October 14, 1999

Business and Finance - Europe

Euro Nobel: Work That Began in 1960s
Leads to Economic Prize for Mundell

By MICHAEL R. SESIT and G. PASCAL ZACHARY
Staff Reporters of THE WALL STREET JOURNAL

Robert A. Mundell loved the euro long before the euro was cool.

The Canadian-born economist's love was requited on Wednesday by none other than the Royal Swedish Academy of Sciences, which granted him the 1999 Nobel Prize for Economics. He was feted for his analysis of exchange rates and the way they affect monetary and fiscal policy.

"Robert Mundell has established the foundation for the theory which dominates practical policy considerations of monetary and fiscal policy in open economies," said the academy. "His work on monetary dynamics and optimum currency areas has inspired generations of researchers." It added that although his work was several decades old, "Mundell's contributions remain outstanding and constitute the core of teaching in international macroeconomics."

Others agreed. "Mundell has pointed out that countries get great benefit from the value of their money being stable," said David Malpass, chief international economist at Bear, Stearns & Co. in New York. "That's worth a Nobel."

An eccentric, white-haired figure who once bought an abandoned Italian castle as a hedge against inflation, Prof. Mundell later became a hero of the economic Right with his dogged defense of the gold standard and his early advocacy of the tax-cutting, supply-side economics that became the hallmark of the Reagan administration.

Prof. Mundell is recognized as having helped lay the intellectual foundations for Europe's new common currency, the euro. Although his academic research and theories helped to inspire the development of a European common currency, he didn't directly participate in its planning.

"The introduction of the euro will represent the most dramatic change in the international monetary system since President Nixon took the dollar off gold in 1971," Prof. Mundell wrote in The Wall Street Journal Europe last year. "In another sense, however, the introduction of the euro may be even more important than the dropping of the golden anchor. The advent of flexible exchange rates did not alter the power configuration of the international monetary system. Both before and after the breakdown, the dollar was the dominant currency in the system.

"But the introduction of the euro is likely to challenge the position of the dollar. In that sense, the introduction of the euro may be the most important event in the history of the international monetary system since the dollar took over from the pound the role of dominant currency in World War I."

The 67-year-old Canadian-born economist said that European economic and monetary union would bring the 11 European nations that adopted the euro stable prices, greater price transparency and reduced transaction costs.

Even so, Prof. Mundell's theories -- many of which he formulated in the early 1960s -- extended beyond the establishment of a European specie.

"He presented a very important framework on how policy impacted economies and the impact of opening and closing economies to capital flows," said Avinash Persaud, global head of research at State Street Bank in London. "This is very relevant today in a world where there is tremendous pressure to liberalize capital flows to developing countries, while many of these countries are trying to maintain control of their domestic economies."

The Columbia academic was also ahead of his times. Mr. Persaud said that "the conflict that these countries are facing today and those EMS [European Monetary System] countries faced in the early 1990s -- a conflict of fixed exchange rates -- but open capital markets, Mundell highlighted in the 1960s."

Despite the rocky road Europe's nine-month-old currency has traveled since its birth at the start of the year -- although it's rebounded from its lows recently, it's fallen 8% against the dollar and more against the yen-Mr. Mundell remains a staunch believer in the currency's future.

Asked in an interview with The Wall Street Journal Europe if he believed the euro would eventually challenge the supremacy of the U.S. dollar as the world's major currency for trade and financial transactions, as a store of wealth and as the major reserve currency held by central banks, Prof. Mundell said, "I did think it would and I do think it will."

He explained that the euro has "only been in operation for nine months, and it's not even completely in operation yet," meaning that euro-denominated coins and notes aren't yet in circulation. "Eventually the euro will rival the dollar."

He said that the euro has already spawned a huge European-wide capital market, especially for bonds, which he called "a critical step."

And although the European Central Bank has been periodically criticized -- especially by British economists and bankers -- for everything from implementing the wrong monetary policies to acting as if it were more of a debating club than a collection of Europe's best policymakers, Prof. Mundell said, "They've done very well; they haven't made any mistakes."

In fact, he said that the euro's depreciation this year was "a great benefit," because it did away with criticism that the ECB was pursuing "too tight" a monetary policy.

Nonetheless, he acknowledged that Europe needed to toss off the yoke of structural impediments that many economists contend have for years retarded economic growth and job creation. "Taxes are a kind of cholesterol, clogging the arteries of an economy," he said in the interview. "European economies have paid a price for higher taxes in slower growth and higher unemployment."

And at time when Germany is considering reimposing a "wealth" tax and other European governments steadfastly maintain high tax rates to support bloated welfare systems, Prof. Mundell said: "My own view is that reducing taxes is the best way we have to keep the boom going: You need two tools, not just monetary policy but tax policy."

"We can use the U.S. lesson for the rest of the world," he said.

To be sure, the Columbia professor doesn't get A-plus grades from everyone, including some admirers, such as Mr. Persaud of State Street. While praising the context he developed for "thinking about policy, today's environment is a much more complex place than Mundell's framework allows," said Mr. Persaud. "We have witnessed currencies collapsing after they have adopted the Mundell-correct response of raising interest rates [to defend falling currencies] -- as in Sweden in 1992, and Thailand and Indonesia in 1997. And the challenges of today -- specifically, the challenges of financial contagion -- are something that isn't well treated in the Mundell framework."

And in being anointed as one of the great and good by the Royal Swedish Academy, Prof. Mundell takes his place alongside another Nobel laureate, economist Milton Friedman. While Prof. Mundell remains an unfaltering defender of the merits of fixed exchange rates and the gold standard as an anchor for price stability, his former University of Chicago colleague has spent the past 45 years preaching the virtues of allowing currencies to fluctuate freely.

Still, Prof. Mundell, who will claim the 906,000 euro ($975,000) prize in December, isn't too old to keep battling his adversaries. In his interview, Prof. Mundell called proponents of flexible exchange rates "absurdly wrong ... You'd have to ask a psychologist why there's a hatred of fixed exchange rates."

In defending fixed exchange rates -- and by extension Europe's new common currency regime -- he dismissed the opponents of fixed exchange rates. "You have fixed rates between New York and California and it works perfectly," said Prof. Mundell.

"It's only when you have departures from fixed rates" that you have problems, added the new Nobel laureate, citing the success Hong Kong and Argentina have had with currencies that are rigidly fixed to the U.S. dollar. "What did it cost the world community to bail out Argentina -- a few billion? -- compared to the cost of bailing out [flexible-exchange rate countries] Indonesia and Mexico? That's very little."

Mr. Malpass thinks Prof. Mundell has got it perfectly right. "The striking thing is that his ideas in the 1960s are so relevant in the 1990s. For example, dollarization in Latin America is a hot topic, given their less-than-optimal economic performance," said the Bear Stearns economist. "He made a big contribution to the field of economics."

-- David Wessel in Berlin and Michael M. Phillips in Washington contributed to this article.

Write to Michael R. Sesit at Michael.Sesit@wsj.com³ and G. Pascal Zachary at Gregg.Zachary@wsj.com⁴

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