This Week In Finance

Milton Friedman on the Future of the Euro

Milton Friedman is interviewed in the December 29 issue of Forbes on the occasion of his 85th birthday, and the Nobel laureate has some very interesting things to say on a number of topics. In this week's column, we'll focus on Dr. Friedman's thoughts on European Union and the fate of the euro.

For approximately four decades, economists, government officials, pundits, and businesspeople in Europe and the United Kingdom have debated the wisdom of creating a single trading block with neither borders nor currency differences. Although this block has gone by several names over that period (e.g., the EEC - European Economic Community, and, more recently, the EU - European Union), the long-term goals have always been the same: to create a single market in which goods could flow with a minimum of inefficiencies (think: the U.S. and its fifty states), and to trade with the world at large on the same basis.

To this end, a great deal of effort has been directed toward "economic union" - the creation of a single economic entity made up of several different political entities (i.e., countries) which would be guided by a single European central bank, and which would have a single currency - the "euro." In order to be admitted into the EU, a country must have its economic house in order - budget deficits, national debt levels, and unemployment rates must all fall within specified guidelines. (In other words, countries whose economies have been poorly managed need not apply.)

The benefits of a well-functioning economic union for its participants are many - among them, the lack of the costs currently borne in exchanging currencies among countries now doing business in Europe. Imagine a firm headquartered in the UK which imports materials from Spain and Italy, and uses them to produce goods for export to France, Germany, and Holland. Including the pound, the firm has six currencies to deal with!

Dr. Friedman has previously stated his belief that the proposed system is unworkable. What does he think now?

Forbes: "When we last spoke, you predicted that the European Monetary Union would collapse. And it did. Britain and Italy came out."

Friedman: "Yes, it collapsed. I've also been predicting that the euro would never happen. I'm still not sure I'm wrong. The costs have been enormous. To preserve the link between the franc and the deutsche mark, the French had to adopt tight monetary and fiscal policy. They got double-digit unemployment and recession. Britain and Italy floated and have prospered."

Long known for taking controversial positions, Dr. Friedman points out why he believes the experiment is doomed to failure.

Forbes: "What do you think will happen now [in Europe]?"

Friedman: "I'm baffled. I really don't know. Jerry Jordan of the Cleveland [Federal Reserve] has made a very good point. Suppose the euro is in existence, with a central bank overseeing it. What assets is it going to deal with? . . . [I]f it wants to money supply, what does it buy? German bonds, Italian bonds, French bonds? . . . They're going at political unification backwards. . . . I think there's still a substantial chance that between now and then the whole thing will break down."

For those of you that emphasize international issues in your Introductory Finance course, this article provides a good jumping-off point for discussion of contemporary issues dealing with foreign exchange generally, and international financial issues specifically. Point out the short-term and long-term effects of exchange rate changes on the prices of goods we use daily - from the potential effects on automobile and electronics prices of the collapse of Pacific Rim economies, to the effect on trips to London due to continued strength of the pound. From there, it's a really short leap to discussions about the problems faced by firms making decisions about overseas capital budgeting, goods import and export, and hedging.

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