Mundell Predicted Our Economic Instability
THE WALL STREET JOURNAL
April 11, 2023
Mundell Predicted Our Economic Instability
The Nobel laureate knew that floating exchange rates would make the global economy volatile.
By Sean Rushton
As the world attempts to stave off a new banking crisis, it’s worth remembering the lessons of Nobel economics laureate Robert Mundell (1932-2021). Mundell showed that domestic economic policy doesn’t operate in a vacuum but rather interacts with—and affects—global financial forces such as international capital and trade flows.
His “open economy” model considered policy under two very different monetary regimes. One assumed a global common currency system in which a currency’s value was fixed, the quantity of money floated, and exchange rates among currencies were stable. This was the norm when he wrote in the 1950s and had been for hundreds of years. The other scenario, obscure until the early 1970s, assumed balkanized central banks fixing the quantity of money at their discretion, while a currency’s value and its exchange rates floated. Mundell noted that the two systems functioned in completely different ways—a distinction that seems lost on many policy makers today.
For example, he debunked the notion that monetary policy always operates with a “long and variable lag” of six to 18 months. The basis for this claim—Milton Friedman and Anna Schwartz’s 1963 book, “A Monetary History of the United States”—gathered data from the 1870s through the 1950s, a time of mainly fixed exchange rates. Mundell said that under such conditions, there was some truth to the idea of a lag. But in the modern world of flexible exchange rates and lightning-fast capital movements, the idea was “poppycock.”
He gave two examples: 1981-82 and 2008. In both cases, after a bout of rising inflation, tighter U.S. monetary policy contributed to big, sudden capital inflows. In the 1980s, it was the Reagan tax cuts plus the Federal Reserve’s sky-high interest rate. In 2008, it was the Fed’s unexpected reversal from dovish to hawkish policy during the initial phase of the subprime mortgage crisis. In both cases, capital quickly flowed into the dollar, the exchange rate appreciated, and commodity and other asset prices plummeted. In both cases, consumer prices fell sharply in the months following these initial market moves.
Mundell’s decadeslong critique of floating exchange rates, which were implemented in 1973, was based on his deep understanding of how the practice really worked. Far from being a source of new stability and liberation, floating rates would leave most nations adrift, struggling in isolation to manage their currencies in a world suddenly dominated by huge speculative capital flows unlike anything that existed before.
The record bore him out: The floating-exchange-rate system of the past five decades has proved financially volatile and crisis-prone. Mundell cited four major fiascoes linked to exchange-rate swings: the international debt crisis of 1982, the savings-and-loan crisis of the late 1980s, the Asian financial crisis of 1997 and the global financial crisis of 2008. None of these, he noted, would have occurred under the fixed exchange-rate systems of the past.
To be sure, fixed rates carried the risk of other kinds of crises. Wars caused bouts of high inflation followed by painful attempts to restore prewar price levels. Branch-banking restrictions in the U.S. led to local cash shortages during harvest times. But the system itself was fundamentally stable as currency values were fixed and the quantity of money adjusted automatically across the system. Giant, currency-induced capital movements were rare.
Today, the U.S. dollar dominates the monetary world, and its movements, often driven by backward-looking Federal Reserve policies, can destabilize the entire system. In 2021-22 we saw a burst of monetary activism from the Fed, coinciding with a huge expansion of the money supply, a depreciation of the dollar with rising commodity prices, followed by high general inflation. Then, last year, as the Fed belatedly began raising its target rate, there was a big appreciation of the dollar, along with a falling money supply and declining commodity and consumer prices. The yield curve inverted last fall, and now banks are showing cracks, mitigated by an unprecedented federal pledge to back deposits without limit. Despite these quakes, the Fed raised its target interest rate in March, looking in the rearview mirror at lagging 12-month inflation data. The central bank’s “dot plot” suggests another hike still to come this year.
In the years after 2008, Mundell called the global financial crisis the greatest policy blunder in Fed history aside from the Great Depression. The lost wealth, the bailouts, the multiple rounds of quantitative easing with huge up-down cycles for the dollar and price of oil—all contributed to the lost decade that followed where annual gross-domestic-product growth averaged about half its historical level. Anyone confused about the populist discontent that erupted in 2016 need look no further.
To show it has learned its lesson, the Fed should forget long and variable lags and watch real-time market prices. Declare victory in the war on inflation as long as the dollar remains relatively high and commodity prices don’t spike. Beyond that, today’s leaders should take Mundell’s counsel on the need to end large exchange-rate swings, starting with the dollar-euro rate, which he called “the most important price in the world.” Stability there, with future invitations to Japan and Britain to join, would begin to restore order to the system. China, which already maintains a relatively stable exchange rate with the dollar, could be kept at arm’s length.
These reforms could give way one day to an international currency for settlement purposes, which Mundell suggested be made up, in equal measure, of major currencies and gold, to offset the global demand for dollars that keeps the U.S. trade deficit higher than it would be otherwise. Such a system would resolve the defects of the current system, restore financial stability and enable stronger economic growth.
Mr. Rushton is an adjunct fellow at the Jack Kemp Foundation.