To: SSU Students
From: Jude Wanniski
Re: The Original Mundell-Laffer Hypothesis
In Lessons #2 and #3 this summer session, I dug out two articles I wrote for the WSJournal editorial page in the fall of 1974 and presented them as “the early days of supply side.” The first was about tax policy, the second about monetary policy and exchange rates. It was in this hothouse period of supply-side economics, September 1974, that the most important intellectual of our time, Irving Kristol, invited me to lunch at the Italian Pavilion in midtown Manhattan. Irving, who I’ve since come to call “Don Corleone,” the godfather of neo-conservatism (and a lot more), was a professor of social science (or some such) at NYU and also the editor of The Public Interest quarterly. He and his wife “Bea,” who writes important books under her maiden name, Gertrude Himmelfarb, are the proud parents of Bill Kristol, editor of The Weekly Standard, whom you see almost everywhere on the TV talk shows.
At our lunch, Irving expressed dismay that the newspapers were filled with articles about how the oil crisis was a plot by the big oil companies, in league with the Arabs. He knew this was foolishness, as I had been writing, and said he would like me to write an article for Public Interest on the economic ignorance of the national press corps. I replied that the problem was not with journalists, but with economists, that the press corps simply operates as a medium of exchange between the people and policymakers. It was the professional economists who did not know what was going on and were providing the lame reasons that were being reported on the front page on the major newspapers and on radio and television. Irving asked me if there were any economists who knew the true reasons for the oil crisis and I said there were only two that I knew of, Robert Mundell and Arthur Laffer, and that Mundell had predicted the events when President Nixon left the gold standard, informally in 1971, formally in 1973, the previous year. Whereupon Irving asked if I could write an article about these two economists. Take up to 10,000 words, he said, and get it to him in six weeks and he would publish it in the Spring 1975 issue. It was this article that came to the attention of Ronald Reagan’s research team and eventually led to my writing The Way the World Works, which provided the intellectual underpinnings for the Gipper’s 1980 presidential campaign.
At the suggestion of a SSU student who had heard about the article and could not find it, I’ve decided this is a good time to publish it on the website, which we will do in three parts for three weeks. Those of you who have been at SSU in recent semesters will realize how elementary it was in its first presentation, but also how the basics have not changed at all.
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The Mundell-Laffer Hypothesis - A New View of the World Economy
The Public Interest
Number 39, Spring 1975
The United States has been passing through an economic nightmare. It seems like just the other day -- and it was -- that American economists of the first rank spoke confidently of "fine-tuning" the economy to assure a predetermined rate of economic growth within acceptable bounds of inflation and unemployment. And even those in the profession who scoffed at the notion of such fine-tuning, those who argued it could not be done in the fashion prescribed by the New Economics, were prepared to assert that other strategies -- usually pertaining to the supply of money -- could be called into play to keep the United States on the magic path of non-inflationary growth.
Obviously, the profession has been experiencing an intellectual crisis. Over a six-year period, the pragmatic Republicanism of Richard Nixon shot into the twitching patient every antibody the economic doctors of Cambridge and Chicago prepared. And always the vital signs declined. Money was tightened and money was eased. Mr. Nixon became a Keynesian and a "full-employment budget" was installed. Deficits were run on purpose and deficits were run by accident. The Phillips curve, a wondrous device by which politicians supposedly could balance unemployment and inflation along a finely calibrated line, was enshrined in the textbooks. The dollar was devalued and the gold window closed. The Japanese and Germans were reviled as being stubborn, and worse, efficient. The dollar was devalued again, then floated. Wages and prices were controlled through varied stages of stringency, and a jawbone was brandished. At the end of all these exertions, many are beginning to wonder whether the patient was sicker than had been thought or whether the medicine has been making him sicker than he was.
To be sure, the academic theoreticians who pushed these various prescriptions will now all argue that their own brand of medicine was not given time to work -- and besides, the patient was poisoned by all those other medicines. They all have a point in that there is rarely enough time in the real world to see a diagnosis and a prescription through; politicians and the public will always want a remedy that doesn't require the patient to get much worse, for very long, before he gets better. That is one of the inevitable political constraints on economic policy, as distinct from economic theory.
But before one laments the constraints that the body politic places on our economic physicians, it is worthwhile seeking out another opinion. It is always possible there is an expert around with a superior diagnosis of our economic illness -- one that does not require politically impossible prescriptions. And, in fact, there are two such experts around today: Robert A. Mundell, 42, a Canadian who is professor of economics at Columbia University, and Arthur B. Laffer, 34, of the University of Chicago's graduate school of business. For the past several years, they have attempted to effect what some would call a "Copernican revolution" in economic policy. And, with every passing year, they are getting a somewhat more respectful hearing from their fellow economists -- though, of course, theirs is still very much a minority point of view*.
It is the purpose of this article to show how the Mundell-Laffer “model" of the world economy works, and why its implications are not politically unattractive -- i.e., would not involve a period of suffering by the world's population in order to achieve improvement. The model is really quite simple and, except for its applications, is not even particularly novel. It is just, as Laffer says, "that nobody's thought much about it this way for about 50 years or so."
One of the reasons the Mundell-Laffer hypothesis is getting a respectful hearing these days is that it easily explains phenomena that other theories can explain only with immense difficulty and complication. Though they are not in the business of forecasting, Mundell and Laffer's predictions of what would happen as a result of particular policy changes have held up astonishingly well these past years. Laffer in 1971 said the U.S. dollar devaluation would not mean a turn from deficit to surplus in the U.S. trade balance. There wasn't one. In February 1973, when the dollar was devalued again, he said it would mean "runaway inflation" in the United States. In January 1972 -- almost two years before the Yom Kippur war -- Mundell said the price of oil, and then of other commodities, would rise dramatically if the U.S. economic policy makers proceeded to do what in fact they did. Later in the year, he said that if the Western economies did what they in fact subsequently decided to do, there would be increased world inflation, a general rise in interest rates, and an accelerated use of the Eurodollar. In 1973, he bet an eminent U.S. economist $1 that U.S. inflation would be far worse in 1974 than 1973, and another $1 that sometime in 1974 the price of gold would hit $200.
Maybe Mundell and Laffer were lucky -- right for the wrong reasons, as some may say. But it certainly would seem to be worth the effort to understand their reasoning -- and, above all, to understand their general view of the economic universe and what it is in this view that fundamentally separates them from the great majority of their peers. Their policy prescriptions - - which derive from a kind of synthesis of Keynesian and classical economic thought -- make no sense unless one shares their perspective on the economic universe. After all, Columbus would have found it difficult to persuade Queen Isabella that sailing west to the Indies was good policy if he had failed to convince her that the world was round, not flat.
The world is a closed economy
This is where they start: The world economy is truly integrated and has been for a long time. The proposition sounds reasonable enough, perhaps even trite. Yet while most other economists accept the idea to a degree, the prevailing analytical approach to economic problems and policy is based on a quite different notion: that the U.S. economy is in large part independent of the economies of the rest of the world, especially now that monetary policies are not linked through fixed currency exchange rates. From this prevailing notion there follows the idea that, insofar as the U.S. economy experiences fluctuations in rates of inflation as the result of the economic policies of other governments, such disturbances are limited in scope by the U.S. volume of trade with the rest of the world. These disturbances must be small, the conventional wisdom argues, because U.S. trade is so small in relation to the whole of the U.S. economy. In 1971, when the dollar was devalued by 13 per cent, virtually the entire economics profession in the United States calculated that, because U.S. trade was only five per cent of GNP, the effect of the devaluation on the level of U.S. prices would merely be 13 per cent of five, or a little more than a half-point on the Consumer Price Index. This kind of calculation can be made only by viewing the United States as a closed economy, "with international relationships grafted on," says Laffer. But, they argue, the U.S. economy is not a closed economy; nor is that of any other nation. The only closed economy it makes sense to talk about is the world economy. One cannot understand the American economy within an American perspective; it must be viewed from the perspective of the world economy.
In simplest terms, what they are saying is that prices are tied together around the world, not only by the volume of goods shipped back and forth, but by rapid communication of price changes. To verify this, one of Laffer's students, Moon Hoe Lee, went to the trouble of studying nine countries from 1900 to 1972. He found that (1) their general price indexes indeed moved in step during the period, as long as their exchange rates were unchanged; and (2) that when a country devalued or revalued its currency, it experienced roughly equivalent amounts of inflation or deflation. (The only brief exceptions were observed when a country became isolated during wartime, Japan and Italy during World War II being the clearest examples.) What this means is that if a country devalues by 13 per cent against the rest of the world's currencies, you could expect that it would experience higher inflation than the rest of the world until its prices had risen by 13 per cent more than those of the rest of the world. So far from such a revision of exchange rates having only a minor effect -- via foreign trade -- on the Consumer Price Index, it has an exactly proportioned effect relative to the price level in the rest of the world.
This isn't exactly a revolutionary idea but, as Laffer says, it hasn't been thought about for quite a while. Here's J. Lawrence Laughlin writing in 1903:
The action of the international markets, with telegraphic quotations from every part of the world, precludes the supposition that gold prices could in general remain on a higher level in one country than another (cost of carriage apart), even for a brief time, because, in order to gain the profits merchants would seize the opportunity to send goods to the markets where prices are high.
Laughlin talks about gold, but implicit in his statement is that apples are affected similarly. Say there are a million apples in a country selling at 10 cents each, but that there exists an unqualified demand for 1,000,001 apples. If the extra apple can't be gotten from the rest of the world at less than 11 cents, cost of carriage apart, the price of all apples will rise to 11 cents. In this illustration, the volume of trade involved is only one part in a million -- but price still changes by 10 per cent.
Going a step further, Mundell has revived the proposition, and Laffer has documented empirically, that money, like apples and gold, is also subject to these international forces of supply and demand. When, for example, there is an excess demand for money in the United States relative to the rest of the world, we will import money and run a balance of payments surplus -- i.e., more money will be coming into this country than is going out. When there is an excess supply of money in the United States, we will export money and run a balance of payments deficit. This idea also has its roots in earlier centuries, but is still a minority view among economists everywhere. Balance of payments deficits are thought to represent not a market phenomenon but a structural problem -- i.e., "capital flight" or "undercompetitiveness." Laffer has further demonstrated that when a country's growth rate accelerates relative to the rest of the world its balance of trade worsens; and vice versa. (As a child grows, it consumes more than it produces.) But such a deficit is not cause for alarm. What is then happening is something perfectly natural. As long as its government does not speed up its own money creation, the country will export bonds to pay for its deficit in trade. All that is occurring is that the rest of the world has decided the country in question, with its higher growth rate, is a good place in which to invest. (Just as parents invest in their growing children.)
This way of looking at deficits and surpluses in one's balance of payments and balance of trade is strikingly different from the prevailing way, and has large implications for economic policy. But more about that later.
Myths of devaluation
While the above approximates the Mundell-Laffer long-distance view of the economic universe, it is necessary to move in closer and examine the terrain piece by piece before the direction of policy becomes apparent. A most important thesis, again one that cuts against the predominant thinking, is this: When money supplies and currency exchange rates change, the terms of trade remain unchanged. Somewhere at the root of our economic policies of the past several years lies exactly the opposite assumption.
Put simply, what Mundell and Laffer say is this: If a bushel of U.S. wheat can be traded for a bottle of Italian wine when $1 equals 100 lire, then, even though the United States devalues the dollar so that it is only equal to 80 lire, the bushel will still trade for the bottle. There may be a temporary confusion, which economists call “money illusion,” but it is only temporary. That is, the U.S. farmer may temporarily accept 80 lire in payment for his wheat, because it still equals $1 -- and his first interest is in dollars. But when he discovers that $1 is now worth only four-fifths of the bottle, he will insist on getting $1.20 worth of lire so he still gets the whole bottle. As a result, the dollar price of U.S. wheat goes up by the full amount of the devaluation. Or the lire price of Italian wine goes down.
It is thus the contention of Mundell and Laffer, borne out by considerable empirical evidence, that devaluation has no "real" effects, but results only in price inflation in the devaluing country relative to the country or countries against which the devaluation occurs. By reducing the amount of goods its money can buy, the devaluing country creates an excess demand for its money. If it simply prints more money, there is no balance of payments improvement -- which was what devaluation was supposed to achieve. If it doesn't, its citizens will simply import money (by exporting bonds) to satisfy the excess demand, and this will show up as a brief “improvement” in the balance of payments.
But isn't it true, as the textbooks and newspapers have been saying for a generation, that when a country devalues, the goods become more expensive, so it buys fewer of them, while the goods that foreigners buy, from it are cheaper, so the foreigners buy more of them? And the net result is a nice improvement in the devaluing country's balance of trade? The answer is: No.
Laffer points out that by looking only at what happens to the demand for imports in each country following a devaluation, the textbooks see only half of what happens. What about the demand for exports?
When the United States devalues its currency, for example, the goods it exports fall in price in terms of foreign currencies. Under normal supply and demand conditions, the residents of the United States should then buy more of its export goods and have less incentive to produce them. Abroad, the goods foreigners export to the United States rise in price relative to U.S. currency. They should then have less incentive to buy their own export goods and want to make more of them, increasing exports to the devaluing country. This would mean the U.S. trade balance would worsen in real terms if it devalued.
Here, Laffer is merely pointing out the logical inconsistencies of the current theory; in fact, he argues, devaluation only invites inflation and will not affect the trade balance. His empirical study of 15 devaluations between 1961 and 1967 shows no relationship between devaluation and improved trade balances. In most cases, trade deficits in fact worsened in the years following a country’s devaluation simply by the law of probability -- since there is no causal relationship -- trade balances should improve half the time and worsen half the time.
“Most of Great Britain's economic problems over the last 30 years have come about because of London's fetish with the trade account,” says Mundell. “It is forever trying to increase exports and decrease imports, and in the process of trying to send more goods out and allow fewer in has systematically reduced the efficiency of its economy.” It has also, of course, experienced massive inflation. West Germany, on the other hand, has accepted a series of major currency appreciations that should have doomed its trade balance. Yet its domestic economy remains vigorous and its trade balance in surplus, and inflation has been very moderate.
* There is no joint Mundell-Laffer paper. Mundell, the prime mover, writes the theory. Laffer, more the empiricist, provides the data support, contributing slices of theoretical inspiration along the way.