Interview transcript

Professor Mundell, first of all, congratulations to the reward.

Professor Robert A. Mundell: Thank you.

And second, you’re very welcome now to the Nobel Foundation for this discussion or conversation. You were rewarded for, in particular, having provided the basic tool of analysis or model to help us understand how economic policy functions in a world with high international mobility of capital. And how monetary and fiscal policy have different effects on national economies if we have floating exchange rates or fixed exchange rates. What was the inspiration of your work? To what extend was it that you looked up the world and saw some problems? And to what extent were you inspired by peer groups, by other scholars, by your teachers, etcetera?

Professor Robert A. Mundell: Well, my first inclination is to say all of the above. But all three of those were important. But in my early days, I wrote my dissertation for MIT at the London School of Economics, really under James Meade, but my dissertation was five chapters on the theory of capital movement, but it didn’t mention money. Money was not … it was a pure development of the classical model to which its higher form is, I think it had been developed, and so there was no monetary or macro, what you would call, what we would call macro considerations, in it. But in the … after I had completed that framework, I felt that now that was a very safe and good box to have for studying economic, long running economic problems, but it wasn’t a good way of analysing, of course, exchange rates and financial problems that hadn’t been modelled in the international economy. And it was then the attempt to find a way of modelling it that became important. And where, I think, the breakthrough in my own thinking of this occurred was with the development with what became my paper. My first paper and most important paper on this model was published in the Quarterly Journal of Economics in May 1960, with the monetary dynamics of fixed and flexible exchange rates.

And in that paper, I think the key element, breakthrough, that I thought for myself that I was making was in the seeing the economy as determined by a combination of two basic macro economic conditions. One is equilibrium in the goods and services market, and equilibrium in the foreign exchange market. And so that led to a kind of international counterpart, if you like, of an IS/LM framework, and so had one curve which gave us macroeconomic equilibrium which was very similar to a kind of generalised IS/LM curve, but with exports and imports in it, and then the other curve was a balance of payments equilibrium equation. And then interest rates and exchange rates would then be the principle variable thing, determining that kind of equilibrium. Now for me, that was an illumination of thinking because it was a way in which I could quickly move from that framework into a general equilibrium framework and put as many markets in as I wanted.

Could you say that to some extent that you were inspired on the domestic equilibrium from Hick’s analysis, that always dominates thinking for closed economies?

Professor Robert A. Mundell: Yes.

And then you introduced the international aspects for capital movements. James Meade has had some interest in this, but he was never able to develop a general model. He looked at different cases.

Professor Robert A. Mundell: Yes.

Your main contribution I think was that you made some general analysis which meant that previous analysis fell out as special cases of your general approach.

Professor Robert A. Mundell: Well, Meade’s work was … the part of Meade’s work that was … could have been relevant was in his mathematical supplement to the balance of payments, and in that model he had some kind of integration of the Keynes’ and Hicks‘ formulation that was good, and somehow I never picked up on that. It was … of course, I sat there, but he never did anything with it himself, he never seemed to bring that into his, any of his analysis, and … I was working when I was thinking about that in terms of the classical version of the model, not when I was writing my thesis, working, thinking about Meade. But it was in Chicago, I think, where I discovered I say, I mean I first read Metzler’s work, on … saving the rate of interest. And I should say it was rather Metzler’s work that that was the closed economy version of what became my first paper, the first major paper on this, on the macro side in 1960 on monetary dynamics.

So the dynamic part of it was very much from Metzler?

Professor Robert A. Mundell: No, of course Metzler in … this whole framework that was flowering at Chicago at this time, but the dynamics were of course completely different from Metzler’s because the subject was different. But the pattern of development was the same. Simonson and Metzler in all my dynamic works, just as Metzler was in a way a student of Paul Samuelson, I mean a colleague of his, but it was Samuelson’s dynamic analysis that spurred everybody, despite of me, and I learned that very well. And that shows it, so it was a combination of a little bit of Metzler, definitely Metzler and Samuelson. Samuelson’s technique, Metzler’s analysis of the closed economy dynamics and then my formulation of that in the framework of two grand markets, the dominating policy making in the international economy. And then later became, this is the point I wanted to make, this is 1960 and I think that paper was the most important paper I wrote.

And I came up with a formulation that was really quite different from what the others had thought,  …

And then subsequently in my other papers, Kyklos and The International Disequilibrium System, 1961. That was an important paper but that took the framework of the much more the IS/LM framework, the Hicks IS/LM framework, that was not a Metzlerian type paper, that was more a Hicksian type paper in the open economy. Hicksian with Metzlerian and Samsonian dynamics in it. And then came the work on the monetary fiscal policy mixed with the IMF, and that was a question, partly, a question of selling. It was a question of people … I thought, with Jack Polak when I came to the IMF, Jack Polak was there, Fleming was away, and Polak asked me to work … study this question that caused Hicks so much controversy, on the appropriate monetary fiscal policy mix for the United States. And everybody was saying different things about it. And I came up with a formulation that was really quite different from what the others had thought, and evolved the policy mix idea that was important. But then this was put in the Keynesian type framework because the desire … everyone’s speaking Keynesian language in order to communicate with the communists at that time, it was necessary to speak the Keynesian language.

And then later this paper, which is published in March 1962 in Staff Papers, came under attack from the Federal Reserve. Of course, remember I was arguing that the United States should shift its policy mix from the current what was called the Samuelson-Tobin neo-classical synthesis of lowering interest rates to expand growth and have a budget surplus to siphon off the inflationary effects of that. I was arguing this policy mix would move away from equilibrium. You had to reverse it completely. So it was subject to attack, couple of attacks from the Federal Reserve papers on that, so I decided then I had to underline the point very clearly and what I assumed in that IMF paper was there was some degree of capital mobility.

But in order to make my points more clearly in this more sharper framework, to respond to the criticisms from the Federal Reserve, I assumed perfect capital mobility. And then this is the model that some people consider the Mundell-Fleming, or my part of the Mundell-Fleming model. But actually the Mundell-Fleming model started in 1960 with those other papers I did, and it doesn’t matter so much whether you use a classical or a Keynesian framework for them because the structure is the same. You see, in a general equilibrium system, you have one set of assumptions of rigid prices and flexible output. In the other you have rigid output and flexible prices. And the isomorphism is there.

This is very much the international background, but at that time in the world economy, most countries had fixed exchange rates, the Bretton Woods system, and also international mobility of capital was very low. Still, you emphasised the international capital mobility and the floating exchange [- – -] Where you influenced by the fact that you were a Canadian, that Canada had this somewhat special regime? Canada had the floating exchange rate from time to time and maybe capital mobility was higher also between Canada and the United States? Was your Canadian background important for your inspiration?

Professor Robert A. Mundell: I know that my Canadian background is important for both this and for the optimum currency areas framework. Definitely the fact that Canada had a system of the first country to have flexible exchange rates. It’s not really clear to many people, people don’t understand. I don’t think anyone’s ever told people why Canada has had flexible exchange rates. It had a fixed exchange rate and exchange controls in the late 1940’s. And then Britain in September 1949 devalued the pound 30% devaluation, to 2 dollars and 80 cents from 4 dollars and 3 cents. And Canada, the Canadian government for some reason, without any basic theory, devalued the Canadian dollar by 10%. The sort of idea is well we’re sort of in between Britain and the United States and we’re closer to the United States than we are to Britain economically, so we would go 20% or we would go 10%. But it was a mistake. A weighted average, exactly. Maybe a trade. But it was a mistake because there was nothing in the Canadian economy that said they should have devalued. But they did devalue.

But very soon after there was an influx of capital coming into Canada, then the Korean War broke out, raising the demand for Canadian products and raw materials. So Canada was engulfed with capital. What they should have done is just appreciate the Canadian dollar back to a parity where it was, but they couldn’t do that without appearing to have made a mistake in 1949. So they floated. And then they left this out and there was a big discussion with the IMF. And anyway, Canada had all through the 1950’s had a floating exchange rate. It didn’t float very much. It floated upwards. It went up to a premium against the Americans and then they had to talk it down and they had to … they didn’t like the way it was working and so they ended up going back to fixed rates. But I was definitely saying you needed a model to study flexible exchange rates. But what models existed to study? There is in the open economy there was the matrix multiplier type, two country multiplier and matrix multiplier type model, and these models had no monetary policy in them, they just assumed interest rate … and money wasn’t in it. And then there was this very good paper, excellent, very important paper by Laursen and Metzler which had two economies, two markets, goods and services markets and the balance of payment equilibrium with flexible exchange rates.

So that was the first model you had of a flexible exchange rate system, but it was in the context no money was in it, but you had flexible exchange rates and you … they have to be interpreted as real exchange rates. But it was a very ingenious paper and a very important paper. And that paper assumed no capital movements because they had controls over capital movements in the assumption in that paper. Well obviously, in the Canadian context that didn’t work, because after Canada had a floating exchange rate, after a while it took away its controls, there was no function to have … controls anymore And you had perfect capital mobility effectively between Canada and the United States except for the two currencies which always prevents an ideal situation from developing, you had capital that was completely free to move between Canada and the United States. So this was a natural IFM modelling, fixed or flexible exchange rates I model world of capital mobility. I agree with you, it was the … Canadian background there was quite important.

You mentioned your other important contribution, the so-called theory of optimum currency areas. Instead of asking the question “Should a nation have floating for fixed exchange rates?” you re-formulated the question and said “In which areas should people chose, regardless of nation states, fixed, floating rates, or should they form a monetary union?” And of course this idea about monetary union has become more and more important over the years, and the most important development recently of course is the European Monetary Union has been established. Do you think this was a good idea to create the European Monetary Union? Your theory of optimum currency areas emphasised the importance of high labour mobility within an area that had a common currency. And many people believe that Europe does not yet have that kind of labour mobility. And many people think that Europe is not the optimum currency area by your definition. What is your reflection about that? What do you think about the idea of European Monetary Union?

Professor Robert A. Mundell: Yes, it just is for the background on that and the paper on optimum currency areas and the first paragraph I think ends with something to the effect that we talked about the argument for flexible exchange rates being based on money illusion etc., and then it said this paper casts doubt on one of the alternatives to adjusting the terms of trade through flexible exchange rates. And so this paper has to be looked upon as really a kind of criticism of flexible exchange rates and with the conclusion that unless currency areas were contiguous with regions defined by factor mobility. That was the point. So you can look at that in two ways. I was … here again the Canadian influence is important. I first gave that paper in 1957 at a faculty seminar at UBC British Columbia, and what I did was to argue that flexible exchange rates between Canada and the United States wouldn’t help British Columbia if there was a decline in demand for lumber products in here at terms of trade problems for British Columbia or something of that nature. Canada/US flexibility wouldn’t help. You’d have to have a separate currency for BC in order to apply … British Columbia, in order to apply the arguments for flexible exchange rates and that would be true in any country with multi-regions or with zones in the country of inflexibility.

So it was really the genesis of the paper was in large part that flexible exchange rates aren’t going to do what people think they’re going to do because in between Canada and the United States this wasn’t … and I still believe that it doesn’t really, it isn’t a good system between Canada and the United States and between other countries that have money regions. If you have flexible exchange rates between Italy and elsewhere it doesn’t help the problem between the North and South of Italy. It doesn’t help the problem in the different parts of Spain, the different parts … etc., etc. So you could if the argument for flexible exchange rates were really valid you really should separate countries up into smaller and smaller regions. The only trouble is that as you do that you lose more and more of the functions of money, and as the regions get smaller and smaller the basic argument for flexible exchange rates begins to break down because as the region gets smaller it becomes more open, and then you can no longer assume that workers have this money illusion that they’re going to not see the link between the exchange rate and domestic prices and their wage rates. So that was the argument.

So what will happen with the dollar now when you get the European currency? Will that out-compete the dollar in world economy or is dollar so strong that it will stay as a dominating currence in currency world?

… in 12 years time that Euroland is going to be considerably larger than the dollar area of the United States itself.

Professor Robert A. Mundell: We have the short run aspects of this and the intermediate and long run aspects. The long run growth of the dollar area and the Euro area will depend in a large part on the growth of population in the economies. I can see certainly that right now you can think of the GDP area, the transactions area of the dollar is now about … US GDP’s about 9 trillion, and the EU 11 countries have a GDP of about 7 trillion, but as the other countries come into the Euroland, as Sweden and Britain, Denmark and Greece, and I think they will come in maybe three or four years, we don’t know, but I think they will come in, and as countries in central and eastern Europe start joining either by currency boards or coming completely into the Union, by the year in 12 years time that Euroland is going to be considerably larger than the dollar area of the United States itself. Now of course the dollar area is likely to grow because there’s a growing movement in Latin America to link some more currencies to the dollar, just as the Euro area is going to grow. But certainly in getting up to say a dozen years from now, you can imagine that most central banks would want to hold their assets about evenly balanced between Euros and dollars.

So there’s going to be a big demand if you get to that steady state of equilibrium, a big annual demand for Euros because the euro is very underweight in terms of portfolios of all around the world, compared to what the equilibrium certainly will be in a few years. So you could imagine a demand, an annual demand for Euros even with no growth of dollars of something like 50 or 100 billion dollars every year and this is going to have a big impact on exchange rates, that is going to add greatly to the strength of the euro against the dollar.

But doesn’t that depend if the increased demand for the euro were to happen with the exchange rate must also depend on to what extent Europe increases its supply of Euros.

Professor Robert A. Mundell: Of course, to the extent that this does happen. The money supply in Europe will have to expand.

To satisfy increased demand.

Professor Robert A. Mundell: Just when European currency gets introduced in the middle of 2002, you have right now in the United States outstanding currency produced in the United States might be 350 or 400 billion dollars, but two thirds of that is outside the United States. Only a fraction of that is held by Americans for pocket cash. So you’re going to get the same phenomenon working with Euros and people are going to balance their portfolios, dollars and Euros as the two super currencies in the world.

Okay. It was nice to talk to you and thank you very much for devoting your time to this interview. I know that you’re busy in Stockholm. Thank you very much.

Professor Robert A. Mundell: Thank you.

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