Robert Mundell passed away over the weekend of April 3. He was 88 years old. We have lost another giant of economics.
The New York Times published a 2,182-word obituary. The Wall Street Journal printed a 664-word editorial remembrance that focused on Prof. Mundell’s contributions to economics. The Journal’s obituary was 748 words including details of his personal life. You can read those pieces and learn quite a bit about his contributions to economics.
When I think of Prof. Mundell, the first thing that comes to mind is his theory of optimum currency areas. What characteristics should a group of states or countries have to be an optimum currency area? The obituaries talked about his role in developing the Euro and his contributions to supply-side economics. I’ll dispense with the idea that he played a role in the Euro. While he used Western Europe as an example and noted the intention of the (then) Common Market to move toward a currency union, he did not advocate for the Euro. Along with most economists, Prof. Mundell agreed that the Eurozone was nowhere near an optimum currency area. I’ll discuss the other two issues shortly. But first I want to examine his most important contribution to the field, a discovery that most economists take for granted today. This finding is rarely mentioned by economists. That’s a measure of how deeply embedded the idea has become in the profession.
Factor Mobility Can Be a Substitute for Product Mobility
In 1957, he published “International Trade and Factor Mobility.” Here he developed a model that showed trade in factors of production could be a substitute for trade in goods and services.
Interestingly, Mundell took this result almost for granted, writing
This proposition is implied in Bertil Ohlin, Interregional and International Trade (Cambridge, 1935), Ch. 9; Carl Iversen, Aspects of the Theory of International Capital Movements (London, 1935), Ch. 2; and J. E. Meade, Trade and Welfare (London, 1955), Ch. 21, 22.
Unbelievably, this is footnote 1 on page 321. Having assumed the economics profession already knew about this result, he proceeded to develop the relationships between trade mobility, factor mobility, and the volume of trade. (Factors of production are inputs used to create goods and services. Labor, physical capital, and raw materials are often used in examples.)
Mundell showed that impediments to trade would lead to increased factor mobility between trading countries. Similarly, impediments to factor movement would increase the volume of trade. In fact, he developed the conditions under which substitution of commodity for factor movements will be “complete.” Here’s what he has to say (pp. 321-322):
In a two-country two-commodity two-factor model, commodity-price equalization is sufficient to ensure factor-price equalization and factor-price equalization is sufficient to ensure commodity-price equalization if: (a) production functions are homogeneous of the first degree (i.e., if marginal productivities, relatively and absolutely, depend only on the proportions in which factors are combined) and are identical in both countries; (b) one commodity requires a greater proportion of one factor than the other commodity at any factor prices at all points on any production function; and (c) factor endowments are such as to exclude specialization.
Commodity price equalization means the price of a product will be the same in trading countries (after converting the currencies to a common unit). It’s generally agreed that this will occur if (1) the product being traded is not differentiated, (2) trade is frictionless in that there are no transportation or insurance costs and no barriers to trade such as tariffs. Add the conditions above and commodity price equalization implies factor price equalization. That means the wage rate for labor used to produce the product in question will be the same across all producing and trading countries (again, after converting currencies).
This is a remarkable discovery. Today economists take it for granted. That’s undoubtedly the main reason Mundell’s valuable contribution to the field is often overlooked.
Optimum Currency Areas
When Mundell finished describing the characteristics of an optimum currency area, he offered his opinion that he doubted this theory would ever have a practical application. If nothing else, his theory has produced numerous research papers in economics looking at the issues of why the U.S. appears to be closer to an optimum currency area while the Eurozone is not.
The “Optimum” in Optimum Currency Areas
“Optimum” implies a tradeoff between benefits and costs. The optimum will often occur at the point where marginal benefit equals marginal cost. A “currency area” is more accurately described as a monetary union in which all member states or countries adopt a single currency. Crucially, this is the same as fixing the exchange rate among members of the currency union. The exchange rate is always equal to 1.
For example, what is the exchange rate between a $1 bill in Colorado and a $1 bill in Idaho? The two bills will buy $1 in goods and services in both states. The exchange rate between Colorado and Idaho will be $1/$1 = 1.00. I’ll discuss the difference between a currency union and a fixed exchange rate between two countries’ currencies.
The benefits of using a common currency are created by market integration and increased efficiency. Trade between Idaho and Colorado is less costly because each uses the same currency for transactions. This avoids the cost of converting currencies. In addition there will be efficiency gains because the extent of specialization in production is likely to increase.
The costs occur because of possible economic asymmetries and decreased economic stability. The underlying issue is shocks to the economy. If the shocks have roughly the same size impact and occur at the same time among countries, the central bank will be able to offset the shock in the same direction in all countries. On the other hand, if some countries go into recession while others continue to grow, the central bank faces a dilemma. Should they use expansionary policy to fight the recession? Doing that will probably lead to inflation in the other countries. Similarly, if the central bank simply continues current policies, the countries in recession will be left to their own devices while the others continue to grow without added inflation.
Consider another example. Volkswagen, headquartered in Germany, is the largest auto producer in the world. While other countries host car companies (Fiat in Italy, Peugeot and Renault in France), Germany produces 30.8% of Europe’s 16.77 million per year.
Suppose something happens that has a negative impact on auto production. In fact, in April, 2021, global car output fell because of a shortage of semiconductor chips. Germany will be affected more than other countries. This is an asymmetric shock, an event that affects different countries’ economies in different ways. Germany’s economy will slow. Spain and France are also likely to see decreased growth. What should the European Central Bank do? Fighting the slowdown in Germany, Spain, and France means expansionary policy. But the economies of other countries will continue to grow at higher rates than those three. Some of them will experience inflation.
In fact, this is exactly the example presented earlier. When there are asymmetric shocks, a currency union’s central bank will face an impossible situation.
Currency Unions and Fixed Exchange Rates
Some countries fix their exchange rate with respect to another (anchor) currency. For example, Denmark keeps the Krone-Euro exchange rate in a 2 percent band. Why doesn’t Denmark just adopt the Euro?
The answer is option value. Denmark retains the option to widen the band. Fifteen percent is allowed by Europe’s Exchange Rate Mechanism. The value of this option is the possibility of even more flexibility in the future should Denmark decide to allow the Krone to float vis-a-vis the Euro.
Do Optimum Currency Areas Exist?
There is one good example of an optimum currency area: The United States. The U.S. has a high degree of mobility of products, labor, capital, and raw materials. There is obviously a common currency. But there are asymmetric shocks. For example, an increase in global oil prices is likely to create higher output and income in Texas, North Dakota, Pennsylvania, Louisiana, and other oil producing states compared to, say, Maine. Perhaps we should call the U.S. a Pretty-Good Currency Area.
Every economist who has looked at the Eurozone has concluded it is nowhere near an optimum currency area. Perhaps a Not-Very-Good Currency Area is appropriate.
Empirical Tests of the Optimum Currency Area Hypothesis
But the question of whether an optimum currency exists remains unanswered. As I mentioned earlier, the optimum would occur where the marginal benefit of increased market integration and increased efficiency equals the marginal cost of more economic asymmetries and decreased economic stability. Those concepts do not lend themselves to quantitative measurement.
Instead, economists have focused on trade. The seminal work is by Richard Baldwin. He estimates that the creation of the Eurozone increased trade among member countries by between 5 and 15 percent. His best guesstimate is 9%. And most of those gains occurred in the first few years after the adoption of the common currency.
But what about the U.K., Sweden, and Denmark, the three EU members that did not adopt the Euro? Trade between them and Eurozone countries increased by 7%, almost as much as trade among Euro-using countries.
These results do not support the idea that the Eurozone is an optimum currency area.
Conclusion and a Personal Note
I taught economics for 37 years, as well as doing some research. During my career, Prof. Mundell’s ideas were increasingly accepted by mainstream economists. Yet a quick search in several principles of economics textbooks turned up zero hits on his name.
I’ll be among the first to admit that Prof. Mundell’s work is, by and large, not very accessible to beginning students in economics. But some of his ideas – optimal currency areas, the desirability of fixed exchange rates, and supply side economics – should be amenable to inclusion. And, of course, his name should be mentioned when the idea of factor mobility substituting for product mobility is introduced.
- American Economic Review, June 1957 47:3 pp. 321-335 ↑
- Much of the material in this section is based on Robert C. Feenstra and Alan M. Taylor, International Economics (5e 2021) pp. 366-375. Worth Publishers Macmillan Learning, One New York Plaza, Suite 4600, New York. ↑
- Richard Baldwin, In or Out: Does It Matter? An Evidence-Based Analysis of the Euro’s Trade Effects (London: Centre for Economic Policy Research, 2006). ↑