Bubble trouble

National Review, Sept 28, 1998

NOBEL laureate Milton Friedman recently talked to NR about the global financial crisis, the stock-market drop, and the political and economic fallout from both.

NR: Is deflation now a bigger threat than inflation?

Friedman: No. I do not think there is any real danger of deflation. We know how to stop deflation -- print money. The Fed has plenty of ability to print money. Because of what's happening in the Far East and around the rest of the world, the prices of imported goods are behaving differently from the prices of domestic goods. The best indication of the price level of non-traded goods is what happens to money wages. And money wages have continued to go up, showing no sign of deflation.

NR: Do you foresee a recession anytime soon?

Friedman: A recession is very possible. We have been having them for two hundred years. The world hasn't changed. But nobody has a good record of predicting a recession in advance. There's an enormous amount of noise in an economic system. You have daily, monthly, weekly ups and downs. And almost always, just before a recession starts, most forecasters are predicting continued expansion.

NR: Have the recent troubles in the stock markets been noise?

Friedman: I have believed for some time that the stock market was in a bubble, and that bubble just burst. And it's a good thing to have bubbles burst, because you cannot sustain a bubble indefinitely. And if the bubble goes too far, the bursting has very serious consequences. The best example of that is Japan, where the bubble went too far in the late 1980s, and when it burst in 1990 Japan took action which led to, by now, eight years of seriously depressed conditions.

NR: What accounted for our bubble?

Friedman: A tendency for people to extrapolate the past too far. What accounted for the tulip bubble in the Netherlands some centuries back? What accounted for the Florida land bubble, the Japanese bubble? Bubbles occur because there's a mass psychology that develops and that tends to project what's going on and thinks it will always continue to go on.

NR: Some commentators say all this might slow the worldwide turn to free markets. Is that a threat?

Friedman: Yes, there's a real threat, not in the United States but in other countries around the world. What's happening is not attributable to free markets but in almost all cases to the absence of a free market. Russia's problems do not arise from a free-market economy. Most agricultural land in Russia is still collectively owned and not available for private purchase or sale. The large enterprises have remained essentially state-controlled monopolies. And the problems of the Far East did not arise because free-market capitalism was given free rein. They arose because those countries followed monetary and fiscal policies that were not consistent with free markets. The three countries in the Far East -- Singapore, Hong Kong, and Taiwan -- whose markets were most closely free markets, are the ones which have done better in this most recent period. Hong Kong is in the process of undoing something that it took many years to create. Hong Kong established a reputation that government would not intervene, and would allow the markets to work. And now, the Hong Kong government has started to intervene in the stock market. They are risking throwing away the accumulated reputation of years for very little benefit.

NR: Does the United States have any obligation to provide liquidity to the rest of the world?

Friedman: None whatsoever. I believe that the International Monetary Fund is a major source of the present difficulties in the Far East and in Russia as well. The IMF did not bail out South Korea; it bailed out the banks in London, New York, and Berlin that were making loans to South Korea. The effect of the IMF has been to encourage foreign investors to undertake ventures that were not economically justified because they had the expectation that if they got into trouble, the IMF would be there to bail them out.

NR: There's one school of thought that argues that currency devaluations started this whole mess. Others say that currency devaluations only speak of deeper fundamental problems.

Friedman: There are three arrangements that need to be kept separate. One arrangement is a truly fixed exchange rate, like the dollar in California and New York, the use of a single currency. A second arrangement is a pegged exchange rate in which a central bank undertakes to keep the exchange rate at a specified level. The third arrangement is a truly flexible floating exchange rate. Now, experience has shown that both the first and the third are tenable arrangements that can survive. There is no case of any country that had a floating exchange rate having an international financial crisis. They may have internal problems, but they don't have balance-of-payment problems because the adjustable exchange rate prevents it. On the other hand, there are numerous examples of pegged exchange rates which have had the experience the East Asian countries have. A central bank and a pegged exchange rate is an untenable combination. If a country wants to have a fixed exchange rate it should abolish the central bank and adopt a currency board. If it doesn't want to do that, it's best off floating. The problem was caused by the attempt to combine a pegged exchange rate with an activist central bank. The source of the breakdown was the bad policies followed by the central bank. If there had not been a pegged exchange rate, those policies would have been reflected internally, but would not have created an international financial crisis.