conversableeconomist

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.\”


conversableeconomist

Research and Development Tax Credit

Back in the mid-1980s, when the world was young and I was just leaving economics graduate school, I wrote editorials on economic and environmental issues for the San Jose Mercury News for a couple of years. (At that time, the paper was booming, because in those pre-Internet times, it carried much the help-wanted advertising for Silicon Valley.) In 1981, Congress had passed a tax credit for research and development, but it has been passed on a temporary basis. Remarkably enough, in 2011 the
the R&D tax credit still languishing in temporary status, expiring every few years and then being re-authorized, currently set to expire at the end of 2011.

The theoretical case for government support of R&D is unchanged over time: new technology provides social benefits that often greatly exceed the private benefits received by the inventor, and so society can in theory be better off by subsidizing such activity. However, two things have changed  since I was writing editorials advocating a permanent R&D tax credit back in the mid-1980s. There is now a body of research strongly suggesting that the tax credit is cost-effective at increasing research and development. And much of the rest of the world, agreeing with this research, now offers more aggressive support for industry R&D than does the United States.

Research supporting an R&D tax credit

The R&D Credit Coalition hired Ernst and Young to write a report on the evidence. Unsurprisingly, both given the parade of evidence over the years and the source of the funding (!), the report is called: \”The R&D Credit: An effective policy for promoting research spending.\”  Their overall conclusion is that an R&D tax credit could increase industry R&D spending by 10-20% over the long run, depending on design. Clearly, this isn\’t a revolutionary change–just a sensible step to take. Here\’s a useful figure summarizing the results of studies of how an R&D tax credit affects R&D spending.

International Trends

While U.S. policy on an R&D tax credit has been running in place for 30 years, many other countries have embraced such a policy. For example, here is an OECD report from 2008 on the spread of such incentives:  \”Recent years have seen a shift from direct public funding of business R&D towards indirect funding (Figure 3). In 2005, direct government funds financed on average 7% of business
R&D, down from 11% in 1995. In 2008, 21 OECD countries offered tax relief for business R&D, up from 12 in 1995, and most have tended to make it more generous over the years. The growing use of R&D tax credits is partly driven by countries’ efforts to enhance their attractiveness for R&D-related foreign direct investment.\”

Here is the Figure 3 referred to in the quotation. Cross-country comparisons of tax policy can be hazardous, because the conclusions can depend on just how certain provisions are classified. Nonetheless, it\’s striking that the U.S. ranks 24th in its tax support for industry R&D of the countries in the figure.