Columbia University's Robert Mundell, whose thinking contributed to the intellectual foundation of the euro zone, is in high demand here at the Lindau Meeting on Economic Sciences for obvious reasons. He's taking advantage of the attention to propose a new international monetary system.
Prof. Mundell, a Canadian who received the Nobel Prize in economics in 1999 for his work on common currency areas and his analysis of monetary and fiscal policy under various foreign-exchange rate regimes, believes the summaries of the causes of the financial crisis have underplayed the impact of the U.S. dollar's surge in the aftermath of the bankruptcy of Lehman Brothers Holdings Inc. in September, 2008.
"The Fed allowed the dollar to soar by 30 per cent," Prof. Mundell told the more than 300 young economists assembled Thursday in this Bavarian town to gain insight from 17 Nobel laureates. Money got tight. Commodity prices collapsed, including oil, which plunged 70 per cent over the following few months. Inflation turned negative in early 2009 from a rate of more than 5 per cent in the summer of 2008. The deflation threat that led to the Fed's second asset-purchase program was born.
Of course, the Fed, the captain of the team of global central banks that champion flexible exchange rates, would never use policy to manipulate the value of dollar. Prof. Mundell says this mentality must change.
Big financial crises are a prewar and a contemporary phenomenon: they were relatively common before the Second World War, and they are a regular feature of the global economy of the last few decades. In the 1950's and 1960's, they were no major financial blowups. These were the years of the Bretton Woods arrangements, under which countries fixed their exchange rates to the U.S. dollar, which was in turn tied to the price of gold.
Bretton Woods collapsed in 1971 when the Nixon administration stopped converting dollars for gold. A certain degree of stability followed as the dollar became the unparalleled unit of exchange in the global economy. (That wasn't enough to keep investors in the U.S. during the inflation shock in the later 1970's, when the greenback lost half its value against its German counterpart. The dollar reverted back to its previous level, which became a huge problem for emerging-market countries, according to Prof. Mundell, because their U.S.-dollar denominated borrowing was suddenly significantly more costly.)
Then along came the euro 1999.
A currency backed by the strongest economies of Europe gave global investors an alternative to the greenback when they grew wary of the state of affairs in America. Prof. Mundell argues the shift of investors back and forth between the dollar and the euro has introduced instability to the financial system. To ease the volatility, Prof. Mundell says the Fed and the European Central Bank should co-operate to fix the value of the euro-dollar exchange rate.
"Before the (Bretton Woods) system broke up, the dollar represented the mainstream of the global economy and any country that fixed to the dollar would be fixing to most countries," Prof. Mundell said in an interview Thursday. "Now, with two big economies, the dollar has been split in two, with big swings between (the dollar and the euro). Third countries, they can't win. If they fix to the dollar, they are going to suffer with the euro-dollar exchange rate and the same if they are fixed in euro."
The U.S. and Europe also would benefit, Prof. Mundell said. Just as he thinks the surge in the dollar in 2008 was the biggest factor behind the U.S. recession, Prof. Mundell says the eventual rebound in the euro greatly contributed to the European debt crisis.
How would this fixed-exchange rate regime work? Prof. Mundell said U.S. and European authorities should choose an appropriate euro-dollar rate, say $1.30, and then keep it trading within an appropriate band. When the euro got too weak, the Fed would enter the market to support it; the ECB would do the same for the dollar. In time, Prof. Mundell would add China, creating a troika of the world's three biggest economies. This combination could then serve as the backing for a new global currency.
Prof. Mundell participated in the private symposium earlier this year in China to discuss the international monetary system. He used the gathering to present his proposal, and said he had a long discussion with U.S. Treasury Secretary Timothy Geithner about it.
However, Prof. Mundell is equating the treasury secretary's intellectual curiosity with a willingness to upend U.S. currency policy. The G20 will discuss reform of the monetary system at its summit in Cannes, France in November, but few, if anyone, expect any significant changes.
But these kinds of things take time. Prof. Mundell wrote his seminal paper on optimal currency areas in 1961. The euro zone came almost four decades later.