Milton Friedman’s Money Machine

March 22, 2011 09:10

The government is running a $1.6 trillion deficit. Nothing can be done politically to stop this. We are on a runaway train. The main brakes were removed in 1971. The only brake now is that of the bond vigilantes, but the Federal Reserve is the buyer of bonds today, along with Asian central banks. Stockman observed that “the Fed’s QE2 bond purchases have been so massive that it is literally buying Treasury paper in the secondary market almost as fast as new bonds are being issued.”

By Gary North at Whiskey & Gunpowder

Milton Friedman believed in the free market most of the time. The trouble was, whenever he approached the coercive monopoly known as civil government, he came up with logical solutions based on the idea that civil government can be made more efficient by adopting pseudo-market arrangements. He came up with ideas justifying the imposition of the Federal withholding tax in 1943. That was going to be a temporary wartime tax, the public was assured. He believed the government could collect far more revenue through withholding. He was correct. This made government far more efficient than ever before at extracting wealth.

He promoted the idea of educational vouchers issued by local governments and based on taxes extracted from the public. He did not consider the obvious fact that the courts would make this the wedge by which the state would take over private education. He and I debated this in 1993.

Most of all, he promoted the idea that storing gold in government vaults to back the currency is wasteful. It wastes gold. It wastes storage space. It wastes armed guards. So, to make monetary policy more efficient, the Federal Reserve should increase money — he never said which M — by 2% to 5% per annum. He wanted central-bank-controlled fiat money.

The only critics from the fringes of academia were the Austrian School economists. We knew that an efficient government is a dangerous government. We also knew that a central bank that does not face an outflow of gold in response to its policies of monetary inflation will inflate far more than would be allowed in any gold-related economy.

I responded to this argument, which had been picked up by The Wall Street Journal, back in 1969.

Hans Sennholz responded on many occasions. So did Murray Rothbard. But we were not taken seriously. We were not part of the mainstream. Academic economists had long since abandoned any support of a gold coin standard. They did not all support Friedman’s idea of a restrained Federal Reserve. In fact, very few of them supported it. They wanted flexibility. They still do.

Once Nixon closed the gold window, there was no turning back. The monetary base grew, all of the various Ms grew, prices rose, bubbles grew and blew, and the Federal debt rose to today’s gigantic, unsustainable level — unsustainable apart from mass inflation followed by hyperinflation.

The abolition of a currency convertible on demand into gold was only one part of Dr. Friedman’s contraption. The other part was his suggestion of floating exchange rates. This deserves special consideration.

Milton Friedman’s Contraption

Friedman easily took apart the idea of fixed exchange rates. Fixed exchange rates are a form of price control. Friedman was a good enough economist to know that price controls produce shortages. The artificially undervalued currency goes out of circulation. The overvalued currency produces gluts. There will be runs on central banks.

Domestic purchasers of foreign goods say to the central bank: “Sell us the artificially undervalued foreign currency at the official price.” The central bank runs out of foreign currencies. Trade collapses. There is then a devaluation. The official prices of the foreign currencies are raised to new fixed exchange rates.

It was easy for Friedman to expose this as ridiculous. “Just float the currencies,” he said. “Let the free market set their prices.” This was good advice. Price controls do not work as promoted. They always produce gluts or shortages.

But then Friedman recommended his old favorite: pure fiat currencies. He said that these can be managed rationally by means of a fixed rule governing a predictable expansion of money. “Turn it over to the Federal Reserve. All will be well if the Federal Reserve does not tamper with the rate of growth.” As John Wayne said in The Searchers: “That’ll be the day.”

Nixon adopted Friedman’s contraption. First, there would be no more convertibility of gold for foreign official government agencies.

For a little less than two years, there were universal price controls on American goods. These controls led to shortages and a disruption of international trade. The dollar was not officially floated until December 1973.

When the price controls came off, prices rose. In 1975, Gerald Ford launched the WIN plan: Whip Inflation Now. The recession of 1975 did exactly that. Then came the worst monetary inflation in American peacetime history: 1976-80. Gold and silver soared.

Friedman’s contraption clearly was not working. Floating exchange rates were not the problem. The abolition of the gold exchange standard was the problem.

Friedman’s contraption has engulfed the whole world in monetary inflation, bubbles, and busts.

Stockman on the Contraption

In a lecture to the Mises Institute on March 12, David Stockman blames floating exchange rates and the abolition of the gold standard.

That the demise of the gold standard should have been as destructive of fiscal discipline as it was of monetary probity can hardly be gainsaid. Under the ancient regime of fixed exchange rates and currency convertibility, fiscal deficits without tears were simply not sustainable — no matter what errant economic doctrines lawmakers got into their heads.

Back then, the machinery of honest money could be relied upon to trump bad policy. Thus, if budget deficits were monetized by the central bank, this weakened the currency and caused a damaging external drain on monetary reserves; and if deficits were financed out of savings, interest rates were pushed up — thereby crowding out private domestic investment.

This is an accurate assessment of what happened. But the anchor to this was not the fixed exchange rate system, because the IMF had no real authority to enforce them. The anchor was the promise of the United States to sell gold at $35 an ounce. When the chain was cut, and the U.S. kept its gold, the international currency system was cut adrift. The anchor resides in the vault of the New York Federal Reserve Bank.

In the good old days, there was pain, Stockman observed. “Politicians did not have to be deeply schooled in Bastiat’s parable of the seen and the unseen. The bitter fruits of chronic deficit finance were all too visible and immediate.” This ended in 1971.

During the four decades since the gold window was closed, the rules of the fiscal game have been profoundly altered. Specifically, under Professor Friedman’s contraption of floating paper money, foreigners may accumulate dollar claims or exchange them for other paper monies.

But there can never be a drain on U.S. monetary reserves because dollar claims are not convertible. This infernal engine of fiat dollars, therefore, has had numerous lamentable consequences but among the worst is that it has facilitated open-ended monetization of the U.S. government debt.

The government is running a $1.6 trillion deficit. Nothing can be done politically to stop this. We are on a runaway train. The main brakes were removed in 1971. The only brake now is that of the bond vigilantes, but the Federal Reserve is the buyer of bonds today, along with Asian central banks. Stockman observed that “the Fed’s QE2 bond purchases have been so massive that it is literally buying Treasury paper in the secondary market almost as fast as new bonds are being issued.”

Is all this Friedman’s fault? Stockman lets him off the hook, to some extent.

By contrast, under the contraption that Professor Friedman inspired, trade account imbalances are never settled. They just grow and grow and grow — until one day they become the object of fruitless jabbering at a photo-op society called G-20.

In all fairness, Professor Friedman did not envision a world of rampant dirty floating. Indeed, it would have taken a powerful imagination to foresee four decades ago that China would accumulate $3 trillion of foreign currency claims or more than 50% of GDP, and then insist over a period of years and decades that it did not manipulate its exchange rate!

My response: it was all Friedman’s fault, intellectually speaking. When an economist recommends a policy, he also recommends its effects. Friedman failed to see what Austrian School economists had predicted: the unleashing of fiat money, and manipulated rates — dirty floating. Dirty floating is all there is in a world run by government-licensed central banks without gold coin convertibility. But for our saying this, decade after decade, the economics profession has marginalized us.


Milton Friedman was always too clever by half. He advised governments to get more efficient, and they did so. They used his advice to expand their power and expand their reach into our wallets.

We told him so. He did not listen. His followers did not listen. Today, they all sit mute at the side of the road, mumbling about potentially excessive deficits and potentially excessive price inflation, but generally approving of the Federal Reserve.

The problem is the original contraption: (1) government’s monopolistic control over money and (2) central banking as such. Here, Friedman was supportive of government.

The problem was not floating exchange rates or the breakdown of Bretton Woods in 1971. Those were the inevitable results of Bretton Woods, as Henry Hazlitt warned in the late 1940s, and was fired by the New York Times for saying so.

The problem was not even the Genoa Conference of 1922, the contraption designed to solve the inflation that came as a result of the suspension of redemption in the second half of 1914, when World War I broke out.

The problem was the mass confiscation of the people’s gold in 1914: first by commercial banks, then by the central banks.

Milton Friedman’s contraption was just one more ill-fated attempt to deal with the results of the original confiscation. It was one more case of his outlook: “The government was right to confiscate the gold and end the gold standard. That was an efficient way to fight a war, just as withholding taxes are efficient, and vouchers are efficient.”

Milton Friedman spent his career defending the efficiency of the free market. But, on the really big issues, he sold his peers on the efficiency and good will of government politicians and bureaucrats. “Trust them to be efficient.”

The Austrians said the same thing, but added, following Forrest Gump’s mother, “Efficiency is as efficiency does.” The state gets more efficient only in order to tyrannize people on a cost-effective basis.

Milton Friedman’s contraption was the unchecked welfare-warfare state: unchecked by annual taxation without withholding and unchecked by the gold standard.

If that’s efficiency, include me out.

Gary North
Whiskey & Gunpowder

Gary North, at the age of 25, was the youngest elected member of the Economists’ National Committee on Monetary Policy. Gary has served as a senior staff member of the Foundation for Economic Education and as a research assistant to U.S. Congressman Ron Paul. Gary North is also the author of Mises on Money and the editor of the Reality Check free e-letter.

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