Milton Friedman Saw the Euro Crisis Coming

The libertarian economist predicted Europe's current problems 17 years ago.


Milton Friedman
Roger Ressmeyer/CORBIS

Among the general public, Milton Friedman is mostly remembered for the libertarian views outlined on his PBS show Free to Choose. Among economists, he is best known for his monetarist position on Fed policy. What's less well known is that he was also a soothsayer, accurately predicting the euro crisis that now has the global economy in upheaval.

The Nobel laureate believed the boom-and-bust business cycle was mostly caused by central banking errors that allowed a country's money supply to fluctuate. Thus, he advocated for a policy rule under which the Federal Reserve would engineer a steady 4 percent increase in the money supply each year to help prevent recessions.

Friedman came to that view by collaborating in the 1960s with National Bureau of Economic Research economist Anna Schwartz on a major history of U.S. monetary policy. Perhaps their most important finding was that Federal Reserve policy errors had allowed the money supply to drop sharply in the early 1930s, dramatically worsening the Great Depression.

At the time, the Depression was widely seen as a failure of capitalism. The work of Friedman and Schwartz opened the door to the neoliberal revolution of the 1970s and '80s by showing that bad monetary policy had destabilized an otherwise well-functioning economy. By the 1990s even many liberal economists had concluded that market economies work, so long as monetary policy makers provide a stable backdrop.

Ironically, the political right would become increasingly skeptical of efforts by central banks to alter the money supply even as the political left was coming to embrace some of Friedman's ideas. Conservatives began to worry about the potential for abuse of a discretionary Fed. Some even called for constraining monetary policy makers, for example by establishing a single currency to be used across multiple countries.

The most important such currency is, of course, the euro. That project, which began in 1999 with 12 members, has since expanded to 19 countries, including much of continental Europe and Ireland. The year before it launched, however, Friedman offered a strikingly prescient observation about the coming eurozone experiment.

In a 1998 interview, Friedman was asked whether he believed the European Monetary Union would be a success. The economist responded that he was dubious.

"There are some cases where a single currency is desirable and some where it is not," Friedman said. "It is most desirable where you have countries that speak the same language, that have movement of people among them, and that have some system of adjusting asymmetric effects on the different parts of the country. The United States is a good area for a common currency, for all those reasons. But Europe is the opposite in all these respects."

He continued: "The exchange rate between different currencies was a mechanism by which they could adjust to shocks that hit them asymmetrically—that hit one area differently from another. The Europeans have, in effect, entered into a gamble in which they have thrown away that adjustment mechanism. It may work out all right. But on the whole, I think the odds are that it will be a source of great trouble."

What Friedman understood was that, despite being a free trade area, goods and capital both move less freely through Europe than through the United States. In addition, the European Commission in Brussels spends a small fraction of the total that the governments of the member countries spend. They, not the European Union's bureaucracies, are the important political entities. Under those circumstances, flexible exchange rates are essential.

Let's say a country is affected by a negative event that calls for lower wages relative to other countries. Pre-euro, that could have been achieved simply through currency devaluation. Today, it requires thousands upon thousands of separate wage changes in all the country's industries and jobs.

So why implement a single currency at all? The answer is politics, not economics. The aim of the euro was to link Germany and France so closely as to make a future European war impossible. Eventually, it was to lead to a sort of United States of Europe. Instead, the euro has exacerbated political tensions between northern and southern European nations. How to handle shocks that in the past could have been accommodated by exchange rate changes has become a divisive political issue.

Recent history shows the monetary policy that's appropriate for Germany probably won't be right for Greece. Friedman called it the one-size-fits-all problem.

But it's not only that. Today, many people assume that Germany favors tight money per se. And indeed, because Germans fear inflation, they insisted the eurozone be biased toward contractionary policy. But back in 2005, the European Central Bank (ECB) had in place a policy that was actually too contractionary for Germany, which at the time suffered from over 11 percent unemployment. Just a decade ago, news articles were calling Germany the sick man of Europe.

ECB policy since 2008 has continued to be far too contractionary. I've argued European institutions should target nominal GDP growth at something like 4 percent per year. The ECB opted for a strict inflation target of just under 2 percent and has been falling short of even that. It recently had to resort to "quantitative easing," like that undertaken here in the Untied States after the Great Recession, to avoid the opposite peril: deflation. ECB policy is supposed to be appropriate, on average, for the entire eurozone. In reality, since the recession it's been about right for Germany but much too contractionary for most other members.

So it's not just that an otherwise appropriate monetary policy isn't working for Greece because of that country's special circumstances. Greece needed the ability to devalue its currency both to correct its own country-specific imbalances and also to offset the incompetence of ECB policy makers in Frankfurt. At least half a dozen eurozone members would have greatly benefited in 2010 from being able to devalue their currencies, but the euro prevented that from occurring.

The failure of the euro should have boosted the libertarian movement. Today's events were predicted with amazing precision by the most famous American libertarian of the 20th century. Moreover, this crisis is an almost perfect example of the "fatal conceit"—a concept from another prominent libertarian, Friedrich Hayek, who warned of the dangers of allowing technocrats to dream up complex new policy regimes without any mechanism for adjustment if things don't go according to plan.

Instead, too many economists on the right are claiming the euro isn't the problem. Yes, Greece suffers from an excessively regulated and inflexible labor market, which has hampered its economy's ability to grow. But Europe's one-size-fits-all currency is also a problem—a severe one that Milton Friedman saw coming from nearly two decades away.