Domitrovic on Mundell-Fleming.

Yesterday, historian and Econoclasts author Brian Domitrovic added a comment on Paul Krugman's summary of the Mundell-Fleming model that was so interesting I'm giving it its own post. Thanks Brian.

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Krugman doesn't get the Mundell-Fleming model right. Here's Mundell in 1963, in the paper that won him the Nobel and founded the model: "fiscal policy has no effect on unemployment under flexible exchange rates."

Furthermore, Krugman makes no mention of the major control in Mundell's model, namely that the major countries have seignorage rights and the minor ones don't. Major country currencies don't depreciate at the rate minor country currencies do in the event of manifestly currency-weakening moves such as the debasement of the currency or extreme budget deficits. (Witness the dollar in the face of near-zero interest rates and the outsized deficits of the last 2 years).

That's why Mundelll said that for major currency issuers (the US and the EU qualify today), the policy toward crisis should be tight money and tax cuts. Tight money incurs a rush of foreign capital into countries with seignorage rights. This money will not merely sit in banks earning the nice new interest but will be lent out if there is a new higher rate of return in the real economy thanks to tax cuts. In turn the major economy will grow, necessitating new net monetary creation. Monetary tightness, it turns out, will not be monetary tightness at all, on account of the accommodation of real growth.

So: stabilize the currency and cut taxes, with no "austerity." This is the solution that the US and the EU could coordinate today and put to pasture this crisis for good.