Robert Mundell — Nobel Prize–winning Canadian-American economist, father of the euro, and one of the most influential academic economists in recent history — passed away last week.
Mundell won the Nobel for his brilliant work spanning monetary policy and trade, largely published in the late 1950s and early 1960s, going back to his early days as a student at MIT and an economist at the IMF. He built one of the most influential open-economy models of the 20th century: the Mundell-Fleming model, which showed that economies could not simultaneously have fixed exchange rates, monetary autonomy, and free capital flows, also known as the “Mundell-Fleming trilemma.” He also wrote many excellent related theoretical papers on trade, including on the mobility of factors of production.
On the policy side, Mundell also greatly influenced the early supply-side movement. He was a professor at the University of Chicago from 1965 to ’72, overlapping with Art Laffer, who taught at the University of Chicago from 1967 to ’76. Mundell’s influence on the Reagan era and its embrace of supply-side economics cannot be understated.
However, his most famous and perhaps lasting influence came in the realm of monetary policy, as an advocate of fixed exchange rates in what he viewed were optimum currency areas. This advocacy of fixed exchange rates drew a sharp contrast with fellow UChicago economist Milton Friedman’s support for floating exchange rates.
The epic debates between Mundell and Friedman over exchange rates began in the early 1960s when the fixed-exchange-rate system of Bretton Woods still reigned (most countries had fixed their currencies to the U.S. dollar, which was in turn linked to gold).
During this era, in 1953, Friedman published an essay titled “The Case for Flexible Exchange Rates,” in his now-famous book Essays in Positive Economics. Friedman’s main argument (which I myself find to be most compelling) is that fixed exchange rates can lead to the importation of inflation from other countries due to the condition of Purchasing Power Parity, and that without flexible exchange rates, price surges in one country must crop up in the next. Friedman argued a regime of fixed exchange rates wouldn’t last long before the risk of inflation encouraged economies to float their currencies.
This argument eventually won when Richard Nixon ended gold-dollar convertibility in response to rising inflation in the 1970s, and Bretton Woods was slowly replaced de facto by the current regime based on floating exchange rates. Nonetheless, throughout the late 20th century, Friedman and Mundell clashed frequently on the subject. Mundell believed trade flows were highly sensitive to exchange rates and argued that floating exchange rates and a volatile dollar were responsible for U.S. recessions in the early 1980s as well as the Great Recession much later.
Interestingly, as Paul Krugman points out, Mundell’s academic work and policy views on exchange rates were partially influenced by his Canadian background (he grew up in Ontario and British Columbia) and the floating of the Canadian dollar/U.S. dollar exchange rate in the 1950s, the first major currency to float in the post-war era. Canada experienced a rather nasty and prolonged recession in the late 1950s, which Mundell partially attributed to the newly floating exchange. Mundell saw Canada’s return to a fixed exchange rate in 1962 as a wise decision (Canada would later go back to floating its currency again in 1970 and has ever since).
And though Friedman won the Bretton Woods debate, Mundell would later strike back in the debate over a fixed-exchange-rate system in Europe, which would ultimately become the euro. Mundell also advocated for a North American currency union in the early 2000s, though unsuccessfully.
In December 2000, the Financial Post Comment pages led by Terence Corcoran orchestrated the Nobel Money Duel, an extended debate between Robert Mundell and Milton Friedman. Mundell famously said, “The advent of the euro has demonstrated to one and all how successful a well-planned fixed exchange rate zone can be.”
Friedman, however, responded prophetically:
If the existence of the euro induces a major increase in flexibility, the euro will prosper… If not, as I fear is likely to be the case, over time, as the members of the euro experience a flow of asynchronous shocks, economic difficulties will emerge. Different governments will be subject to very different political pressures and these are bound to create political conflict, from which the European Central Bank cannot escape.
Fast-forward ten years, and the European sovereign-debt crisis exposed the euro’s vulnerability. Later, in 2016, Britain would vote to leave the European Union political project. What Mundell missed is the necessity of a fiscal union to support a monetary union.
During the debate, when asked to predict the number of currencies that would exist in the future, Friedman famously said it would depend on the success of the euro and the “wild card” in the currency world, “the internet and the emergence of one or more varieties of E-money,” decades ahead of digital currencies entering the common lexicon.
While Friedman may seem to have won on flexible exchange rates, Mundell and many of his followers have not given up. Mundell protégé and former Trump Federal Reserve nominee Judy Shelton famously argued for a new Bretton Woods conference to be held at Mar-a-Lago to discuss a new system of fixed exchange rates.
Mundell’s influence and brilliance is still felt around the world (regardless of one’s views on exchange rates, the Mundell-Fleming model remains arguably the most famous model in international macroeconomics informing stabilization policy), admired by academic economists ranging from Keynesians such as Paul Krugman to market monetarists like Scott Sumner and supply-siders such as Brian Domitrovic. Rest in peace.