A winning choice

By Llewellyn H. Rockwell, Jr.
web posted October 18, 1999

World central banks have long planned to sell what remained of their gold stock. Just the prospect pushed the price down to $250 an ounce last month. But then they changed their minds, and the price rocketed to $315. Why do central banks own gold anyway? And why would they have any worries about selling off what they have left? To understand why requires a history lesson, one that intersects nicely with the career of Columbia University's Robert Mundell, the 1999 Nobel Laureate in economics.

Mundell's specialty is monetary economics, particularly as it affects international trade. In the 1960s, when nearly everyone else was clinging tightly to Keynesian orthodoxies about inflation and unemployment, he began to examine the relationship between government policy and money's value on international exchange.

He observed that the Bretton Woods system (which Keynes helped create) was breaking down due to the U.S.'s relentless expansion of the money supply. In a regime of floating exchange rates, the inflated currency would depreciate relative to the sound currency. But with fixed exchange rates under inflation, he said, the result would be gold outflows and an eventual forced devaluation.

As remarkable as it seems, economists in those days weren't thinking much about money. They viewed inflation as something that reduced unemployment and otherwise caused no distortions in production and trade. Mundell's contribution highlighted the dangers of monetary manipulation.

But these dangers were not only internal. He recognized that policies made on the national level generate international effects. That is as true of tax policy as it is of monetary policy. His warnings went largely unheeded until the early 1970s when a loose Fed policy did indeed bring about massive gold outflows and a final breakdown of Bretton Woods.

Instead of restoring the classical gold standard, President Nixon took us in exactly the wrong direction: eliminating gold altogether as a foundation of the monetary system. At that point, all bets were off because the Fed was free to inflate without limit. The result was a phenomenon in the mid-1970s that no Keynesian could explain: prices soared as production stagnated.

Mundell now found himself able to apply the theoretical work he had done in the 1960s. He was nearly alone in explaining the workings of a floating exchange rate system, particularly one where monies have no underlying tie to the markets they serve. Money had to be made sound, he said, else the dollar would continually lose its value on international exchange and disrupt trade flows.

He further argued that floating exchange rates had made government spending useless as an economic tool. No longer could the government push and pull levers on the budget machinery and expect the economy to respond. Markets had become super sensitive to government attempts to manipulate the growth rate and the real value of currency. Entrepreneurs responded to inflation, not by simply paying their workers more, but by increasing their investments in real capital even as cash holdings declined in value.

Mundell, at his best, was advancing claims made by the Austrian School since Ludwig von Mises' earliest warnings (1912) about the dangers of inflation. He worked to advance the anti- inflationist argument at a time when most economists thought such concerns were silly.

Moreover, in the late 1970s, Mundell played the leading role in identifying the one policy that was likely to bring about renewed economic growth: tax cuts. Jude Wanniski has identified him as the real intellectual guru behind the Reagan tax cuts.

Not that Mundell bears responsibility for the failure of the Reagan administration to keep taxes low, curb government spending, or re-institute a gold standard. It is more useful to look at the big picture. His understanding of economics is far richer than the Keynesian view he went up against, and far richer than the Friedmanite/monetarist view that finds salvation in floating exchange rates in a sea of paper currency.

The Nobel Prize committee cited the Euro as a hook for recognizing Mundell. It's true that he prefers fixed to floating exchange rates. At the same time, the Euro is inherently flawed because it is a composite of paper currencies vulnerable to manipulation by the European Central Bank. It is precisely the fear of a monetary system without backing that led the world central banks to hold on to their gold rather than sell it, if only as a symbolic sign of stability.

The Nobel committee should have cited the monetary devaluations of this past decade to illustrate Mundell's theoretical relevance. His biggest flaw is that he hasn't been nearly adamant enough in insisting that the only long-term solution to international monetary crises is not fixed rates, currency boards, or new regional currencies, but a real gold standard that would put government out of the money-making business entirely.

The Nobel Prize for economics has been hit and miss recently. Last year it went to Amartya Sen, whose murky thoughts on poverty and development conclude in a hymn to governments that redistribute wealth every which way. The year before, the winners were honored for a pricing formula that ended up bankrupting Long-Term Capital Management, on whose board they sat.

Robert Mundell has not only been right when others were wrong. He is a theoretician who works in the old-fashioned way: not through econometric pyrotechnics, but with clear language and good sense. It would be a shame if a decline and fall of the Euro came to be seen as proof that this economist had nothing to teach the world.

Llewellyn H. Rockwell, Jr., is president of the Ludwig von Mises Institute in Auburn, Alabama.

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