Nobel prize in economics, 1999

"Mundell chose his problems with uncommon - almost prophetic - accuracy in terms of predicting the future development of international monetary arrangements and capital markets."

"Although dating back several decades, Mundell's contributions remain outstanding and constitute the core of teaching in international macroeconomics."
 
"Robert Mundell has reshaped macroeconomic theory for open economies."

"Robert Mundell has established the foundation for the theory which dominates practical policy considerations of monetary and fiscal policy in open economies."

"His work on monetary dynamics and optimum currency areas has inspired generations of researchers."

With the breakdown of the system, money supplies became more elastic, accommodating not only inflationary wage developments but also the monopolistic pricing of internationally traded commodities. Each time the price of oil was raised in the 1970's, the Eurodollar market expanded to finance the deficits of oil-importing countries; from deposits of $223 billion 1971 they would explode to $2,351 billion in 1982(International Monetary Fund, IMF International Statistic Yearbook, 1988 p. 68).

Inflation in the United States had now become a major problem. It had taken twenty years, from 1952 to 1971, for U.S. wholesale prices to rise by less than 30 percent. But after 1971, it took only eleven years for U.S. prices to rise by 157 percent! This mainly peacetime inflation was greater than the war-related inflations from World War II (108 percent over 1939-48), World War I (121 percent over 1913-1920), the Civil War (118 percent over 1861-1864) or the War of 1812 (44 percent over 1811-1814). The greatest inflation in U.S. history since the War of Independence took place after the United States left gold in the decade after 1971.

That inflation in the 1970's was worldwide can be seen from the price indexes of the G-7 countries in Table 2, noting the index values for 1971 in comparison with the standard base of 100 in 1980. Only in Germany did consumer prices in the decade of the seventies fall short of doubling. In Italy and the United Kingdom, prices more than tripled. The breakdown in monetary discipline was worldwide, engulfing all the G-7 countries and to an even greater extent most of the rest of the world.

Table 2. Consumer Prices in G-7 Countries, Selected Years 1950-98

Source:IMF International Financial Statistics,(International Monetary Fund, various years).

In the United States, three back-to-back years of two-digit inflation (1979-81) created a crisis situation. The price of gold hit $850 an ounce in early 1980, and silver went to $50 an ounce. On March 14, 1980, President Jimmy Carter announced his new program: an oil import fee, and credit controls. The plan was a disaster and real output plummeted in the second quarter. In December 1980, a month after the presidential elections, the prime interest rate hit a record of 21.5 percent! The United States seemed to be on the brink of financial disaster.

Gone were the days when, with David Ricardo, economists could think of money as a "veil." The existence of big government and progressive income taxes guarantees non-neutrality. One route was through the fiscal system. With steeply progressive tax rates, rising from zero to 70 percent at the federal level, and up to 85 percent counting state and local taxes, inflation was pushing taxpayers into higher and higher tax brackets even at unchanged real incomes. Taxes had to be paid on interest receipts even though the bulk of the high interest rates represented inflation premiums. Soaring tax revenues coupled with government's high marginal propensity to spend led to an increasing share of government in the economy. No wonder the stock market hated inflation!

Supply-side economics began as a policy system alternative to short-run Keynesian and monetarist demand-side models. It was based on a policy mix that delivered price stability through monetary discipline, and economic stimulation of employment and growth through the tax and regulatory systems. It was partly a continuation of my work on the policy mix in the early 1960's. In the spring of 1974 I presented a paper at a conference on global inflation in Washington, an excerpt of which was reported (Rowland Evans and Robert Novak, 1981 p. 63) as follows:

"While the Ford administration was insisting that only a tax increase could fight inflation, Mundell argued that an immediate $10 billion reduction was essential to avoid even bigger budget deficits fueled by "stagflation," the lethal combination of inflation and stagnation inherited from Nixon by Ford..."

With my arrival at Columbia University in the fall of 1974, a "club" of what later would become dubbed as "supply-siders" met from time to time at a Wall Street restaurant to discuss economic policy and particularly what to do about the rising inflation and unemployment. The conclusion was that cuts in marginal tax rates were needed to create output incentives to spur the economy, and tight money would produce price stability. The need for tax cuts and tight money became more urgent as inflation increased in the late 1970's and inflation, via "bracket creep," was pushing taxpayers into ever-higher income tax brackets. Within a short time, a political convert, Jack F. Kemp, Congressman from Buffalo, parlayed the ideas into a bill calling for a 30 percent tax cut, most of which would be enacted in a sweeping 23 percent tax cut spread over three years, followed by an indexing of the tax brackets for inflation. In the election campaign of 1980, Kemp was a candidate for the presidency but bowed out after Ronald W. Reagan agreed to incorporate the Kemp-Roth bill in his agenda for the economy. After Reagan's election, the first phase of the new policy mix was introduced with the Economic Recovery Act of 1981.

Meanwhile, the Federal Reserve, under the chairmanship of Paul Volcker, at long last woke up and tightened monetary policy. After a steep, but short, recession, the economy embarked on one of its longest-ever expansions at the same time that inflation was increasingly brought under control. The new policies shifted the Phillips curve downward and to the left, allowing unemployment and inflation to decrease at the same time.

There was a sequel to the tax cut, the arms buildup, the policy of disinflation and Reagan's landslide reelection. The Tax Reform Act of 1986, the second phase of the supply-side revolution, lowered the marginal tax rate in the highest tax bracket to 28 percent, the lowest top marginal rate since 1932. The 1982-90 expansion was the second longest up to that time and, along with the arms buildup, helped to convince the leaders of the Soviet Union to leave Eastern Europe free to choose its own system.

Growth continued until the nine-month downsizing recession of 1990-91, which probably cost President George H. W. Bush reelection. Expansion resumed in the spring of 1991 and continued at least until the end of the decade, making the combined period 1982-2000 the greatest expansions in the history of any country. Over the period no less than 37 million new jobs were created! The Dow- Jones Average soared from below 750 in the summer of 1982 to over 11,000 by the turn of the century.

Meanwhile, the withdrawal of the Soviet Union from Eastern Europe—itself, as already noted, partly due to the success of supply-side economics--made unification of Germany possible and brought with it renewed impetus for European monetary and political integration. The fiscal spending associated with German spending on its new states gave a jolt to the exchange- rate mechanism(ERM) of the European Monetary System ( EMS). A few countries left the exchange- rate mechanism, and others opted for devaluation within it. Nevertheless, by January 1, 1994, the European Monetary Institute came into being, and, by the middle of 1998, so did its successor, the European Central Bank. On January 1, 1999, the euro was launched with eleven members. A new era in the international monetary system was unfolding.

The introduction of the euro redraws the international monetary landscape. With the euro- upon its birth the second most important currency in the world,- a tri-polar currency world involving the dollar, euro, and yen came into being. The exchange rates among these three islands of stability will become the most important prices in the world economy.

The creation of the euro will doubtless lead to its widespread adoption in Central and Eastern Europe as well as the former CFA franc zone in Africa and along the rim of the Mediterranean. Expansion of the wider euro area—counting not only currencies entering with an enlargement of the European Union, but also currencies fixed to the euro—will eventually give it a transactions area larger than that of the United States and will, inevitably, provoke countervailing expansion of the dollar area in Latin America and parts of Asia. Other currency areas are likely to form, adapting to local needs the example of Europe. But stability for the near future will be best assured by stabilization with one of the "G-3" areas.

The 1970's was a decade of inflation, but the 1980's was a decade of correction and the 1990's a decade of comparative stability. The experiment with flexible exchange rates in the 1970's started off as a disaster, from the standpoint of economic stability, but nevertheless, it set in motion a learning mechanism that would not have taken place in its absence. The lesson was that inflation, budget deficits, big debts and big government are all detrimental to public well-being and that the cost of correcting them is so high that no democratic government wants to repeat the experience. Consequently virtually all of the developed OECD countries had drastically reduced budget deficits and whittled inflation rates down to those of the pre-1914 international gold standard.

In many respects economic performance in the 1990's compares well with that of the first decade of the century. Prudent finance then as now produce similar effects. But in two respects our modern arrangements—I am trying to avoid the word "system"--compares unfavorably with the earlier system: the current volatility of exchange rates and the absence of a global currency.

The volatility of exchange rates is especially disturbing among countries each of which have achieved, according to local definitions and indexes, price stability. The volatility therefore measures real- exchange- rate changes and involves dysfunctional shifting between domestic and international-goods industries and aggravates instability in the financial markets.

How much flexibility is good? If we think of the euro as the "ghost of the mark" could we look at past variations in the mark-dollar rate as an augur of the dollar-euro rate in the future? Between 1971 and 1980 the mark doubled against the dollar, to $1 = DM1.7; between 1980 and 1985, it halved, to $1 = DM 3.4; between 1985 and the crisis of 1992, it more than doubled, to $1 = 1.39; and it has since fallen to $1 = DM 1.9. The mark-dollar rate has fluctuated up and down by more than 100 percent, a mountain of volatility that would make the ERM crisis of 1992 seem like a little hillock. Comparable movements of the dollar-euro rate would crack Euroland apart.

Nor does looking at the yen-dollar rate give us more comfort. The dollar has gone down from 250 yen in 1985 to 79 yen in 1995, and then it went up to 148 yen in 1998 (with forecasters expecting it to hit 200!), and down to 105 yen in early 2000.

The twentieth century will not see fixed exchange rates again among the G-3. But it is entirely possible that a new international monetary system will emerge in the twenty-first century. Convergence of inflation rates has become remarkable, better than that associated with parts of the Bretton Woods era, comparable to the gold standard itself, as Table 3 shows:.

Table 3. Inflation Rates Among the Big Three

Source: IMF International Financial Statistics, January 2000, 57.

*Germany cost-of-living index for 1995-98, the European Monetary Union Index of Consumer Prices for 1999.

It may seem a long way off, but I believe that given such the degree of inflation convergence some sort of monetary union of the three areas would not be impossible. The same conditions would result from a three-currency fixed- exchange- rate system with agreement over a common inflation rate and a fair distribution of seigniorage. If such a fixed- exchange- rate arrangement among countries that had converged is conceivable, it would not be such a far step toward a reformed international monetary system with a world money of the kind initially proposed back in the days of Bretton Woods.

To conclude this section, what lessons can we take from the last third of the twentieth century? One is that flexible exchange rates, at least initially, did not provide the same discipline as fixed rates.

A second is that the costs of inflation are much higher in a world with progressive income tax rates.

A third is that the need for, and means of, attaing monetary stability can be learned. A fourth is that the policy mix can shift the Phillips curve.

Experience breeds its own reaction: Plato the inflationist gave birth to Aristotle, the hard-money man. The reaction in the 1980's gave a boost to central bank independence. Governments forced into the Maastricht mold had to cut back on spending growth as well as deficits. Supply-side economics pointed to one of the mechanisms for strapping down ministers of finance.

One lesson, however, has yet to be learned.. Flexible exchange rates are an unnecessary evil in a world where each country has achieved price stability.