The Case for Flexible Exchange Rates in 1953 and 1969: Friedman versus Johnson

Both were written by University of Chicago economists, both argued for flexible exchange rates, both achieved classic status, and their titles are almost identical — yet, the paper observes, “a comparison of the arguments presented in the two essays has never been made.” Friedman, at Chicago from 1946 to 1977, published “The Case for Flexible Exchange Rates” as a chapter in his 1953 Essays in Positive Economics; the essay was a revision of a 1950 memorandum he had written as a consultant to a U.S. government agency in Paris, and he had had difficulty finding a publication outlet for it beforehand. Johnson, at Chicago from 1959 to 1977, published “The Case for Flexible Exchange Rates, 1969” sixteen years later in two outlets — as a Hobart Paper in May 1969 and in the Federal Reserve Bank of St. Louis Review in June 1969 (the paper’s page citations are to the latter). Johnson’s introductory footnote acknowledged “the indebtedness of all serious writers on this subject to Milton Friedman’s modern classic essay,” but he provided no specific citations to arguments Friedman had made earlier. The paper notes that prior treatments compounded the gap: Moggridge’s biography of Johnson covered the 1969 essay’s arguments in detail without mentioning Friedman’s essay, as did Helliwell’s (1978) review of Johnson’s contributions; Obstfeld’s (2020) retrospective acknowledged Johnson’s debt to Friedman but set out to assess how Johnson’s arguments had endured, not to compare them with Friedman’s.

A series of citations in which prominent economists credited Johnson and did not mention Friedman at all. Kindleberger (1976, 29) called Johnson the “Archbishop of Canterbury” of flexible exchange rates without referring to Friedman in the paper. McKinnon (1981, 536) wrote that Johnson’s essay “is unusually pungent and more contemporary that the earlier [1953 article] of Friedman.” Obstfeld’s own eighty-two-page 1985 review called Johnson’s the “classic academic case for flexible exchange rates during this period,” and, because the review focused on the 1960s onward, did not cite Friedman’s paper. Black (1978, 814) and Williamson’s 1983 The Exchange Rate System likewise cited Johnson and not Friedman. Cooper (1999, 104) referred to both but held that Johnson’s “widely read paper” had summarised the debate “tendentiously” and that Johnson “both reflected and helped shape the prevalent view among academic economists, if not bankers and government officials.” The paper is careful to say this reading reflected some and not all international economists, and that it belongs to a particular period.

It takes Obstfeld’s (2020) inventory of Johnson’s arguments as its point of departure, describes each of Johnson’s arguments, and then checks what Friedman wrote on the same issue “if it was indeed discussed by Friedman.” Obstfeld had sorted Johnson’s claims into areas where Johnson “over-promised” — six of them, some overlapping — and areas where he made “good calls,” nine of them. The paper works through both lists in order. The consequence worth noting for a reader is that the comparison inherits Obstfeld’s selection of what counts as Johnson’s major arguments; the paper does not construct an independent inventory. It also drops one Obstfeld item, Johnson’s prediction that smaller countries would keep pegging to larger countries’ currencies, on the ground that Friedman dealt only with larger countries.

On exchange rates and fundamentals, both men held that fundamentals determine floating rates, but Johnson expected smooth and predictable adjustment while Friedman expected overshooting. Johnson wrote that a freely flexible rate “would tend to remain constant so long as underlying economic conditions (including government policies) remained constant,” with private speculators limiting random deviations, and that “trends in exchange rates should normally be fairly slow and predictable.” Friedman agreed that instability of rates is “a symptom of instability in the underlying economic structure,” but added that the initial change in rates “will be greater than the ultimate change required,” with “the actual path of adjustment” possibly involving “repeated overshooting and undershooting of the final position” — which the paper flags as “clearly an anticipation of Dornbusch’s (1976) overshooting model.” On trade and capital restrictions, both predicted floating would remove the balance-of-payments rationale for controls; Friedman additionally argued controls would be evaded (“Ways will be found to evade the controls”), an argument Johnson did not make, and the paper records that both can be said to have over-promised here, since floating eliminated neither protectionist pressure nor calls for capital controls — while allowing that floating “appear[s] to have facilitated a significant reduction” of the barriers in place in the 1960s.

Johnson’s belief in a long-run Phillips curve trade-off, and his prediction that central bankers would lose prestige under floating. Johnson wrote that “flexible rates would allow each country to pursue the mixture of unemployment and price trend objectives it prefers,” and that long-run exchange-rate trends would be dominated by divergence in price trends — i.e. purchasing power parity. The paper stresses what makes the first striking: Friedman had delivered his AEA Presidential Address showing there is no long-run trade-off between inflation and unemployment when inflation is fully anticipated in December 1967, and published it in the American Economic Review in March 1968; Johnson “apparently did not come over to Friedman’s view until the mid-1970s.” Friedman never postulated a stable short-term trade-off and wrote in 1953 that to achieve internal stability the “internal price level is to be maintained constant”; he did not discuss long-run PPP, and the paper corrects Dunn’s (1983) claim that he had. On central-bank prestige, Johnson predicted the fixed-rate system’s collapse would strip central bankers of the standing and political power it gave them; Friedman attributed support for fixed rates instead to misinterpreted historical evidence, gold-standard traditionalists and reformers who distrusted the price system, and did not predict any such loss. The paper’s own reading is that monetary policy’s demonstrated power — Volcker’s disinflation, but also Friedman’s own decades of evidence — made the prediction fail.

On most of the substantive case. Working through Obstfeld’s “good calls,” the paper matches Johnson and Friedman on: domestic policy autonomy (Johnson’s “fundamental argument”; Friedman’s “each country to pursue internal stability after its own lights”); the claim that under fixed rates other countries’ policy stances determine domestic inflation; rejection of the discipline hypothesis, including the shared argument that adjustable pegs invite destabilising speculation by offering a one-way bet; the non-viability of the classical gold standard in the mid-twentieth-century political milieu; the requirement of a central fiscal authority for a successful fixed-rate regime; rejection of the Nurkse reading of the interwar experience, with both arguing that destabilising speculators must lose money and both allowing the same exception for professionals who profit by leading amateurs astray; the prediction that floating would not hamper trade, both expecting forward or futures markets to develop for hedging; and rejection of the ratchet hypothesis as resting on accommodative monetary policy. On buffering, both held flexible rates could absorb internal and external demand shocks, but Friedman added that they could not fully eliminate the effects of external demand shocks — a lowered “real” income abroad cannot be undone, only prevented from being magnified by monetary disturbances.

It credits Johnson with spelling out fiscal federalism and Friedman with anticipating the OCA literature, and it keeps the two claims distinct. Johnson argued that fixed-rate systems require an “international mechanism for compensating excessively distressed regions,” and the paper notes he benefited from exposure to Kenen’s classic 1969 OCA paper — presented at a 1966 conference Johnson co-organised with Mundell. Friedman, in a footnote on the sterling area, identified the key difference between U.S. states and sterling-area members as the former being “all effectively subject to a single central fiscal and monetary authority” and having “effectively surrendered the right to impose restrictions on the movement of goods, people, or capital between one another,” and wrote that politically independent nations firmly adhering to a fixed standard plus free movement “would, in effect, be an economic unit for which a single currency … would be appropriate.” The paper reads this as delineating a fixed-rate area on the basis of factor mobility, as Mundell (1961) would, and as identifying fiscal and monetary centrality, as Kenen (1969) would. The distinction it preserves: unlike Johnson, Friedman did not assert that fiscal integration entails transfers from low- to high-unemployment regions to smooth asymmetric shocks. The paper also adds a caveat of its own in a footnote — that the notion the fiscal instrument can smooth shocks “proved to be overly simplistic,” since transfers against permanent shocks can lock resources in place.

One thing: a discussion of the limited-flexibility reform proposals that emerged in the 1960s and therefore could not have appeared in Friedman’s 1953 essay. Johnson identified the two — the wider band proposal, under which par values would fluctuate within a range wider than the one per cent either side allowed under Bretton Woods (he mentioned five per cent as an example), and the crawling peg, under which the range would stay at one per cent or widen “somewhat” but the par value itself would be set by a moving average of recent market rates and so drift with market pressure. Johnson showed some sympathy for these in lieu of freely flexible rates, writing that both required “a great deal of empirical study” and that in the meantime advocates of flexibility “would probably be better advised to advocate experimentation with limited rate flexibility.” The paper observes that the wider-band concept became the target zone proposal of the 1980s and 1990s, and that McKinnon and Cooper — two of the economists who had singled out Johnson’s essay as the more influential — were among the target-zone proponents.

The paper’s concluding section offers a numbered series of observations, and the first six — the ones bearing on the essays themselves — are all about packaging, context and standing rather than about the arguments. First, Johnson’s essay was more pragmatic, endorsing a gradual move via crawling pegs and wider bands — regimes that gained prominence in the 1970s and 1980s. Second, context: Friedman wrote before the major European currencies and the yen became convertible, at a time when the dollar shortage and trade protectionism dominated the agenda, and his essay contained subsections that strayed from the theme (“Role of European Payments Union,” “The Sterling Area,” “The Current Rearmament Drive”); by the late 1960s the Bretton Woods system’s own problems had put exchange-rate regimes at the centre of policy discussion. Third, writing: Johnson was a first-rate synthesiser, and his essay was thirteen pages against Friedman’s forty-seven, which contained repetitions of key ideas — the paper notes Friedman’s 1953 essay was “somewhat of an exception” to his usual quality, retaining much of the bureaucratic style of the memorandum it grew out of (and rejected by Forbes). Fourth, Johnson was the better publicist, placing the essay in two 1969 outlets associated with the rise of monetarism and then in the 1970 Bürgenstock volume, while Friedman buried his in “a collection of mainly random chapters.” Fifth, timing: writing in Bretton Woods’ waning days, with two decades of postwar experience and the Canadian float to draw on (the only data chart in his paper was of the Canadian dollar), made it easier to link Johnson’s arguments to the system’s collapse. Sixth, standing: by the late 1960s Johnson was a highly respected member of the profession’s establishment, straddling monetarist and Keynesian camps, whereas official monetary institutions regarded Friedman’s exchange-rate views as unorthodox — James (1996, 213) records governments and monetary authorities in the 1970s regarding him “as an eccentric outsider” on exchange-rate issues.

No — it calls the claim “overstated,” on the ground that most of the profession had already embraced flexible rates by 1969. Three pieces of evidence are offered. Machlup’s 1964 monograph listed the twenty-four “best known” economists, Friedman and Johnson among them, who favoured “freely flexible” exchange rates. Friedman’s 1968 Dollars and Deficits claimed that “probably the great majority of economists who specialize in money and international trade favors abandoning any fixed price for gold and permitting greater flexibility in the price of the dollar.” And Samuelson was quoted in March 1968 saying that a poll of experts in international economics would find “eighty percent of them favoring floating exchange rates as a result of Friedman’s influence.” The paper’s conclusion from this is conditional and carefully worded: “to the extent that either of the two essays helped shaped the economic profession’s view in favor of flexible rates, it would have been Friedman’s; it could not have been Johnson’s since much of the profession already favored flexible rates at the time that Johnson’s article appeared.” On bankers and government officials the paper concedes the position was different — Halm (1969, 5) found it “surprising that fixed exchange rates meet with the almost unanimous approval of bankers, businessmen, and government officials” — and grants that Johnson’s more polished prose would have been more accessible to that audience.

Events, not essays. Its closing position is that what converted most of the profession, and bankers and government officials, to flexible exchange rates by the early 1970s were the recurring balance-of-payments crises experienced under Bretton Woods; the two essays “provided the intellectual underpinnings” for flexible rates and for the view that the regime was no longer viable. It quotes Brunner and Meltzer (1976, 2) to the effect that the early-1970s adoption of flexible rates was “more of a triumph for events over policymakers than for economists over events,” and closes by characterising Johnson’s contribution as bringing “an establishment’s voice to bear on the issue — a voice that closely echoed the arguments made by Friedman many years before.”

The role of the IMF. Friedman asked “what, if any, functions the IMF would have in a world of flexible rates” and speculated the Fund’s role would be greatly diminished — perhaps a short-term international lender “along commercial lines, though I see no particular need for such an institution in a world of fully convertible currencies,” an adviser on internal monetary and fiscal policy, and possibly a clearing agency. Johnson, writing sixteen years later, foresaw a continuing central role for the Fund. The paper records this in a footnote as “a major miss” on Friedman’s part, and lists it among the genuine differences rather than folding it into the overall verdict. It also names one thing neither man foresaw: that floating exchange rates could themselves be a source of shocks, including shocks originating in capital markets such as shocks to risk premia and global portfolio preferences.