From monetarist principles, Friedman derived his mistaken idea that floating is a valid substitute for fixed exchange rates based on gold. Not only is this idea wrong; it is also dishonest as well as outright suicidal. Friedman suggests that under floating trade imbalances are automatically rectified. The currency of the deficit country depreciates while that of the surplus country appreciates. As a consequence imports of the former become dearer and are throttled, while those of the latter become cheaper and get boosted. The process continues until balance is restored.
The intellectual seductiveness of this “theory” is obvious. However, it has a fatal flaw without any redeeming features. It ignores the changes in the terms of trade, that is, in the amount of imports that unit of exports can buy. The devaluing country invariably suffers deterioration while the revaluing country experiences improvement in its terms of trade. Rather than restoring trade balance, floating makes the imbalance worse. Whatever ‘benefits’ the deficit country may derive from devaluation are ephemeral. They vanish just as soon as the inventory of imported ingredients that go into its exports runs out. Thereafter the deficit country has to pay more, not less, for these essential ingredients. It will see its deficits grow rather than contract. In effect, the devaluing country is selling its resources abroad at ‘fire sale’ prices. The alleged benefits of devaluation are entirely illusory.
History bears out theory. The United States has been running a trade deficit vis-à-vis Japan for half a century. Since 1971, following Friedmanite precepts, the dollar depreciated 3-fold against the yen. As a result, the United States has been impoverished in terms of industrial and financial prowess. If Japan also suffered, it was because its surplus funds were placed in escrow at the behest of the United States. Indeed, Japan could not spend its accumulated surpluses without creating a major crisis upsetting the U.S. Treasury bond market.
It’s amazing that this perfectly predictable outcome was not foreseen by a single economist working for the innumerable think-tanks around the world, and during the intervening forty years, the captains of finance did not see that they are running their ship into the iceberg straight ahead.