Greece and Milton Friedman’s case for flexible exchange rates

The deterioration of the Greek economy is not unique in the Euro-zone (EZ), only more acute than that of its peers. As discussed in our previous post on this topic, the flaw in the design of the Euro-zone (EZ) is one-size-fits-all monetary policy in a monetary union. Some get too much slack, when others need more of it.

In a centrally planned system, such as the US federal government, states that are lagging see their share of fed spending stable (in fact, increased through social benefits) whereas their contribution in taxes is comparatively reduced. It’s easy to understand, therefore, that this acts a counterbalancing mechanism in a downturn.

The EU’s remedy for Greece has centered on internal devaluation, a broad term that encompasses austerity and reducing wages. It has brought hardship but, so far, few of the  desired gain in competitiveness. The alternative route, advocated by Nouriel Roubini, is to exit the Euro and let the new currency depreciate. Competitiveness up, trade deficit down.

Let’s present the argument in the words of Milton Friedman.

Update on events

The sense of progress that the new plan laid forth by the European council to address the crisis was supposed to create was thrown into disarray by the stunning news that the Greek government will submit the plan for approval by its people through a referendum next year. In dispute are the strings attached to the financial aid, namely more austerity, which clearly has made matters worse, thus far.

Case currency devaluation

The following quotes, from “The Case for Flexible Exchange Rates”, by Milton Friedman shed light on the ineffectiveness of an internal devaluation:

Wage rates tend to be among the less flexible prices. In consequence, an incipient deficit that is countered by a policy of permitting or forcing prices to decline is likely to produce unemployment rather than, or in addition to, wage decreases. The consequent decline in real income reduces domestic demand for foreign goods and thus demand for foreign currency with which to purchase these goods. In this way it offsets the incipient deficit. But this is clearly a highly efficient method of adjusting to external changes. If the external changes are deep-seated and persistent, the unemployment produces steady downward pressure on prices and wages, and the adjustment will not have been completed until the deflation has run its sorry course.

The issue of debt

Note that Milton Friedman’s quote, above, assumes an incipient deficit, whereas, right now, Greece is deep into debt. If wages could be cut by half, hypothetically, everything else equal, it would double the debt burden.  The efficient method is laid out below:

The argument for a flexible exchange rate is, strange to say, very nearly identical with the argument for daylight savings time. Isn’t it absurd to change the clock in summer when exactly the same result could be achieved by having each individual change his habits? All that is required is that everyone decide to come to his office an hour earlier, have lunch an hour earlier, etc. But obviously it is much simpler to change the clock that guides all than to have each individual separately change his pattern of reaction to the clock, even though all want to do so. The situation is exactly the same in the exchange market. It is far simpler to allow one price to change, namely, the price of foreign exchange, than to rely upon changes in the multitude of prices that together constitute the internal price structure.


In the case of Greece, it’s a little more involved than simply switching from a  pegged currency to a floating regime, as did Argentina, which also defaulted on its debt, in 2002, resulting in a striking recovery. They first have to switch back to their old currency, the Drachma, from their current one, the Euro. This requires that they set an initial FX rate between the two currencies and use it to restate all prices in Drachma.  In itself, it’s just a change of numéraire: no one is (yet) worse or better off. But in the first minute the currency is allowed to float, we can expect the GRD/EUR rate to increase, and narrow the competitive gap relative to countries that remain in the EZ, such as Germany.

Why, exactly, would the FX rate be expected to increase, i.e. the Drachma depreciate? One reason is, if you start from the premiss that Greece is uncompetitive, given sticky internal prices, but a free float, the adjustment will come from the exchange rate to restore purchasing parity. Of course, there are many other factors that come into play, in the present situation.


One Response to Greece and Milton Friedman’s case for flexible exchange rates

  1. […] zone in October, which included a second bailout of Greece. We followed up with an overview of the dilemma the Euro zone is facing, namely reinforced integration (a US-like federation) vs breakup. It turns out the agreement on a […]

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