Features & Departments World of Ideas: Robert Mundell

World of Ideas
Interview by Barb Clapham

This interview is the first in a series of discussions with people who have made a significant contribution to the world of business. Their innovative ideas have had a profound impact on economic theories and practices of their country and have often challenged conventional wisdom. At the same time, their ideas have transcended national significance and have had lasting effects on the emerging world economy. The interviews probe the ideas of these great leaders as well as the men and women behind the ideas.

The first interview in the series is with Robert Mundell, the 1999 Nobel Prize winner in economics.

Winning the Nobel Prize is one of the more recent accomplishments in the outstanding career of Robert Mundell. Born in British Columbia, his influence has extended far beyond Canadian borders and his theories have influenced world leaders. Mundell is the co-founder of supply side economics, used during the Reagan administration, and has acted as an adviser to numerous organizations, including the International Monetary Fund, World Bank, European Commission, Federal Reserve Board, United Nations, and the Government of Canada. A renowned expert on currencies, his theories on a single European currency helped inspire the creation of the euro.

Mundell has also had a stellar academic career, having taught at McGill University in Montreal, the University of Chicago, Geneva Institute for International Studies, the University of Waterloo, and most recently, Columbia University in New York. This true citizen of the world is currently on leave from Columbia University and spends much of his time at his castle in Italy.

I met recently with Mundell, who shares his views on the euro, the yen, and why he thinks the Canadian dollar will never again be at par.

Much of your work revolves around the concept of optimum currency areas. Could you comment on the effectiveness of this system?
We have moved into a situation of three big currency areas: the U.S. dollar area, the European euro area and the Japanese yen area. These three big economies account for about 60% of the world economy. However, I think a major defect is that this is a threat to prosperity. The huge fluctuations in rates between the dollar and the euro and the Japanese yen do a great deal of damage, not just to the countries themselves because it is destabilizing financial markets, but they are doing great damage to Asia and to other countries in Europe and Africa.

What suggestions would you make to improve the exchange rate policies currently used in North America?
The U.S. dollar is the most important world currency. The question is not for the United States to make a change, because the U.S. dollar has been the most important currency of the 20th century, and will probably remain so for another decade or two before the euro becomes a rival. The question is whether Mexico would be better off with a fixed exchange rate with the United States. Mexico had a fixed exchange rate with the U.S. dollar from 1954 until 1976. Throughout that period it got the American inflation rate, which was much, much better than what it got after they gave up their fixed exchange rate. Mexico lost its stability when it gave up its fixed rate, went into hyperinflation and the Mexican peso had to go into currency reform. It would be much better for Mexico to regain its stability by going back to fixed exchange rates.

What about Canada?
Canada is in a different position. Canada had fixed rates up to 1950, then moved to flexible rates in the 1950s, then to a fixed rate again from 1962 to 1970, then it floated again. Since it has floated, the Canadian dollar has gone way down. In 1974 it was US$1.04. A couple of years ago it was as low as US$0.62. Now it is around 2/3 of an American dollar. So, Canada also has lost a lot of monetary stability compared to the United States, but of course nothing like Mexico.

There is not the same sense of urgency for Canada as there is in Mexico and many Latin American countries which have a history of monetary instability. Canada doesn't have a history of monetary instability, it only has a history of lax monetary and fiscal policies which have not been as good as they could be. I believe that Canada would have been better off if it had maintained a fixed exchange rate with the U.S. dollar all the way through. If it went back to a very clear-cut, rigid fixed exchange rate system in which they locked the Canadian dollar to the American dollar, then they would have American inflation and American interest rates. Over the long run, Canadians would be much better off with that. But the Canadian dollar is a bit of a symbol of nationalism in Canada, and many people would have put it into perspective.

So, for Canada you advocate a fixed exchange rate. You are not looking at a common currency for North America?
If there is to be a common currency, it would be, in my view, the U.S. dollar. It would involve complete dollarization. I don't know whether Canadians are willing to go that far, to give up the loonie, the symbols of being able to create their own policy.

A good friend of mine, Herbert Grubel, formerly a Member of Parliament with the Reform party, has a proposal for an Amero, which would be a North American separate currency. That is a good idea in some ways, but politically I think it is a non-starter because I just don't think the United States would ever scrap the U.S. dollar for the sake of making life a little better for Canada or Mexico. As well, the fact is that the dollar has worldwide importance in a way that goes far beyond the continental importance of North America.

At what level would you fix the Canadian dollar?
Three Canadian dollars equals two American dollars; which is more or less what it is right now. If Canada fixed the exchange rate of the Canadian dollar to the American dollar, as it was fixed for most of Canadian history (either to gold or the U.S. dollar), then America would determine the inflation rate in Canada; the U.S. inflation rate and the Canadian inflation rate would be the same. But, historically the American inflation rate has been lower than the Canadian inflation rate. From this, Canada would get the benefit of being part of a huge monetary area.

It also is quite important because then Canadian pensions would be fixed in American dollars, too. Instead, over this long period, think of Canadian pensions fixed in Canadian dollars compared to American dollars. After all, the Canadian dollar has lost more than a third of its value against the American dollar. They would be much better off being fixed to the American dollar.

Once the rate was fixed, would an adjustment mechanism be required to periodically change the rate?
The only reason you would ever want to change it would be if the American economy became unstable; a lot more unstable than you think Canada would be. You have said "There is no possibility ever, ever of the Canadian dollar achieving parity with the American dollar, barring a revolution in the United States."

The Canadian dollar was higher than the U.S. dollar in the mid-'70s. Why can't this happen again?
Given the fact that it is 67 cents now, there is no possibility of it going back to parity. Since 1974 Canada has had much more inflation than the United States, so prices have risen much higher in Canada. If the Bank of Canada tried to turn back the clock on all this inflation, we'd have major deflation in Canada. We'd have to lower prices and wages by 1/3. You couldn't possibly do it. It is completely politically unrealistic and it would be stupid economically.

When countries make mistakes with their monetary systems, they have to let bygones be bygones. They can't go back again. The Canadian dollar will never be the equivalent of the American dollar again, barring, as I say, a civil war in the United States or some big event that suddenly made the United States unstable, which of course would be a tragedy for Canada, too. I don't think that is going to happen.

Recently 13 Asian nations announced plans to form a currency pact to protect their respective currencies. Is this the beginning of a yen currency region?
I don't think that there can be a single currency region in Asia. I'm a little bit skeptical of the possibility of a currency area in the Pacific comparable to what exists in Europe, because you still have the political tensions between China, Taiwan and Japan. Until those issues are resolved I just can't see China and Japan, at this stage, being part of the same currency area. Europe has been more successful in developing a single currency, however the euro has fallen about 25% since its inception.

Do you think it is undervalued?
Yes, but not too much. I would like to see the euro come back up, but I'd like to see it come back up to about parity with the U.S. dollar. I think it would be very good for Europe if it could keep their exchange rate at about one U.S. dollar = one euro.

Why do you think the euro is having so much trouble?
Well, first of all, the euro is not traded yet; you have to wait two more years before the euro is even traded. I think it was a great mistake on the part of the European Monetary Institute to put off the introduction of a new currency. They didn't need to do it this way.

There are other reasons for the fall of the euro. One is the sudden liquidity effect created when one currency replaces 11 currencies. The one currency is much more liquid than the sum of the 11 currencies. Imagine carrying 11 currencies around in your wallet, compared to dollars. The dollars are much more liquid than the components. So what you get is a sudden liquidity effect. The euro is more productive, so it is as if you are creating, we don't know how much, 10 or 15% more money. So there is excess money slopping around Europe.

Do you think the euro should be fixed?
Yes. In my opinion, the Europeans should fix the euro to the U.S. dollar. Had they done that at the start, it would have stabilized the euro. It would have been better because this way the currency has gone down, it has overshot in a downward direction.

Interest rates in Europe are much lower than they are in the United States - about 2% lower, which is a reflection of the fact that people believe the euro is undervalued. I think it was a mistake to let the euro go down this much. In the same way, I think it was a mistake for the Bank of Canada to let the Canadian dollar go down to 62 cents American. That was a blunder, too. It doesn't do any good to the Canadian economy when the currency overshoots in a downward direction. Currency markets are by their very nature unstable. They fluctuate up and down.

What should the Bank of Canada have done?
They should have just fixed it. They could have stopped it falling, because they know, if they have any sense of history, that currencies will overshoot. We have all this experience of Canadian history to rely upon. During the period of the late 1950s and the early 1960s, the Canadian dollar was about US$1.03-1.04, above parity. And then in 1961 the Minister of Finance said they wanted to get the Canadian dollar down to increase the economy, etc., and that he planned to use the resources of the Bank of Canada to lower the Canadian dollar. After he said that, the bottom dropped out of the market. It just crashed. In a panic the Bank of Canada and the Minister intervened and fixed it at 92.5 cents. It was at least better to fix it than let the hole find its way down to 80 cents.

Colin Clark (the Australian economist) has said that 25% is the maximum taxable capacity of a country. If it is higher, ill effects kick in, such as people moving out of the country, evading taxes and the like. Do you think Canada has a "brain drain" problem and, if so, do high tax rates account for it?
Clark said the maximum taxable capacity was 25%, and I'm not sure he is wrong in this. Maybe it is 30%, maybe it could be 33% or something like that, but I know it is not 40%. In the long run, if a government takes 40 or 50%, temporarily the government can collect the revenue because people run down their savings and they pay their taxes out of their savings. But what they start to do then is to make other arrangements. They change their jobs, they decide it is not worth working so long, instead of working and paying more than half your income to the government, it is better to work half a year and then go to the Caribbean the rest of the year and enjoy yourself at a lower level of income and then come back. Canada is one of the richest and luckiest countries in the world, but I think that the Canadian government has very much overshot its long-run equilibrium of a high-growth economy.

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