Critical Evaluation of Milton Friedman's Views

In this essay, we will evaluate Friedman's view that using the free
market is the best way to achieve a balance of payments equilibrium.
The evaluation will be done with particular reference to the other
macroeconomic objectives of sustained economic growth, low
unemployment and stable prices.
Firstly, Friedman looks at the possibility of drawing on reserves or
borrowing from abroad. He argues that this would be undesirable
mainly because this essentially sees less demand for exports
competing with imports, and hence reduces industrial output.
Employment decreases as a result, harming consumption and
economic growth.
I would argue that it depends on what is being imported. For
example, countries like Brazil and India who see large FDI inflows
may in the short run suffer from a current account deficit, but in the
long run benefit from an increase in capital accumulation. This
stimulates labour productivity and meaning firms have lower costs,
hence becoming more competitive internationally. It helpss correct a
balance of payments deficit and increased exports demand increases
industrial output, and hence employment.
Secondly, lowering prices through lowering inflation can stimulate
exports and discourage imports. However, Friedman argues that this
can only be achieved by tight monetary policy or fiscal policy e.g.
raising interest rates to make it more expensive for consumer and
business borrowing, hence reducing consumption. The significant
fall in AD needed to achieve lower inflation can lead to recession
and increase cyclical unemployment as firms find themselves with
excess spare capacity.
On the other hand, this depends on what stage of the economic cycle
a country is in. For example, the UK economy pre-recession may
have benefited from even higher interest rates to deter consumption,
and hence lower demand pull inflation. Friedman is being too
general in his argument that lowering domestic consumption harms
our macroeconomic objectives.
Thirdly, with fixed exchange rates one can officially devalue a
currency, such as when Britain devalued the sterling. Ceteris paribus
this makes a country's exports cheaper and more competitive and
imports more expensive. Friedman's main argument is that changes
in rates are often postponed, hence worsening the situation; in 1992
the prospect of the sterling's devaluation prompted flight from the
currency, hence putting more pressure upon the GBP to devalue.
Just because changes in rates are often postponed doesn't mean there
is a problem with an exchange rate system though, merely that the
system is being mismanaged. In cases such as the sterling's
abandonment of the ERM in 1992, the Bank of England should have
acted much quicker to react to a long term over-valuation of the

GBP. China's experience with a fixed exchange rate proves that with
good management, a country can combine increased short term
stability with long run sustainability.
Floating exchange rates are seen by Friedman as the panacea to a
current account deficit. He argues that under this method exchange
rates adjust themselves using the free market, and indeed speaks
against any government intervention in the currency market.
Friedman argues that the government is just as prone as private
investors to make mistakes, and they are prone to pegging the rate to
unsustainable levels.
However, I would argue that with floating exchange rates firms,
especially in markets approaching perfect competition, are still more
vulnerable to short term shocks to floating exchange rates, forcing
them to be more conservative. In contrast, fixed exchange rates
mean domestic businesses know what they'll receive and pay,
leading to increased certainty. This means they're more confident in
investing into capital, which will increase productivity. Lower
production costs can then be passed onto consumers, making a
country's exports more competitive. China has seen great success
pegging their currency to the USD, having attracted FDI inflows of
$350 billion since 2009, which has enable them to quickly increase
their capital stock and hence sustain high economic growth.
Friedman provides no evidence that businesses and investors are just
as certain about floating exchange rates compared to fixed rates.
Indeed, I would question whether depreciation is always an effective
solution in reducing a current account deficit as Friedman suggests.
For example, Britain has experienced a persistent deficit since 1999
despite being under a floating exchange rate. One possibility for this
is Britain's dependence upon imported goods, meaning that in the
short run where demand for imports is more inelastic, depreciation
leads to an increase in the overall value, hence worsening our
balance of payments.
This however is only a short run explanation as eventually imports
should become more elastic as businesses can renegotiate contracts
etc. A more long term explanation could be that Britain depends on
importing raw materials for production. This means that depreciation
increased production costs for domestic firms, offsetting any gains
in competitiveness. Under this scenario the only result of
depreciation is increased inflation within the UK economy.
Instead, the Bank of England has placed a stronger emphasis upon
the UK 'productivity puzzle', where labour productivity has been
'exceptionally weak' post recession. This, I would argue, is a more
important factor in resolving a balance of payments deficit than
exchange rate systems, because if labour productivity growth falls
behind other countries, then our production costs increase relative to
other countries, resulting in further losses of competitiveness.

Finally, Friedman seems to immediately dismiss the role of trade

barriers in a successful economy. He seems to have not considered
that tariffs in some cases may be necessary for example, cigarettes
upon consumption produce negative externalities such as the harms
of passive smoking. Tariffs may have an important role in
internalising external costs, and hence reduce consumption closer to
socially optimum levels.
In conclusion, I would agree with Friedman that a floating exchange
rate is the best system to use in most cases, because it removes the
need to hold foreign exchange reserves and the risks of
mismanagement by government institutions. He seems to place too
much emphasis upon exchange rate systems though, and not enough
upon supply side improvements after all, without competitive
domestic producers, it is impossible to resolve balance of payment
problems regardless of exchange rates!