The Mundell Puzzle Jude Wanniski May 5, 2000

At the conclusion of last week’s lesson I posed a question as an exercise: I'd like all of you to think of a puzzle that Mundell presented to me 25 years ago, in 1975, when I was struggling to learn his analytical model. Jerry Ford was President as I recall Mundell posing the question: "Suppose President Ford came on television tonight and asked everyone viewing to take out all the cash in their wallets and purses and to cut the bills in half, and to assure them that each half would now be legally worth as much as the whole. What would happen to prices?" Please think this through as carefully as you can and submit your answers. The best will get a prize of some sort, which I will think about carefully.

Of the many submissions, the clear winner was Mat O'Donnell, who avoided the trap most fell into, thinking a doubling of the money supply would cause a doubling of prices. I’ll have to confess that Mundell never told me what his answer would be, but after struggling with the question for a very long time, I realized Bob wanted me to see for myself the fallacy of the quantity theory of money that underpins Milton Friedman’s demand-side monetarism. Let’s hear from Mat and then discuss his answer:

As I understand it, there are two ways to interpret the question, and the results would depend on the interpretation.

1. Mundell wants us to imagine the government doubling the amount of cash in circulation. After cutting a \$1 bill in half, you now have two pieces of paper, each worth \$1. When I get paid next, I will still receive my weekly salary of \$100, just as I did last week. However, now if I cash my paycheck, I will receive 100 more or less square pieces of paper. I think such an expansion in cash would have a negligible effect on the economy, since cash money represents a very small percentage of the "money" in circulation. Most money is held in bank accounts, securities and other financial instruments that provide income, security, convenience or all three. Investors who have kept shoe boxes full of \$100 bills will reap a windfall, after a significant amount of cutting. There would be some localized discontinuity since some debtors will be repaid with "cheaper" money. For example, I borrowed \$5 from my brother-in-law the day before Ford's speech, cut it in half while watching TV, and gave him half of the original bill in payment of my debt. There might also be increased demand for tables at a popular local restaurant immediately following Ford's speech. But given that dollar-denominated activities, e.g. my paycheck, did not change after the speech, things should settle out very quickly.

2. Mundell could mean a wholesale revaluation of the currency, by in essence dictating a 2 for 1 split. This would apply to all forms of dollar-denominated value. Thus my bank savings account which stood at \$150 before the speech, would be valued at \$300 after the speech. Likewise, my weekly paycheck, \$100 before the speech, would be \$200 when I received my next paycheck. The effect of this action would depend on how the revaluation was implemented. My assumption is that it would apply to both sides of the balance sheet. Thus assets, like my savings account, would double and my liabilities, for example the \$500 I owe on my car, would also double. This is only right, since some of my assets, like my savings account, are someone else's liabilities, for example my bank. As long as the re-valuation is balanced, and instantaneous, the effects would be negligible. Even those stuck with physical cash, would be allowed to cut their bills in half. If it only applies to cash, i.e. asset, accounts, then I win big time and the economy has to go through a painful period of adjustment. This, in my opinion, constitutes a de-valuation as opposed to a re-valuation of the currency. In this case, debtors win at the expense of creditors. Before the speech, my bank had \$150 on deposit from me, and held a loan worth \$500. On their balance sheet, assuming I was their only customer, they showed \$350 in capital (\$500 asset - \$150 liability). After the speech, their capital shrunk by \$150 to \$200 since my checking account was now worth \$300 (\$500 asset - \$300 liability = \$200 capital). Also, I could pay off my loan more quickly, add to my savings, etc. Of course, other assets would double in value, like cars and beer, so I would have to pay more for these things. So, in an unbalanced devaluation, asset values double, prices double, more or less, and creditors, like banks, lose their shirts.

This represents my stab at economics after 2 years at SSU, and of course careful reading of TWTWW.

Cheers, Mat O'Donnell

* * * * *

Mat’s answer is not perfect, but in the absence of a true test, I can’t guarantee that mine is perfect either. We can dispense with his scenario number two, though, as Mundell clearly did not intend a monetary “reform” of the kind countries enact after a hyperinflation, when the basic unit has several zeroes after the “1,” which should represent a loaf of bread, for example. The Russian ruble could buy a loaf of bread in 1989, when I visited Moscow. After the big inflation wrought by “shock therapy,” it took 1000 rubles to buy a loaf of bread and 300 to buy a postage stamp. The monetary “reform” that lopped three zeroes off the ruble also lopped three zeroes off all assets and liabilities on public and private balance sheets. Mexico did the same in the early 1990's, after 15 years of inflation had increased the general price level in pesos a thousand-fold. There are no winners or losers in such a zero-sum adjustment, as debtors and creditors -- including tax collectors and taxpayers -- knock the zeroes off their assets and liabilities. Holders of cash are given time to exchange old for new.

If Mundell had this type of reform in mind, he would have presented his problem differently. In asking us to cut the cash we have on hand in two, he pushes us in a different direction. As Mat O’Donnell realized, dollar contracts would remain unchanged, so the price level would be unaffected on that account, at least. His contract with his employer, \$100 for a week’s work, would remain the same. His mortgage payments to his saving-and-loan bank and his car payments to his bank would remain the same. The “money supply” would not double, only the amount of currency on hand. Unless your family has a practice of hoarding cash, in which case you would have a windfall increase in your cash wealth, you would not notice much difference in your personal situation in the exchange economy. Some of the wealthiest people in the nation carry only a few dollars in their pockets while some of the poorest save everything they have in cookie jars. The windfall gains to those who have significant amounts of cash would be offset by the increased future tax liabilities of the population as a whole. Why? Because the dollar is non-interest-bearing debt of the federal government. The publicly held national debt is about \$3.6 trillion last time I looked and of that \$578 billion is in non-interest bearing debt, roughly \$60 billion in bank reserves and \$518 billion in currency. With the currency portion cut in half, the national debt would increase to \$4.1 trillion. But there would be \$518 billion more in non-interest bearing currency than the economy needs for transaction purposes at the existing general price level.

If we were on a gold standard, it would be easy to see that the Federal Reserve would have to sell \$518 billion in bonds from its portfolio in order to maintain the gold price. Unlike a sudden burst of government spending which runs up the national debt -- as in World War I -- the doubling of circulating dollars does not automatically increase consumer spending on goods and services, which would of course put upward pressure on prices. Roughly 80% of the dollars in circulation are overseas, either in the drug trade or as circulating media in countries where the dollar has been more reliable than the local currencies. These global dollars would also be in surplus and would tend to put upward pressure on the price of gold unless cleared from the market by bond sales in which the dollars are extinguished. Keynesians would argue that the fresh currency would be added to aggregate demand and thus cause an inflationary spending boom. Mundell, I think, would posit that the national economy would act the same way a family unit would in realizing its debt has suddenly gone up by \$518 at the same time it has discovered \$518 in a paper bag on the front lawn. It would use the one to liquidate the other.

When we say the market would act in this rational way, we of course net out those who squander the windfall with those who see an opportunity in buying assets at the higher interest rates which would accompany a surge in the national debt by \$518 billion. The average family probably holds less than \$100 in cash, most of the rest in ATM machines, cash registers and bank vaults. The ATM machines would quickly be cleaned out -- by the banks. Because banks would have most of the money, it is easier to see how quick they would be to accept interest-bearing bonds from the Fed in exchange for the surplus cash. One respondent to the Mundell puzzle somehow assumed people would rush to their banks and ask for full-length currency which they could then cut in half. No, no. They would get dollars cut in half by the tellers.

Without a gold standard to anchor the general price level, it would be more difficult to predict the effects of a halving of all existing dollars. The surplus coming in from abroad would be automatically mopped up, as they are today, with no impact on the price of gold and on the general price level. In this floating world, with Greenspan already worried about an overheated economy, he might have to raise interest rates at a faster clip, but it's not clear in a rational market why that would necessarily occur. For there to be a monetary inflation resulting from this or any other action, it has to be accompanied by a rise in the dollar price of gold -- and if the net effect of the monetary authority is to see no such increase in the gold price, there will be no permanent effect on the general price level. The action would cause a redistribution of "wealth," but that would simply amount to windfall gains being matched by windfall losses.

* * * * *

Should we assume this analysis is correct? Not at all. It is simply the best the SSU students could come up with and my best assessment after 25 years of thinking about the problem. This lesson is bound to produce heated disagreements, but they will be welcomed here. As for Mat's prize, I will send him a leather-bound, autographed copy of TWTWW, to sit next to his well-worn, dog-eared copy. There are only 400 such copies in existence and I number them the way an artist numbers limited edition silk-screens. Those of you who did not win a prize are invited to invest in this limited edition, which will of course increase my money supply, but not the price of the book.