Mundell-Laffer on the External Sector; c.1975

Tom posted a link to an article he came across from the late Jude Wanniski's Polyconomics which was a review of a paper written by Mundell and Laffer in 1975. I was a subscriber to Wanniski's analysis some years ago until his sudden passing.

It is titled "A New View of the World Economy", and provides what they believed was an operative description of the external sector in 1975. This was just a few years after the US completely abandoned the gold standard so perhaps at that time, people were very eager to come up with some new ideas as to what a new framework for understanding the global economy would be. Here is an interesting excerpt:

Going a step further, Mundell has revived the proposition, and Laffer has documented empirically, that money, like apples and gold, is also subject to these international forces of supply and demand. When, for example, there is an excess demand for money in the United States relative to the rest of the world, we will import money and run a balance of payments surplus -- i.e., more money will be coming into this country than is going out. When there is an excess supply of money in the United States, we will export money and run a balance of payments deficit. This idea also has its roots in earlier centuries, but is still a minority view among economists everywhere. Balance of payments deficits are thought to represent not a market phenomenon but a structural problem -- i.e., "capital flight" or "undercompetitiveness." Laffer has further demonstrated that when a country`s growth rate accelerates relative to the rest of the world its balance of trade worsens; and vice versa. (As a child grows, it consumes more than it produces.) But such a deficit is not cause for alarm. What is then happening is something perfectly natural. As long as its government does not speed up its own money creation, the country will export bonds to pay for its deficit in trade. All that is occurring is that the rest of the world has decided the country in question, with its higher growth rate, is a good place in which to invest. (Just as parents invest in their growing children).

Some observations:

The authors seem to treat all "money" as a singular fungible commodity, seemingly ignoring the fact that there are different currencies in every country; and the relative value of each (as indicated by an exchange rate) can change over time. Ignoring "Hickey's Law" ;) that a currency must stay in it's currency zone.

They state that a country with a higher growth rate will exhibit a balance of trade that "worsens", implying exports: good, imports: bad. This flies in the face of our current global situation where China has had MUCH higher growth than the US while at the same time running an external surplus with the US that is unprecedented in the entire history of human civilization.

Mundell and Laffer posit that a country can EXPORT bonds to "pay for" real imported goods; and that the country taking possession of a foreign country's bonds looks at such a transaction as an "investment".

These are bizarre descriptions of international transactions. This was written in 1975, just a few short years after the US dropped the gold standard in full so perhaps some understanding is in order as the authors may have been "brainstorming" to try to come up with a new framework.

But Wanniski's affirming review of these claims was written in 2005, and I am not led to believe that either Laffer or Mundell have significantly changed their perception of reality. Both Mundell and Laffer are still influential within economic policy circles. These beliefs may still influence policy recommendations they are making to this day.