To: SSU Students
From: Jude Wanniski
Re: The Mundell-Laffer Hypothesis, Part II
If this second of three parts of the "Mundell-Laffer Hypothesis" written a quarter century ago seems elementary to those of you who have been studying at SSU, it is because I was just then learning about "money" myself. In the process of writing this for Irving Kristol's Public Interest, I spent countless hours with Bob Mundell and Art Laffer, on the telephone and in person, making sure there were no errors. This forced me to learn the most basic concepts about money in general and the "dollar" in particular in a different way than these were being taught then, and now, in our schools of higher learning. I've learned much more about money and banking in the years since, but I'm also surprised at how clearly I saw the classical foundation in those early days of my supply-side education. In the third and last part, which will run next weekend, monetary policy is merged with fiscal policy. For those of you who are becoming serious about political economics, I suggest you download these three parts into your own computer, for future reference. You won't find it in every library.
* * *
The Mundell-Laffer Hypothesis - A New View of the World Economy
The Public Interest
Number 39, Spring 1975
Exchange rates need never change
According to Mundell-Laffer, the world would be much better off with a system designed to keep exchange rates permanently fixed. If 2.5 Deutschemarks will always be equal to $1, or 300 yen always equal $1, all currencies would be identical except in name. The world would in effect have a common currency. Interest rates, prices, and the rate of inflation would then be the same everywhere, broadly speaking, just as they are within a large country like the United States with its common currency.
In the Mundell-Laffer scheme of things, a common currency is not a utopian fantasy; it has been around before. For decades prior to World War 1, the world had a simulated common currency as national currencies were tried to the pound sterling and the pound was fixed to gold. In the years after Bretton Woods (1944) until about 1967, or even 1971, the world had a simulated common currency bound to the dollar. The system was flawed, but still enormously successful.
There are substantial benefits to be had, by the world and all its component parts, through use of a common currency, simulated by a properly constructed fixed-exchange-rate system. Conversely, the world and its component economies are now paying an enormous penalty for the absence of a common currency -- the penalty of rampant inflation. But before the benefits of a common currency are examined, consider the supposed penalties of not having an independent national currency. Even if, as Mundell and Laffer claim, devaluation does not improve the U.S. competitive position in the world and only causes price inflation, isn’t monetary policy useful in stimulating production and employment in the United States, making it worthwhile to retain national control over it? Again, say Mundell and Laffer, the answer is no.
Just as trade between a U.S. wheat farmer and an Italian winemaker is only stimulated momentarily by the confusion of an exchange rate change, so there is no lasting stimulation to commerce internally from pumping money into the system faster than the system is demanding it -- i.e., beyond the real growth demands of the economy. There may be a brief confusion in the terms of trade between Kansas farmers, California vintners, and Detroit automakers, or the workers who are paid to produce these goods. But there will be less and less confusion as they learn to read the signals and extract their meaning. As soon as this has been accomplished, the overwhelming effect is price inflation. And, because monetary stimulation increases the rate of inflation, thereby “taxing” cash balances and other financial assets, there is an immediate lowering of real income and offsetting subtraction from output. If the horse will not drink if there is a gallon in the trough, you can’t make him drink by adding liquidity.
If monetary stimulation can increase production only by increasing someone’s credit at the expense of someone else (a creditor who is paid off in inflated currency, a contractor who has agreed to supply goods and services at a fixed price, or a worker tied to a wage contract), the increased production gained by such deceptive means can be of value to a politician only insofar as the cost of price increases can be pushed far enough into the future so that some other politician will have to deal with it. If the market becomes conditioned to see immediately through the deception, and discounts the future accordingly, the politician gets no gain whatever.
On the other hand, there are distinct advantages to the politician, and to the economic interests of his constituency, in a common currency or a properly constructed fixed-exchange-rate system.
The "bonus" of a world currency
The world economy gets a bonus, something extra, by having the economies of scale of a common currency. On narrow grounds, even the opponents of fixed rates agree with this. But Mundell and Laffer go beyond the narrow grounds.
Here is the usual financial argument on behalf of fixed rates: Suppose each of the 50 states of the U.S. had its own monetary authority, and its own currency. Interest rates and the rate of inflation would vary widely. Business would still be transacted between states, but in each interstate transaction requiring a contract both buyer and seller would have to insure themselves against a change in the exchange rate, say between Kansas and Nebraska. This effort would require a sizable layer of personnel, expertise, and capital, which would otherwise be doing something more useful. As always, consumers would pay higher prices for everything, the cost of "hedging" being added in at the retail level. The dollar cost of providing "hedges" between 50 currencies would run into billions per year.
It may be argued that such an overhead expense is not really a colossal amount of money to pay in order to retain the advantages of independence. In the same way, if it were really deemed important by national governments to have independent monies, the extra tens of billions of dollars worth of resources required to maintain commerce in a world of floating exchange rates could be defended. But Mundell and Laffer identify the costs of floating in a different dimension as well. It is not only that the floating system has financial costs because of added coverage requirements, but also that there are dramatic and inescapable increases in the amount of error in a system of many, rather than few, monetary authorities. This point is crucial to an understanding of why the world economy is now in such a mess. It becomes obvious why Mundell can write so casually that, throughout history, “the gains from using a common international medium are so great that some means of creating one have always been found.”
Again, consider Kansas and Nebraska. If each had an independent monetary authority, each authority would have to be considerably wiser and more efficient than if they arranged a compact to pool their mistakes. Imagine that on a given day in July, there are a thousand economic transactions in Kansas that have to be made with the available supply of money. If the Kansas monetary authority erred on that day by not anticipating the precise number of transactions and the quantity of money required to make them, one of two things would happen. If the amount of money were insufficient, some of those thousand transactions could not be completed at prevailing prices. Prices would have to fall until the amount of money was sufficient. If prices did not fall (which is likely in that prices seem to go up easier than they come down), some of the transactions would not be completed unless money substitutes were available. Which means the supply of goods would have to fall, resulting in lower output and higher unemployment in Kansas.
Alternatively, if the Kansas authority overshot the mark and produced too much money, all the transactions would be completed, but because buyers had more money than sellers had goods, the prices of goods would be bid up until supply equaled demand. So, on that day in July, if too much money is supplied, there is inflation; if too little is supplied, there is some deflation and some reduced output.
On that same day, the Nebraska authority is having a similar problem. With so many transactions to be completed, only by miraculous good luck is it going to produce the precise amount of money required.
But consider what happens if the Kansas and Nebraska monetary authorities agree to buy and sell each other's currencies at a fixed rate, say one Kansas dollar for one Nebraska dollar. If this is so, and Kansas produces $100 too little money to effect its 1,000 transactions, and Nebraska produces $100 too much, a party in Kansas will observe there are 100 too many Nebraska dollars and 100 too few in his own state. He then borrows 100 Nebraska dollars and presents them at the Kansas monetary authority. In accord with the Kansas-Nebraska agreement, he gets the 100 Kansas dollars he wants for the 100 Nebraska dollars. With this transaction, each state has precisely the amount of money it needs and there is no unemployment in Kansas and no inflation in Nebraska. On the following day, Kansas can overshoot a little and Nebraska undershoot a little, and over the course of months -- and certainly years -- they can make sure that the use of each other's money nets out to roughly zero. That is, neither state will have a balance of payments deficit or surplus.
But what if, you will wonder, both Kansas and Nebraska undershoot at the same time? Say Kansas is short $100 and Nebraska short $50. In sharing the error, both come up short $75, which means Nebraska is worse off than if it didn't have the agreement, but Kansas is better off. But even if one is going to assume that Nebraska will be consistently right and Kansas consistently wrong, it is still to their mutual advantage to compromise their errors -- if only because each gains from the other's prosperity and loses from the other's depression.
This is not simply a theoretical example. It is, in fact, exactly the way the 12 Federal Reserve Districts operate, with each responsible for issuing currency in its region. The districts have daily, monthly, and yearly balance of payments deficits and surpluses with one another, but they are so attuned to correcting the money supply to fit demand that the deficits and surpluses are not even apparent to the public, which believes there is only one U.S. currency instead of 12. (Check the left center of any bill for the issuing bank.)
The Bretton Woods system
This is almost, but not quite, the way the Bretton Woods system operated. Instead of setting up a system that would approximate the fashion in which the 12 Federal Reserve Districts correct balance of payments differences with each other, by expanding or contracting the money supply, the Bretton Woods agreement tried something else.
Imagine, in the above example, that instead of all 50 states balancing payments with one another by expanding or contracting the money supply, one state had a different role. New York, say, would not have to stay in balance with the other states. Theoretically one state could be excused, because if 49 states have zero balances, the 50th automatically has a balance of zero. New York could then use this extra measure of freedom by making sure that the system as a whole had "proper" monetary policy, so that with economic growth in the system as a whole, commerce would not be hindered by a paucity or excess of money growth.
What, though, is the proper quantity of money? That is the question New York would have constantly to decide. The answer goes something like this: The chief cost of excessive expansion of money is the strain put on the availability of natural resources. If New York raised the quantity of money at too rapid a rate, it would increase the nominal amount of transactions. But, as previously mentioned, this would come about through the destruction of the real value of someone's financial assets. The increase in nominal transactions generated by these artificial means -- inflation -- results in a more inefficient use of the nation's resources than would otherwise occur. One way New York could solve its hypothetical problem of determining the proper rate of money growth would be to adopt a metal as money, such as gold, thereby tying money creation directly to a natural resource. This, too, is not a theoretical example. It is the way the world economy worked for decades, even centuries, up to 1914. During this period, Great Britain fixed the price of gold by regulating the quantity of money in the world and by buying and selling gold, doing so with such precision that all the while it maintained only a very small inventory of gold. Nor was there a general international monetary agreement in this period. The rest of the world simply found it so advantageous to fix their currencies to the pound sterling, while sterling was fixed to gold, that it occurred ad hoc.
This was also the Bretton Woods system, arrived at formally. The United States played the role for the world economy that, in the hypothetical example, New York played for the 50 states, and that Britain played in earlier centuries. Although the Bretton Woods system was flawed, it did provide the framework that made possible a quarter-century of uninterrupted prosperity and growth in the Western economies. The flaw, however, led to its abandonment.
The flaw in Bretton Woods lay in the fact that the people who were responsible for running the system didn't know how it was supposed to work. Go back to our hypothetical New York example. If 49 states are maintaining external balance by expanding or contracting their money supply, and New York is expanding the quantity of money to accommodate economic growth in the system as a whole, then if New York expands too fast everyone in the system has too much money and there is a general inflation. If the other 49 states do not desire to have inflation, they have to print less of their own currencies. If New York keeps pumping out money, and the other 49 states are contracting their monies accordingly, the result is inevitable. At the extreme, everyone in the United States is transacting business with New York dollars. All the states are running huge surpluses in the balance of payments with New York, and New York is running a stupendous balance of payments deficit. But New York doesn't care. It has become the sole supplier of money, and as banker of the game receives in return for its banking service the real goods of all other states.
So it was with Bretton Woods. For a while, everything worked well. After World War II, the United States had most of the gold in the world, far more than it needed. It didn't worry about providing precisely the correct growth of money supplies, but acted in a way that made sure there was more than enough money rather than too little. When the war-torn countries got on their feet, it still did not matter that the United States was overexpanding its money creation, because the others wanted some of the U.S. gold to hold for a rainy day, and they were now prosperous enough to acquire some. By restraining its money growth, West Germany, for example, would import dollars. If the number of dollars were more than needed by West Germans, after being turned in for Deutschemarks, the West German monetary authority, the Bundesbank, would have some left over to buy U.S. gold. After several years of this, the U.S. gold board was down from $24 billion to $12 billion, valued at $35 an ounce.
In this arrangement, all the economic incentives drove the United States to create more money than was really needed, and forced the other countries to produce less of their own currencies if they wanted to avoid inflation. People and enterprises all over the world did more and more of their business in dollars, finding the United States always there to supply money when needed, while their own monetary authorities seemed to be cutting back. In exchange for its real good, the banking service, the United States was receiving other real goods -- autos, radios, etc.
But it's one thing for New York to drive everyone else's money out of the other 49 states, and quite another for the United States to push out foreign currencies by running constant balance of payments deficits. For the most part, the U.S. deficits were not the fault of the United States, but the natural result of its having been the most efficient supplier of money in the world. The dollar became, says Mundell, “the major intervention currency, a reserve asset for central banks, the standard of contract, the standard of quotation, the invoice currency, the major settlement currency, the major reserve asset for commercial banks, the major traveler's currency, the major external currency for indexing bonds, and the major clearing currency.” In so many ways, foreigners were demanding dollars rather than their own national currencies.
2. At one time Mundell believed with the rest of the profession that the government could retard the economy by contracting its money supply, but after so much government manipulation over so many years private commerce has become exceedingly adroit in switching to money imports and substitutes, chiefly trade credit and credit cards, both of which are sources of liquidity.
3. Those who lent money at a fixed rate of interest, or contracted to supply goods or services at a fixed price, or who agreed to work for a year or longer at a fixed wage, discover that the addition of these marginal transactions, through excessive monetary expansion, has put prices up, and their wages have lost purchasing power. While those who borrowed or bought enjoy an offsetting benefit, the net effect is a weakening of the relationship between reward and effort. Henceforth, if excessive policies continue, they will demand compensation in the form of higher interest rates, higher fixed-price contracts, and higher wages and/or cost of living adjustments.