-: Hello, this is Rose Friedman
inviting you on behalf of Instructional Dynamics
to another of our bi-weekly conversations
with Milton Friedman, Professor of Economics
at the University of Chicago.
We are taping this on Monday, May 20th, 1974.
This is a little late for this tape
because we attended a conference in Williamsburg
on flexible exchange rates.
We'll discuss that conference somewhat later on,
but, the most important monetary event of this,
of recent days has been the difficulties
of the Franklin National Bank.
Would you like to comment on that?
-: The two events are not entirely unrelated.
According to the newspaper stories
the source of the difficulty
of the Franklin National Bank
was, were massive losses in the estimated range
from something like 17 million dollars
to 40 million dollars.
Massive losses in foreign exchange speculation
allegedly by a trader who was not authorized
to operate on such a magnitude on his own.
These are really tremendous amounts
because the foreign exchange business
operates on very narrow margins.
A one or 2% move on a foreign exchange rate
is a large move, so, a loss of 17 million
means that operations were being carried out
in the sums that must've amounted to 50 times that
or three or four hundred million dollars.
It's inconceivable, almost inconceivable
that any official of a trader of a bank
could have been authorized to take positions
of that magnitude, to commit his bank
to positions of that magnitude without authorization.
But, the interesting question is not that,
the interesting question is why should this have been
the occasion of so much concern?
Many an industrial or a financial enterprise fails
without it being the occasion of stories
throughout the press about the danger
of a great financial panic,
without the Federal Reserve being moved
to issue public statements,
the New York Federal Reserve Bank
getting in to the act and so on.
To take an example of recent history,
equity funding
failed as a result of fraud some time back.
I don't know,
I don't remember what the actual numbers are
but the total amount of money lost
was far greater than any amount of money
that it was, was conceivably capable of being lost by,
certainly by innocent people
in the Franklin National Bank case.
Being a national bank, it was a member
of the Federal Deposit Insurance Corporation,
deposits were guaranteed,
there certainly would've been very little or no loss
to depositors, even if it had closed down
and not been re-financed and continued in operation.
The explanation for the far greater concern
for Franklin National Bank
than for the equity funding
is
not the size of the losses
but the historical fact that, in the past,
on many an occasion
the failure of a bank has been the trigger
that has produced
a wide-scale banking panic.
For example, one of the most famous
historical cases was the failure
of the Knickerbocker Trust Company
in New York, in 1907,
which was the occasion for the
the Panic of, so-called Panic of 1907,
when you had a concerted agreement
by all banks that they would not pay out
gold or currency over their counters,
that all checks were marked for,
to be settled at the clearing house only.
I described it in that complicated way
because the actual term that was then implied was,
that was then used, was to say that banks
had suspended payments.
If you used that expression today you would think
that the bank had closed,
but that isn't exactly what had happened.
They had suspended payments in the sense
of not agreeing to pay out cash over the counter.
But the banks continued open for business
and people could
make payments back and forth to one and other by check.
The problem for the banks then
was that they were required to pay gold
over their counter in return for a deposit,
and with a great run on the banks
because the Knickerbocker Trust failed
and there were rumors that other banks
were fail, were going to fail and there was the usual
contagion of fear that deposits
would not be convertible in to cash,
there was a great considered run on them
and they suspended payments in that sense
in order to stay open.
But that did trigger, of course, a decline
in the quantity of money, it did trigger a very,
very sharp panic
and severe recession.
And that was the kind of pattern
that had been followed many times in the past.
It was repeated again in a different form
in the 1930s,
when the most prominent case
was the failure of the Bank of the United States
on December 11th,
1931.
It too triggered a widespread fear
that banks were going to collapse,
caused a great run on banks and led to a,
it was really the climactic event, the date,
the shift in the character of the Great Depression
from being a rather ordinary,
but extremely, though extremely severe recession
to being a major catastrophe.
It is these memories of the past
that cause an event such as the danger
to the Franklin National Bank
to be greeted with the concern that it was greeted with.
It's not clear that that concern is any more justified
because we now have what we did not have then,
namely the Federal Deposit Insurance Corporation
which assures that the failure of one bank
does not lead to the losses by its depositors
and which has been extremely effective
in the course of time in preventing isolated
bank failures from leading to runs.
But, whether justified or not,
the reaction was one of widespread concern
and panic that there might be financial catastrophe,
and the Federal Reserve Board was induced
to come out and say that it was going to serve
as lender of last resort,
that it was to make announcements
that Franklin National had large volume
of assets which were eligible for discount
at the bank and that the bank would make the discounts.
It led the Federal Reserve Bank of New York
to make announcements of a similar kind
and I understand, though this is not in the papers,
to engage in advance arrangements
and negotiations trying to set up a merger
between Franklin National Bank and another bank
in order to see that it continued operating.
This is likely, it looks at the moment
as if this will prove a Tempest in a Teapot,
the Franklin National Bank is apparently
going to be recapitalized and will survive,
the stockholders have agreed to
put, eddy up
enough money to make good the capital efficiency.
However, that doesn't mean that it will not have any effect.
The operations of the Federal Reserve
during the past week will probably mean
that we shall see a short, but at least a short,
maybe more than a short, but we will see
a sharp increase in the quantity of money
in the next month or two as a result
of the operations of the attempts
by the Federal Reserve to assure
the financial markets that there is going to be
no financial collapse or financial panic.
This reminds you of what happened
in May of 19 -
In May 1971 on the occasion of the failure
of the Pan Central which was
different from both the Franklin National
and the equity funding because the failure
of the Pan Central
meant
that a lot of market paper,
a lot of financial
bills,
commercial paper,
which had been issued by the Pan Central
suddenly became of doubtful value
and it meant that not only that but there was a great shock
to the confidence in the commercial paper market.
It was very difficult for even eminent
first-rate corporations to raise money
in the commercial paper market
and therefore they turned to the banks
and the banks suddenly had a large demand
for additional demand for loans.
And on that occasion, the Fed prides itself
on the rapidity with which it came to the rescue,
on the large amounts of funds that it poured
into the market, on the fact that this event
was absorbed without any major financial consequences.
A similar phenomenon is under way now
in making the, assuring the market
that Franklin National will not be allowed
to multiply and accelerate.
The Fed will be pouring high-powered money
in to the market, they have been doing so already,
and this will come out undoubtedly
in a very sharp increase in the quantity
of money over the next month or so.
That will add to the problems which the Fed will have
in bringing it back down to the more moderate
rate of increase in the quantity of money that,
on the one hand, has been their announced objective
and on the other has been their actual
performance over the past 3 or 4 years.
-: Let's go back and discuss the conference a little bit.
-: Well, as all of you know,
in the, within the past year or so
there has been a dramatic change in the character
of the International Financial System,
from a system which was ostensibly
erected on the basis of fixed parodies,
fixed exchange rates supported by governments,
to a system of rather freely floating exchange rates.
In the course of the past four or five year, five years
there has been a group of people who have met
from time to time in connection with this issue,
they have called themselves the Burgenstock Group
simply because Burgenstock was one of the places
in Europe at which the group met, although
the first meeting was held in Long Island at Oyster Bay.
This group has been organized by three people,
Fritz Machlup
formerly of Princeton,
now retired from Princeton and teaching at NYU,
Fred Bergsten of the Brookings Institution,
and Bob Roosa who was at one time
under-secretary to the treasury and more recently
has been a partner of Brown Brothers and Harriman.
The aim of this, these conferences,
which have been supported by foundation funds
has been to bring together academic people
on the one hand and what were called practitioners
on the other, by practitioners meaning people
in the banks or in financial institutions
or in multi-national corporations
who are involved in day-to-day exchange,
foreign exchange transactions, but also officials
of central banks of various countries.
The idea of the original series of meetings was to
examine
the problems
that would be raised by flexible exchange rates,
it was an attempt to try to bridge the gap
to some extent between the academic group
and the practicing group,
the academic group having by this stage
largely become persuaded that floating exchange rates
were both inevitable and desirable.
The practicing group, looking with horror
in the main at that prospect,
having adjusted themselves to operating
in a world in which exchange rates
were being fixed and kept in line
by governmental bodies, by central banks, and the like.
And the idea of the conference was to explore
what were the problems
that would arise
in
getting to a flexible rate system.
The series of conferences serves
an extremely useful function in instructing
both the academic people
about some of the practical problems
and in bringing home to the practical people
that there were no, there was no really effective
alternative to a greater measure
of flexibility of exchange rates and help,
therefore, to pave the ground,
ground for the developments that did occur.
The meeting this time was the first meeting
since floating exchange rates had become a reality,
and the aim of the meeting was,
the title of the meeting, the subject matter was
"What have we learned
"from a year of flexibility of exchange rates?"
I found it an extremely interesting
and fascinating conference
as someone who had all along been in favor
of floating exchange rates,
it was interesting to see how it had worked.
A number of conclusions
were very clear from the discussions running over three days
among this group.
In the first place there was, by this time,
essentially unanimous agreement on everyone's part,
theorist, practitioner in the private world,
central bank official,
there was essentially unanimous agreement
that
it's hard to conceive how the world
could've gotten through the past year
with any system other than floating exchange rate.
Given the
blows which were struck
on the International Financial Mechanism
by
worldwide inflation at differential rates
in different countries, by the Middle East war,
by the oil crisis, there seemed to be unanimous
agreement that whether floating exchange rates
were a good system or a bad system
for the long pull they had been an absolute
necessity for that year.
In the same place, it was widely agreed
that businesses had found it surprisingly
easy to adjust to it.
That they had learned to operate the system
and it had not interfered significantly
with the course of trade,
with the course of,
with the volume of exchange among countries.
However,
on the,
those were the two main positive findings.
On the negative side, there was a good deal
disappointment, of disappointment expressed
that the fluctuations in the exchange rates
had been as wide as they had been.
And the
argument was made
particularly, mostly by the practitioners,
and here one has to distinguish
between different kinds of practitioners.
Here, on the one hand,
you have the people in the banks
who are engaged in the day-to-day trade
who are making the market,
on the other hand we had representatives
of multi-national corporations
who are in the, who are faced with the necessity
of adjusting funds in different currencies,
the customers in a way being the multi-national banks,
the providers of the service
being the multi-national corporations,
the providers of the services being the banks.
And here there was widespread agreement
that the banks in particular had been unable
to take a very long-range position,
that they were involved in day-to-day trading
and that they had tended to develop,
rather than, a stabilizing speculation
rather than going against the market,
they had had to follow the policy
of essentially what was called a Bandwagon Effect,
of going with the market, and as a consequence
the argument was that one of the hopes
that had been expressed by proponents
of flexible exchange rates, like myself,
had been that speculators by,
private speculators would stabilize the market
and keep the fluctuations in the exchange rate
from being as wide as they otherwise would.
Well, at least for the first year,
this hope seems not to have been realized.
The banks have been unable
to take any substantial position,
the experience of Franklin National
was cited several times as to what happened
when banks did take a substantial position.
There had been developed a private market
in the form of the International Money Market
in Chicago, where private speculators
might come in and take positions
but while this had been, had grown very rapidly
in its own terms it had not really taken off
in the sense of amounting to any substantial
contribution to the total of all the international
exchange transactions, those were still in the main
been done on an interbank basis.
There were some comments by the customers,
by the multi-national corporation people
that after all the banks were better off,
the traders were better off when rates did fluctuate,
that was the business they were in.
And there were comments made about the total,
the very large volume of profits which banks
had made out of their foreign exchange speculation.
This subject never really got itself resolved
but, I guess, part of the emphasis
was that one year was a very short time,
that this was a learning period,
that it would take a longer period of time
before the thing settled down
and particularly before you discovered
where there were sources of
stabilizing speculation.
Another issue that was discussed was,
and that had been of much concern was whether,
what was gonna happen to the cost
of exchange transactions.
Now this cost really consists of two different things,
one is a bid-ask spread and is the commission
in which the dealers take,
and the other part from a private point of view,
which is of cost, is that if you have a payment
to make in pounds, let us say six months from now,
you may now go in to a forward market
and buy pounds
and this will
enable you to cover that obligation
without undertaking an exchange risk,
without being subject to the possibility
that the exchange rate will change.
This cost is not really a social cost
because if you pay a premium on that score
in the future while somebody else
is on the other side of it and is getting the gain.
So that, but nonetheless
the question not so much of the cost in that area
as the availability of such hedging markets
was discussed and it was widely agreed
that futures markets had not developed,
had not become any greater or more widespread
or any, to any significantly greater extent
that they had been before that,
in this first year at least.
The possibility of hedging in making
forward transactions for long periods
had not developed as many people had hoped it would.
There was a great deal of controversy
about the question of whether at this stage
the central banks should come back in or not,
whether, maybe, it was the central banks
who could provide the stabilizing speculation
and it was kind of a curious thing,
some of the bankers and businessmen
thought they could but it was,
as I expressed a view there,
it was like wanting some more
of the hair of the dog that bit you, the real problem
that you got in to was exactly because of the,
what turned out to be destabilizing
speculation of the banks.
We had a very interesting story told
about what had happened in Japan
over the last year or two,
by some of the Japanese participants,
and that is really a striking example
where you had ostensibly floating exchange rates
but not really floating exchange rates.
What happened was that the Japanese
Central Bank,
the Bank of Japan, and the government first,
in the early stages of the floating,
tried to keep the exchange rate of the yen
from appreciating and in the process they accumulated
something over 10 billion dollars of additional reserves.
And then, after it had appreciated, and went too far,
they tried to keep it from depreciating
and we made some very rough calculations
that were really fascinating but it seems
that in the past year and a half
the Central Bank of Japan
lost something like a billion and a half dollars
in exchange speculation,
that is to say in order to keep the yen from appreciating
it paid something like 300 yen per dollar
for 10 billion dollars.
And then, some months later,
for a period of six months it sold
yen at 265 yen to the dollar,
so it bought dollars at 300,
I say sold Yen, it sold dollars.
It bought dollars at 300, and it sold dollars at 265,
so it lost something like close to 15% on every trade
and it accumulated in the first instance
10 billion and then it sold NET 10 billion dollars
so that means it lost about a billion and a half dollars
and nobody knows who benefited, who gained,
or whatnot from that episode.
The other main topic that was discussed extensively
was the question of the implications
for the market of the oil crisis.
There are the estimates of the very large
flows of funds that are alleged
to go to the oil companies that,
perhaps, something in the order
of 150 billion dollars a year,
I've talked about that on these tapes before
and you will know that I am very sceptical
that any such sums will eventuate.
But nonetheless a question was raised
and I may say among the people who were present
were some officials of oil companies
so that we had some expertise on this subject,
the question was raised about the feasibility
of transferring such substantial funds
and what that would do to the foreign exchange market,
to the flexible rates,
to the breadth of the market and so on.
I cannot say that there was any very definite conclusion
that was drawn on this.
Some of the participants were quite optimistic
about the possibilities of the euro-dollar
market handling it,
others or the participants were quite pessimistic.
One thing can be said for sure,
on the basis of this discussion,
whatever dissatisfaction was expressed with the system
of floating exchange rates there was essentially
no belief whatsoever that it was likely to be replaced
in the near future
by
any very different system.
-: We have a question from Kerry Ridgeway,
who's an assistant Professor of Economics
at the University of Nevada, Las Vegas,
and the, this question sort of fits in
to the spirit of this, the discussion
we've just been having.
Mr Ridgeway writes, several years ago
you participated in a seminar
sponsored by the Schoffman Foundation.
During this seminar, while discussing the fact
that the development of centralized governments
has not proceeded as rapidly as many classical
liberals expected it would in 1946,
you made the following statement:
"Nobody is ever persuaded by ideas,
"what people have been persuaded by is experience."
He goes on, "This leads me to believe
"that you would probably disagree with the following
"much-quoted passage from the General Theory of Employment,
"Interest and Money, by John Maynard Keynes:
"The ideas of economists and political philosophers,
"both when they are right and when they are wrong,
"are more powerful than is commonly understood.
"Indeed, the world is ruled by little else.
"Practical men who believe themselves
"to be quite exempt from any intellectual influence
"are usually the slaves of some defunct economist."
-: That certainly does fit in directly,
because the question is what role
have these conferences had in spreading
the idea of floating exchange rates
and leading to its adoption.
Let me turn directly to, to Ridgeway's question.
There is not, I believe, a real inconsistency
between the statement I made
and the statement Keynes made.
To say that people are not persuaded by ideas,
that they are persuaded by experience
is not equivalent to saying that ideas
have no meaning or have no consequences.
Experience has to be interpreted
and it has to be reacted to.
Consider the case of the,
immediate case of the floating exchange rate.
The idea of floating exchange rates, it's a very old one.
I have, myself, been in favor of it
and have written in favor of it
for something over 20 years, 25,
my first article was really on this subject,
was really written in 1950.
Advocacy of it goes back much farther.
The group of the University of Chicago economists
associated with Henry Simons and Lloyd Metzler
back in the 1930s were in favor at that time
of freely floating exchange rates.
But,
for years
the preaching for floating exchange rates
fell completely on deaf-ears.
Why?
Because experience didn't seem to bring a need to.
We got in to floating exchange rates
not because anybody was persuaded by these ideas,
that floating exchange rates were a desirable system,
but because there was no alternative.
We got in to floating exchange rates
because the United States got in to the position in,
finally in 1971 where it felt it could no longer
meet the demands that were likely
to be coming forward for gold, its gold reserves
that had declined sharply to less than half
of what they had been a few years earlier,
it was running a large balance of payments deficit.
Central banks throughout the world
were accumulating dollars
and some of them were threatening
to ask that the dollars be honoured in gold.
As a result,
the US was forced into,
or felt it was forced in to closing the gold window.
This didn't change the fundamental idea
or the structure, on the contrary,
what the Smithsonian agreement reached,
at the end of 1971 there was an attempt
to re-establish the system of fixed exchange rate.
But it didn't work, it broke down.
So, it was experience that led to the adoption
of a floating exchange rate.
However,
this experience, as I say,
had to be interpreted.
The writing which had been done
about the floating exchange rate provided
a basis on which it was interpreted.
It was in this way that the economists
and political philosophers exerted influence.
Had nobody been talking about floating exchange rates,
had that idea not been around
it might well have been that the outcome
would've been not the kind of system
we've seen in which reliance was placed
upon the market but, rather, a system
of much more widespread exchange control,
of much more widespread restrictions.
Again, let me take you back.
If you go to the period after the end of the war
the ideas that dominant at that time
were the ideas of centralized control,
of central planning, and as a result
the reaction to an essentially similar kind
of foreign exchange problems,
well they were different, but,
to major foreign exchange problems
at the end of World War 2,
was a widespread adoption
of exchange controls, a system which is,
I've just been indicating Japan has still been a follower.
So I think that the writings of intellectuals
play an extraordinarily important role
but the role which they play is in providing
the framework in terms of which people
interpret experience and in the second place
in leaving ideas around to be picked up
when the time for them is right.
Let me give another example
of exactly the same thing which is now very topical,
and that has to do with the problem
with escalator clauses and of widespread indexation,
a topic I have been talking about
on these tapes for some time.
The intellectual ideas for this are very, very old,
I discovered in looking back in to 'em
that the first such, the first interest
in such an escalated clause comes, that I can find,
the first documented reference is in 1707
when a fellow by the name of Fleetwood
who was a Cambridge Don was asked to interpret
a clause, for some reason an Oxford contract
for Oxford provisions for hiring fellows
at one of their colleges.
And, according to this contract or arrangement,
I'm not sure exactly what it was,
something which had been adopted 300 years earlier in 1400,
no person was supposed to be retained
as a fellow in the college
if he had an outside income of more than £5 a year,
a private income of more than £5 a year,
and Mr. Fleetwood was asked,
we now have somebody who now has an outside income
of seven or £8 a year, are we required
by the terms of this stipulation to
get rid of him?
And, so, Fleetwood was led by this to go back
and examine the course of prices
over about a 600 year period,
he constructed a price index number
and on the basis of this price index number
he asserted that now the counterpart in 1707
of £5 in 1400
was about £26
and thus it was only if the private income
exceeded £26 that the fellow should be separated.
That is a reliant, obvious application
of an escalator clause to a wage contract.
Widespread use of escalator clauses
was explicitly proposed in 1807 by John Wheatley,
it was supported by
William Stanley Jevons,
it was supported by Alfred Marshall,
it was supported in this country by Irving Fisher,
indeed every, every important economist
of the last 100 years has been in favor of it
and has written on it.
And yet, in this country and in the modern world
it has gotten very little attention
until circumstances made it
come alive
because of the very rapid recent inflation.
Now it is suddenly a hot issue.
But, even now,
what is the main thing people are pointing to?
Not to the writings of Marshall and Fisher and of Jevons,
but to the experience in Brazil
which has adopted
a system of indexation
along the lines of the theories spoke about.
-: I think we've come to the end of our time.
Thank you very much.
Remember, subscribers,
if you have any questions or comments
please send them to Instructional Dynamics,
450 Ohio Street,
Chicago, Illinois,
60611.
We shall be visiting with you again in two weeks.