In the obituaries following the passing of economist Robert Mundell this past week, it was noted he won the Nobel Prize in economics, but omitted that he largely lost the political debate. With the exception of the establishment of the euro, macroeconomic events have gone in the opposite direction of his theories.
The purpose here isn’t to prescribe, but rather to describe policies as they are, and what their investment implications might be. To skip ahead, they’re bullish for gold, despite the metal’s recent decline.
Mundell’s key insight was that policy makers face a “trilemma.” They cannot control domestic monetary policy by simultaneously adjusting interest rates, controlling currency exchange rates, and permitting the free flow of capital across borders. Pick any two of the three.
Under the post-World War II Bretton Woods system, exchange rates were fixed versus the U.S. dollar, which was convertible into gold at $35 an ounce. Capital flows also were restricted. But the system broke down in 1971, when President Richard Nixon ended the greenback’s convertibility, ultimately leading to the floating exchange rates that prevail today.
Mundell’s prescription was to fix exchange rates, curbing a central bank’s ability to manipulate interest rates, and instead use fiscal policy to pursue macroeconomic goals. His fans say this produced what would come to be called supply-side economics, with the tax cuts under President Ronald Reagan spurring growth and the tight monetary policies of Federal Reserve Chairman Paul Volcker reining in double-digit inflation. Exchange rates were anything but stable, however, with the dollar soaring from record-high U.S. interest rates, making for a global monetary squeeze.
That’s history. Mundell is known more recently as the father of the euro, which was based on his theory of an optimal currency zone. Key to the success of a single currency is labor mobility, so workers can go where the opportunities are.
In theory, euro-zone workers can move all the way from the south of Italy as far north as Finland. In reality, there is less cross-border movement. The region has widely disparate local economies, with differing levels of productivity, from richer Northern Europe to the poorer south. Before the creation of the common currency, those differences could be compensated for by exchange rates; the Italian lira, for example, would decline against the German mark.
The use of the euro makes that impossible. So Greece underwent an “internal devaluation” during its…