EDITORIAL

Robert Mundell—Three Brilliant Ideas,One Nobel

Dominick Salvatore, Fordham Univiversity

The Nobel Prize in Economics Science, awarded to RobertMundell in 1999, is most deserved and long overdue. Al-though most economists make no major original contributionduring their lifetime, Bob Mundell has made at least three—each of which deserving a Nobel. These are the theory ofoptimal currency areas, the Mundell-Fleming model, andsupply-side economics. This allowed different economicnewspapers and magazines to stress the contribution closestto their political, economic, or regional interest as the princi-pal reason for the Nobel. Thus, the conservative Wall StreetJournal stressed Mundell’s contribution to supply-side eco-nomics, the liberal New York Times concentrated on theMundell-Fleming model, while European-based The Econo-mist considered Mundell’s contribution to the theory of opti-mal currency area as his most significant contribution, callinghim “the father of the euro.” In fact, each of these brilliantcontributions is deserving of a Nobel.

Mundell’s theory of optimal currency areas spells out theconditions required for the benefits to exceed the costs fora nation belonging to an optimal currency area. The mostimportant among these is an “adequate” labor mobility.Without sufficient labor mobility, a member nation affectedby an asymmetric shock will find itself powerless to dealwith the shock, because the nation can use neither monetarypolicy nor exchange rate policy (limited as they might be

Journal of Policy Modeling 22(3):305–309 (2000) 2000 Society for Policy Modeling 0161-8938/00/$–see front matterPublished by Elsevier Science Inc. PII S0161-8938(00)00016-8

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in their effectiveness in today’s world of highly integratedinternational capital markets), and fiscal policy is likely tobe highly constrained by the fiscal discipline that would inevi-tably be imposed on members (the Maastricht Treaty in thecase of the European Union). In the absence of adequatelabor mobility, the nation affected by an asymmetric shockcan then only wait for the imbalance (say a recession) to becorrected gradually on its own. Serious political problemscan also arise if the nation experiences a growth rate muchlower than that of the other members of the optimal currencyarea over the course of many years.

With adequate labor mobility, on the other hand, a nationthat is a member of an optimal currency area and faces arecession will experience an outflow of labor and other fac-tors that would eliminate its high unemployment, quicklyreestablish economic equilibrium, and return to a rate ofgrowth similar to that of the other participating countries.This is, in fact, exactly what happens when a region of theUnited States falls into a recession in relation to other re-gions, thus allowing the common currency (the dollar) towork well. In Europe, on the other hand, labor mobility isnotoriously low, and so the problem of how to deal withasymmetric shocks and widely different growth rates remain.This is one reason that Italy and Germany have been growingat a much slower rate than Ireland and The Netherlands. Itis easy to see why, if this situation were to persist for manyyears, it could create serious political problems for the lag-gard nations.

In fact, a problem is likely to arise for a country that is amember of an optimal currency area even without the coun-try being affected by an asymmetric shock, if the country(such as Italy in the European Union today) is much lessprepared and capable of rapidly restructuring its economyand keeping pace with the other member nations in takingadvantage of the benefits from the expansion of the scale ofoperation that economic integration brings. This shows how

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simple-minded those economists have been who believedthat the euro would stimulate growth and quickly resolveEurope’s unemployment problem.

More sober economists understood that the introductionof the euro would stimulate economic restructuring in theEuropean Union, which eventually would lead to muchhigher growth. But they failed to comprehend that this wouldtake time, and in the meantime, some countries (such asItaly) would face even more serious short-run problems inthe form of high unemployment, and much slower growththan the other countries participating in the optimal currencyarea. It is not difficult to anticipate that if growth remainssignificantly lower and unemployment significantly higher inthe next few years than in other member countries, Italymight face serious political problems. All of this type offundamental analysis follows directly from Mundell’s bril-liant contribution, which remains as valid today as 40 yearsago when he made it.

The second brilliant contribution made by Mundell wasthe open-economy macromodel that carries his and Flem-ing’s names. This was justly called and remains the “work-horse” of international finance nearly 40 years after its intro-duction. Despite some recent attempts to push this modelaside (as evidenced by some authors of international text-books dropping it from their books), the Mundell-Flemingmodel remains without doubt the best tool for examiningthe working of the international economy and evaluatingthe effectiveness of monetary and fiscal policies under fixedand flexible exchange rate systems. The model elegantlyshows why, in a world of high capital mobility, monetarypolicy is very effective while fiscal policy is completely inef-fective under a flexible exchange rate system (like the onewe have today), while the opposite is the case under a fixedexchange rate system (which Mundell prefers).

Here, Mundell’s contribution is the model and not neces-sarily his personal preferences. To his credit, Mundell has

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remained consistent in his preference for a fixed as opposedto a flexible exchange rate system. On the other hand, manyeconomists who preferred a flexible exchange rate systemduring the Bretton Woods period (1945–1971) subsequentlyswitched back to preferring a fixed exchange rate system. Itseems that the grass is always greener in the neighbor’s yard.When we had fixed rates, these economists concentrated onthe theoretical benefits of a flexible exchange rate system,while complaining about the all-too-obvious real disadvan-tages of the fixed exchange rate system operaing at the time.After the collapse of the Bretton Woods system, aware of theunexpected large exchange rate volatility and misalignmentsthat have accompanied flexible rates, they are now callingfor the reestablishment of some form of fixed exchange rates,remembering the advantages but forgetting the disadvan-tages of such a system.

We must remember that the present flexible system wasnot established by an agreement of international monetaryauthorities but was forced on the world by the collapse ofa the fixed exchange rate system for lack of an adequateadjustment mechanism. All the heroic attempts to reestablisha fixed exchange rate system from 1971 to 1973 failed, andthe world was pushed onto the present flexible exchangerate system by default. No fixed exchange rate system couldprobably have survived the two petroleum crises, the double-digit inflation that resulted from them, and the subsequentdeep recession created to stop the inflationary spiral duringthe 1970s and early 1980s. Be that as it may, it would hardlybe possible to conduct this type of analysis without Mundell’sbrilliant contribution.

The third of Mundell’s contributions is his role in thedevelopment of in supply-side economics. Although highlycontroversial, no one can deny the importance and relevanceof this idea over the past 2 decades the world over. Supply-side economics was the inspiration behind the deregulationmovement, which started in the United States in the 1980s

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and was subsequently adopted by Thacher’s Britain and em-braced by most other countries of the world. To some extent,the return of the United States to being the most competitiveeconomy in the world and its rapid and continued growthsince the early 1990s is the direct result of the deregulationmovement, which was inspired by supply-side economics.Indeed, there are few aspects of the international economytoday that cannot be profitably analyzed by one of Mundell’scontributions.

The high honor conferred by the Swedish Academy ofSciences to Mundell in 1999 is amply deserved and too longdelayed. Mundell is certainly the most original economist ofthe 20th century. Forty years ago, he talked about things thatwere not even at the horizon of the economics profession. Asone of his now-famous former students remarked, “He mightas well been from Mars then.” And it did not take the NobelPrize for most of us to recognize and appreciate Mundell’sbrilliant contributions—and on a more personal level, totreasure his friendship and wisdom.