The Importance of Being Mundell Jude Wanniski October 13, 1999

The announcement out of Stockholm that Bob Mundell is this year's Nobel Laureate in economics was both exciting and timely. We have been waiting at least 15 years for this to happen, not simply because it is a nice honor and a million dollars for a deserving fellow, but because it gives him the standing to consolidate the supply-side revolution he began. It was this 67-year-old Canadian who now professes at Columbia University, after all, who was the prime mover in seeing the basic rot in the world economy that developed out of various demand models that surfaced out of the Great Depression. If it were not for Mundell, Ronald Reagan would not have been elected President, there would have been no supply-side tax cuts, here or around the world, and we would not be smiling at a Dow Jones Industrial Average above 10,000 with no inflation. The prize is timely in that for the last decade -- during what we might call the Bush/Clinton demand-side counter-revolution -- Mundell for the most part has been on the sidelines. He gives a speech here, writes an article there, but always is constrained by the fact that while the economics profession has admired his genius, it has resented his role in threatening its neo-Keynesian and Monetarist paradigms. The prize now permits him to speak out more forcefully to protect what he has wrought, at a time when it is under attack almost everywhere -- by a Federal Reserve fighting "inflation" with unemployment, a Republican Congress that has reverted to the Old Time Religion of austerity on taxes and spending, and strains appearing in Europe over Mundell's favorite baby, the euro.

The prize, after all, is technically for his work in 1960-63 on optimal currency areas, when he was chief international economist for the International Monetary Fund. As you might guess from the term, the work provided the intellectual foundations for the euro, which is now in its infancy and suffering the kinds of growing pains to which he alluded in his two-part Wall Street Journal op-ed a year ago. As the price of gold has risen from the euro's starting point on January 1, there have been variable effects on the eleven nations. These extract varied social costs, which could cause political disenchantment with those most affected due to tax-rate arbitrage, that were not anticipated by the Eurocrats who did the final designs.

Our David Gitlitz now sees it in Germany, where the year-old Social Democratic government of Gerhard Schroeder already is entering a state of political paralysis. With social-welfare spending rising and tax revenues flat, Schroeder is proposing an "austerity" budget to meet EMU deficit requirements: A roll back of various welfare-state provisions, including subsidies for the East, under the non-Mundellian argument that budget cutting will in itself pave the way for stronger growth. Even Germany's proposed corporate tax cut would be offset by a new wealth tax. But with unemployment showing no signs of ebbing from levels around 10.5% (and nearly twice that in the East), Schroeder's political support is dwindling, as seen in the SD loss of four state-level elections in the past month, and the budget standing little chance of passage as proposed. An opposition proposal to cut the top marginal rate from 53% to 35% is being dismissed by the government as a budget buster that "cannot be taken seriously." Under the current governing paradigm, in all likelihood it will not be. The problem has developed because of the incorrect design of the EMU; there will be more pain ahead for the EMU "have-nots." To a degree, the most affected governments can defuse the political unrest from dead-end economic prospects by piling up the welfare-state guarantees. That only means higher tax burdens and less economic growth.

The strains on the euro could be insurmountable with inflation, which Mundell would see presaged by a rise in the price of gold. In his WSJournal series, Mundell noted that while the euro eventually will be a great currency, "It is also necessary to note 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," as were the Roman denarius, the British pound sterling, and the U.S. dollar. He warned the European central banks against "dumping" their gold reserves, as "Europe may find that its gold holdings have a hitherto unnoticed use in building confidence in the euro."

It is for this reason I expressed hope this morning, in an e-mail to Mundell, that he fortify the arguments that Jack Kemp made in his two letters to President Clinton about Y2K. The United States may get through Y2K with only lost output that later could be made up with faster economic growth. But if the dollar price of gold climbs as the result of errors by the Federal Reserve in responding to the shifting liquidity demands of Y2K, the impact on Euroland easily might cause so much social distress that the experiment in monetary union would be set back for a generation. Where President Bill Clinton brushed off Kemp's June 11 letter urging a temporary fixing of the dollar to gold to get through Y2K, it would make a greater impression on Treasury Secretary Larry Summers, who calls these shots, if the new Nobel Laureate urged him in that direction. Summers is no supply-sider but is wary of Mundell, who got his Ph.D. when he was 23 from Paul Samuelson at MIT in six months! Summers is Samuelson's nephew. Michael Mussa, who is the chief economist at the IMF, was a student of Mundell's at the University of Chicago. So was Jacob Frenkel, who heads Israel's central bank. Mexico's booming economy ended as soon as the Salinas administration gave way to the Zedillo administration -- with Mundell's student, Francisco Gil Diaz, losing influence and students of Yale's James Tobin rising in ascendency and instigating the peso devaluation.

It was a struggle between Mundell and Tobin in 1960, which Tobin won, that brought on the international turbulence of the last 40 years. The Nobel Committee only alludes to it. It was Tobin who argued that fiscal policy should be used to contain inflation and monetary policy to spur growth. Mundell insisted Tobin had it backwards. You keep monetary policy tight, tied to gold, to fight inflation. You use fiscal policy -- cutting tax rates or increasing spending on public works -- to combat recession. Tobin, who was a member of John Kennedy's Council of Economic Advisors, got his formula accepted by the Establishment, after the Kennedy tax cuts of 1964, which were a residue of the old classical model that we now know as supply-side economics. Kennedy got the tax-cut idea not from his advisors but from West Germany's Ludwig Erhard.

We can be sure that Mundell will speak respectfully about Tobin, Milton Friedman, and all his intellectual adversaries. Now, though, he has the opportunity to defend the Reagan Revolution when the Gipper is unable to defend it with his own biographer. One of Mundell's earliest insights, which he passed on to me 25 years ago, is that like a carpenter, an economist cannot be successful over time with only one tool in his box. He must know all the models and be ready for just the right one to use in a changing world. The supply model is still the right tool to build the foundation for the new millennium.