Wednesday, October 5, 2011

When Milton Friedman Blessed Foreign Exchange Futures Markets

Leo Melamed tells the story of “Milton Friedman’s 1971 Feasibility Paper” in the Fall 2011 issue of the Cato Journal

“In 1971, as chairman of the Chicago Mercantile Exchange, I had an idea: a futures market in foreign currency. It may sound so obvious today, but at the time the idea was revolutionary. I was acutely aware that futures markets until then were primarily the province of agriculture and—as many claimed—might not be applicable to instruments of finance. Not being an economist, the idea was in need of validation. There was only one person in the world that could satisfy this requisite for me. We went to Milton Friedman. We met for breakfast at the Waldorf Astoria in New York. By then he was already a living legend and I was quite nervous. I asked the great man not to laugh and to tell me whether the idea was “off the wall.” Upon hearing him emphatically respond that the idea was “wonderful,” I had the temerity to ask that he put his answer in writing. He agreed to write a feasibility paper on “The Need for Futures Markets in Currencies,” for the modest stipend of $7,500. It turned out to be a helluva trade.” 

The same issue publishes Friedman’s 1971 paper, “The Need for Futures Markets in Currencies,” for what I think is the first time. Friedman writes: 

"Bretton Woods is now dead. The president’s action on August 15 [1971] in closing the gold window was simply a public announcement of the change that had really occurred when the two-tier system was established in early 1968. ... The U.S. is a natural place for the futures market because the dollar is almost certain to continue to be the major intervention
currency for central banks and the major vehicle currency for international transactions. Exchange rates will almost surely continue to be stated in terms of the dollar. In addition, the U.S. has the largest stock in the world of liquid wealth on which the market can draw for support. It has a legal structure and a financial stability that will attract funds from abroad. It has a long tradition of free, open, and fair markets. It is clearly in our national interest that a satisfactory futures market should develop, wherever it may do so, since that would promote U.S. foreign trade and investment. But it is even more in our national interest that it develop here instead of abroad. As Britain demonstrated in the 19th century, financial services of all kinds can be a highly profitable export commodity."