Trilemma or dilemma? Impossible trinity or impossible duality?

In a number of newspaper articles during the last weeks a paper presented at the Jackson Hole conference by Professor Hélène Rey of the London Business School is quoted that argues that global capital flows, for example driven by monetary policy  in the US or other big countries, means that even a floating exchange rate does not give a country autonomy in its monetary policy. The trilemma (or the „impossible trinity“ of fixed exchange rates, free capital flows and independent monetary policy, as it was called by Stanley Fischer and many other writers) seems to be a dilemma, which means that flexible exchange rates do not free monetary policy. As the Financial Times put it: “The choice is this: impose capital controls or let the Fed run your economy.”

Just for ease of reference for future articles on the matter, please find below an excerpt from the conclusions of a paper of mine published in 2001.

From the conclusion of:

Heiner Flassbeck: The Exchange Rate – Market Price or Economic Policy Tool, UNCTAD Discussion Paper, No. 149, 2001, p. 44ff.

“Fixing the exchange rate in one way or the other doesn’t create but only reveal the existing lack of monetary autonomy in a system of free capital and goods flows. There is no „impossible trinity“ but an „impossible duality“[1]. To open the capital account and to loose national monetary autonomy is not contingent on the exchange rate regime. Interest rate differentials not strictly covered and sterilized by the dominance of PPP in exchange rate expectations are bound to distort any attempt to achieve successfully national monetary targets. This is true for small open economies as well as for big closed ones. The latter may only be big and closed enough to ignore the outcome on its external accounts.

It is one of the great errors of economics in the 20th century to have suggested to politicians that there is such a thing as national sovereignty in economic policy, if a unilateral monetary system is installed which is „flexible“ enough to buffer external shocks. There can be no such thing. The existing monetary systems are barely able to balance monetary disturbances without major friction, let alone real shocks. The worldwide crisis of 1997/1998, in combination with the current Euro crisis and the erratic movements of the Dollar-Yen rate, shows that national sovereignty in the sense of an effective insulation from such events does not exist. All nations of the world are affected in one way or another. The loss of national sovereignty, the impossible duality, is an immediate result of the opening of the goods and capital markets, not the result of an inappropriate monetary order. There is, therefore, no alternative to international cooperation in exchange rate policy, if free trade and a largely free movement of capital are to be guaranteed.

The idea of a cooperative global monetary system is to preserve on a multilateral basis equal conditions to all parties involved, more or less in the same way as multilateral trade rules shall apply to every party in the same manner. That is why the main idea behind the foundation of the International Monetary Fund in the 40s of this century was to avoid competitive depreciations in a world without a multilateral solution to the currency problem. In a well-designed global monetary system the need and the advantages of the depreciation of the currency of one country has to be balanced out against the disadvantages of the others. As changes in the exchange rate deviating from PPP affect international trade in exactly the same way as changes in tariffs and export bounties do, it has to be subject of multilateral negotiations. Reasons for the real depreciation and the necessary dimension have to be identified in multilateral negotiations. If such rules are applied, the real exchange rate of all the parties involved will remain more or less constant as strong arguments to create competitive advantages on the level of the nation state will hardly be found. Real appreciations which may have happened in one country due to overshooting wages may be compensated by an adequate depreciation of the currency, but not more than this. Unjustified unilateral action will force retaliatory action by the trading partners.

To fix rates unilaterally forever as realized in different currency board regimes all over the world or in Dollarizations may have its merits in providing a stable monetary framework for countries with per se unstable institutions. But fixed rates vis à vis big and stable as well as flourishing countries are a mixed blessing. To keep the rates stable without destroying the production potential and the job opportunities of these countries is an extremely ambitious and in many cases unresolvable task. In Western Europe only the very highly developed countries achieved to fix their exchange rate without major blows to the D-Mark as anchor[2]. But even these countries could only succeed because they were part of a much wider multilateral institutional arrangements (the European Monetary System and the European Union) in which they could ask for orderly workouts in case of a crisis which is not the case for unilateral approaches like currency boards.

The only way out for high-inflation or high-growth countries not being a member of a monetary union is to resort to controls of short-term capital flows. If they are able to avoid destabilizing inflows and outflows either by taxing these flows or by directly limiting their size, the hardest choices and misallocations due to erratic exchange rate changes can be avoided. But the resort to controls doesn’t replace the search for an adequate exchange rate system. If a high-inflation or high-growth country opts – despite capital controls – for free trade of goods with its neighbors, it has to find ways how to preserve its competitive position, i. e., how to devalue or not to revalue its currency.

All in all this means to return – as in the Bretton Woods system – to a mix of adaptable exchange rates in combination with controls in case of crisis. Since the most problematic sector of the financial market „casino“  by far is the foreign-exchange market a „monitoring“ and „early warning system“, should be developed by the large industrial countries in cooperation with the emerging nations. The prompt adjustment of nominal exchange rates should prevent large imbalances in foreign trade and a cumulative build-up of foreign liabilities. Even in such a system, destabilizing capital movements cannot be entirely excluded, but they are less likely to occur, because the markets have been given clear guidelines, and because untenable interest constellations and massive real under-or over-evaluation should be avoided. In this case the system can minimize though not fully avoid surveillance and intervention into the capital account.

Regional cooperation up to a regional monetary union can be a temporary answer to the challenges coming up with globalization and liberalization if global solutions are out of reach. But regional monetary systems too do not prevent crisis and turmoil on the capital market once and for all. Given the unresolvable conflicts in a world of different nation states in any monetary system that has been tried out after World-War II, the Bretton Woods system just as much as the European Monetary System of the 1980s and early 1990s, recurring crisis-like phenomena that forced governments and central banks to intervene have been unavoidable. Only with the creation of the European Monetary Union, the European countries have gone a step further than in the fixed exchange rate systems of the past and have thereby done away, once and for all, with the speculation surrounding relative exchange-rate relations. This is an achievement for the global economy. But it cannot be copied easily by others as the political conditions may not be as favorable as in Europe. Multilateral efforts, nevertheless, to lead the developing countries into regional arrangements are unavoidable as long as global progress seems to be out of reach.”

[1] Cooper (2001) reaches a similar judgement.  J. R. Hicks (1968) had taken the same position already.

[2] In a recent article Das (2000) argues that fixed rates „are difficult to sustain in a world of increasing capital mobility“ as they may come under speculative attack.  But, at the same time, he admits that a country with „significant policy autonomy“ under flexible rates may „have trouble gaining credibility in international financial markets“ (p.19). Obviously, the same effects may apply in both systems. A fix rate may not be credible and policy with flexible rates may not be credible. Speculation may test a commitment to defend a rate or lead to overshooting and thereby harm the economic policy objectives of governments. These kind of arguments lead to nowhere if the interaction of prices, wages, interest rates and exchange rates are not explicitly analyzed.

Anmelden