Interview: Robert Mundell
The Nobel laureate explains what is needed to save Europe’s single currency and calls for greater global coordination of monetary policies, in conversation with Robert Pringle
22 Aug 2011
Robert Mundell was awarded the Nobel prize for economics in 1999 “for his analysis of monetary and fiscal policy under different exchange rate regimes and his analysis of optimum currency areas”. Since 1974, he has been professor of economics at Columbia University. In 1970, he was a consultant to the Monetary Committee of the European Economic Commission, and in 1972–73 a member of its Study Group on Economic and Monetary Union in Europe. His writings include over a hundred articles in scientific journals and numerous books.
The euro area is in deep trouble. For somebody who has been closely involved in the euro project from the beginning, this must be painful to watch. How did it happen?
When countries have their national currency, there are two mechanisms that enforce fiscal discipline: the first is a currency crisis, and the second a solvency crisis. When poorer members of the European Union (EU) joined the eurozone, left-of-centre governments were protected by their immersion in the euro from any currency crisis and they unwisely imitated the welfare entitlements of their richer neighbours. This was spending that could be barely financed when the world economy was prosperous, but was disastrous when it took a dive. The Stability and Growth Pact was supposed to enforce discipline, but it was a complete failure. The euro subsidised in effect fiscal profligacy in countries such as Greece, shielding it from high interest rates until the second mechanism of solvency crisis took over too late.
What is the way out?
It is necessary to have policies for the short, intermediate and long run. The policy for the short run is to manage the debt crisis. This must involve austerity and adjustment, along with policies for growth in the ailing countries. Austerity and adjustment must involve ceilings on government spending, broad-based scaling-back of welfare and pension entitlements, increases in retirement ages toward 65, 67 and ultimately 70 years, privatisation of selected government enterprises and revision of labour laws to create a freer labour market and increased employment.
The policy for the intermediate run is to work toward some kind of fiscal harmonisation and authority. In my view, it would be desirable to create a European sovereign debt bond. Since the economic and monetary union (EMU) area is not a sovereign entity, it would, I think, have to be an EU debt, available for all members on equal terms when they join the euro area, with interest paid by nations at EU rates in proportion to the debts transferred. I am aware of the great difficulties, and a formula would have to be worked out to avoid creating moral hazard. It must be realised that with the very high debt levels of some countries and the euro-area governments as a whole, there is no solution as easy as that that confronted the US in 1792.
In the long run, the time is ripe to take a big step toward the creation of a United States of Europe. The position of the EU is, in some respects, similar to that of the US in the 1780s, when the Confederation was facing difficult problems of making policy at federal level. It is an old adage that confederations always fail unless they are transformed into a more centralised structure. Europe can only play its part – and it is a much-needed role – on the world stage if it has a strong central democratic government that can make effective decisions for 27 countries.
What fiscal rules are needed to maintain discipline inside such a union? Should individual nations follow a balanced budget rule (cyclically adjusted)?
A good rule is to run surpluses in the good years to finance deficits in the bad years. But because the level of debt in the euro area is dangerously high, countries should aim for a surplus of about 1–2% over the cycle.
What is the connection between the problems of the euro and the international monetary system?
A break-up of the euro area, which I do not expect, would profoundly affect the international monetary and political system. It is possible that a collapse of the euro area would set back political integration in Europe for decades, if not forever. Probably out of the rubble would come a strong new D-mark and a new currency area around it. It would involve a devastating loss in strength to Nato and could have tragic implications for European security if the temporary decline in US power persisted.
Of course, some might take heart in the soaring dollar. Before the D-mark area in the 1980s and the creation of the euro in 1999, the dollar was alone as the dominant global unit of account and reserve money in the world economy. The creation of the euro split the mainstream core of the world economy into a dollar area and a euro area. A break-up of the euro area would, to some extent, reinstate the dollar as the world currency and the rest of the world would be stuck with no alternative to financing the massive US debt levels. But the gain to the US from the increased strength of the dollar would be more than offset by the diminution of power of her great ally.
Is a lasting solution to the euro’s problems dependent on progress towards reform of the global system?
There is not at present anything I would call a ‘global system’. The system of fixed exchange rates endorsed at Bretton Woods was a global system. Its purpose was to end the chaos and instability of exchange rates of the inter-war period. When the International Monetary Fund (IMF) endorsed ‘managed flexible exchange rates’ in the late 1970s, it did away with the substance of the global system, while retaining the bureaucracy of the institutions. The Bretton Woods system of fixed rates from 1945–71 was a period of strong growth, high employment and low inflation, without the terrible crises since that time. I believe it would be useful to go back to a fixed exchange rate system anchored to a stabilised dollar-euro rate and coordination of US and European monetary policies.
But even a good reform of the international system is not going to solve Europe’s debt problems. No fixed exchange rate system can outlast gross fiscal imprudence.
What I meant was this: assuming the Europeans in the eurozone got their act together – say, they leap into a federal system as you suggest – the euro area would still be subject to great strains from swings in the euro rate against the dollar. In the absence of wider international reform, is it possible to make Europe by itself ‘an island of stability’?
I don’t believe Europe can be an island of stability any more than the US can with the huge swings in the dollar-euro rate, which I think precipitated both the Greek crisis and the Lehman et al crisis. You see, in the old system, as also under the gold standard, a small change in the exchange rate precipitated immediate changes in monetary policy. This doesn’t happen under the current non-system, and that is why the US got into the catastrophic third quarter of 2008 when the dollar soared by 30% against the euro.
How did euro-dollar rate swings precipitate the Greek and Lehman crises?
Exchange rate swings can have a big impact on an economy and its financial situation. The effect depends on how large they are and partly on what caused the swings. While a strong dollar that arises from a booming export market is beneficial (to the US), an appreciated dollar that arises from financial stringency may be detrimental. The weak dollar and easy money in the late 1970s brought about a weak dollar and double-digit inflation, while the soaring dollar in the early 1980s brought about the 1982 international debt crisis and the US 1982–83 recession.
A similar sequence in the financial crisis of 2008 was even more spectacular because of large swings in the dollar-euro rate over an incredibly short period of time. The build-up to the all-time-high-point of the euro against the dollar of $1.64 in June 2008 weakened the debt-deficit positions of the euro area by cutting the euro area’s nominal growth rate, weakening fiscal revenues, cutting exports and worsening the net capital position of debtor countries. The apex of the euro debt crisis was put off temporarily, largely because of the euro’s dive after June, at one point reaching $1.24 in October.
But exchange rate succour for the euro area was devastating for the US economy. The dollar rose and gold fell by 30% in the next few months while the price of oil tumbled from $148 a barrel to less than $35. This was tight money with a vengeance, and the cost-of-living index duly complied, with a drop from the annualised June level of 5.5% to 0% by the end of the year and -2% in March 2009, the month when – six months late – QE1 commenced. No wonder the system crashed!
How did the soaring dollar affect the crisis?
It aggravated the fall in housing prices, increased foreclosures, reduced export demand and brought about the near-failures of Fannie Mae and Freddy Mac saved only by government bailout. It also made Lehman Brothers too expensive for foreign buyers, and government failure to intervene led to the biggest bank collapse in world history.
Euro area governments have always tried to keep discussions of the euro to European bodies and heads of government, discouraging discussions in international fora. Is this a mistake?
It is to be expected that Europe knows its own self-interest better than others. But they were wrong in this instance because at the beginning they greatly underestimated the magnitude of the problem – as did most others. It was better to have the IMF included in the bailouts both because of the additional financial support and because of the readier technical assistance from the IMF. I suppose that Europeans feel ‘possessive’ about ‘their problem’ just as Americans might about California’s fiscal problem.
In March you gave a speech at a conference in Nanjing in the presence of several world leaders. What was the message of your speech?
My message was that the dollar no longer represents the mainstream core of the world economy, as it had since the first world war and especially during the Bretton Woods era. This means it is no longer nearly as suitable as an anchor for other currencies that want to fix exchange rates. The weakening of the ‘hegemony’ of the dollar was begun with the formation of the European Monetary System in the late 1970s and the D-mark bloc that finally turned into the euro area. With the creation of the euro, Europe’s monetary power became concentrated in that single asset and this was the ultimate blow that undermined the universality of the dollar. The problem wouldn’t have been so serious had the dollar and euro fluctuated within narrow margins of each other, but the policy of both the Fed and the ECB has been to allow, if not even encourage, huge gyrations of the dollar-euro exchange rate.
It is a matter of the highest importance to both the eurozone and the dollar area to keep fluctuations of the dollar-euro exchange rates within narrow bounds.
How?
There are many ways, but the easiest and best between two large countries of comparable size is for each country to support the foreign currency at its low point. For example, suppose the low point of the euro were set at $1.20 and the low point of the dollar at $1.40. Then the Fed/Treasury intervenes to buy euros at the former price and the European Central Bank (ECB) intervenes to buy dollars at the latter price. The advantage of choosing lower limits rather than upper limits is that the market has to believe that neither bank will run out of its own currency!
After elaborating on this point, I discussed ways in which the Fed and the ECB would stabilise the exchange rate within margins and back this up with the coordination of monetary policies that is necessary for equilibrium in a common monetary area. If that could be achieved it would restore the mainstream core with about 40% of world output, and it would then be a comparatively simple matter to include China in the arrangement, along with an agreement on eliminating sterilisation of money flows that perpetuate disequilibrium in the balance of payments.
What response have you had?
At that meeting the officials seemed very interested, but perhaps doubtful that a political agreement could be reached between Europe and America on that subject. The big problem is that it requires leadership and that is usually up to the politicians. Unfortunately, politicians don’t like to talk about exchange rates.
Would such a system, bringing in China, mean that China also would be subject to discipline?
Yes. If China could no longer sterilise proceeds from intervention, its payments would automatically be brought into equilibrium.
Meanwhile, global net current-account imbalances persist and may be growing larger again. Are they harmful? Do you see a direct connection between these imbalances and the Great Financial Crisis?
You have to make a distinction between the two major ‘culprits’ in this case: the US and China. The US spends about 4% more than it produces, giving rise to its large deficit, and part of that is due to the role of the dollar in the international monetary system. The US deficit is the way in which the rest of the world accumulates dollar assets in their reserves. The deficit gives the US a higher standard of living, but it could ultimately weaken the US if dollar reserves in the rest of the world became too large a proportion of the US money supply.
The other big imbalance is China’s surplus. This surplus has lasted more than a decade. It persists because, in its effort to control inflation, China sterilises its surplus. The surplus is good for China because it allows China to maintain a net creditor position in the world economy at the same time it is developing on the basis of imported capital.
Big changes in US monetary policy and the US deficit can have a big impact on the rest of the world. The best examples are during 1979–84, when expansionary monetary policy was reversed and the soaring dollar brought on the international debt crisis. Something similar happened in 2007–09 when first easy money and a low dollar was followed by the soaring dollar that bankrupted so many financial institutions.
Many view a world currency as a mirage because there is no prospect of a world government – no world central bank, so no world currency.
You could say the same for a lot of things. For example, No world government, no world peace. It is true that a world government would make it easier to have a world currency. But it is not a sine qua non. Under the gold standard you got something close to a world currency without hardly any political integration.
A monetary union involves a concession or sharing of sovereignty. Under the gold standard, countries voluntarily gave up monetary independence in exchange for the benefits of a common global standard. Today, we live in a world of state money with managed paper currencies. You could have a global monetary union if countries agreed to share a common reserve currency. But it would only survive in a world of peace and it could only be negotiated if the world were a security area, ie, a war-free zone. The gold standard itself was not war-proof.
Remember that in 1941 President Roosevelt asked his Treasury secretary, Morgenthau, to make plans for a world currency after the war and that started the ball rolling that led to the British and American proposals at Bretton Woods. Both contained plans for a world currency. As it turned out, the 1944 Bretton Woods agreement did not incorporate a world currency. But less than 25 years later, there was 1967 IMF agreement on the special drawing right (SDR), a kind of gold dollar, that was at least the embryo of a world currency. This was to correct an omission in the IMF agreement. The SDR was not successful so we are not even as well-off as we were, from the standpoint of an international money, in 1944. But the creation of a world currency today, or even a movement toward a fixed exchange rate system of the kind that existed at Bretton Woods, would itself be a catalyst for a desirable increase in global cooperation and coordination.
The gold standard promoted global financial and economic integration without a world government. Should we look to a standard, not a currency?
It is not easy to create a standard out of the blue. Most monetary standards have historically piggy-backed on their predecessors. Thus the pound sterling originated as the weight of silver that was equal to one Roman libra, which was equal to five gold aurei, or bezants. The dollar in the late 1930s was as good as gold and it became widely used even after it became inconvertible. It took a long time for the dollar to become as widely known as it is today and it would not be easy to duplicate this with a new currency unless it were anchored to something equally familiar.
The only two independent paper currencies today that have a chance as a global unit of account are the dollar and the euro. Other currencies could become important but only insofar as they are at least indirectly convertible into one or the other of those currencies. All ‘universal’ global units of accounts have been based on one or both of the precious metals, except for the dollar – which started as the ghost of gold – and the euro (the ghost of the dollar). We have no basis for thinking that a standard can be created on its own. It would be like trying to replace English with Esperanto as a world language.
This goes to the distinction you often insist on between the unit of account function of money and other functions.
Keynes wrote that money of account is the primary concept of money. The age of money replaces the age of barter when a unit of account has been adopted, and the age of state money begins when the state declares the right to determine what things should answer as money to the current unit of account. Today, all civilised money is, without dispute, state money. The entire world became Knappian (G.F. Knapp, author of The State Theory of Money (1905). He was the first economist to describe a world of fiat currencies.)
The creation of money has been historically associated with the nation state. Money became political when money creation became a fiscal resource of the first magnitude. Inflation became a means of imposing unofficially a capital levy in all countries where government debt became an important ingredient in finance. When in the 1930s the US Supreme Court denied the validity of gold clauses it solidified the role of money as a fiscal resource and the primacy of the unit of account function which is under the control of the state.
In a TV interview recently you said that tying the dollar and the euro to each other and to gold could be one way the world could move forward to a better monetary system. What kind of link would work best?
I believe strongly in the need to fix the dollar-euro rate and have coordination on policies. With respect to the gold part, I was responding to a question about whether gold was dead. I said it was as far as creating a gold standard of the kind that existed before the First World War. But I said it was not necessarily dead as far as using gold as an asset for central banks to trade among each other at a fixed price. For that to occur, the price of gold would have to be fixed in terms of some currency. The US fixed the price of gold in 1934 and that lasted until 1971. The US in 1948 held 70% of the world’s monetary gold stock. But that system broke down after the inflations of three wars and massive gold sales from the US to Europe. If anyone were today to fix the price of gold it would not be the US, it would have to be Europe.
Can you conceive Europe taking such a step?
I doubt Europe would do it unilaterally. If the dollar-euro rate were fixed with coordinated monetary policy between the US and Europe, it might be conceivable to have a joint fixing with an agreement to sell gold at a high price and buy it back at a much lower price. To organise that arrangement would take strong leadership on both continents. There are also other options that might be better, including the dollar-euro fix without any initiative, at least at the moment, with respect to gold.
Which would be the best monetary standard?
From a technical point of view, the best monetary standard would be to ‘dollarise’ the whole world (or as many countries in it that want to participate) and have an International Monetary Council to govern the Global Reserve System for the benefit of the world economy. A single currency, managed in such a way as to be reasonably stable, would contribute to making the world economy as stable and efficient as the US economy. Of course it would only work if the political details could be worked out. If only North America and Europe joined, it could be called the Atlantic Monetary Council.
What would require a common monetary policy? What would be the objectives of such a policy?
The proposal would solve the problems caused by the split in the world economy into large currency zones – the dollar and the euro area – and bring all countries fully into a global system. It recognises that the benefits claimed for flexible exchange rates are illusory. As I have maintained for many years, the theory that exchange rate changes improve the balance of trade of countries with depreciating currencies is a fallacy not generally subscribed to by any of the great economists.
It almost goes without saying that such a standard would require close monetary coordination. Uniting Europe and the United States monetarily would mean a common price level and inflation rate and agreement on joint monetary objectives.
What should be the monetary policy objective?
The monetary policy target of the Atlantic Monetary Council would be to preserve the value of money.
So it would be a world (or North Atlantic) central bank with an inflation target?
No, a simple inflation target – for example, targeting some definition of consumer prices – is a naïve idea. It has not proved a good guide to those central banks that have adopted it in recent years. Prices have to be allowed to go down, as well as up. The aim should be to preserve the value of money over the longer term.
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