Word that the United States might freeze out Canada from a new North American trade arrangement brings to mind where the greatest economic policy revolution since the New Deal came from. Supply-side economics, the call for a stabilized dollar and tax-rate cuts to vanquish stagflation in the 1970s, and put into place to near perfection by Ronald Reagan in the 1980s, owed its existence to a boy lost in thoughts over U.S.-Canada trade in the 1930s and 1940s.
Robert Mundell accepting the Nobel Prize
That youngster was Robert A. Mundell, the 1999 economics Nobelist and founder and first articulator, with his University of Chicago colleague Arthur B. Laffer, of supply-side economics. Mundell grew up among the dairy farms outside of Kingston, Ontario, the still small city that announces the beginning of the St. Lawrence River, that monster of a waterway that begins as Lake Ontario narrows into it at the northwestern bulge of upstate New York. Mundell (who turns 86 next month) credits his childhood observations of the local cheese producers, how they looked at changes in the flexing US-Canadian dollar exchange rate to determine their production and shipment schedules, as the origin of his interest in economics.
As a young man, Mundell worked his developing views on the matter into one of the most influential articles in the modern history of economics. This was his “Theory of Optimum Currency Areas” that appeared in the American Economic Review in 1961. In this article, Mundell argued that a place that should have one currency is not necessarily a nation, but an extra-national region where people regularly do transactions with each other.
His chief exhibit was eastern and western Canada and the U.S.—“the East, which produces goods like cars, and the West which produces good like lumber.” Each of these regions was characterized, in 1961, by intensive labor mobility within, the national boundary crossed innumerable times a day (think of Detroit and Windsor), such that it made no sense other than to speak of them as coherent economies. If there had to be two currencies, Mundell said, let it be between East and West—not North and South, Canada and the U.S.
It was his own experience in riverside Ontario watching small producers interrupt their intensive schedules to see what the dollar was doing before they made an investment in their operation or took the ferry across to New York State. This was an expenditure of time and energy, the most precious resources in economic activity. If an economy is integrated, it should not have separate currencies, so that resources will be used efficiently. An optimum currency area is an integrated economy.
Governments, however, want to manage economies, and by definition, governments operate within national boundaries. Mundell’s ingenious solution to this problem was outlined the next year in an article on “internal and external stability.” If a country thinks it needs more money in the system, eschew central bank operations, Mundell argued, keep the exchange rate fixed, and expand fiscal policy through tax-rate cuts (as he soon specified). This “policy mix” will draw money from abroad. Money will come from international sources because it will earn more thanks to lower tax rates and not be subject to devaluation given the fixed exchange rate. No need for Keynesian institutions of monetary policy and demand management. Fix the exchange rate and cut tax rates—that will get your region, and your nation, rolling.
As Larry Kudlow and I discussed in JFK and the Reagan Revolution, Mundell first proposed these ideas as President John F. Kennedy was mulling how to pursue his fiscal-monetary policy mix as the United States battled persistent recessions and a gold drain in the early 1960s. JFK chose Mundell’s version of the policy mix, recommitting to the dollar’s legacy gold price and cutting tax rates. This was by coincidence perhaps, but the next time it would not be.