Could the election of Donald Trump to the US presidency presage a return to the Mundell-Laffer policy mix? Known variously as “Reaganomics” or “supply side economics”, economists Robert Mundell and Arthur Laffer, starting in the early 1970s, advocated what at the time was considered a highly unorthodox mixture of policies. These comprised sound monetary policy—which at the time implied tighter rather than looser money—to combat inflation and achieve external balance; fiscal policy, principally in the form of tax cuts, both to provide a demand side boost and to expand long run or potential output on the supply side; and regulatory reform, intended to boost productivity and, therefore, medium- to long-run prospects for economic growth.
In particular, the prescription that monetary policy should be tight while fiscal policy should be loose, simultaneously to achieve both external and internal balance, flew in the face of the conventional wisdom embraced by both Keynesians and the monetarists of the time. The conventional view was that fiscal and monetary policy needed to both be either tightening or loosening, and these were not thought of as separate instruments which could target separate policy goals.
With the election of Ronald Reagan to the US presidency in 1980, and with the hawkish Paul Volcker already at the helm of the Federal Reserve, the US did, indeed, adopt the Mundell-Laffer policy mix, and, after an adjustment period, entered a period of economic boom which continued, with minor hiccups, until the great financial crisis of 2007-08 and on.
Today, there is a real prospect that Trump will return to a suitably modified version of this policy mix after he assumes office in January 2017.
His campaign pledges already include tax cuts, increased government spending on infrastructure, and regulatory reform. What is more, it is noteworthy that, during the campaign, Trump was critical of the low interest rate policy pursued by the US Fed under its current chairperson, Janet Yellen. He argued, correctly in my judgement, and as I have argued in these pages on numerous occasions, that the Fed was fostering asset price bubbles and seriously distorting the economy, which has had the effect of penalizing ordinary savers while enriching the wealthy, thereby worsening wealth and income inequality in the bargain.
Commenting shortly after Trump’s victory, economist Judy Shelton put it even more starkly. Shelton, who is a friend and a fellow member of Mundell’s Santa Colomba Conference, has rightly argued that there is a wider rethinking of monetary policy occurring across the advanced economies—most notably in the UK, where Prime Minister Theresa May has very directly criticized the low-interest policy of the Bank of England. Speaking to Financial Times, Shelton said Trump strongly believes that the Fed’s “intervention and elongated accommodative monetary policy has created a false economy”.
Early signs suggest that the mere fact of a Trump victory, even before policies are unveiled after his inauguration or even Cabinet choices are confirmed, has increased the market’s sense that the days of near-zero inflation and a liquidity trap may be nearing an end. This may be gleaned by the drop in prices of treasury securities and the implied increase in inflation expectations that may be inferred from the behaviour of treasury inflation-protected securities (TIPS).
If this market trend continues, it may well pave the way for a succession of interest-rate increases and the eventual unwinding of other elements of unconventional monetary policies (UMPs), which have continued well past their sell-by dates. But this will require a differently constituted Fed or one with a different chairperson. Trump will have the opportunity to appoint two new governors in 2017, although Yellen is secure until her term as chairperson expires in 2018.
The larger question is whether there is a case for a more fundamental rethinking of the monetary policy regime in the US and elsewhere. Recall that the original Mundell-Laffer policy mix, as articulated after the collapse of the Bretton Woods system in 1971, involved the recreation of a global unit of account, intended to replace the dollar-gold standard which had prevailed since 1944.
Readers of this column will be aware that on numerous occasions I have pointed to the absence of a global monetary order. Our current so-called system of
inflation-targeting central banks tied together by flexible exchange rates is, in reality, a non-system.
It is associated with, in addition to other distortions, excessive volatility in exchange rates and global capital flows, which are destabilizing to advanced and emerging economies alike.
Those with short memories seem to forget that our current era of fiat paper currencies tied together with flexible exchange rates is an aberration compared to the historical norm. That norm is a system of national currencies tied to one or more commodities—typically gold, silver, or bimetallism—and with an implied system of fixed exchange rates. That system gave the world monetary stability over the course of centuries.
While it seems likely that Trump will embrace at least two legs of the Mundell-Laffer tripod—expansive fiscal policy and regulatory reform— will he seize the third, which is sound money?
Vivek Dehejia is a Mint columnist.