Why Robert Mundell Is Wrong About the Dollar/Euro

Nobel Laureate Robert Mundell and his followers have made some noise of late about the need to achieve a fixed exchange rate between the dollar and the euro. About their desire for an exchange rate fix they're certainly correct, though they're wildly incorrect in suggesting that inflation and deflation can be cured if the U.S. Treasury simply ties the dollar to the euro.

Where Mundell et al are right is more than obvious. Contrary to the broadly held view inside the economic commentariat that there should be an absence of policy in the form of floating exchange rates, the greater truth is that currencies are mere concepts meant to facilitate the exchange of actual goods. Money in its truest form should be a stable measure of value much as the foot is an unchanging measure of length, and as such, country currencies should have fixed definitions in terms of each other to facilitate the trade that underlies all economic activity.

The irony here is that what makes the Mundell crowd so correct about the need for fixed exchange rates is what exposes how very wrongheaded their thinking is about currencies more broadly. Money in the modern world is a paper concept lacking any kind of definition, so for anyone to assume that inflation and deflation can be whipped through the simple act of pegging currencies to one another is to redefine inflation and deflation altogether.

By the above definition, China could avoid inflation by virtue of pegging its yuan to the dollar. No doubt that was the plan of Chinese monetary authorities back in the ‘90s, but with dollar policy having become very irresponsible in the U.S. beginning in 2001, our devaluation transmitted our inflationary problem to China.

Looking at the dollar and the euro, the same concept applies. No doubt they could and should tie the currencies together at a fixed rate, but depending on the policies underlying both in a currency fix, they could continue their joint decline versus gold on the way to an exacerbation of inflation. The dollar/euro fix under such a scenario would be an inflationary one, and it would show up in the rising price of gold and other commodities.

Conversely, if policy were to move substantially in the other direction, the dollar and euro could rise in concert with each other and while the pegged currencies themselves may signal currency calm, their joint strength if extreme would foster a very real deflation that would reveal itself through declining commodity prices. Money is but a veil, and to assume that fixed exchange rates among paper currencies lacking definition would erase inflation or deflation is the height of naivete.

Assuming a looming dollar rise versus the euro, far from a recessionary signal as the Mundell crowd suggests, if the dollar's rebound pointed to actual dollar strength - as opposed to substantial euro weakness - the U.S. economy would strengthen as falling commodity prices would force a reorientation of capital back into productive endeavors, and away from the hard, commoditized assets least vulnerable to devaluation. A strong dollar would drive an investment boom into innovative ideas, all the while reducing wage and pricing pressures of the nominal variety.

To use but one example supporting the above claim, when President Nixon severed the dollar's link to gold in the early ‘70s, and the dollar collapsed, the rise of the Japanese yen against the greenback was not evidence of deflation, but rather positive evidence that Japan would not join the U.S. in its rush to inflation that authored a lost decade. Japan's economy didn't implode in the ‘70s as a result of the yen crushing the dollar; instead its economy boomed.

In a recent op-ed endorsing the Mundell prescription, it was suggested that "when the dollar declines significantly against the world's second leading currency, the euro, commodity prices rise." What the writer missed first in making this incorrect assumption is that the interplay between paper currencies tells us very little, and doesn't have to suggest rising commodity prices as the writer assumed. Indeed, the dollar could be rising against commodities all the while weakening against an even stronger euro such that gold, oil, wheat and others would be declining in both currencies.

Of course over the last 10 years the dollar's sharp decline versus the euro did in fact signal true dollar weakness as evidenced by the commodity boom. What should be noted here is that the euro's relative strength versus the dollar in no way spared Euroland, or for that matter England, Australia and Canada (the pound, AUD and CAD have all risen against the dollar since 2001) from inflationary monetary error. Put more simply, the dollar's substantial weakness masked a run on all paper currencies around the world (the Swiss franc too) that revealed itself through broad currency weakness versus gold.

The above explains why the rush to real estate was global in nature. When the U.S. devalues - meaning it inflates - our devaluation is always and everywhere a global event. And as is always the case when money is cheapened, capital finds its way to safe havens least vulnerable to devaluation. 

Mundell and his acolytes correctly acknowledge that the weak dollar authored a housing boom, but when a strengthening dollar happily began to drive a housing correction that would properly put the banks too exposed to real estate out of business in 2008, they oddly sought an even weaker dollar to prop up housing and banks that should have been allowed to die. In short, the policies they endorsed explain why our economy remains sluggish. Devaluation never works for the capital misallocations it authors, the currency weakness perpetuates the latter on the way to even greater mistakes, plus it erodes the value of the very investment streams that drive productive economic activity.

Looking to the present, just as the dollar's fall against the euro over the last ten years didn't spare Euroland inflationary pressures, the dollar's presumed rise versus Europe's paper currency will in no way be deflationary given how depressed the greenback's been for the past decade. A fix to a wilting euro would serve to perpetuate the weak currency downturn that we continue to suffer, and it would in no way erase inflation.

So while fixed exchange rates are a laudable goal, to seek them without an objective commodity definition for the fix would tether the U.S., Europe or both to poor monetary policies that would retard growth in Europe, the U.S., and the rest of the world. Fixed exchange rates are only as good as their underlying definition, and with the euro and dollar lacking any anchor at present, the Mundell policy in favor of continued dollar weakness through a euro peg is anti-growth, and will ensure yet more years of subpar economic performance.