For Love of Money: Why Central Bankers and Speculators Need Each Other

Until the early 1980s, there was a running dispute within the economics profession that descended to the level of a spectator sport. One side was eloquently represented by John Kenneth Galbraith, the other by Milton Friedman. Together they accomplished for economics what Norman Mailer and Gore Vidal did for literature. Friedman published, or perhaps merely allowed to be published, a slender treatise entitled Friedman on Galbraith, which consisted of a roundtable discussion convened to examine, in something less than the spirit of scientific inquiry, the inexplicable global appeal of his rival. For his part, Galbraith was wont to open speeches with a canned joke about the night he was awakened at 3:00 a.m. by an Israeli journalist asking his reaction to Friedman's appointment as an adviser to Israel. "With Milton Friedman as your economic adviser," a sleepy Galbraith told the Israeli people, "you have nothing to worry about from a few hundred million hostile Arabs."

It was a rare case of a dispute between academics that was so bitter because the stakes were so high. Perhaps the most critical question in their debate was what precisely had caused the Great Depression. Galbraith argued on behalf of John Maynard Keynes that the cataclysm had been caused by inherently unstable free markets. Friedman, holding new evidence, explained that the depression was the result of the failure of central banks to respond to a reduction in the money supply. So the government, and not the market, had failed.

By the early 1980s Friedman's view pretty much had replaced Keynes' as the new orthodoxy in economics departments. But what this meant in practice was less clear. Keynes' ideas had spawned government?controlled financial structures around the globe and embedded within central banks and government treasuries a certain smugness about their ability to manage markets. The paradigmatic post -- World War II financial institutions, the World Bank and the International Monetary Fund, had been conceived by Keynes himself precisely to prevent the free markets from regaining control of international capital flows. More importantly, currency exchange values had been placed under the control of central banks -- in part because Keynes had persuaded others of the evils of freely floating currencies.

The new financial order depended for its credibility on Keynes' misdiagnosis of the Great Depression. Yet long after Friedman corrected the diagnosis the old bureaucracies remained. In fact, the Bretton Woods twins still stand more than firm -- since 1981 the World Bank's budget has tripled to $1.39 billion from $435 million, while its staff has doubled to about 10,000. And while the world left the dollar standard in 1971, exchange rates are still managed -- with varying degrees of effectiveness -- by central bankers.

THE DAWN OF FREE MONEY

I had always imagined Milton Friedman in his Chicago study slowly growing mad as the real world took its sweet time catching up to his explanation of it. Gregory J. Millman's new book put my mind at ease on this point. In his enthusiastic description of the slow demise of the postwar financial order, the author recounts a poignant moment in November 1967 when Friedman played an active role in its undoing. The economist had long watched the British government prop up its currency while pursuing reckless fiscal policies. One day he decided to sell the British pound short -- an act worthy of Keynes, who was a frequent financial speculator.ffi

Friedman soon discovered, to his surprise, that the market for his wager did not exist. Chicago bankers refused to lend him the pounds to sell, on the grounds that the Federal Reserve and the Bank of England still disapproved of private speculation in currencies. He complained at length in a series of articles in Newsweek. The articles suggested to Leo Melamed, then a member of the Board of Governors of the Chicago Mercantile Exchange, the possibility of a currency futures market. Clutching a letter from Friedman (for which he had paid $5,000) Melamed requested the permission of George Shultz, then President Nixon's secretary of the treasury and formerly Friedman's close colleague at the University of Chicago, to open the new market. When Shultz saw no reason to refuse, he exposed the contradiction at the heart of the postwar financial system: it was administered by people with an ideological commitment to free markets.

In August 1971, when President Richard Nixon announced that the dollar no longer would be convertible to gold, he blamed speculators for "waging an all?out war on the dollar." In breaking the back of Bretton Woods he could more honestly have blamed the foreign governments -- the French, in particular -- that refused to hold increasingly inflated dollars. More honestly still, Nixon could have blamed his own inflationary fiscal and monetary policies. But from the moment of Nixon's announcement the markets assumed responsibility for the dollar's value. The subsequent profusion of new financial instruments, such as futures and options, was one response to the explosion in currency speculation. In May 1972, the market in currency futures opened. Friedman, along with every other small investor, was able to sell the British pound short. The first entirely free market for currency speculation in the postwar era was born.