Friday, May 13, 2011

Hooliganism and the Unholy Trinity

. Friday, May 13, 2011

I’m with Krugman on this:

Putin says we’re hooligans; Brazil accuses us of “currency wars”; and the Chinese are, well, being their usual charming selves. But what’s going on in the international currency scene?

I don’t know why I didn’t think to put it this way before — and I don’t know if anyone else is saying this — but what we have here is a classic example of the Mundellian impossible trinity, aka the trilemma, which says that you can’t simultaneously have free movement of capital, a stable exchange rate, and independent monetary policy. …

So, how does this apply to current issues? Advanced countries, very much including the United States, are weighed down by the aftereffects of the 2008 financial crisis; this has led to low investment returns. Meanwhile, emerging markets are in much better shape, so capital wants to go there.

And this creates a problem for the EMs. They don’t want their currencies to rise sharply…

But not letting the currency rise would be inflationary – that is, Brazil doesn’t want to give up on its independent monetary policy. So what’s the answer?

All those accusation of hooliganism, currency wars etc. are in effect demands that the trilemma be resolved by having America give up having an independent monetary policy — basically, that the Fed give up on trying to stabilize the US economy so that emerging markets aren’t faced with the uncomfortable tradeoff between massive appreciation and imported inflation. But this shouldn’t and won’t happen.

Yes. And thinking in terms of the Trilemma is important because it helps us understand domestic politics within an international context. Brazil and the other EMs are worried about (nominal) exchange rate appreciation because it hurts their exporters, which is a politically powerful group. Inflation hurts consumers (and creditors), which is also bad for democratically-elected politicians. So that leaves capital controls, which remains the preferred trade-off of many EMs.

This is an illustration of how the U.S. really is still the most powerful global economic actor, as everyone else is having to adjust to U.S. policy rather than the other way around. The same thing happened (in slightly different ways) during the collapse of Bretton Woods, as Yglesias noted:

This is one reason why I’ve grown impatient with nostalgia for the good old days of the Bretton-Woods system.This system, which really was working great in its heyday, essentially involved the United States playing precisely the role that we now reject. The dollar was pegged to gold, other currencies were pegged to the dollar, foreign countries could change the dollar price of their currencies, and we couldn’t reset the value of the dollar. This worked fine as a means of facilitating catch-up growth in Japan and Western Europe but that growth make it impossible to sustain, so it wasn’t sustained and there’s no practical method of bringing it back.

I would add one thing. The Trilemma refers to the ubiquitous "small, open economy" and therefore leaves out a component that is highly salient for politics: one country in the system can have all three of free capital movement, fixed exchange rates, and independent monetary policy. As Dr. Oatley explained awhile back, this is because exchange rates are not monads:

But in what sense does the US not pegging the dollar imply that the dollar is not pegged? China and the other East Asian governments peg to the dollar. And even Japan, which doesn't peg the yen, does limit its fluctuation as if it has a target zone. For all practical purposes, then, the dollar is pegged against many of its most important creditors (the Euro is the only exception, but the euro area as a whole is a debtor rather than creditor area). If this wasn't the case, we wouldn't be having this conflict.

More generally, any discussion about the unholy trinity needs to recognize the n-1 problem. In any system of n countries there are n-1 independent exchange rates. Think about a three-country system. If China pegs to the dollar and South Korea pegs to the dollar, the China-South Korean rate is fully determined by the cross rate.

As a result, every exchange rate system (other than a gold standard) has one degree of freedom: one country can attain a fixed exchange rate, and capital mobility, and monetary independence. Whichever country holds this position gets to set monetary policy for the system as a whole. International monetary politics revolve who gets this degree of freedom and how it is employed. …

This suggests that we are back in a world very much like the late Bretton Woods: the US has a pegged exchange rate against many of its major creditors and capital mobility and monetary autonomy. The current conflict is a consequence of East Asian governments forcing the US to accept a peg at a rate it does not think is appropriate. Like Geithner and Co. now, the Nixon administration believed it couldn't devalue an over-valued dollar unilaterally.

And this is why the U.S. gets called “hooligans” and everything else.


Hooliganism and the Unholy Trinity
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