A Reconsideration of the 20th Century

Prize Lecture, December 8, 1999 By Robert A. Mundell
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The twentieth century can be divided into three distinct phases to understand the emergence of the monetary system as it is today:

1900-1933 • International Gold Standard • Breakdown during the war • Restoration in the 1920s • Demise in the early 1930s

1934-1971 • Devaluation of the Dollar • Establishment of $35 Gold price • End of the Bretton Woods System

1972-1999 • Collapse into flexible exchange rates • Outbreak of massive inflation + stagnation in 1970s • Return to monetary stability and birth of the Euro

1: Mismanagement of the Gold Standard
• World War I made gold unstable
– Deficit spending pushed European nations off the gold standard – Gold reserves accumulated in the US where Federal Reserve monetized it

• Post the recession of 1920-21, US engineered a deflation bringing price level towards the pre-war equilibrium • Around 1925, Germany, Britain and France returned to the Gold standard
– However, Gold prices were 40% above their pre-war equilibrium and reserves and supplies were smaller – The reserves of these countries were insufficient

• The scarcity of gold and the increasing demand ultimately led to a decrease in the general price level

Late 1920s: • 1920s saw a deflation in general price levels of agricultural products and raw materials • This was accentuated by the Wall Street Crash of 1929 • Percentage loss of wholesale prices in some of the countries is given belowJapan Deflation 40.5 % Germany Belgium 22.0 31.3 Itay 31.0 US 29.5 UK 29.2 France 28.3

• Adoption of Gold standard-> Increase in Gold prices->Deflation • The dollar price level in 1934 was the same as 1914 • The only solution was to stop the monetary demand for gold

Early 1930s: • 1931 saw the failure of Viennese Creditanstalt, the biggest bank in Central Europe • The chain reaction spread to Germany and Britain resulting in a reimposition of control and deflationary monetary policy • Several countries followed Britain in going off the gold standard • However, US changed its policy objective from maintenance of price stability to maintenance of gold standard • US Federal Reserve increased the rediscount rate from 1.5% to 3.5% which pushed it deeper into a deflation and depression spiral • This was followed by the Smoot Hawley Tariff act which was followed by retaliation abroad and world trade decreased significantly - decreasing imports and exports by over 30% • Then, in 1932, President Herbert Hoover signed the Revenue Act, which imposed the largest tax increase ever
– Unemployment increased to 24.9% and Real GDP fell 22%

Causes For Failure
• Federal Reserve was inconsistent at critical times – Held on to Gold Standard from 1914-21 when gold prices were unstable – Price stability in 1920s which was successful – Moved back to the Gold standard towards early 1930s • European countries moved on to the Gold standard without weighing consequences • Mass movement to or from the Gold Standard brings with it, respectively, deflation or inflation • According to Mundell, had Gold price been raised and price stability maintained, there would have been no Great Depression, Nazi Revolution and WW II

Phase II
• US reverted back to Gold after an year of flexible exchange rates • Gold value of Dollar decreased 40.94%, Gold being priced at $35/Ounce

1944 (Bretton Woods)

• Keynes' General Theory (new theory of policy management for a closed economy) published • Tripartite Accord among the United States, Britain and France (a precursor of the Bretton Woods agreement) signed

• Countries were required to establish parities fixed in gold and maintain fixed exchange rates to one another

Bretton Woods System
• Countries required to fix their currencies to the value of Gold and with respect to each other
Difference between Bretton Woods and Gold Standard

1. A special clause allowed any country the option of fixing the price of gold instead of keeping the exchange rates of other members fixed
– Because the dollar was the only currency tied to gold it was the only country in a position to exercise the gold option Dollar was actually tied to world price level rather than Gold

2. Not even the United States was on a full gold standard

The Author thus questions the creation of new system at Bretton Woods.!

World War II
• World War II – US benefitted from devalued Dollar and increased Gold inflow in return for the war goods sold to Europe • The United State sterilized the gold imports and imposed price controls • By 1945, the public debt had soared to 125 percent of GDP • At the end of the war, the U.S. price level doubled as a result of the end of price control • The postwar inflation halved the real value of the public debt, increased tax revenues as a result of "bracket creep“ • 1948  Germany & Japan due to huge inflation brought about currency reforms which later proved to undervalue their labor

Federal Reserve System
• 1949 the United States had peaked at over 700 million ounces of gold, more than 75 percent of the world's monetary gold • Monetary and fiscal policy were directed at the needs of internal balance while ignoring the balance of payments • To prevent the effect of Gold losses on money supply post 1949, Federal Reserve System purchased equivalent amount of US Government Bonds • Federal Reserve System was required to keep a 25 percent (reduced from 40 percent in 1945) gold cover behind its currency and deposit liabilities

Robert Mundell
• Problems at hand - Subpar employment levels, sluggish growth, worrisome Balance of Payments deficit • Existing theories suggested low interest rates and high taxes and thus Govt. spending as a policy to tackle the situation • Mundell believed the other way round - lower taxes to spur employment, and tighten monetary policy to protect the balance of payments • The adoption of my policy mix helped the United States to achieve rapid growth with stability

Policy Action
• The policy action could not curb the BOP problem because the underlying reason for the same was different • U.S. deficit was the principal means by which the rest of the world was supplied with additional reserves • If the United States failed to correct its BOP deficit - it would no longer be able to maintain gold convertibility • If it corrected its deficit - the rest of the world would run short of reserves and bring on slower growth or, worse, deflation

Solutions to the problem
• One solution was to raise the price of gold – •
The action was promised to be taken by a Presidential candidate R. Nixon during his election campaign, but nothing came off The other option was to create a substitute for gold – Creation of SDR’s (gold-guaranteed bookkeeping reserves made available through the IMF). Somewhat less than SDR 10 billion were allocated to member countries in 1970, 1971 and 1972, but they proved to be inadequate

• • • •

August 15, 1971, confronted by requests for conversion of dollars into gold by the United Kingdom and other countries, President Nixon took the dollar off gold “Gold Window" at which dollars were exchanged for gold with foreign central banks was closed down. The other countries now took their currencies off the dollar and a period of floating began Floating made the Nascent plans for European monetary integration more difficult December 1971, at a meeting at the Smithsonian Institution in Washington, D. C., finance ministers agreed on a restoration of the fixed exchange rate system without gold convertibility A few exchange rates were changed and the official dollar price of gold was raised but the act was almost purely nominal since the United States was no longer committed to buying or selling gold

Dollar Standard – Start & End
• The major countries fixed their currencies to the dollar without a reciprocal obligation with respect to gold convertibility on the part of the United States • U.S. monetary policy was too expansionary in the following years • After another ineffective devaluation of the dollar, the system was allowed to break up into generalized floating in the spring of 1973

• The policy mix has to suit the system • Fixed- exchange- rate systems work better among friends than rivals or enemies • The superpower cannot be disciplined by the requirements of convertibility or any other international commitment if it is at the expense of vital political objectives at home • fourth lesson is that a fixed exchange rate system can work only if there is mutual agreement on the common rate of inflation

Inflation and Supply-Side Economics
• Breakdown of the fixed exchange rate caused the money to more easily change hands across the globe Oil prices were directly related to the Dollar deposits of the oil importing countries: from $223 B in 1971 to $2,351 B in 1982 Inflation in US
– 1952-1971: Inflation rose by less than 30% – 1971-1982: Inflation rises by 157% – During wars inflation rose by 108% (WW II, 1939-1948), 44% (War of 1812, 1811-1814)

Apart from Germany, for all other countries CPI doubled, in cases of Italy and UK it tripled, during 1970 to 1980.

Ups and Downs in US
• Period 1979-1981
– – – – – Gold hit $850 an ounce and silver hit $50 an ounce. President Jimmy Carter announces oil import fee and other credit control mechanisms Real output hit badly due to inflation Prime interest rates headed for sky at 21.5% With progressive taxes going to 70% and additional state and local taxes, real inflation remained stagnant and people were pushed into higher tax brackets

Solution to the problem came in the form of
– – – – – Cuts in marginal tax rates to create output incentives Tight money to create stability in the economy Ronald W. Reagan came to power and enacted the Economic Recovery Act of 1981 Paul Volker, chairman of the Federal Reserve, introduced a tightened monetary policy Tax cuts, Arms buildup and tax reforms of 1986 helped the period of 1982-90 o be the second longest duration of expansion in US history

Continued growth story
– Period of 1982-2000 was the greatest growth recorded in the history for any country – Over 37 Million new jobs created – DOW Jones moved from 750 to 11,000 over this period

On the Global front
• With the Euro upon its birth 1999, it became the second most important currency in the world. • Dollar, Euro and Yen became the three most important currencies in the world. • Euro spread its wings in Central and Eastern Europe, former CFA Franc zone in Africa and also in some areas of Mediterranean. • Widespread acceptance of Euro was expected to have similar reactions with other dominant currencies in order to provide stability and financial support.

Volatility in the Exchange rates
• • Volatility in the exchange rates would hurt the countries that have already achieved price stability The volatility therefore measures real- exchange- rate changes and involves dysfunctional shifting between domestic and international-goods industries and aggravates instability in the financial markets. Assuming Euro to mimic Mark’s performance:
– – – – Between 1971-1980 Mark doubled against $ to $1 = DM1.7 1980 and 1985, it halved, to $1 = DM 3.4 1985 and the crisis of 1992, it more than doubled, to $1 = 1.39 Since fallen to $1 = DM 1.9

Yen Dollar movements
– Dollar has gone down from 250 yen in 1985 to 79 yen in 1995 – it went up to 148 yen in 1998 – Down to 105 yen in early 2000

• • • We can take from the last third of the twentieth century is that flexible exchange rates, at least initially, did not provide the same discipline as fixed rates. The costs of inflation are much higher in a world with progressive income tax rates. The need for attaining monetary stability.

Governments forced into the Maastricht mold had to cut back on spending growth as well as deficits.
Supply-side economics pointed to one of the mechanisms for strapping down ministers of finance.

One lesson, however, has yet to be learned. Flexible exchange rates are an unnecessary evil in a world where each country has achieved price stability.

• International Monetary System depends on the balance of power between the countries that make it up • 19th Century - Policy coherence of US and UK • 20th Century – Emergence of US • The century ends with Dollar, Euro and Yen are the pillars of monetary stability • It is of utmost importance to have a monetary system that is compatible with the power configuration of the world economy • Within a decade, there is a significant shift in the global power balance with the emergence of China

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