Mundell on the Euro Jude Wanniski March 25, 1998

Many of you probably took the time to read the WSJournal op-eds yesterday and today by Robert Mundell, the most important economist of our time. The unprecedented amount of space given the treatise on the euro by Bob Bartley, the editor of the Journal, is only one indication of its importance. Lengthy treatments on the euro are appearing everywhere, but I have not seen any that are worth commenting upon or reprinting for you until Mundell’s. Despite the fact that he has not yet won a Nobel Prize in economics, his students are in important positions throughout the universe of international financial institutions. What he has written for the Journal will be taken seriously in Brussels as the euro architects attempt to figure out how to make it work when it is introduced next year. Mundell, now 65, was the Canadian wunderkind who became chief international economist of the International Monetary Fund in 1961, when he was 28. He was the prime mover in reviving classical economic theory, which became known as supply-side economics in the late 1970s. However, his ideas were defeated at the IMF in the 1960s by the neo-Keynesians, led by James Tobin of Yale, where they still hold sway under the leadership of Michel Camdessus.

In recent years, I’ve asked Mundell several times about the lack of progress on the design of the euro, specifically how the Europeans could ever hope to make it work without a gold anchor. Mundell, who thinks in terms of epochs, dismissed my concerns and said that as they got closer to the target date, they would realize they will have to think about gold. He seemed to think that to bring up the subject before they were ready to think about it would be a waste of time, which is why his decision to speak out now suggests the timing is right. Some of you who read Part I in Tuesday’s WSJ may have wondered how he could devote so much space to discussing the wonders of the euro without mentioning gold. I said we would have to wait for Part II, as I expected Mundell would “sneak gold” into the equation. I remember Mundell telling me more than 20 years ago that gold would have to be “snuck” into the new international monetary system when the world was ready for one, because it was so demonized by the economics profession after WWII. In order that President Richard Nixon be persuaded to abandon gold in 1971, the demand-side economists representing both Keynesians and monetarists had to ridicule it as a “barbaric metal,” according to the former, or “no better than pork bellies,” in the words of the latter.

 In today’s Part II, he does indeed sneak gold into the equation, on tip-toes. First he gives us a history of monetary events since the first world war, when the dollar replaced the pound sterling as the dominant money. I disagree with many things in Mundell’s account of this history, but I’ve also learned over the years that when he writes in this manner, he speaks in the language of the Keynesians in order to influence them in the direction he wishes them to go. Mundell, for example, does not believe a nation’s “savings rate” is important, but in his piece today he warns it is too low, because it is a matter of faith among the demand-side professionals that this is so. He also warns about the continued use of the dollar as the primary currency for the world, in order to assure the Europeans that he is not a nationalist on these matters: “While the dollar will continue to be an important part of the international monetary system -- and perhaps remain the most important currency for years to come -- it is no longer necessary or even healthy for the U.S. or the rest of the world to rely solely upon the dollar.” We can see the Eurocrats smiling at this.
 
Amidst all the silly talk about the euro making gold obsolete for European central banks, with predictions they will sell it and send its price plummeting, Mundell introduces a note of caution (a stick) and a word of promise (a carrot). Now we see him sneaking gold into the euro. “It would be a mistake to think that Europe’s interest would lie in dumping large stocks of gold in a sell-off. None of the big holders have any interest in depressing the price of an important reserve asset. But Europe may find that its gold holdings have a hitherto unnoticed use in building confidence in the euro.” Yes, the euro eventually will be a great currency, taking its place alongside the Roman denarius, the pound sterling of the British empire, etc., as Mundell gushes forth praise. Alas, “It is also necessary to note, however, that the euro will have two unique weaknesses compared to its great predecessors. First, the euro starts out as a pure fiat currency not linked to gold. Second, the euro is not produced by a strong central state. These weaknesses would be potentially lethal were it not for two mitigating factors: Europe’s large gold reserves will help to overcome the first weakness. The second weakness will be overcome in the short run by the military alliance of NATO and in the long run -- perhaps -- by European political integration.”

The NATO stuff is also window dressing for what comes next. Mundell posits the likelihood of a chaotic transition, as central bankers and other portfolio managers shift from one set of reserves to another. The dollar could get pummeled. “Both the EU and the U.S. would need to take strong defensive action to ease the transition. Neither area would welcome a significant depreciation of the dollar. It is unlikely, however, that bilateral handling of the problem would be amicable. It would be safer to recognize that a problem will exist and create an institutional framework for dealing with it. (One possibility would be to establish a ‘conversion account’ under the auspices of the International Monetary Fund, authorized to accept deposits of gold, dollars, and euros in return for credit balances denominated perhaps in Special Drawing Rights, redesigned to account for the euro.)”

Aha, there we have it. If such a mechanism were created, the euro would be defined in terms of gold and so would the dollar. No other possibility exists. The dollar currency area that covers the western hemisphere and the euro currency area that covers the most productive part of the eastern hemisphere would be on a gold standard. (Shhhh, Mundell would say. It is a “conversion account.”)  What about Asia?: “It is probable that monetary union in Europe will provoke steps toward an Asian monetary bloc, spearheaded by Japan, China or the members of the Association of Southeast Asian Nations.” If asked, my guess is that Mundell would tell you that the Asian member nations of the IMF would have access to the “conversion account” as long as they deposited gold or dollars or euros, and agreed to abide by the convertibility rules. Japan has already signaled a willingness to discuss an Asean currency bloc. You may remember my “Open Letter to Anwar Ibrahim” of Malaysia (10/14/97), urging him to get the Asian/Islamic world together behind a common gold currency. It is really very easy to do, but Mundell knows it must be made to sound difficult because the thousands of people making six-figure bureaucratic salaries need to justify their wages and the myriad conferences they hold from spa to shining spa.

When you puzzle at the steady upward march of the Dow Jones Industrial Average, always remember that the upside has to do with the peace dividend, which will continue as long as peace exists. Mundell may have lost to the Keynesians when he was 28 years old, but he is a patient man, and still not too old to enjoy sweet victory. The senior staff of the IMF threw him a 65th birthday party last fall. He also celebrated a few weeks later when his wife Valerie gave birth to Nicholas, the newest supply-sider, another peace dividend.