12 April 2021

Vox: Krugman on the Mundell difference

Nobel Laureate Robert Mundell passed away on 4 April 2021... Mundell highlighted the difficult tradeoffs in creating a currency area and cmae to be seen as the father of both supply-side economics and the euro.

In this column, Paul Krugman describes the evolution of Mundell’s contribution to economic thought and policy, from his early pathbreaking models that remain the foundation of modern international macroeconomics to his later views that were more controversial and less influential in the profession. He also offers an explanation of how the man who brought Keynesian analysis to the open economy and highlighted the difficult tradeoffs in creating a currency area could come to be seen as the father of both supply-side economics and the euro.

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The opening sentence of Robert Mundell’s 1963 paper “Capital mobility and stabilization policy under fixed and flexible exchange rates” — one of the two most influential in a series of pathbreaking papers he published in the late 1950s and early 1960s — is curious: “The world is still a closed economy, but its regions and countries are becoming increasingly open.”

“Still”? Was Mundell thinking of a future with interplanetary trade, so that eventually the world as a whole wouldn’t be a closed economy? OK, he probably wasn’t, but if he was, it would have been in character. Mundell, who passed away on 4 April, was an economist ahead of his time.

Specifically, those seminal papers were written in an era when many of the restrictions imposed on international transactions during the Depression and WWII were still in place. Britain’s foreign exchange controls persisted until Margaret Thatcher came to power; France didn’t abolish its controls until 1989. Yet in those papers Mundell envisaged a world with high mobility of capital and perhaps other factors of production; indeed, his stabilisation paper made the strategic assumption of perfect capital mobility, with money flowing instantly to equalise rates of return across countries.

And over the decades that followed, as capital flows surged and fixed exchange rates gave way to floating rates, Mundell’s work provided an essential guide.

In what follows, I’ll try to explain Mundell’s contribution to economic thought and policy.

Let me admit from the outset that the trajectory of Mundell’s ideas makes this a tricky project. Most of his influence within the economics profession comes from a handful of brilliant papers written when he was very young; most of his public prominence came from arguments he made later in his career, which often seemed to conflict with his earlier work. 

Now, great economists often change their views over time, as they should when new information arrives. Mundell, however, changed his whole intellectual style; if you were to read his Nobel lecture without knowing who wrote it, you might never have guessed that it was the same man who devised those crisp little models several decades earlier.

But let me begin with those models, which remain the foundation of modern international macroeconomics.

Loonie tunes

When Mundell was awarded the Nobel Prize, I was among a number of economists who noted that his most influential work seemed inspired by Canadian experience. In retrospect I may have understated the case: the Canadian model arguably underlay all three of Mundell’s key contributions to international macroeconomics.

As I already pointed out, in the late 1950s and early 1960s capital movements were in general circumscribed by extensive controls. Yet Mundell found it useful to posit a world of perfect capital mobility, partly for analytical clarity, but also because it was “a stereotype towards which international financial relations seem to be heading.” And Canada, “whose financial markets are dominated to a great degree by the vast New York market,” was, he suggested, already pretty much there.

It seems plausible, then, to guess that Canadian experience contributed to Mundell’s consistent early focus on the role of capital mobility, and factor mobility in general, in the international economy. This focus was already apparent in 1957 when he published “International trade and factor mobility”, a still widely read paper arguing that trade could substitute for factor movements and vice versa.

Canada’s openness to capital flows wasn’t its only distinctive feature. In a world of fixed though adjustable exchange rates, it stood out for having spent an extended period allowing the loonie — the Canadian dollar — to float freely, something it had to do if it was to have any monetary independence. Surely this distinctive Canadian experience helps explain why Mundell focused so early on macroeconomic policy under a floating-rate regime, which was academic speculation for most countries at the time but lived reality for his home nation. 

And Canada’s decision to let the loonie float also offered a concrete example of the Impossible Trinity implied by his 1963 paper. A country can’t have free movement of capital, a fixed exchange rate, and effective monetary policy – it must choose two out of the three.

There was also one more thing about Mundell’s home nation that was special in the 1960s and that remains special today — the country’s unusual economic geography. Although Canada’s land area is huge, its climate ensures that the vast bulk of its population lives in a fairly narrow but very long strip just north of the US border; Vancouver and Toronto are 2,000 miles apart. Canada is in effect closer to the US than it is to itself.

Canadian geography clearly influenced Mundell’s vision in the 1961 paper that rivals his stabilisation paper in influence, “A theory of optimum currency areas”. He worried that a flexible exchange rate wouldn’t do much for Canada, both because the economic bases of the country’s east and west were so different and because, he argued, they didn’t constitute a single labour market. This led naturally to the idea that factor mobility is a key determinant of whether or not nations should have their own currencies and/or allow their currencies to float.

So, Mundell in effect used Canadian experience to motivate questions about how open-economy macroeconomics would work in a world where markets were being freed up. What did we learn from his answers?....

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