Canadian Professor Robert Mundell, who advised the US Reagan Administration during the 1980s and the Chinese government over a subsequent quarter century, died April 3 after a long illness. He was 88.
He won the 1999 Nobel Prize in economics. He was a visionary thinker who transformed economic policy, if not the economics profession, which rankled at his criticism of its simplifying assumptions. If he was an outsider in academia, Mundell was influential in policy-making in the United States, Europe and China.
In the United States, Mundell was the visionary theorist of what Wall Street Journal writer Jude Wanniski dubbed “supply-side economics.” He was the father of Europe’s common currency, the euro. And as an adviser to the People’s Republic of China and a visiting professor at the Chinese University of Hong Kong, he helped train a generation of policymakers.
No other modern economist, not even John Maynard Keynes at the peak of his fame during the Great Depression, had so much influence over the world’s largest economies.
Mainstream economics lives in a fantasy world of perfect markets and homogenous inputs. To the Keynesians of the 1970s, one unit of demand was as good as another: the central bank can ease monetary policy or the government can spend money, and consumers spend the money and make the economy go.
To Milton Friedman and the Chicago monetarists, money supply drove the economy, and the main task of economic policy was to keep the rate of money supply growth in line with the economy’s long-term growth potential.
By the late 1970s, loose fiscal and monetary policy pushed the inflation rate up to 14% while unemployment hovered around 8%. That was “stagflation,” a combination of low growth and high inflation. It’s something that doesn’t exist in the academic models – but did in the real world.
For one thing, inflation pushed Americans into ever-higher tax brackets. The 1979 capital gains tax of 60% on nominal gains meant a real effective rate of more than 100%. Taxpayers in the top bracket paid a crushing 70% rate.
Mundell cut through the conventional wisdom and proposed tax cuts to stimulate growth and tighter monetary policy to control inflation. Championed by the Wall Street Journal editorial page, Mundell’s recommendations persuaded Representative Jack Kemp and then presidential candidate Ronald Reagan.
The Republican establishment derided Mundell’s idea as “voodoo economics,” as Reagan’s rival George H W Bush put it during the 1980 presidential primaries. But Reagan won, and Mundell’s wisdom was embodied in the 1981 Kemp-Roth tax cuts. America’s economy grew by 8% in 1982. Meanwhile Federal Reserve Chairman Paul Volcker, Mundell’s friend and ally, crushed inflation with tight monetary policy.
Behind Mundell’s practical advice lay a deep insight into the nature of economies.
When economists say, “assume efficient markets,” they mean in plain English, “Imagine a world in which an NYSE specialist makes a market in your kid’s lemonade stand.”
Most economists assume that the present value of every future income stream is calculable, and that all risks are insurable. But that is plainly wrong; in an economic driven by technological change, it is impossible to insure the existing “investment opportunity set” by purchasing assets that might be invented in the future but do not yet exist.
A simpler problem is the present value of household income. Households do not float initial public offerings to sell equity on the strength of their future capacity to earn. The prospects of individual households are too uncertain.
To some extent the markets for consumer debt, especially home mortgages, fulfill this function, but they are subject to any number of constraints and distortions, as we learned in 2008 at great cost.
But government debt backed by future tax revenues broadly reflects the future prospects of the economy.
Mundell first offered in 1960 to measure the general economic effect of changes in tax and monetary policy according to the way they change the market’s willingness or capacity to discount future income streams.
In Mundell’s framework, markets are always more or less imperfect, because they are never willing to discount all future income streams. Therefore, for example, if a tax cut leads to more economic growth and with it more household income, the tax revenues of the Treasury will rise.
To finance the tax cut in the short term, the government may have to issue debt. But in this case, the increase in federal debt constitutes an increase in wealth.
That, Mundell argued, arises from the imperfection of markets: It is easy to assign a present value to the future cash flows of corporations in the form of corporate bonds, but much harder to assign a present value to the future income of households.
An increase in government debt that arises from government actions that cause an increase in future household income, such as a supply-side tax cut (or spending on productive infrastructure) constitutes wealth, just as bonds issued by a corporation for the purposes of financing productive investments.
Mundell’s other great accomplishment, the European common currency, arises from a similar insight about imperfect markets. The Keynesians look at the short-term effect of demand stimulus in a closed economy.
If people save too much, and there are no profitable investments to take up the savings, the economy slumps, as it did in the 1930s. The government therefore spends for them. (“Two pyramids, two masses for the dead, are twice as good as one; but not so two railways from London to York,” in Keynes’ celebrated witticism.)
Mundell, whose doctoral adviser at MIT was the arch-Keynesian Paul Samuelson, internationalized the Keynesian model and drew radically different conclusions.
One country may have a surplus of savings, and another a deficit of savings (typical of industrial countries with aging populations in the first instance, and developing countries with young populations in the second).
One country invests in another (just as retirees “invest” in young families by lending them money to buy homes). But that requires investment across currencies, and currency instability blocks the exchange of savings.
Stable currency parities – requiring government intervention in foreign exchange markets – are the solution. By targeting monetary policy to traded prices, including foreign exchange rates and commodities (including gold), moreover, central banks reduce uncertainty about the future price level and promote investment and risk-taking at home.
That is a highly oversimplified account of Mundell’s great contribution to economics. But it illustrates his uncanny ability to find the weakness in the assumptions of an economic model, and to address that weakness with a simple and effective policy proposal.
For a long whle Mundell’s career was stalled, despite the triumph of his theory in the practice of the Reagan Administration. The economics profession repaid his propensity to point out its errors by treating him the way the Athenians treated Socrates, minus the hemlock. A future Nobel Laureate told me at the time that he dare not state his views clearly, because “I don’t want to be marginalized like Bob Mundell.”
After he received the Nobel Prize in 1999, Mundell achieved the superstar status he deserved.
I never studied with him (he came to Columbia University shortly after I graduated), but had the privilege to learn from him. During the late 1980s and early 1990s I was chief economist at Jude Wanniski’s consulting firm, Polyconomics. Jude kept Bob on a small retainer, and the great man felt obligated to take my phone calls and accept the occasional lunch invitation.
I would ask his counsel, and he would give me one of his old articles to read; I would then report back to him, and he would inform me that I hadn’t understood a word, and refer me to yet another source, the better to be rid of me. This went on for the better part of three years, by the end of which I had a glimmer – only just – of what he was talking about.
When he once allowed me to thank him in print for help with a journal article, I felt as if heaven had smiled on me.
Mundell was a genius. His engagement with the world was ironic, playful, even quirky. He looked at things differently than ordinary mortals, turning over every assumption and unerringly identifying its weakness.
Young economists watched him sit in back of their seminars in terror; he could ask one question that undid a decade of doctoral research. Well could I imagine how Watson felt after a talk with Holmes.
Bob knew before almost anyone else that the economic future lay in China. In 1994, after I had left Polyconomics for Bear Stearns, Bob convened a small meeting at his apartment on Claremont Avenue near the Columbia University campus to discuss funding for an economics graduate school in China.
He never raised the needed money, but spent years lecturing and teaching in China, and had enormous impact on Chinese thinking. He is one of a tiny group of Western economists – another is the 2006 Nobel Laureate in Economics Edmund Phelps, also a professor at Columbia – who helped shape Chinese economic thinking.
There never was an economist like him, and it is hard to imagine that economics will be graced with another mind like Mundell’s in the future. Those of us who are left to take up today’s problems will find ourselves scratching our heads and asking, “What would Bob say about this?”
My prayer is for comfort for Bob’s family, and inspiration for those he did his best to teach.