying imports. The real phenomenon is the other way around. In order to maintain an artificial system of multiple exchange rates, you are now forcing real distortions on the economy. Eliminate this system of multiple exchange rates and you enable your real economy to operate more effectively.

If it be true, that the raw materials that you are importing are being subsidized very heavily now, and if the effect of the alternative arrangements would be to eliminate that subsidy, then you ought not to be importing them now. What justification is there for paying 10 Israeli pounds to produce something that is only worth 9 pounds when you get it produced?

None. So if you are right, it would be an argument in favor of the reform, not against. The only way that what you describe could happen is if now you are subsidizing undesirable imports for productive purposes. I’m not saying that you are, I’m not making any judgment on that. I don’t know enough about your economy to know, but I believe you have conjured up a complete figment of the imagination.

You remind me of an episode in a debate I once had with Bob Roosa, who was formerly Under Secretary of the U.S. Treasury, and now is a partner in Brown Brothers-Harriman. Years back I had a public debate with him in Washington on the subject of flexible exchange rates. He literally floored me in the question and answer session, when he said at one point, that if we establish flexible exchange rates, there would not be a market. [Added later: The actual interchange went:

“Professor Friedman: . . . Do you deny that the market will set a price?

“Dr. Roosa: I deny that an actual market will exist.

“Professor Friedman: You deny that a market will exist in exchange?

“Dr. Roosa: I do, yes.”

From: Milton Friedman and Robert Roosa, The Balance of Payments: Free versus Fixed Exchange Rates (Washington: American Enterprise Institute, 1967), p. 185.]

That’s the same kind of figment you’re conjuring up.

From The Collected Works of Milton Friedman, compiled and edited by Robert Leeson and Charles G. Palm.

SPEAKER: (Unintelligible)

FRIEDMAN: This is a proposition that people have been putting forward now for some thirty or forty years, and nobody has yet demonstrated an empirical case in which you have such instability.

This isn’t a new problem. Canada has had a floating exchange rate for many years. It has been studied to the death. Nobody has been able to find any sign of unstable speculation. If you want to speculate on exchange, how do you make money? You make money by buying something when it’s cheap and by selling it when it’s dear. In the process, you raise the cheap price and you lower the expensive price. Therefore, speculation that makes money reduces the fluctuation in the price; it doesn’t increase it. Now, your argument—suppose you were right—(SPEAKER) . . . Excuse me. . . . (SPEAKER) . . . if you analyze that you will find that that’s a sure way to lose money. You are always looking for the next sucker—it’s a chain letter game. At the end of that chain letter, it collapses. In any event, there have been lots of studies of this. I do not know anybody who studied any exchange rate market, however small, who has been able to find a successful case of destabilizing speculation.

Excuse me. . . . What’s that?

SPEAKER: (Unintelligible) [What about the study by Nurkse?]

FRIEDMAN: The Nurkse study has since been re-examined by a number of different people, who have looked at the evidence, and I believe that the consensus has been that it was not a satisfactory demonstration. The case to which Don is referring is a study by Ragnar Nurkse of the experience of France in the period of the 1920’s.

In the postwar period we’ve had lots of experience. In any event, let’s suppose you were right. Then what you are saying is that the Bank of Israel, anybody who has half a mind, can make a lot of money. If you were right, then it’s the easiest thing in the world to speculate and make a fortune. If you’ve got destabilizing speculation, you simply have to buy the other way around, and you’ll end up making a fortune. So if you want to make a fortune, and you believe in your views, you should be in favor of a flexible exchange rate.

Let me say one more thing. If you look at the experience of central banks who have speculated in the market, in the main they have lost money rather than made it. This suggests that central banks have, in fact, been a destabilizing influence on the market. That was the case of the German Central Bank, that was the case of the Japanese Central Bank, it was the case for at least two or three years of U.S. Federal Reserve transactions. When you totalled up the transactions, on completed transactions, they ended up losing money. That means they must have been destabilizing the exchange rate.

One really ought not to judge these kinds of issues, without looking into some of the empirical evidence on it.

SPEAKER: (Unintelligible)

FRIEDMAN: Don’t resist it. . . . Wonderful—why should Israel refuse to take it? (LAUGHTER)

From The Collected Works of Milton Friedman, compiled and edited by Robert Leeson and Charles G. Palm.

SPEAKER: (Unintelligible)

FRIEDMAN: And who would get them—who would get the few million? You’ve got to have somebody on the other side of that account. . . . (SPEAKER CONTINUES). . . .

Nothing. I have examined this argument. I wrote an article quite a number of years ago called “In Defense of Destabilizing Speculation.” It was reprinted in the collection of my essays entitled The Optimum Quantity of Money. In that article, I examined exactly this analysis. I said if somebody is losing money, somebody must be making money. The way to interpret that situation is that in a country that has destabilizing speculation, the speculators are buying gambling services. After all, in a way you can interpret Las Vegas, or Reno, Nevada as a case of destabilizing speculation, on the part of the customers. You can interpret the amateurs in the stock market as a case of destabilizing speculation—they are paying for the privilege of gambling. In that case I argued, the way to interpret the situation is that the country is providing two products jointly. It’s providing gambling services—in return for which it’s getting rewarded by the proceeds from the destabilizing speculation, along with the industrial activity that is generating the exports and the imports.

If somebody is engaging in destabilizing speculation and losing millions, somebody is making them, and I repeat the question I asked before: “In this context are you really unwilling to put the gnomes of Tel Aviv up against the gnomes of Saudia Arabia?” That’s the issue—that’s the only issue—because you can counterspeculate and make the money that he’s willing to lose.

SPEAKER: (Unintelligible)

FRIEDMAN: What are businessmen for? The whole justification of a free enterprise business system is that businessmen are qualified to cope with uncertainty. There are very wide fluctuations in raw material prices. Does that prevent businessmen from engaging in long-term production?

Look at what has happened to the price of any number of products, coffee, cocoa, copper, tin, rubber—all of these products have moved all over the line. Has that prevented businessmen from engaging in activities that use those products? You know, I don’t understand. Why do you want to have businessmen if they are not willing to take risks? If they are not able to deal with uncertainties in the market? I don’t believe that’s a problem. I believe the only people that are worried about the gyrations are the government civil servants who want to know what’s going on.

SPEAKER: (Unintelligible)

FRIEDMAN: They were different in kind. You have had many cases of attempted controls on outflows. You have had many cases of attempted price controls— to fix the price of a currency—but so far as I know—before Schacht, it was never the case that it was illegal for the citizen of one country to make an exchange of currency of his country with a citizen of another country at any price that was mutually agreeable to them.

The fundamental distinction of the Schacht system of exchange control was the requirement of permits for transferring currency. In the British case in World War I for example, the British

From The Collected Works of Milton Friedman, compiled and edited by Robert Leeson and Charles G. Palm.

tried to take over foreign assets from British citizens. You could call that a species of exchange control, but they did not have a situation in which a citizen of Britain was unable to make a transaction with a citizen of the United States without going through the Bank of England, to exchange pounds for dollars at a mutually agreeable price. He couldn’t do it at the official price. To do it at the official price, he had to go through the Bank of England, but to the best of my knowledge, the particular form of exchange controls, which Schacht introduced which made it illegal for citizens of a country to take the paper currency of that country and exchange it with the citizens of another country—or with anybody else—with somebody inside the country, at mutually agreeable terms—to the best of my knowledge that did not characterize previous attempts at exchange control.

What’s that?

SPEAKER: (Unintelligible)

FRIEDMAN: That’s true—you couldn’t have it when you had no paper currency.

You had many cases of paper currency. You had the whole John Law episode, you had the Assignats, you go back to the paper currency in Venice. China invented paper currency. There are many previous examples of paper currency.

But, so far as I know, you never had the situation where it was illegal for an individual of one country to engage in this kind of transaction. Maybe I’m wrong on that. I’ve asked historians on it and I’ve never found a counter-example.

SPEAKER: (Unintelligible)

FRIEDMAN: On your main point I agree with you. It is perfectly feasible to separate these various elements. You could eliminate the subsidies without eliminating the fixed rate. However, if you’re going to maintain a fixed rate, with an independent national currency, you are going to have exchange controls. And they are indirectly or directly going to be a form of subsidy.

Whoever is given the entitlement to acquire foreign exchange is implicitly going to get a subsidy. The only way you can get out of that is by saying that you are going to auction off the exchange entitlements. In that case you have a floating rate. So I do not think you can separate a floating rate from subsidies. But it is true that you could instigate a floating rate while keeping subsidies. That’s true. I find it very hard to see any argument for doing it. The only valid argument for your subsidies and your exchange control is that if you have a fixed rate, you have to have them.

As I argued here in 1972, I could see a great merit to an honest-to-God fixed rate. I could see a great merit to Israel abolishing the Bank of Israel and using the U.S. dollar as its currency. That would be, of course, your surest guarantee against an Arab potentate being able to manipulate the Israeli economy.

SPEAKER: (Unintelligible)

From The Collected Works of Milton Friedman, compiled and edited by Robert Leeson and Charles G. Palm.

FRIEDMAN: I only wanted to say that I think you can have an honest-to-God fixed rate, if you want it, but you don’t want it. I’m not saying you necessarily should have it, but I can see a great merit in it.

I continue to think your Arab potentate case would simply be an additional source of export income to Israel. I really don’t see how he would do any great harm to the Israeli economy. Most of your economy is going to operate internally on Israeli dollars. Much of your foreign trade is carried on in foreign currencies anyway. You are talking about operations that impinge on a relatively small part of the total economy—and those operations, as you admit, would cost the Arab potentate money. Why do you suppose you wouldn’t be able to get the benefit of that? (SPEAKER). . . . That may be. Suppose it is. Much of that import content is made available through funds that are acquired in foreign currency, not through the sale of pounds. And of course so far as the sale of pounds is concerned, you have an unlimited supply of pounds to sell to him, if he wants to buy pounds. So you really only have to worry about the other side of that issue.

Obviously, the way to handle your Arab potentate is to print all these pounds, sell them to him, and then refuse to buy them back.

More seriously, I really believe this Arab potentate thing is a figment of the imagination. I just cannot see it as a real possibility.

SPEAKER: (Unintelligible)

FRIEDMAN: Personally, I would prefer not to do it, but I am a political realist. And I realize that you would inevitably have it. As I’ve always said, I’m in favor of cleanliness. I’m in favor of a clean fixed rate—if you’re going to have a fixed rate. I’m in favor of a clean floating rate if you’re going to have a floating rate. But as between a dirty fixed rate and a dirty floating rate—I prefer a dirty floating rate.

SPEAKER: ALEX (Unintelligible)

FRIEDMAN: I tried to emphasize the fact that the special situation in which the government is the recipient of a large amount of foreign exchange is a very important feature of the Israeli situation. As I said, and as you said, and I agree, the government is going to be a net seller of foreign exchange, not a net buyer. But that doesn’t mean that the fixed versus floating rate situation is not important.

What it means is that there’s a certain sense in which you will inevitably have a dirty floating rate—the sense in which the government is providing funds to the market. But there’s quite a difference between a government that provides funds to the market in the course of disposing of excess foreign exchange, and sells it to the market at the market price without trying to influence the market price and the case in which the government is trying to influence the market price by the amount it sells. In the latter case, which is really a case of a fixed exchange rate, the government does not have a great deal of power. The price at which it can sell its excess to the market is determined within fairly narrow limits. The proof is that if the government had all the power that you attribute to it, why would it have had to go into all the extreme manipulations of

From The Collected Works of Milton Friedman, compiled and edited by Robert Leeson and Charles G. Palm.

multiple exchange rates, of subsidies here, restrictions there? Why would it have had to repeatedly give up and change the exchange rate?

The government does have some power as a recipient of foreign exchange, but it’s very limited. The elasticities of demand and supply are not zero. They are pretty sizeable, and under those circumstances, the market exchange rate that is consistent with your position is determined within fairly narrow limits.

SPEAKER: (Unintelligible)

FRIEDMAN: It is a big buyer and seller—but it is not a monopolist by any manner or means. (SPEAKER CONTINUES). . . . It’s a big actor, I agree; it’s a big actor, but don’t overstate it, don’t overstate it. Much of the government foreign exchange receipts are really devoted to purchasing government goods—particularly military goods. If you are really going to talk realistically about this in numbers, you ought to net out the military component.

But if you net out the military component you will find that the government share is not so overwhelming.

SPEAKER: (Unintelligible)

FRIEDMAN: Let me translate the statement which has just been made. The statement which has just been made is that the foreign exchange control arrangements have been enormously effective in preventing Israeli citizens from getting foreign exchange, if they desire to get it. That’s the statement which has been made. I can understand that a man in charge of foreign exchange control would make such a statement. I cannot understand that he will expect the rest of us to accept it.

You are exporting in dollars, you are not exporting in pounds. You are importing items denominated in dollars, you are not importing in prices in pounds. And therefore, the volume of your exports and the volume of your imports will be determined by world prices. Now this does affect domestic prices. But you now have the situation where you have a major difference between the landed price of most goods and the domestic price. You have a wedge between these two. And the large part of the effect that worries you can be absorbed by eliminating that wedge—rather than having it feed right straight through to the domestic price. Indeed, eliminating these subsidies and restrictions would eliminate the wedge between the landed price and the domestic price. And thus would have none of these serious adverse consequences that you foresee.

5/2/13