Sunday, January 9, 2011

Mundell on the Continued Malaise in Europe and the U.S.

Like E.F. Hutton in the old commercials, when Columbia University’s Robert Mundell speaks, supply-siders listen. The Nobel laureate, 78, is the most consequential living economist, having recommended policies that helped President Kennedy defeat recession for a burst of strong growth in the 1960s, enabled President Reagan to overcome stagflation in the 1980s, established the euro in the 1990s, and helped China enact a stable currency in the 2000s as part of its hyper-growth plan. In short, for half a century Mundell’s ideas have shaped the world. Therefore, his surprising diagnosis of what ails today’s economy – exchange rate volatility between the dollar and the euro – is worth considering.

Despite the commentariat’s tendency to define supply-side economics as “tax cuts,” the framework first propounded by Mundell in the early 1960s actually centers on monetary rather than fiscal policy. He recognized early in his career that the world was moving away from the gold-anchored, fixed-exchange rate currency system of the previous 150 years, so he focused his scholarship on how fixed versus floating exchange rate systems work in an open world economy.

In Mundell’s view, an increasingly interdependent global trading system cannot function optimally with scores of national currencies floating relative to one another, subject to governments’ discretionary monetary policies. Volatile exchange rates discourage trade and international investment, requiring complex and costly financial arrangements such as derivatives to reduce the risk. Mundell’s theory of Optimum Currency Areas aimed to reduce regional exchange rate static by uniting geographic areas under single currencies, assuming conditions such as labor and capital mobility and similar business cycles. These areas, in turn, may harmonize exchange rates with other major currency blocks to reduce turbulence further.

Mundell’s theory rests on three assumptions. First, discretionary national monetary policy yields fewer advantages than stable exchange rates, and is often the source of major crises such as the Great Depression and the 1970s stagflation, to say nothing of our two recent boom/busts. Second, nations cannot change their terms of trade through currency manipulation – a currency devalued by 50 percent will cause import prices, and eventually all prices, to rise by a similar amount, cancelling any initial advantage. Third, floating currency is not needed to balance payments among nations. In an open global economy, current account deficits are balanced by capital account surpluses. Moreover, such deficits are rooted primarily in long-term factors such as demographics and relative economic development, not currency prices.

If monetary policy is to be non-discretionary and internationally-focused, how would Mundell improve domestic economic growth?

This is where Mundell turned to fiscal policy. Recognizing the ineffectiveness of Keynesian spending in an open economy model – because much of the stimulus simply flows offshore – and the intrinsic flaw of focusing on consumption (demand) rather than production (supply), Mundell highlighted marginal tax rate cuts as a means to attract new foreign capital while incentivizing additional domestic work and investment.

Regarding today’s economy, Mundell believes the euro, despite European debt problems, remains the correct policy. He points out that the U.S. – an Optimum Currency Area in its own right – has member states near default on their debts, e.g. California, yet no one suggests the Golden State withdraw from the dollar zone. Moreover, he explains, such a move would be futile, as the withdrawing state’s obvious goal would be to issue its own currency and then promptly devalue it. Under such conditions, markets would not accept the new currency.

Most importantly, Mundell believes Europe’s recurring debt crises and the U.S. pattern of recession and recovery are linked to what he calls the most important price in the world – the euro/dollar exchange rate. This rate links the world’s #1 and #2 economies, accounting for 40 percent of world GDP.

Mundell believes the U.S. subprime meltdown was caused in large part by the dollar’s steady decline against the euro and gold from 2002-08, which drove capital into hard assets, particularly real estate. Mundell argues the crisis became a disaster when the weak dollar suddenly reversed, shooting up 30 percent against the euro and gold in summer 2008. The dollar’s sharp appreciation, he argues, broke the economy’s back, triggering the financial disaster and recession. The crisis abated when the dollar declined against the euro that fall.

As Mundell explained in a December 2010 Bloomberg interview, in the three years since the crisis first began the two currencies have traded places annually, with the dollar soaring versus the euro for months at a time, damaging U.S. trade and slowing recovery while Europe rallies, followed by a reversal where the euro spikes, plunging Europe back into recession and debt crisis while the U.S. expands. Stabilize the euro/dollar exchange rate at a healthy level, say $1.35, and the cycle will end and both economies will recover.

Mundell’s current view is the Fed’s lower dollar strategy – which he supports – will be undermined, leading to another dollar rise against the euro and another stalled recovery. He predicts a paltry 2011 growth rate of 2 percent, far below the level needed to generate new jobs.

Supply-siders who watch the dollar price of gold may be surprised to hear Mundell talk of a soaring dollar. Mundell’s argument seems to be that in terms of current recessionary pressures, the relative swings between the two mega-currencies has more immediate impact than the dollar’s absolute value against the stable barometer that is gold. Later this month, Mundell will clarify the issue in Hong Kong, with a speech entitled, “Is Gold the Answer to Currency Wars and Unstable Exchange Rates?”

Mundell’s perspective, unconventional but thought provoking as always, may be the key to global recovery. The man who in decades past reshaped the economies of the U.S., Europe and China strongly advocates an agreement to fix exchange rates between the euro and the dollar. With such an arrangement, complimented by a pro-growth cut to the U.S. corporate tax rate, he foresees a new era of jobs and prosperity.

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