In the following interview, Nobel laureate and economist Robert A. Mundell discusses the international monetary system.

Prof. Robert A. Mundell is one of the world’s most respected macro-economists and undoubtedly the leading authority in the field of monetary systems. Earlier this year, he spoke with the editors of the Journal of Financial Transformation about the impact of currencies on the world economy.

Currency and the economy

Q: In recent years we have observed significant fluctuations of major currencies against each other. What are the most important factors that determine currency prices today?

Mundell: Exchange rates are determined by supply and demand. The most important factor in affecting supply and demand is expectations about the future. Under hard fixes, such as the gold standard or credible currency board systems or even traditional fixed exchange rate systems such as the Bretton Woods arrangements, the expectations are for stability, and that lets the exchange rate be used as a guide for private-sector planning. Under flexible rates, the main factor in determining expectations is government policy, including central bank policy, especially with regard to changes in interest rates and fiscal policy.

Q: In recent years we have experienced very high volatilities among the major currencies. How do you feel such high volatilities will affect the purchase of services like banking, among which differentiation is weak and substitution opportunities are strong?

Mundell: I believe that the arrangement of flexible exchange rates between national paper currencies with its attendant instability and volatility among each of the nearly 200 countries of the IMF is an absurd arrangement that is at the root of the global macro-economic problems that we have today. Apart from its global inefficiency, it discriminates especially against the smaller countries. As a result, such instability of exchange rates creates instability in the financial sectors of every country. There are no advantages for services.

Q: There has also been a lot of debate about how economic productivity of countries should be compared, whether nominal currency rates or GDP per person employed (PPP) should be used. Which one would you recommend?

Mundell: Both methods are needed for the two different meanings of productivity. It depends on what you want to use the productivity measure for.

Q: The factors used in the evaluation of inflation rates across countries are very different. Doesn’t this make the whole exercise of evaluating PPP very hard, if not redundant?

Mundell: The relation between PPPs and exchange rates is not random. There is lots of evidence that the disparities are a function of, i.e., per capita income. I think more theoretical work needs to be done.

Q: The U.S. dollar has come under a great deal of pressure in recent years. Economic development, which should be used to help it appreciate, is used as a justification that it should fall, since economic growth in the U.S., unlike most countries, is tied to imports, and consequently large trade deficits. Where do you see the dollar going from here?

Mundell: I think the dollar will hover around where it is for a while, and then depreciate, but not cataclysmically.

World currency

Q: You have suggested that if the world had a single currency — a world currency, as you call it — there could be significant benefits gained, such as common or similar inflation and interest rates.

Mundell: Yes.

Q: How well do you think the euro has been able to achieve similar objectives across Europe?

Mundell: Superbly.

Q: Looking at the euro from another perspective, how well has it performed generally?

Mundell: From the perspectives and goals of both Europe as a whole and each individual country, without exception, the euro has been an unqualified success. It needs, however, to be accompanied by improvements in the financial structure with euro bills and bonds playing a larger role.

Q: I am aware that you are a big fan of the Tuscany region in Italy. I am sure I do not need to inform you just how much the prices of goods and services have risen since the arrival of the euro, despite what inflation figures show. Don’t you feel that the same threat could face the establishment of a world currency?

Mundell: There is the puzzle that people think prices have risen since the euro, but it does not show up in the statistics. That could mean that people notice the prices that have risen, but not those that have fallen. I have seen both the fall and the rise in prices in Tuscany. But, the most noticeable are the rises in prices, because they involve restaurants and tourist and export goods that would be expected to rise with the increase in trade brought about by the euro. The evidence is still anecdotal. But I believe that special effect could be modeled fairly easily. There is a general view that the mental conversion of 1,936 lire to 1 euro has involved price surges because the conversion ratio is close to 2,000. If people are used to paying 30,000 lire for a lunch, then why not 30 euros instead of 15 euros? It does seem that there has been an escalation of this type. Is it harmful? The producers are helped, the consumers are hurt, and the country as a whole benefits or loses depending on whether the products in question are net exports or imports. I believe the increases in prices have been mainly in exportables, including in this hotel prices, restaurant prices, etc., bearing in mind that Italy is among the world’s top three tourist destinations. It means, therefore, that Italy has gained, not lost, by the increase in prices. Before the euro, the lira was undervalued on a PPP basis; now it is less under-valued or possibly at par.

Could it happen in the world economy? The answer is, yes. I don’t believe any country would be hurt by it. But they should be aware of it. Would a world currency joined by China and India involve rising prices? I think that given the undervaluation (by the PPP consideration), they would. But India’s prices are rising fairly briskly staying out. Notice, however, that I have not advocated a single currency for the world economy. A common currency yes, but a single currency no. The latter would not be possible short of a global empire or dictatorship.

Q: Today, we already have three major currencies, and if China and most parts of Asia-Pacific peg their currencies to the yen, or even choose it to replace their own, we could even have three major currency blocks. Would better coordination of these currencies achieve the same objective as the world currency or are political pressures too powerful to maintain such relationships?

Mundell: The possibility of an Asia-Pacific fixed exchange rate zone becomes more likely the more the Americans follow policies that have been called Japan-bashing and China-bashing. The tripling of the yen against the dollar from September 1985 to April 1995 ruined the Japanese banking system. China wants to avoid a similar problem. So unless the United States accepts the need for global monetary reform and perhaps a reformation of a Bretton Woods type system, China and Japan will be pushed into each other’s arms, however reluctantly.

Q: Can a world currency really help improve international trade? Would you say that has happened across Europe?

Mundell: It would be a great benefit to people the world over, and the only losers would be the speculators who thrive on instability.

This article was reprinted with permission from Canadian Treasurer.

Another View of The Euro

Why does Europe need a single currency? “We seem to be able to manage without it. The idea made sense in its way when it was first proposed half a lifetime ago. In those days, countries had built fences around their currencies to stop them escaping. Our own exchange controls were as obstructive as any. A single currency would be one way to overcome them. Now, though, the barriers are down, money can flow freely across frontiers, we can pay our bills with plastic and debit our accounts at home or extract negroni vouchers from holes in the wall – and Europe’s biggest money markets are still in the City and outside the eurozone. All this was under way long before the European Central Bank arrived to impose its monetary policy on a dozen different economies, with different results. The euro, of course, is a totem, but so is, or was, the [European] constitution.”

Christopher Fildes, The Spectator (UK) rofessor Robert A. Mundell is Professor of Economics at Columbia University in New York and winner of the Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel 1999. This interview first appeared in The Capco Institute’s Journal of Financial Transformation, published by Capco, a global financial services and technology solutions provider (www.capco.com/journal.html).