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Money and Economic Development
The Horowitz Lectures of 1972
Milton Friedman

SECOND LECTURE: Monetary Policy in Developing Countries

Open Inflation Versus Repressed Inflation

Fundamentally, the distinction between open and repressed inflation is much more important than the distinction between one rate of inflation and another.

By open inflation I mean a situation in which prices are allowed by the government to rise to whatever level is required to clear the market. Under the heading of prices I include wages, commodity prices, interest rates and, most important of all, exchange rates.

By repressed inflation, I mean a situation in which at least an important class of prices, though not necessarily all prices, are prevented from rising to clear the market by governmental measures such as fixing maximum legal prices, where “prices” again include wages, commodity prices, interest rates, and exchange rates.

Open inflation is not desirable. However, if the inflation is moderate it does no great harm to economic efficiency or economic development, though it may do considerable harm to the political fabric of society.

On the other hand, repressed inflation is extremely harmful to efficiency, to development, and to respect for the law. It is an attempted cure that is far worse than the disease.

The most dramatic example that I know of the different effects of open and repressed inflation is provided by experience in Germany after the two world wars. After World War I, as you know, there was a hyper inflation, in which prices rose at fantastic rates, during some periods doubling or more than doubling every day. In fact, in those periods, employers often paid workers their wages three times a day, before breakfast, lunch, and dinner so that they could run out and spend them before they depreciated.

The hyper inflation did immense damage to the social coherence and political stability of Germany. It undoubtedly was a major factor in paving the way for Hitler later on. Nonetheless, from a purely economic point of view, the economy continued to function at a high level until the very final months of the hyper inflation. Prices were free to move and hence it continued to be possible to use a price system to organise the economy.

After World War II, Germany again faced an inflation problem, but the problem was far smaller in magnitude. If the inflation had been open, prices after the war would have had roughly to quadruple, i.e., it would have taken a four-fold increase in prices to absorb the money supply. That seems large, but it’s trivial compared to the price rise after World War I.

But the inflation was not open. There was price control covering almost all items. Ordinarily it is impossible to enforce price control when legal prices are so far from market clearing prices; it is impossible to prevent the emergence of black markets. However, it was possible to enforce price control in Germany after World War II because Germany was occupied by American, French, and British forces. The occupation forces were willing and able to enforce the control more rigidly and ruthlessly than any domestic police or armed forces would have done.

The result was that output in Germany was cut to roughly half of its pre-war level. People were driven to engage in barter. Workers in a factory producing aluminum pots and pans, for example, would work for two or three days, get paid in the form of pots and pans, and then spend the rest of the week scouring the countryside for a farmer who would pay potatoes or other food for the pots and pans. Nobody was willing to buy and sell for official money at prices that were about one-quarter of the market clearing prices. Cigarettes, coffee, and cognac came into wide use as substitute unofficial money to reduce the disadvantage of pure barter. I have often said that the cognac that came into use as unofficial money at that time was surely the most liquid money the world has ever seen.

The great German economic miracle of 1948 was produced simply by the elimination of price control. Ludwig Erhard, then the economics minister, removed all the price controls one Sunday afternoon. He did it on Sunday because the offices of the American, British, and French occupation authorities were closed on Sunday, and he was sure that if they had been open they would have countermanded his order.

The elimination of price control produced a doubling of German output within a fairly brief period. It did so not because of any new capital investment, not because of the discovery of new techniques or the opening of new markets, but solely because the price system was permitted to operate freely.

Perhaps the most pernicious and widespread type of repression of inflation in under-developed countries is the attempt to peg the exchange rate. I think of India—an enormous country with extremely poor people that has tremendous potential for economic growth. India has many energetic, able, enterprising people, much capital, yet its record is depressing. I believe that the main reason for the failure of India has been its attempt to repress inflation and particularly to peg the exchange rate. India finally devalued some time back, but not by enough, and then, instead of letting the rupee exchange rate float, it decided to peg it at a new level. The result has been to force India to ration imports, subsidise exports and import competing goods, to waste her resources, not for serving any national purpose, but simply to preserve an artificial exchange rate.

In many under-developed countries in recent decades, the easiest route to wealth has been special access to import permits and to foreign exchange at pegged rates.

If these comments about India seem to have some relevance to Israel as well, that is not purely coincidental. Israel too has been trying to peg her exchange rate and has introduced extensive exchange control. All the evils of this process have been manifested, including the evils of subsidisation of some industries, of an effective multiple exchange rate system in which some industries get IL.8 or IL. 10 effectively to the dollar, while other industries get IL.6 or IL.5 or IL.4 or IL.3.

All of you have had more experience than I have had with this process. I doubt that there exists a person in this room who could not give an example of the waste and inefficiency produced by exchange controls, but I was impressed by a small example in my own case, coming here to give these lectures. Thanks to the exchange controls, we were informed by the people here, when we were half way round the world, that our tickets would have to be paid for in Israeli pounds. The result was that instead of getting the benefit of a round-the-world rate we had to divide the trip in two parts. The sponsors here paid something like $300 more for our travel expenses than they would have had to pay if they had simply reimbursed me in dollars for the relevant part of our trip.

I didn’t benefit from that. I made exactly the same trip. How did it benefit Israel to hand over $300 more to Japan Airlines or TWA or whichever airline it was, simply in order to get the satisfaction of having the ticket paid for in the first instance in Israeli pounds rather than in dollars?

That is a very small example, but it’s typical of the kind of waste and inefficiency that is introduced by exchange control, which in turn is a consequence of a pegged exchange rate.
There are much more fundamental reasons why it is especially tragic and especially unwise for Israel to have extensive exchange control and to peg exchange rates.

We come to take things for granted and to suppose that they have always been with us. You now have a system of exchange control under which, according to the letter of the law, any one of you can get dollars for pounds only by applying for permission to a governmental official—to the Bank of Israel or to some other official. That method of exchange control is a modern invention. To the best of my knowledge, it never existed before 1934. Before 1934, if a country’s currency was termed inconvertible, that meant that a holder of that country’s currency could not get gold on demand at a fixed price. To the best of my knowledge, before that date it was never illegal for a citizen of one country to exchange the currency of his own country for the currency of another country, at whatever rate was mutually agreeable to buyer and seller.

Who do you suppose invented the modern system of exchange control? It was Hjalmar Schacht in 1934 in Germany. What did he invent it for? He invented it primarily in order to despoil the Jews. Under the Nazi regime, Jews were trying to leave Germany. Of course, they naturally wanted to take their property with them. They couldn’t take their physical property so they wanted to sell it for marks and convert the marks into foreign currency. Schacht introduced the regulation that nobody could convert marks into dollars without permission of the government in order to have an effective device whereby he could prevent the Jews from taking their capital out.

Today you have many immigrants from Russia. It is highly welcome that Russia is letting people out. But do you think it is ethically right and proper that Russia should say to the Jews, “You may leave, you may take with you some property that you can carry, but you may not take your wealth. You may not convert your assets into roubles and your roubles into pounds or dollars. That’s prohibited.” Is there anybody here who thinks that this policy is ethically right and just? I doubt it. Yet that is also exactly the policy of Israel.

Israel says to her citizens: We don’t prevent you from leaving, but if you want to convert your property into dollars you have to get permission from the central bank. Don’t misunderstand me. I am not saying that Israel’s reasons for this policy are the same as Germany’s or Russia’s. Quite to the contrary. Israel places a high value on human liberty. Respect for the rights of the individual is one of the highest jewels in the crown of Israel. But that crown has been tarnished by the adoption by Israel, in this area, of precisely the totalitarian philosophy that underlies the German and the Russian restrictions on the movement of people and capital. Israel has adopted a practise that derives from the philosophy that a man’s property belongs to the state, not to him. You do not believe in that philosophy even though you have adopted the practise. II goes against your basic values, and that is why you have been unable to enforce the practise.

We all know that the exchange controls are much more sweeping on paper than in fact. We all know that, fortunately, anybody who really wants to get his capital out can find a way to do so. In my opinion, that reality is the true Israel. As a Jew, rather than as an economist, I say to you, why don’t you get rid of the false appearance, why don’t you abolish the exchange controls and make your practise conform to your values. Set your people free.

I understand, of course, that the plea of necessity will be offered to justify your practise. There has never in history been an infringement on human liberty that was not justified by the plea of necessity. For Israel today, the plea of necessity rings utterly hollow. You will benefit and be far better off if you eliminate these exchange controls root and branch, if you let the exchange rate be a free market rate, if you permit your citizens to make their own deals on whatever terms they find acceptable, with people inside or outside of the country.

When I was here ten years ago, I summarised my conclusions about the Israeli economy by saying that two Jewish traditions were at war in Israel. One tradition was a tradition of 2,000 years. It was a tradition that had enabled Jews to survive in the Diaspora. It was a tradition of getting around government regulations. It was a tradition of finding those areas in the market where it was possible to operate. By taking advantage of that tradition and using ingenuity and intelligence in that way, the Jews were able to survive in the Diaspora and to prosper in those countries where the restrictions were fewest.

The second tradition is much more modern. It is a tradition of a hundred years, a tradition of socialism, of having a central government, and of letting planners run things. Fortunately, for Israel, I concluded then, the first tradition is far stronger than the second!

In the few days I have been here, I have gotten the impression that fortunately the first tradition remains the stronger—but you know, it would do no harm to help it along a little.


1. Nominal income is net national product; money is currency outside commercial banks plus all deposits (time and demand) of the public at commercial banks.
2. Each rate of change is computed as the slope of a least squares straight line between the natural logarithm of the variable (income or money) and time fitted to three successive phase averages.
3. This summary is adapted from Milton Friedman, The Counter-Revolution in Monetary Theory, Occasional Paper 33 (London: Institute of Economic Affairs, 1970), pp. 22-26.
4. See my "The Optimum Quantity of Money" in The Optimum Quantity of Money and Other Essays (Chicago: Aldine Publishing Co. 1969).
5. "Government Revenue from Inflation, "Journal of Political Economy, Vol. 79 (July/August, 1971), 846-856.

Reprinted from Money and Economic Development The Horowitz Lectures 1972 by Milton Friedman, copyright © 1973

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