Wednesday, October 31, 2007

Milton Friedman on International Monetary Relations

Warren Buffett has mentioned frequently his concern about the twin deficits in the U.S.- the current account deficit and the budget deficit. The current account essentially refers to our balance of trade with other countries. The United States current account deficit has significantly increased lately, in both nominal terms and in terms of GDP. (See chart) The budget deficit refers to our government's income account, and the fact that it spends more than it receives through taxes.
On the current account, I came across this Milton Friedman analogy and discussion from his book, Capitalism and Freedom:

In discussing international monetary relations on a more general level, it is necessary to distinguish two rather different problems: the balance of payments, and the danger of a run on gold.(note:read dollar today) The difference between the problems can be illustrated most simply by considering the analogy of an ordinary commercial bank. The bank must so arrange its affairs that it takes in as service charges, interest on loans, and so on a large enough sum to enable it to pay its expenses- wages and salaries, interest on borrowed funds, cost of supplies, return to stockholders, and so on. It must strive, that is, for a healthy income account. But a bank which is in good shape on its income account may nonetheless experience serious trouble if for any reason its depositors should lose confidence in it and suddenly demand their deposits en masse. Many a sound bank was forced to close its doors because of such a run on it during the liquidity crises described in the preceding chapter.
These two problems are not of course unrelated. One important reason why a bank's depositors may lose confidence in it is because the bank is experiencing losses on income account. Yet the two problems are also very different. For one thing, problems on income account are generally slow to arise and considerable time is available to solve them. They seldom come as sudden surprises. A run, on the other hand, may arise suddenly and unpredictably out of thin air.
There are four, and only four ways, in which a country can adjust to such a disturbance and some combination of these ways must be used.

1. U.S. reserves of foriegn currencies can be drawn down or foreign reserves of U.S. currency built up...
2. Domestic prices within the U.S. can be forced down relative to foreign prices...
3. Exactly the same effects can be achieved by a change in exchange rates as by a change in domestic prices...
4... Instead, direct governmental controls or interferences with trade could be used to reduce attempted U.S. expenditures of dollars and expand U.S. receipts.
Warren has said that he expects 3 to happen, through a fall in the U.S. dollar exchange rate, and this is probably right. 1 has already happened on a large scale through foreign accumulation of U.S. dollars, and central banks have been weary about continuing to build up their reserves. 4 could happen through tariffs, such as the one trying to be brought up against China for their undervalued currency. Or there is 2, which is essentially deflation. Regardless of which combination is taken, it is clear that the effects of a persistent current account deficit are all troublesome.

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