Wednesday, April 28, 2010

The "Father of Supply-Side Economics" on US-China Currency and the Economic Crisis

The Heritage Foundation recently hosted an interesting event on "The Dollar, The Euro, and the International Monetary Order" with, among others, Nobel Prize-winning economist Prof. Robert Mundell (described by Heritage as "the academic founder of supply side economics").  NRO's Sean Rushton gives a nice rundown of Mundell's quite impressive bio here:
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.
The full video of the event is below, and Mundell's remarks start at about 1:15.  For those of you who don't have the time to watch, Rushton also helpfully summarizes most of Mundell's comments (emphasis mine):

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.
Rushton omits the beginning of Mundell's lecture, but there's also a lot of good stuff in there too.  For one, Mundell essentially lays out (from 1:32:50 to 1:37:00) some reasons why a country like China would pursue a fixed exchange rate policy and what that country does with the foreign currency reserves that it might accumulate as a result of the peg.  As to the latter question, Mundell explains that China purchases US assets and debt (bonds, treasuries, etc.) with its dollars - something most of us already knew.  But it's Mundell's answer to the former question that I found most interesting.  In Mundell's opinion, the primary benefit of China's fixed exchange rate was/is not, as American currency hawks would have you believe, some pernicious international trade advantage, but rather domestic price stability.  Indeed, Mundell states that "China has had a better record of price stability since 1997 than any G-7 country, and they've done it... through a fixed exchange rate."  Interesting, huh?

The statements excerpted by Rushton above are also important, as they demonstrate Mundell's firm beliefs that (i) one of, if not the, biggest cause of the financial crisis was the significant US dollar devaluation undertaken by the Bush administration to improve American exports' global competitiveness; and (ii) the surest course to preventing future global meltdowns is pegging the US dollar, the Euro and the Chinese yuan (or RMB) and maintaining a strong, stable dollar.

So to summarize, Nobel Laureate, "father of supply-side economics," and presidential/Chinese economic adviser Robert Mundell is of the strong belief that (a) domestic price stability, not international export advantage, is China's primary reason for its historic RMB peg to the US dollar; (b) pursuing an export-driven weak dollar policy was and will be disastrous for the US economy; and (c) a fixed USD-RMB-EUR system would improve global trade and is the best way to prevent another collapse.

Now, I'm certainly not qualified to agree or disagree with Mundell's currency theories, but that's (once again) not my point.  Instead, it's more important for me to just keep showing all of the serious and divergent ideas out there about global currency issues, particularly those from well-respected monetary gurus showing very sound and sensible reasons for China's currency policies - ones that have nothing to do with conspiratorial allegations of predatory Chinese trade policies or breathless (and dangerous) demands that China appreciate the RMB.  These "other" ideas deserve wide circulation because they are a vital counterweight to the current demagoguery out there in the US-China currency debate.  When guys like Mundell speak up, whether you agree with them or not, they further undermine the ridiculous certitude of American currency hawks like Paul Krugman and Sen. Chuck Schumer that China is intentionally manipulating its currency in order to prey on US industries and steal American jobs, and that some sort of dramatic RMB appreciation (and weaker US dollar) will magically solve the US and global economic crisis.

And the lesson, as always, is: when someone tells you with utter certainty that China is through its currency policies preying on the American worker, or that a stronger Chinese yuan and weaker US dollar will definitely improve the American economy, just stop listening.


Anonymous said...

I disagree with Mundell on the cause of the crisis being the fall in the dollar from 2002 through 2008. The dollar became overvalued in the late 1990s and early 2000s--I know from traveling abroad and seeing how cheap things were. (A dinner with great seafood and wine overseeing a setting sun in New Zealand for $32 including tip convinced me.)

Our financial crisis was caused by too much leverage. Leverage at the household level, leverage in the banks, and leverage in investments (the proliferation of hedge funds, private equity, SIVs, and securities lending, etc.) With so much leverage, all it took was a moderate shock in asset prices to cascade into a calamity.

Mundell does have some interesting observations. I agree that China outsourced monetary policy to the Fed, which promoted price stability in China. And I'll buy into the the weaker dollar promoting inflation through higher energy prices--but the cause of the crisis, no.

I've never understood the supplier-sider's infatuation with a "strong dollar". A stable, fair valued dollar should be the goal.

Simon Lester said...

I've never understood the concern with "exchange rate turbulence". There's also turbulence with the price of gas, milk, apples, etc., but free market types don't call for fixing those prices. Why do so with currencies?