The Corner

Robert Mundell on the Financial Crisis

The Washington Post reports this morning that the president has “seized the reins” on financial reform, so it’s a good moment for Reaganite conservatives to reach a consensus on what actually went wrong on Wall Street and, by extension, what reforms are appropriate.

They should listen to Prof. Robert Mundell, known as the father of supply-side economics, who discussed the financial crisis last week at the Heritage Foundation — Mundell comes on at about 1:15, though the whole video is worth watching.

For those not familiar with the Nobel Laureate, Mundell has been a guiding force behind major economic expansions since the early 1960s. His work as a young man likely influenced the Kennedy administration to ignore its Keynesian advisers in favor of tax cuts and sound money, leading to the robust expansion of 1961–68. Mundell correctly predicted the inflationary disease of the 1970s and advocated the supply-side policy mix that spurred two decades of non-inflationary expansion in the 1980s and ’90s. Mundell’s writing on optimum currency areas was the basis for the euro’s creation in 1999, erasing exchange-rate barriers across the world’s second largest economy. And Mundell has been an important adviser to China for two decades, guiding its economy out of Communist infancy to become the significant financial power it is today.

Mundell argues the recent crisis had three distinct parts.

Part One was the real-estate bubble and subsequent bank-solvency crisis, which began in 2006. He says the bubble was generated primarily by the dollar’s fall after 2001, as U.S. monetary authorities made clear they wanted a lower dollar to improve exports. As the greenback dropped on foreign exchanges and against gold and other commodities, investors pursued the classic inflation hedge: They borrowed and bought hard assets, expecting to repay the debt with cheaper future dollars. Real estate, already roaring due to 1997’s expanded housing tax deduction, went into overdrive, goosed by subprime lending and mortgage securitization.

Part Two of Mundell’s analysis is the most intriguing and least understood aspect. He argues that, as the real-estate bubble burst, large quantities of fresh liquidity were demanded by the public and banks. In summer 2007, the world’s central banks supplied it and no liquidity crunch developed. But by summer 2008, spooked by rising inflation, the U.S. Federal Reserve failed to provide adequate cash, leading to dollar scarcity. Four key symptoms of tight money appeared within months: the dollar rose 30 percent against the euro; gold fell 30 percent; oil fell 80 percent; and the inflation rate dropped from 5.5 percent to negative levels. As a result, Mundell believes, Lehman Brothers collapsed, the stock market went into free fall, and a near-panic ensued. This phase was entirely preventable and constitutes one of the worst mistakes in Fed history, Mundell says. The crisis eased in early 2009, as the Fed upped the money supply, but the damage was done.

Part Three of Mundell’s analysis is the recession of 2008–09, with bailouts, rising unemployment, and skyrocketing deficits. He predicts decent growth this year, but believes unemployment will remain high and the recovery will be weak.

He says the U.S. must extend the Bush tax cuts and should also cut the corporation tax rate from 35 percent to 15 percent, to spur investment and recapitalize banks. Importantly, he says the U.S. should fix the dollar’s value against the yuan and the euro, thus creating an enormous common-currency area free of exchange-rate turbulence, which will prevent future debacles. It should be clear that Mundell sees a low and unstable dollar as culprit Number One in the crisis, and as the Bush administration’s biggest mistake.

A political footnote: The real-estate bubble bursting into the solvency crisis, plus oil at $150 per barrel, coincided with the election of 2006 in which the GOP lost its twelve-year congressional majority. The 2008 crisis coincided with further Republican losses. Coincidence? You be the judge.

With the economy now on the mend at least somewhat, the GOP will require a smart economic message to explain what it has learned and how it will do better if returned to power. They should listen to Mundell, as Reagan did.


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