The economist Robert Mundell died on April 4. Although known primarily for his work on international economics—he’s popularly known in economic circles as the “father of the euro”—he played a vital role in the creation of what came to be known as supply-side economics: the idea that big tax cuts will so stimulate economic growth that revenues will not fall. Important supply-siders such as Arthur Laffer and Jude Wanniski credited Mundell as the originator of their ideas. And while these ideas have engendered decades of hotly contested debate, Mundell’s foundational work is still very vital today, even to the pandemic recovery that America has embarked upon in the early days of the Biden administration.
Mundell’s primary interest was international macroeconomics, which he developed while working at the International Monetary Fund in the 1960s. His work was pioneering because most economists tended to ignore the international sector in their macroeconomic analyses. But after the abandonment of fixed exchange rates and the adoption of floating rates in 1971, the basic macroeconomic equation fundamentally changed. As the financial journalist David Warsh explains, the new international monetary regime greatly empowered monetary policy, which had been viewed as a macroeconomic sideshow previously, while de-emphasizing fiscal policy, which had been viewed as the primary economic lever.
I hadn’t yet met Mundell in the mid-1970s when I was doing work for Congressman Jack Kemp that involved helping him develop what would eventually become the 1981 tax cut. Mundell was an important, if unseen, presence even then. Jack and Jude talked about him all the time as the ultimate guru to whom we all owed a debt. It took me a long time to understand why his work was so important, mainly because the works of his that I had read at that time weren’t especially insightful. I remember asking Jude what work of Mundell’s I should read, and he told me Man and Economics. I did as he suggested, but it failed to enlighten me much on the subject of tax policy.
In May 1974, what would turn out to be an extremely important conference, sponsored by the American Enterprise Institute, took place in Washington. Organized by Laffer and the monetary economist David Meiselman—a close associate of Milton Friedman—its focus was primarily on bringing together divergent strains of monetarist thought on the problem of inflation, which at the time was growing in importance. The conference proceedings were published as The Phenomenon of Worldwide Inflation in 1975.
A key point made by Mundell in his paper for the conference was that inflation had important real effects on the tax system: It pushed workers into higher tax brackets when they got cost-of-living pay raises, it forced investors to pay taxes on illusory capital gains, and it diminished the value of depreciation allowances for corporations. Thus taxes were rising sharply in the 1970s, slowing economic growth and, ironically, making inflation worse, Mundell said.
Jude Wanniski, then an editorial writer for The Wall Street Journal, met Mundell for the first time at that conference. Mundell told me that the two of them retired to his hotel room after his lecture and they talked all night. By that time, Mundell had left the University of Chicago, where he had influenced Laffer, and joined the economics department at Columbia University. Mundell told me that after he and Jude returned to New York following the AEI conference, Jude stayed at Mundell’s apartment for several days and slept on the couch—Jude’s home was in New Jersey—reading Mundell’s papers and being tutored by him.
The discovery of Mundell’s work led Jude to write an article that appeared on the Wall Street Journal editorial page on December 11, 1974, which first laid out Mundell’s prescription for stagflation: tight money to fight inflation and tax cuts to stimulate growth. Mundell told me that he essentially co-wrote the article, and Jude quoted Mundell as saying:
The level of U.S. taxes has become a drag on economic growth in the United States. The national economy is being choked by taxes—asphyxiated. Taxes have increased even while output has fallen because of the inflation. The unemployment has created vast segments of excess capacity greater than the size of the entire Belgian economy. If you could put that sub-economy to work, you would not only eliminate the social and economy costs of unemployment, you would increase aggregate supply sufficiently to reduce inflation. It is simply absurd to argue that increasing unemployment will stop inflation. To stop inflation you need more goods, not less.
This article led directly to Mundell being invited to a White House meeting on December 19, 1974, to discuss options for economic stimulus, at which he repeated his tight money plus tax cuts policy prescriptive. Mundell told me he met Kemp for the first time that day, on his trip to Washington for the White House meeting. The following day, Kemp mentioned Mundell for the first time in a House speech, quoting extensively from Jude’s article from the previous week. A few weeks later, Kemp was mentioned in a Wall Street Journal editorial for the first time. Jude undoubtedly was the author.
The Ford administration, however, rejected Mundell’s idea for a permanent tax reduction in favor of a one-shot tax rebate, which President Ford proposed in his first State of the Union address in 1975. The Tax Reduction Act of 1975 gave taxpayers a 10 percent rebate on their 1974 federal income tax payment, with a minimum of $100 (roughly $500 today) and a maximum of $200, payable in the second quarter of 1975. A key reason for the administration’s reticence to cut taxes permanently was its view that deficits were inflationary and that tax cuts would increase the deficit.
In the spring of 1975, Jude wrote an article for The Public Interest, a small academic journal edited by Irving Kristol, on the “Mundell-Laffer hypothesis.” The vast bulk of the article had to do with international monetary policy, Mundell’s and Laffer’s specialty; it was only in a footnote that Jude mentioned taxes:
“There are always two tax rates that produce the same dollar revenues,” says Laffer. “For example, when taxes are zero, revenues are zero. When taxes are 100 percent, there is no production, and revenues are also zero. In between these extremes there is one tax rate that maximizes government revenues.”
As far as I can tell, this is the first public mention of what came to be called the Laffer curve. Although economists dating back to Adam Smith knew that tax rates that were too high could depress revenues, Laffer’s simple curve explained the concept in a way that was very easy to understand, and Kemp used it all the time.
It wasn’t until many years later that I came to understand Mundell’s central contribution to the work I was doing for Kemp, which first appeared in an obscure pamphlet published by the Princeton University economics department’s international finance section in 1971. In it, Mundell explained that the problem with a pure tight money solution for inflation, which most conservatives supported, is that it would cause the economy to collapse as businesses, workers, and consumers readjusted their cost structures and expectations.
Mundell argued that simultaneous tax cuts would both cushion the blow from tight money and make it more effective by increasing real output and the demand for money. Insofar as inflation resulted from too much money chasing too few goods, increasing production was inherently anti-inflationary. As he explained in his essay:
Monetary expansion stimulates nominal money demand for goods, but, without rigidities or illusions to bite on, it does not lead to real expansion. But growth of real output raises real money demand and thus abets the absorption of real monetary expansion into the economy without inflation. Tax reduction increases employment and growth and this raises the demand for money and hence enables the Federal Reserve to supply additional real money balances to the economy without causing sagging interest rates associated with conditions of loose money. Monetary acceleration is inflationary, but tax reduction is expansionary when there is unemployment.
The reason this was important is because it was the exact opposite of what mainstream economics taught at that time. The dominant view was that low unemployment, and hence fast economic growth, was inherently inflationary (i.e., the Phillips curve). Insofar as tax cuts increased growth, it would be like pouring gasoline on a fire. Most economists thought Mundell’s tight money and tax cuts formula was the equivalent of stepping on the gas and the brakes of a car at the same time.
It is not now remembered, but the strongest argument made against the Kemp-Roth bill held that it would be dangerously inflationary. High taxes were actually seen as curbing inflation by reducing consumers’ purchasing power. Indeed, that belief was so widespread that Congress enacted a big tax increase in 1968 precisely because it thought this action would reduce inflation. It failed to do so because the inflation problem was primarily monetary, not fiscal.
I have long argued that a key benefit of the 1981 tax cut was that it made the transition from a high-inflation economy to a low-inflation economy surprisingly brief and mild. While the 1981–82 recession was indeed painful, standard economic models from that period suggested that breaking inflation would require another Great Depression.
The idea that supply-side policies can be anti-inflationary is still controversial—some economists, such as Larry Summers, have argued that Joe Biden’s economic stimulus could cause “overheating” and reignite inflation. Mary Daly, president of the Federal Reserve Bank of San Francisco, has countered this view, making a classic supply-side argument that more production of goods and services is inherently anti-inflationary. As Axios reported:
Many have worried the combination of trillions in spending on coronavirus relief, the Fed’s ultra-loose monetary policy, and Biden’s big stimulus plans for infrastructure, education and manufacturing will set the table for out-of-control price increases.
Daly says that’s unlikely to be true, joining a crew of economists, including Nobel Laureate Joseph Stiglitz, which has vouched for the economic efficacy of big spending on infrastructure.
“I put it in there as a boost overall on growth, should those [bills] pass but I don’t put it in as a big pickup in inflation because I think of it as creating an additional supply effect—more workers coming into the labor force, better output, the roads and bridges and digital infrastructure improve,” Daly says. “This is really good for our economy. It allows us to grow faster.”
Another contribution Mundell made to the development of supply-side economics was popularizing the views of an ancient Muslim philosopher named Ibn Khaldun. In his masterwork, The Muqaddimah, Khaldun argued that high taxes were often a factor in causing empires to collapse, with the result that lower revenue was collected from high rates. “It should be known that at the beginning of the dynasty, taxation yields a large revenue from small assessments. At the end of the dynasty, taxation yields a small revenue from large assessments,” Khaldun wrote.
In 1971, the Journal of Political Economy published an article about Khaldun by economist Jean David Boulakia that quoted this passage. Mundell had been editor of that journal until just before this article appeared, and he was responsible for accepting it for publication. (In private correspondence, Mundell told me that he was familiar with Khaldun before seeing the Boulakia manuscript because he and Khaldun were born exactly 600 years apart.) On September 29, 1978, The Wall Street Journal published a long passage from The Muqaddimah (undoubtedly at Jude Wanniski’s behest). This excerpt caught Ronald Reagan’s eye, and he referred to Khaldun by name at least 10 times during his presidency.
Although Mundell’s 1999 Nobel citation does not mention any of his work on supply-side economics, it would be naïve to think that the Nobel committee was unaware of it, since Mundell was often referred to as a supply-side “guru” in the popular press. It is also well known that the committee thoroughly researches all aspects of a candidate’s life and work before making an award. Therefore, it is reasonable to assume that the committee was well aware that giving Mundell the Nobel Prize for his work in international macroeconomics and monetary theory would be seen as recognition of his work in supply-side economics as well. In a 2006 interview in the Journal of Economics Perspectives regarding his Nobel Prize, Mundell was clear that his work on supply-side economics was a significant part of his intellectual legacy.
In recent years, Brexit has raised questions about the efficacy of the European Union and the euro; the failure of both the George W. Bush and Trump tax cuts to provide any stimulus whatsoever, and the shift in economic thinking represented by Joe Biden’s very Keynesian economic investment program all suggest that Mundell’s major ideas have become passé. But there was a time when they catalyzed radical changes in economic thinking. His life and work are essential to understanding the core economic debates of the 1960s through the 1990s, as well as, in all likelihood, those to come.