Nobel laureate Mundell foreshadowed euro

By Jonathan Lynn

STOCKHOLM (Reuters): Much of the debate about European economic and monetary union was foreshadowed in research nearly 40 years ago by Robert Mundell, awarded this year's Nobel economics prize on Wednesday.

In his seminal article in 1961 on optimum currency areas, Mundell posed the radical question of when it was advantageous for a number of regions to relinquish monetary sovereignty in favor of a common currency.

On Wednesday, the Nobel prize-winner played down the idea that he was the father of the euro, telling Reuters: "That is too strong -- maybe the godfather, maybe a godfather, one of several godfathers."

Mundell's work examined the advantages of a common currency, such as lower transaction costs in trade and less uncertainty about relative prices, and looked at the disadvantages in more detail.

The major drawback is the difficulty of maintaining employment when changes in demand or other "asymmetric shocks" require a reduction in real wages in a particular region.

For Mundell, high labour mobility to offset such disturbances was important for the survival of a joint currency.

"He characterized an optimum currency areas as a set of regions among which the propensity to migrate is high enough to ensure full employment when one of the regions faces an asymmetric shock," said the Royal Swedish Academy of Sciences, which awards the economics prize.

This remains highly relevant to the debate about the single currency, where one of the key issues is labour mobility in response to asymmetric shocks.

For instance if an economic downturn in France or Italy leads to an increase in unemployment, the government no longer has the option, with the single currency, of devaluing or cutting interest rates.

Nor, because of the EMU stability pact limiting budget deficits, does it have much scope to stimulate the economy through fiscal means such as tax cuts or increased spending.

Graham Bishop, adviser for European financial affairs at Salomon Smith Barney/Citigroup in London, and himself a long-time enthusiast for European monetary union, said Mundell's theory had been a key factor in developing a workable EMU.

"If the economic fraternity had all risen up as one and said it won't work, then maybe the politicians would have dropped the idea," Bishop said. "He provided a framework under which it could be demonstrated it had a good chance of working."

It remains to be seen, however, whether EMU will meet the conditions Mundell laid down in his theories.

"One of the huge debates about the euro was whether the relevant parts of the European Union constituted an optimal currency area within the Mundell test. History will give that answer," said Bishop.

Mundell, who has watched the euro have a bumpy birth since it began trading in January -- it has fallen as much as 15 percent from post-launch peaks against a surging dollar and was on Wednesday at US$1.08 -- said it had performed as expected.

"I am very happy that it went down first because European currencies were very overvalued and unemployment was very high and the fact that the dollar was soaring very high against the euro was a good thing for Europe because it made Europe more competitive," he said in a brief interview in London.

He said he expected the dollar to depreciate as the U.S. economy slowed, possibly in 2000, and that he was looking for the single currency to trade between $1.05 and $1.15 next year.

"I could see at the end of next year it even going higher, but that would be something to worry about as it would not be good for Europe."

Mundell, born in Canada in 1932, has had plenty of opportunity to influence the policy debate directly.

After a stint in the research department of the International Monetary Fund in 1961-1963, the time of some of his most important work, he joined the monetary committee of the then European Economic Community's commission in 1970, and its study group on economic and monetary union in Europe in 1972-1973.

Mundell conducted his ground-breaking research when much of the world was governed by fixed exchange rates in the Bretton Woods system, and research into floating exchange rates and high capital mobility must have seemed an academic curiosity.

Besides considering when a country should give up its own currency, Mundell also established the policy implications of different exchange rate regimes.

Under a floating exchange rate, monetary policy becomes powerful and fiscal policy powerless, whereas the opposite is true under a fixed exchange rate.

So if there is free capital mobility, monetary policy can be orientated towards either an external objective, such as the exchange rate, or an internal domestic objective such as prices, but not both at the same time -- a conclusion now considered self-evident by most academic economists and policy-makers.