An economist is lucky if his or her work stands the test of time and remains relevant decades after first being published. Robert Mundell, the 1999 Nobel laureate in economics, is extremely fortunate: His work is actually more respected and relevant now than when it was first published.
In fact, looking at economic headlines over the past year, it’s easy to pick out numerous events to which Mundell’s work applies.
Item: Last New Year’s Day marked the launch of the euro, the new common currency of 11 European Union nations. The euro is intended to help the economic integration of Europe, allowing firms to do business across national borders without having to exchange currencies.
The euro owes much to Robert Mundell.
He was only 29 years old in 1961 when he published an article on Optimum Currency Areas. In the words of the Nobel citation he radically reformulated the problem of different exchange rate systems, by posing an new and fundamental question: Under what circumstances is it advantageous for a number of regions to relinquish their monetary sovereignty in favor of a common currency?”
Mundell asked questions 38 years ago that the EU is answering in real life right now.
Item: Last February, Brazil’s central bank decided to halt its failing efforts to maintain the value of the real. Its value soon slid by more than 40 percent against the dollar.
That was bad news for Minnesota towns like Biwabik, Worthington, Cottage Grove, Willmar and Eveleth. Why? Because a weaker real makes exports of Brazilian soybeans, iron ore and steel cheaper and more competitive.
In a 1963 paper, Mundell wrote about the dilemma that any central bank would face if its government ran big fiscal deficits while bankers were fighting inflation and maintaining a fixed exchange rate. That’s exactly what Brazil’s Banco Central de Reserva confronted a year ago. He concluded that monetary policy can either focus on an external objective, such as an exchange rate, or an internal objective, such as controlling inflation, but not on both.
Last year, Brazil’s congress kept on spending much more money than the government took in. At the same time, the Banco Central tried to keep inflation down and the exchange rate fixed.
Mundell’s work predicted that something had to give, and something did.
Item: Last week the Federal Reserve Open Market Committee said that while it was not raising its target for the Fed funds rate nor the largely symbolic discount rate, it did have a bias toward tightening.
In other words, it was a hint to financial markets and the public that they’re likely to go ahead and raise rates at their next meeting in five weeks. The U.S. stock market immediately dipped, as did foreign exchange markets and equity markets in other countries.
But just a year ago, the Fed was doing just the opposite, cutting interest rates even though the U.S. economy was doing well. This action was apparently based on fears for economic collapse in Russia and continued tremors in Asia.
But these cuts also stoked the fire under U.S. capital markets, driving the Dow to new highs.
Now some economists and at least one influential news magazine are warning that an overly lax Federal Reserve has allowed a speculative bubble to build up in stock and property markets. If that bubble bursts, they argue, the United States faces a much more serious recession than if the Fed had moved to tighten earlier.
Did Robert Mundell also predict all of this?
No, but he did develop much of the theory of how economic policies in one country affect and are affected by policies in another country.
As the century ends, this connection of the U.S. economy to other nations is a salient feature of economic life: Minnesota farmers suffer low prices because demand in Asia is weak. Consumers find stores packed with reasonably priced electronics, toys and apparel because of the dollar’s strength relative to foreign currencies.
We wouldn’t understand these features of an increasingly integrated global economy nearly as well as we do if it were not for Mundell.
He examined the relationships between domestic economic policies and international economics, changing it from a static analysis based on unrealistically rigid assumptions to a dynamic analysis that more fully explored the interactions between domestic policies and international outcomes.
© 1999 Edward Lotterman
Chanarambie Consulting, Inc.