To use an analogy from the tennis court, the central bank is always left thinking of the ‘return’ and can never ‘serve’.The economic scene today has been so disturbed by the Covid-19-induced lockdowns—leading to a lot of theorising on what could happen—that a lot of us have missed the demise of Nobel laureate Robert Mundell. His name would trigger instant recall amongst students of international economics, particularly those who studied at the Delhi School of Economics where Mundell always was in the frame of discussion and debate.
Mundell, along with Marcus Fleming, came up with the ‘impossible trinity’ that is brought to the fore every time there is upheaval in the forex markets and the rupee goes up or down. Central banks virtually have Mundell at the back of their minds when viewing exchange rates, because the unwritten rule is that when in doubt go back to theory—in this, Mundell cannot be missed.
The impossible trinity is about having control over three variables: free capital flows, currency and monetary policy. It is an old rule that befuddles all central bankers. If we have floating exchange rates and there are free capital flows, then the rupee will keep appreciating or depreciating as the FPI comes in and central banks face loss of freedom on monetary policy as they have to perforce sterilise inflows or change interest rates to maintain stability. To use an analogy from the tennis court, the central bank is always left thinking of the ‘return’ and can never ‘serve’.
Accordingly, fiscal policy has to adjust, else there will be issues of inflation. At the same time, if there are fixed exchange rates and the central bank controls monetary policy, then capital flows cannot be open, else, there will be chaos in the markets. The central bank has to recalibrate interest rates all the time.
Often, we have heard Governors of RBI talking of the impossible trinity, and this is what Mundell had introduced decades ago. Given that, even today, the rupee has rarely been fully floating—as there are several instances of RBI buying or selling dollars to manage the currency—there is actually very little freedom for the central bank. Most countries allow free flow of capital; this thus becomes exogenous to the system. The challenge then is balancing currency changes with monetary tools, knowing well that interest rates cannot be looked at as only affecting currency as there are domestic liquidity implications.
While the trilemma is well-known, Mundell was also a proponent of the famous ‘supply-side economics’, which was invented by Arthur Laffer. The basic principle was that if one lowered tax rates, especially for the rich, then the tax revenue will increase for the government. This thought is far-reaching, because, even today, the main reason for cutting the corporate tax rate in India is not just to make companies pay less taxes and reward the shareholders and hence the stock market, but to incentivise investment.
As companies have more disposable profits, they would tend to invest more by also borrowing a multiple of ‘own funds’, thus leading to a thrust for the credit markets. This was a theory of the 1970s which found favour in England and the US. In fact, the concept of Reaganomics was a modified version of supply-side economics which added expenditure cuts to tax cuts. This, however, was not used in India as the theory has stopped at the stage of lowering of corporate tax rates only. Governments have rarely managed to really cut expenditure given the expediency of addressing issues of the social sector.
Another lesser publicised fact about Mundell was that he was a votary of the euro, and while he cannot be called the father of the concept, a lot of work was done on the concept of a common currency for the region. The foresight of having a common currency that goes beyond a common market was epochal. This is something that has worked to a large extent, even though the Greek crisis which spread to the PIGS due to reckless governance did question this concept.
Essentially, what Mundell spoke of is the free movement of labour and capital across markets being an efficient solution. This was the idea of the euro zone, which was an improvement over the European Union that maintained individual currencies but allowed free movement of factors of production. Now, with the Brexit being a reality, one can question whether such concepts are sustainable, but the single market concept is surely something that works well in good times for sure.
The problem really is when things go awry and countries do not follow the rules of the game, and this is where Mundell’s theory runs into a problem. The euro concept worked as long as the so-called great moderation was enveloping the developed world. But once the fissures came out, there was a lot of disagreement, especially between countries like Germany, Austria and the Netherlands, and the PIGS group, as the former had been conservative and followed the rules of controlling deficits, which was an unwritten though accepted rule. That is why this led to ruptures. The same holds for the EU where the majority in Britain felt that, on balance, a united market did not serve their purpose.
Interestingly, Mundell had also mulled on the idea of a single currency called the DEY (dollar, euro and yen). But it may be assumed that this will go down more as a concept than a reality, which is the case with several economic ideas. If the euro did not work, there is little reason for any other basket to be effective. Interestingly, the earlier talks of a BRICS group and probably single market now are no longer being spoken of.
Mundell was definitely not as famous as John Maynard Keynes or Milton Friedman, but surely has an important place in the pantheon of economists, and the ‘impossible trinity’ will be something which will never move out from the discussion rooms of central banks. That’s because there never can be a practical answer!
Chief economist, CARE Ratings, and the author of ‘Hits & Misses: The Indian Banking Story’. Views are personal
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