Supply-Side University Lesson #14
Memo To: SSU Students
From: Jude Wanniski
Re: Robert Mundell, guest lecturer
This is one of a number of talks delivered by Prof. Robert Mundell of Columbia University at a conference on the international monetary system that took place in Washington, D.C., on May 17, 1983. The conference was held less than two weeks prior to the economic summit meeting of the seven largest industrial nations in Williamsburg, Virginia and was co-sponsored by Mundell and then-Congressman Jack Kemp, who introduces Mundell.
Congressman Kemp: It's my real pleasure to introduce the Co-chairman of the conference, our good friend, Robert Mundell. Over the years I have learned that his colleagues in the academic community admire him as much as I do.
Some years ago, Lord Lionel Robbins, Chairman of the Court of Governors of the London School of Economics, remarked, "Bob ~ here I lay down a sociological law — is seldom wrong. Even when you disagree with him you must disagree with him with your hat in hand."
More recently Peter Kenen of Princeton called Bob "the finest mind in our profession." Bob has written several books and countless articles, especially in international monetary policy and economics. He has been a member of the staff of the IMF and an economic advisor to governments, central banks, international organizations and commissions.
Ladies and gentlemen, please join me in welcoming Professor Robert Mundell.
Dr Mundell: Thank you, those words leave me — almost — speechless. I don't disagree with everything that Secretary of State Shultz said. I agree that major issues that should be discussed at Williamsburg include global recession, the debt crisis, protection, the exchange rate chaos of the 1970s, and future monetary policy.
These are the five most important questions, I think, on the economic side, besides the natural political questions of peace and war and disarmament and alignment structure.
But just as economic policy may be too important to be left to economists, political policy may be too important to be left to economists.
We have a curious mixture of what we call in economics "the assignment problem," where economists are put in charge of politics and politicians become economic experts. It has caused a certain confusion, perhaps, in the way economic policy is coordinated around the world. We have had more experience with different international monetary systems in the past dozen years than we have ever had, I think, in the prior history of man.
Since 1970, we have experienced a gold-pinned fixed exchange rate standing on its last legs at an undervalued price of gold. We have had a fixed exchange rate system, such as that enacted at the Smithsonian Institution, but without allowing an automatic link between operations in the foreign exchange market and monetary policy; and without the global discipline of at least one currency convertible into gold.
We have had the floating exchange rate system that was introduced in 1973. We have — after 1976 — what was called "the managed floating rates system," but with the managers not specifying the nature of the management.
We have had great confusion over what monetary and fiscal policy should be. As a result, we have a recrudescence of the international business cycle; since 1968, when the private gold market was separated from the official market, we have had three great recessions, getting progressively deeper and longer.
Since 1968, when the elimination of gold backing of Federal Reserve notes unleashed the Federal Reserve System, we have also had inflation rates that have gone beyond any experience outside of wartime (or its aftermath). Partly because of those recessions, we have had monstrous budget deficits on a scale never before tolerated. We have had higher sustained interest rates than ever before and continuing high and stubborn unemployment. The unemployment rates, which, in 1968, were three percent or three and a half percent, are now eleven percent, and we are faced with the specter of an economic recovery that will involve unemployment rates continuing throughout the 1980s well above eight percent or seven percent, and even after some long-run period, only getting down to six to seven percent, levels that back in the low interest-rate, gold exchange-standard, postwar period would have been considered completely unacceptable.
What happened to three percent unemployment that existed in 1968? What happened to interest rates that under the "Bretton Woods" key currency system, which lasted from the Tripartite Agreement of 1936 to 1971, were usually well below five or six percent? Why is it now interest rates very rarely get under ten percent, except for currencies that are expected to appreciate?
Why is it that from after 1941, unemployment rates, except in very brief periods of recessions, were kept very low throughout the whole OECD world, but have now risen to levels that once were considered universally unacceptable? Why has the global debt problem "suddenly" emerged?
The debt problem is a real crisis, because some of the debtor countries simply are not going to be able to repay their international debts. They can't pay them now, and they have the problem of servicing them. But in the process of servicing them, they will have to build up more debts. So the debts are not going to go away, they are going to increase.
People tend to put problems into separate compartments without fully understanding the complexity of their interacting features. They do not see at once the links between monetary policy, fiscal policy, exchange rate policy, budget deficits, global debts and the role of gold. This parochialism or myopia is excusable in the layman, but unacceptable for economists or bankers charged with the responsibility for making public policy.
Today we have economists who technically are better trained than ever before and who know and have studied much more about monetary and fiscal policy than ever before. Why is it that they are having such difficulty in formulating or agreeing on fiscal or monetary policy in a global economic setting?
Part of the answer lies in the fact that Keynes wrote his General Theory for a closed economy, and Friedman has monetary panacea for a closed economy. Their disciples have not made the needed adaptations to the peculiarities of the open economies with which they have to deal. But this is not the whole answer. The world of policy-making, and especially international coordination of it, is enormously more difficult now than it was under periods of fixed exchange rates and the gold exchange standard.
Policy then was made semi-automatically, because mistakes were instantly punished by gold or foreign exchange losses or gains; basic errors had no survival value.
Today we see that something has gone wrong. Why is policy today so difficult? Why is it that non-economists take charge of policy and seem to be able to do as well as economists?
The answer is that we've been running the world economy without a rudder or its natural compass. The compass of the past was always present in a coordinated international monetary system, such as that provided by the gold exchange standard under the auspices of the International Monetary Fund.
I wish George Shultz had stayed to listen to what I am going to say because many policy makers have harbored a great confusion of fixed exchange rate systems. There are two kinds. One is an automatically correcting equilibrium system such as exists within a multi-regional closed economy with a common currency and a dominant central bank. This is the good kind, and it was on that model that the gold standard of the 19th century was based.
The good kind is in operation everywhere inside countries. The Federal Reserve System represents a system of twelve separate Federal Reserve currencies, lettered in a different way, but with absolutely fixed exchange rates between them to the extent that nobody notices or cares about the different identifying letters. Coordination of monetary policies between districts comes about automatically. Monetary coordination is achieved automatically, just as under a pure gold standard.
If there is a region in deficit, that region loses reserves and its expenditure is cut, bringing about correction of any imbalance. And if a country receives reserves, or a district receives reserves, then that bank will increase its lending and its customers increase their expenditure. There is an automatically working adjustment or re-equilibration process here that goes on. The basic structure is that one region's loss is another's gain, so deficits and surpluses do not have significant inflationary or deflationary consequences.
As we move away toward systems of fixed rates with a lesser degree of monetary integration, we arrive at countries like Panama, which uses a paper currency, which is the U.S. dollar, the same as ours, but also has a metallic currency, the Balboa, convertible into the dollar, which is also a fixed exchange rate system. That is a little bit different.
And then, as we move further along the spectrum, we have the countries in Central America that, for long periods of time until recent instabilities, kept their exchange rates fixed to the dollar; they had no problems in doing it because that was, or it determined, their monetary policy. When the public wanted more money, they had to earn it by generating a balance of payments surplus.
Now it is true that is price fixing, but in almost the same sense that we fix the exchange rate between two $5 bills and one $10 bill. Our unified national monetary system requires price fixing. The price is absolutely fixed, but there is nothing wrong with that, if we want coins, cash and bank deposits to be substitutes for expunging debts. That kind of price fixing is what we need, because the whole concept of a unified monetary system is to have a single money, a common currency, with different denominations interchangeable. If we wanted floating rates within the United States and we believed that fixed rates don't involve a good monetary rule, why don't we break up the United States into twelve different parts and have twelve separate currencies? Or let the big banks issue notes as they used to and float their deposits. Citibank, Chase or Bank of America deposits would exchange at prices determined in a free market instead of at fixed prices as they do now. What ensures the fixed prices is that they keep their deposits freely convertible into Federal Reserve paper currency notes at a given one-for-one price.
There's more unemployment now in certain parts of the South. Why not have a separate currency and devalue it, I ask flexible rate advocates? With separate currencies, you could have the Southwest with twenty percent inflation and the Northeast with ten percent inflation. You could have different interest rates payable on Southern money and on Northern money. We could break up the U.S. monetary system without having a Civil War.
We could tell the Canadians, my compatriots, "Well, you should not keep the Canadian dollar stable at about 80 U.S. cents. You should, if you have unemployment, let the Canadian dollar go down to 50 cents, or to ten cents." When presented in this way, common sense comes out and it is recognized that such a policy would lead to 1,000 percent rise in the Canadian price level. The monetarists in Canada who wanted to float in the 1970s and allowed the dollar to depreciate got a higher inflation rate, but not a lower unemployment level.
There is a lot of unemployment in Britain, but the British pound was $2.50 a couple of years ago and recently it was almost down to $1.40, its lowest in history, and probably, one would hope, the lowest ever, but it hasn't helped employment. All floating rates have done for Great Britain is to create inflation, high interest rates and unemployment.
If depreciation were a cure for unemployment, the British could just set the pound sterling at $1.00. But in fact, all that would do would be to raise the U. K. price level by an extra 50 percent and that wouldn't make British goods any more competitive, because wage rates and other costs would go up too. They might even anticipate the inflation and raise wages prior to other prices exacerbating unemployment.
Exchange rates don't work any more as a device for making countries more competitive, if they ever worked. The scientific evidence on this has not supported the thesis that depreciation improves the trade balance.
Now Secretary Shultz did refer to "exchange rate fixing" — and he used that pejoratively because, when he was the head of the Business School at Chicago, price fixing was a nasty word. As his colleague at the time, I agree with that, and still do. I don't like price fixing, in the sense that governments try to work with price or wage controls, or to direct the economy, as in socialist states. On the other hand, I think "quantity fixing" is an awful word, too.
We have too much quantity fixing in the world's economy. Milton Friedman is a quantity fixer. George Shultz is a quantity fixer. George got us into this mess when he was Secretary of the Treasury back in 1973.
In June 1973 the Committee of Twenty decided that it would give up the idea of international monetary reform until inflation was brought under control in the different countries. When I heard this, I considered it the most astonishing thought that I have ever heard from a presumably competent forum because the whole concept of international reform was to coordinate monetary policies to achieve stable prices either through a designed system of synthetic money or a more natural system such as the gold exchange standard. You must stabilize the growth rate of international money, or at least, as under the gold standard, have a rule which makes that rate predictable.
Let me quickly emphasize that when we talk about fixed exchange rates, we don't talk about pegged rates, where reserves are bought and sold without that affecting monetary policy. That is the bad kind. Right now, we know that the Italian lira is in a kind of disequilibrium, the French franc is in a kind of disequilibrium. There is no point going into the market and pegging the value of the lira or franc against the dollar without allowing that to have an impact upon monetary policy. It will, if its automatic effects are not neutralized or "sterilized" by countervailing, offsetting sales of domestic assets by the central bank.
If the French want to stop their inflation and to prevent the franc from falling from seven or eight francs to the dollar down to ~ at some point it might be ten francs to the dollar ~ if you want to stop that process, it is necessary to step in and stabilize the French franc against the dollar (or reduce its rate of depreciation). This involves intervention (another dirty word at Chicago) in the foreign exchange market as the Bank of France sells dollars and takes in francs, lowering the monetary base of the French monetary system and forcing a tightening of monetary policy that brings about the cure of the inflation by cutting it out at its source. The monetary discipline also imposes budgetary discipline because it means that the real value of the public debt cannot be inflated away.
The argument that a system of fixed exchange rates doesn't operate as a discipline is belied by the facts. It operated as a monetary discipline in all the countries that used a gold standard or a silver standard in past periods of history. It acted as a monetary discipline during the period when the gold exchange standard was in operation, although that discipline became weaker after 1965 when the first stage of the 25 percent reserve requirement was lifted by Congress.
Recently, we do have a number of experiences that illustrate the role of monetary discipline and fixed exchange rates. We had the case of Mexico which, from 1954 to 1976, had a peso worth eight cents. The ratio was l2l/2 to the dollar. For over 20 years, Mexico kept that fixed exchange rate system and until the oil boom, a rate of inflation that was about the same as the U.S. rate of inflation. After Mexico gave up its fixed exchange rate, fiscal and monetary discipline broke down and prices since 1975 have risen more than 400 percent. The good kind of fixed exchange rate system, where deficits are not sterilized, forms a brake on monetary expansion and therefore, especially where governmental credit is weak, on budget deficits.
The same is true of a number of other countries. With few exceptions, among the LDCs monetary discipline was relaxed when countries abandoned the goal of using monetary policy to protect the balance of payments under fixed exchange rates. The idea that fixed exchange rates do not and cannot operate as a monetary discipline is just not factually correct. It is only when the one adopts fixed exchange rates as a mere peg, and the central bank sterilizes the monetary effects of intervention by offsetting the automatic tightening or loosening of the money market that fixed exchange rates become a source of disequilibrium. The idea of a fixed exchange rate system is to provide a monetary rule and monetary stability that is equivalent to the inflation rate in the countries to whose currencies the national currency is fixed.
Nevertheless, if a country fixes its exchange rate to another currency, it has to find a world system currency that itself is stable. It's like a convoy of ships. If the convoy is going in the wrong direction, from the standpoint of a particular ship, that ship wouldn't want to attach itself to that convoy. But if the convoy is going in the right direction, then it can attach itself to it and gain its protection and leadership. That is why we want to have a stable international system in which other countries can have confidence now and in the future. The present system is a mixed system of currency areas (several convoys), the most important of which is the dollar area, followed by the mark area and the EMS, and then by the yen, the pound and the franc.
For various reasons, the international system was destroyed in three steps in 1968, 1971 and 1973. The U.S. economy had been such a big economy that other countries fixed their rates to the U.S. dollar, and the U.S. did not intervene in the foreign exchange market. Its job was to stabilize international reserves. Therefore, it intervened in the gold market. That was the international arm of its monetary policy and that is what kept the U.S. monetary growth under wraps. U.S. money reserve growth in peacetime was generally very restrained.
Now that system broke down — Bretton Woods broke down —. because eventually, after the inflation caused by three wars, the price of gold at $35 an ounce was repressed; monetary discipline breaks down under the exigencies of war. It became too low in real terms, and when the U.S. ceased feeding the private market, the price of gold went up to its natural level. The price went higher in the 1970s and early 1980s than expected because in 1975 American citizens were, after 30 years of prohibition, allowed to have gold. But gold hasn't done anything different from oil. About 10 to 14 barrels of oil still exchange for an ounce of gold as they have throughout most of the 20th century. That ratio, the real ratio, has been fairly stable. What has been unstable is that the currencies have come down against gold, oil, silver, platinum, copper etc. just as there are two types of fixed exchange rate systems, there are two types of gold standard. There is the type of gold standard where you simply stabilize the price of gold and not allow fluctuations in gold reserves to have an impact on monetary policy, sterilizing gold movements and preventing any impact on bank reserves. The other type is a completely automatic system where gold policy becomes monetary policy and open market operations are dispensed with (except possibly to supplement gold with credit in the growth process)....
Today we'll discuss both long-run issues of reform in the system and short-run issues about the optimal policy mix to handle the recovery. I think that the recovery has at least begun. The best thing that the Reagan Administration has had going for it has been the tax cuts that were introduced by Representative Kemp and enacted by Congress. The reductions in tax rates have been the best part of the economic policy of the Reagan Administration.
But it's not enough. This recovery is going to be, in my opinion, choked off. It's going to be choked off again just as others were before we get close to anything like what we want to call "full employment." It's going to be choked off because, under the way the system works now, this is an arbitrary monetary standard which can only be called a "Volcker standard," which lasts at least until August the 6th and then after that a "Volcker standard II," or it could be some other man's standard. It is not a happy situation. The power of the Federal Reserve gives this man, this single position, more power than almost any other in the whole world, the power to create or destroy hundreds of billions of dollars of wealth. It weakens, in my opinion, the American political system of checks and balances, even though the Fed is responsible to Congress and the Chairman is appointed by the President. It gives far too much power to any single man. I wouldn't want it even for myself. It's too powerful for any one man to have such influence over the whole system. Of course, his power is formally checked by the open market committee, and by Congress and by an unavoidable desire to cooperate with the Administration's economic policy.
The recovery is going to have to be fed with a lot of extra money and people are going to begin to think that inflation is going to be revived. The reviving of inflationary expectations will bring interest rates up again, stock prices will tend to come down again, and we'll get to a state where the recovery will have to be choked off by monetary policy again, unless there is some way of ensuring confidence that current ease does not mean inflationary future monetary policy.
You will only get confidence in future monetary policy if you have a monetary system that doesn't just depend upon pure political, practical politics, and that provides a stable monetary rule such as a gold standard in at least one country. Anyone looking ahead can formulate something about monetary policy in the future. Under this present system, we can expect a fairly rapid — we would have to ~ rate of monetary expansion in 1984. We will probably have a very rapid monetary policy in 1988, if the incumbent seeks reelection. We will have it in 1992 and so on. If we extrapolate the political cycle from the past, every presidential election year, every four years, the rate of monetary expansion would be high, and then the year after the election, the inflation would be up so much that the brakes would be put on, interest rates will scream up at least temporarily, and we would have a mini-recession after every election year and mini-inflation before every election year, exacerbating cycles of unemployment and inflation. In practice, however, as public awareness of what is going on develops, the exact reverse could take place as propaganda battles occur over whether inflation or unemployment is the worst enemy. One would hope that eventually a common realization would spread that we need a better and more predictable coordination of monetary, fiscal, exchange rate and gold policies to cope with the manifold targets of economic policy....
Congressman Kemp. Bob, thank you very much. After listening to you talk about the power of the Federal Reserve Board, I have ideral Reserve decided that that's what I would like to be someday, the Chairman of the Federal Reserve.