To: SSU Students
From: Jude Wanniski
Re: The Mundell-Laffer Hypothesis, Part III
This is the third and final part of the long essay I wrote in the fall of 1974 for the spring 1975 issue of Irving Kristol’s Public Interest quarterly. Reading it 25 years later, some of it sounds oddly Keynesian – as when I talk of gold being underpriced or overpriced. On reflection, I think that is because Robert Mundell and Arthur Laffer were speaking to a Keynesian world and tried to translate their classical ideas in a way that might be understood by their peers. In the years that followed, I moved away from that constraint, with gold at the center, a constant, with the dollar being underpriced or overpriced. Otherwise, the analytical model remains as sturdy now as it was then. You should pay special attention to footnote #4, which is a verbal expression of the Laffer Curve. At the time I wrote these lines in late November 1974, I had not yet seen the Laffer Curve drawn on a cocktail napkin by Laffer, a few weeks later on December 4, 1974, at the Two Continents Restaurant in the Washington Hotel, across the street from the U.S. Treasury. It was Mundell, in truth, who wrote footnote #4, as I had made a special trip from my home in Morristown, N.J., to his Manhattan apartment in Morningside Heights, for the sole purpose of getting that footnote exactly right. As I recall, we sat down after dinner and spent an hour writing it and rewriting it until he was satisfied with it. More than anything else, this footnote established the intellectual foundation for the Reagan tax cuts of 1981 and, to a lesser degree, those of 1986. You will also find near the end of the actual text this partial paragraph which sums up the philosophical essence of the Mundell-Laffer Hypothesis:
It is a distinctly different approach from the monetarist who sees everything as depending on the proper amount of money printed by the federal reserve, or from the neo-Keynesian who sees everything as depending on "demand management" by the government. Both of these "macroscopic" theories are inherently managerial in nature. Mundell and Laffer go back to a older style of economic thought in which the incentives and motivations of the individual producer and consumer and merchant are made the keystone of economic policy.
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The Mundell-Laffer Hypothesis: A New View of the World Economy
The Public Interest
Number 39, Spring 1975
Gold and dollars
Such was, and still is, the power of the dollar, deriving from the power of the American economy. Just as Kansas is the most efficient supplier of wheat, and Brazil the most efficient supplier of coffee, so the United States is the most efficient supplier of money. It would be ridiculous to expect Kansas to run a zero balance of trade in wheat, importing as much as it exported, or Brazil a zero balance of trade in coffee. So too, it was imperative that the United States run ever-increasing deficits in its export of money. Bretton Woods broke down because U.S. politicians and economists did not understand this, and thus did not do the simple things required to perpetuate international economic stability.
What was overlooked was the efficient use of gold in providing a control mechanism and an error signal, as to when the United States was supplying too much money or too little. If the world economic system's real growth, year after year, would average three per cent, and the increase in the world money supply would average five per cent, there would be a world inflation rate of two per cent. As a purely private commodity, gold in 1944 at $35 was overpriced. But as world prices moved up year after year, and gold remained at $35 an ounce, eventually it became underpriced. By 1960, external demands for U.S. gold became so great at this bargain price that the U.S. government would sell gold only to other central banks. What emerged then was a collective agreement among central banks not to reduce further U.S. gold stocks. But the gold pool thus formed broke down in 1968 when gold losses to the private market became serious.
According to Mundell and Laffer, what the United States could have done to avoid the last decade of grief was to have concentrated on keeping the dollar more attractive than $35-per-ounce gold. Neither individuals nor central banks would come to the U.S. Treasury with dollars and demand their conversion into gold as long as the level of real growth in the world called for X number of dollars and only X number were supplied. If the United States was afraid of “losing” any more of its $12 billion gold hoard in 1967, it need only have acted in the following fashion: Whenever a foreigner holding, say, $100 showed up and demanded an equivalent amount of gold out of the Treasury hoard, the Federal Reserve would know it had mistakenly issued 100 too many dollars. By contracting the money supply in that amount, the Fed would only have to sit back and wait: Somebody else in the world, needing 100 dollars in order to make a transaction and finding the world was short by that amount, would come to the Treasury with the equivalent amount of gold and demand dollars.
Instead, by partially closing the gold window in 1968, the United States only succeeded in making the dollar less attractive relative to gold and began the process that culminated in the current economic nightmare. Immediately, the private market developed an unofficial price of gold higher than $35 an ounce. This effectively immobilized the gold held by central banks as reserve assets. Why? Central banks hold reserves as a cushion against unexpected international demands, arising from an internal crop failure, for example. But if such demands arose while gold was selling unofficially at higher than $35, the central bank would have to give up its gold at the official price and lose the difference. Every central bank thus locked up its gold and began scraping together new reserves -- i.e., dollars. The U.S. central bank, of course, didn’t have this concern acquiring dollar reserves -- because it is the central bank that creates dollars.
The demise of Bretton Woods
At the time, the popular belief in the United States was that the Western European and Japanese economies were amassing these dollar reserves by running trade surpluses with the United States. There was a common vision here of a Japanese manufacturer, using cheap labor, peddling a television set here for dollars, then simply banking the dollars. An American would lose a job, and a substitute job would not be created because the dollars earned by Japan would not be spent. The U.S. economy had become “uncompetitive,” or so the story went, and as the balance of payments deficits mounted, the idea took hold that the reason for all this was that the U.S. dollar had become “overvalued.”
What Mundell and Laffer say actually occurred was that, as foreign central banks immobilized their gold reserves, “money” became scarcer in these countries. In order to transact business, foreigners borrowed dollars and turned them in at their central banks for their own currency, and month after month the foreign central banks would show large holdings of dollars. To most Americans, this looked pretty frightening, since these dollars were perceived as claims against U.S. goods and services. What was not apparent in the balance of payments deficits was the original transaction, the foreign "borrowing" of dollars, which meant that the United States had an equal and offsetting claim against foreign assets.
In a world economy whose growth depended on a proper growth of the common currency (i.e., the dollar), the United States under the Bretton Woods arrangement would have to run ever larger balance of payments deficits for everyone's good. But Mundell perceived that, by forcing the immobilization of gold, the United States intensified this process and increased its deficits beyond the "normal" level. Then, instead of regaining control of the deficit by tightening up on dollar creation, which would have made possible once again the conversion of dollars into gold (or creating a world money into which the dollar was convertible), a grievous policy error was made. President Johnson sought to slow the outflow of dollars to reduce the U.S. payments deficit, first by voluntary restrictions on U.S. overseas investment (1965), then by making it mandatory (1968). A series of regulations was put in place to keep dollars from going abroad. The result was that the private market found a way around the U.S. regulations, and through financial innovation created a much worse headache for Washington. As Mundell stated in April 1972:
Failing an international money, a market solution will always develop, but it is one field in which market solutions are not optimal. The commercial banks, using the dollar, have now created an international money. It is the Eurodollar system or the international dollar system.
The financial innovation, which has taken on a life of its own, was the private substitute for the imperfectly working official system. The foreign branches of U.S. commercial banks accommodated the thirst for dollar liquidity abroad that the U.S. government was trying to choke off. Because foreign deposits of U.S. dollars are not subject to the reserve requirements imposed against domestic deposits, the banks could and did become efficient private creators of money. When the Fed slowed its creation of dollars, the Eurodollar market speeded up its creation, and vice versa. In an important 1974 empirical study, Laffer found this relationship to hold in each of the last 14 years. The Federal Reserve could now only kid itself into thinking it could slow down the economy by contracting money growth, or stimulate the economy by expanding money supply. The marketplace had found a substitute for the Fed.
In their imperfect understanding of what was happening in the world economy from 1967 on, U.S. policy makers dealt a quick coup de grace to the Bretton Woods system. In Mundell's words:
No event in history can be said to have a single cause. But if one were seeking the most important policy origins of the 1971 (monetary) crisis one would have to blame it on excessive monetary looseness in the U.S. in the first six months of 1971, when monetary expansion was more rapid than in any comparable period in a quarter century! The monetary acceleration exaggerated the overflow of dollars and engulfed Europe in dollar liquidity in the spring of 1971. In August, European central banks demanded gold. Rather than pay it out, the U.S. suspended convertibility. The 1934-71 era of $35 an ounce became a closed book in history.
There followed, between August 1971 and February 1973 (when currency exchange rates were set on a common float), a further comedy of errors. U.S. policy makers, hypnotized by the idea that the U.S. economy was suffering from an overvalued dollar, “won” a 13 per cent devaluation of the dollar in the agreement Treasury Secretary John Connally got from foreign ministers at a meeting in the Smithsonian Institution. The U.S. officials grumbled that the devaluation should have been three or four per cent higher to get all the benefits. As events demonstrated, there were not going to be any benefits at all.
Recreating the “money supermarket”
In the Mundell-Laffer perspective, the world after 1944 had enjoyed all the efficiencies and economies of scale of a “money supermarket.” But with flexible -- then floating --exchange rates, the supermarket would close and be replaced by “mom and pop” money stores. It is the global equivalent of what would suddenly happen if each of our 50 states were forced off the common U.S. currency into independent monetary systems.
Nor will Mundell and Laffer be surprised if the world comes back to a money supermarket, a fixed-exchange-rate system that again tries to approximate a world currency. In June 1969, at a conference celebrating the 25th anniversary of Bretton Woods, Mundell took note of the powerful forces driving toward exchange-rate flexibility and predicted that by 1980 the world would have tried it, abandoned it, and turned away from any advocacy of it. It will probably not take that long. Already, many U.S. officials no longer look upon dollar depreciation as signaling an improvement in the U.S. “competitive” position. And West German bankers, economists, and politicians no longer worry that an appreciation of the Deutschemark will harm the German economy. Once this reality is accepted, the “political impracticalities” of putting together a world currency vanish. If politicians can see that their internal economies do not benefit from depreciation of the currency, and if they further see that their internal economies cannot be stimulated to increased output and decreased unemployment by money creation, they will willingly give up this device in order to gain the enormous benefits of the money supermarket, the common currency.
Once this political problem is put aside, all that Laffer and Mundell see is a difficult, but straightforward, engineering problem. In a dozen different ways, the mechanism can be reconstructed so that the benefits of Bretton Woods are back without the flaw of the system.
Thus, instead of all currencies tying to the dollar, and the dollar tying to gold, all currencies can tie to the International Monetary Fund's Special Drawing Rights (SDR) –"paper gold" -- which in turn fix the price of gold. The difference is subtle, but it removes the worst problems of the Bretton Woods system. Instead of the United States getting all the banking profits that were accruing to it because of the international dollar standard, each nation linked into the system would get a proportional share of the profits. The dollar would still be powerful, but the United States could not, as DeGaulle once complained, echoing his friend and adviser Jacques Rueff, enjoy "a deficit without tears." The Eurodollar market would be replaced by the SDR market, and while the dollar would still be dominant, it would not be as conspicuous. And in holding the price of gold at arm's length instead of at the pivot of the system, the West could protect its monetary system should the Soviet Union or South Africa -- the biggest producers of gold --suddenly try to dump the metal on the market and reap unreasonable rewards. With this SDR anchor, the finance ministers of the West would be able calmly and precisely both to maintain external balance and to increase world money in the desired and appropriate amounts.
The economic and social costs of not having such a system operating since 1967, and especially since 1971, have been colossal. Monetary discipline ended when the world moved away from convertibility and onto flexible rates. Much of the world inflation has resulted from the breakdown of Bretton Woods, bringing in its train the crisis in confidence in Western institutions and doubts about the appropriateness of free economies in the modern environment. In return for this mess, the United States now has an independent monetary policy, which amounts to a “right” to have more unemployment when policy errs on the side of tightness and the “right” to have more inflation when policy errs on the side of looseness.
Dealing with "stagflation"
To deal with the domestic economy, the U.S. policy maker operating under a fixed-exchange-rate system would still be left with fiscal policy, which is all that is necessary. Since 1961, Mundell has argued that monetary and fiscal policies are totally distinct policy instruments that can be employed for separate purposes and even utilized in opposing directions. Monetary policy is the appropriate instrument to maintain external balance; fiscal policy is the appropriate instrument to maintain aggregate demand and internal balance. If the world economy has inflation and unemployment at the same time, the proper policy mix is tight money and fiscal ease. The latter should preferably take the form of tax reductions although Mundell agrees that government purchases of goods and services will also have beneficial effects.
The essence of this revolutionary idea is that with a given supply of money, increasing unemployment in the modern age almost certainly means an increase in inflation. In an earlier age, when there were no unions and only minimal welfare and unemployment benefits to those unemployed, a slowing in production would translate itself into lower money wages. Today, an increase in unemployment translates into lower money wages only over a long period. The supply of goods and services simply declines, and the supply that is produced is bid up in price by the employed (with their still high wages) and the unemployed (with their transfer payments). 4
Mundell's first explicit public insistence that the current U.S. “stagflation” called for tax-cutting and tight money was made in April 1971 at a conference in Bologna, Italy, on world inflation. The 180-degree turn in the Ford Administration's policy in January 1975 came in part as a result of Laffer's presentations in late November to White House chief-of-staff Donald Rumsfeld. Laffer, who took the insight from his friend Mundell and refined it to embrace the debilitating effects of transfer payments, also argued the case in a November memorandum to Treasury Secretary Simon:
The best program to combat inflation simultaneously reduces money growth and increases real output growth. In order to increase real output growth, it is first necessary to focus on why people, machines, land, and other factors of production choose to be employed. Secondly, it is necessary to focus on why firms choose to employ these productive factors.
It is taken here as a simple truth that in part productive factors' choice to work is based upon their ability to earn after-tax income. It is likewise taken as a virtually obvious proposition that the more an employer has to pay his factors of production the less he will want.
Marginal taxes of all sorts stand as a wedge between what an employer pays his factors of production and what they ultimately receive in after-tax income. In the case of payroll taxes, for example, if an employer pays an employee $100 he must also pay his share of the social security contribution of about $5.50. Thus the use of the employee's services costs the employer $105.50. The employee on the other hand has $5.50 deducted from his payroll for his share of the contribution and therefore receives $94.50.... The $11 wedge is only the social security taxes. In addition to these taxes, there are also income taxes, sales taxes, property taxes, state and local taxes of all sorts, etc. At our current levels these tax wedge effects are very significant.
In order to increase total output, policy measures must have the effect of both increasing firms' demand for productive factors and increasing the productive factors' desire to be employed. Taxes of all sorts must be reduced. These reductions will be most effective where they lower marginal tax rates the most. Any reduction in marginal tax rates means that the employers will pay less and yet employees will receive more. Both from the employer and employee point of view more employment will be desired and more output will be forthcoming.
What is especially interesting about this line of reasoning is not its heterodoxy. Heterodox it most certainly is: For more than a generation conservative economists have been insisting that inflation must be fought with monetary and fiscal restraint, while liberal economists have been demanding monetary and fiscal ease to combat recession. Even more heterodox, perhaps, is the fact that Mundell and Laffer think of tax-cutting as a way of augmenting supply, when virtually all of their peers see it only as a way to augment demand. Still, what is most interesting is not any particular conclusion but the way of thinking itself: it is so uncommon to hear economists analyze the action's economic problems -- in such microeconomic terms -- in terms of what makes people want to work and produce. It is a distinctly different approach from the monetarist who sees everything as depending on the proper amount of money printed by the federal reserve, or from the neo-Keynesian who sees everything as depending on "demand management" by the government. Both of these "macroscopic" theories are inherently managerial in nature. Mundell and Laffer go back to a older style of economic thought in which the incentives and motivations of the individual producer and consumer and merchant are made the keystone of economic policy.
Moreover, this individual producer and consumer and merchant are seen as members of a world economic community. Thus, Mundell-Laffer's global view of what must be done follows from this same kind of microeconomic reasoning. Governments cannot change the terms of trade either by changing money supplies or by varying exchange rates. Some of them only think they can. If they gave up trying, and pooled their mistakes in a simulated common currency, they would avoid the dreadful cost of their illusion. They need only then manage the rate of growth of the common currency -- a task they can also relieve themselves of by tying the growth rate to the limitations of the planet's resources (of which gold, of course, is one), knowing that if they do not do this, the planet will bark back with a shortage of its treasures. According to Mundell-Laffer, conservationists who fear the West is plundering the earth's resources little realize the enchanting possibilities of international monetary reform.
A "Copernican revolution"?
It is still much too early, of course, to estimate the status of the Mundell-Laffer hypothesis. Though many distinguished economists are beginning rather grudgingly to allow that "there may be something in it," resistance and disapproval are still strong. The suggestion that gold (or an equivalent to gold, say a basket of commodities) could have a useful role in international finance certainly raises the hackles of a generation of economists who were raised to think that the "gold standard" was one of yesteryear's most awful superstitions. And the Mundell-Laffer hypothesis does irritate the ideological sensibilities of those -- whether economists or politicians -- who believe that, world economy or no, a national economic policy can still be "made" by national authorities. And it is always possible that further research and analysis will reveal that Mundell and Laffer have only a part of the truth.
Still, it is unlikely that the hypothesis will simply fade away. The world phenomenon of inflation-with-recession is one of the striking features of our era, and existing economic theories -- whether emanating from Cambridge or Chicago -- do not seem able to give a clear and simple explanation. And as the "epicycles" required for a explanation become even more complicated and tortuous, some sort of Copernican revision will become more appealing. Just where the Mundell-Laffer hypothesis fits into such a revision remains to be seen. Theirs may or may not be the "Copernican revolution" in economics that is needed. But at the very least, one suspects, it can legitimately claim a proto-Copernican status.
4. Taxes should be cut and government spending maintained through deficit financing only when a special condition exists, a condition Mundell and Laffer say exists now. "There are always two tax rates that produce the same dollar revenues," says Laffer. "For example, when taxes are zero, revenues are zero. When taxes are 100 per cent, there is no production, and revenues are also zero. In between these extremes there is one tax rate that maximizes government revenues." Any higher tax rate reduces total output and the tax base, and becomes counterproductive even for producing revenues. U.S. marginal tax rates are now, they argue, in this unproductive range and the economy is being “ choked, asphyxiated by taxes,” says Mundell. Tax rates have been put up inadvertently by the impact of inflation on the progressivity of the tax structure. If the tax rate were below the rate that maximizes revenues, tax cuts would reduce tax revenues at full employment. But a multiplier effect operates if the economy is at less than full employment, and the tax cut then raises output and the tax base, besides making the economy more efficient. Even if a bigger deficit emerges, sufficient tax revenues will be recovered to pay the interest on the government bonds issued to finance the deficit. Thus, future taxes would not have to be raised and there would be no subtraction from future output. Tax cuts, therefore, actually can provide a means for servicing the public debt.
In May 1974, Mundell said the U.S. economy needed an immediate tax cut of $10 billion, or as the economy deteriorated, the figure would grow. In October, he said the implied tax cut should be $30 billion; in February, both he and Laffer moved the figure to $60 billion. The tax cut numbers are only "implied" in the sense that Mundell and Laffer believe deficits would not materialize in those amounts since the tax base would rise; employment, price stability, and revenues would be optimized by putting unemployed resources back to work.