Free-floating anxiety: fans of stable money are nostaligic for a system of pegged exchange rates. They shouldn't be - includes related article on a memorandum to President-Elect Richard Nixon

National Review, Sept 12, 1994 by Milton Friedman

THE fiftieth anniversary of the Bretton Woods conference, which created the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (the World Bank), has been the occasion for a triumph of nostalgia over reality. Nostalgia has converted the twin institutions into major pillars of postwar expansion, transformed the 1971 termination of the system of pegged exchange rates established by Bretton Woods into a major policy mistake, and produced expressions of support for the re-establishment of such a system.

Reality is very different. The IMF and the World Bank have been major failures; they have done far more harm than good and have imposed heavy costs on their members. The world would be far better off today if neither had been established. Both are excellent examples of one of my favorite generalizations: If a private enterprise is a failure, it will close down unless it can get the government to bail it out; if a government enterprise is a failure, it will be expanded.

Even the most casual empiricism suggests that the World Bank and its more recent junior accessory, a reformed IMF, have done more harm than good. They have distributed many billions of dollars of so-called loans, most of them really grants, supposedly to foster the development of poor countries. But the most successful cases of development have been in the countries that have relied least on the Bank and the Fund--the Four Tigers, and more recently Mainland China. Most of the countries that have received extensive assistance from the Bank have done very poorly--India, for example, and most African and Latin American countries.

The reason is clear. The problem with the poor countries is mostly a government sector that imposes excessive restrictions on economic activity and transfers both power and wealth unto itself--in short, too strong a government. But to whom do the World Bank and the IMF make loans? To the government. Hence they strengthen government control, providing money that the people in power can use to entrench their position, in countries where the urgent need is to reduce government power and control. They encourage the propensity of governments to construct monuments, which is indeed what the major output of the Bank has been.

The IMF's assignment was to supervise a system of agreed-on exchange rates among member countries by providing a) assistance to smooth over temporary balance-of-payments problems and b) a forum for agreeing on changes in exchange rates in response to a "fundamental disequilibrium" as judged by the IMF. The agreement linked the U.S. dollar to gold and the currency of other countries to the U.S. dollar. It provided that all members other than the United States would specify an official exchange rate in terms of the U.S. dollar, that each was free to make one change of up to 10 per cent in that exchange rate on its own, but that any other changes required the approval of the IMF; and that the United States would commit itself to buy gold from and sell gold to foreign central banks or other monetary authorities at $35 an ounce in unlimited amounts at their request. The IMF arrangements were intended to eliminate the direct exchange controls that had become pervasive ever since Hjalmar Schacht introduced them in Germany in the late 1930s.

Despite the commitment to fixed exchange rates, numerous changes in exchange rates occurred during the 25 years after the IMF began operation, including appreciation of the German mark in 1961 and 1969, and major devaluation of the British pound in 1949 and 1967, and of the French franc in 1949, 1959, and 1969. Furthermore, exchange controls continued until 1959.

All in all, the much-vaunted Bretton Woods system of pegged exchange rates operated as intended for only eight years--from 1959 to 1967--and even those years were not free from exchange-rate changes. And it worked then only because the U.S. was willing to finance the payments deficits of other member countries.

When President Nixon closed the gold window on August 15, 1971--an act which I believed then, and still believe, he should have taken immediately on his inauguration [see sidebar]--the function that the IMF had been established to perform, and hence its reason for existence, disappeared. It should have been abolished. But it was a government agency, and so instead it simply converted itself into a junior World Bank and expanded. It became an international busybody, offering underpriced loans to countries in trouble at the price of their following its advice on domestic policy--to judge by results, occasionally good, but perhaps more often bad.

True, there have been large, sometimes violent movements in exchange rates during the period since 1971 when exchange rates have been flexible. But, first, some of those are themselves attributable to government interventions, and, second, they have not led to the introduction of direct controls on imports, exports, and capital movements that it was one purpose of Bretton Woods to eliminate but that in practice it kept alive.