- 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.