Wednesday, November 10, 2010

The Effect of the Unholy Trilemma on the International System

. Wednesday, November 10, 2010

McMegan can't find anything wrong with Drezner's post about international politics and the unholy trilemma. Let me try to help her. Drezner's is a decent post, but it reads like he might have been a bit short of time because it's a bit under-developed. First, his claim:

The unholy trinity in open economy macroeconomics is pretty simple. It's impossible for a country to do the following three things at the same time:

1) Maintain a fixed exchange rate

2) Maintain an open capital market

3) Run an independent monetary policy

One of the issues with macroeconomic policy coordination right now is that different countries have chosen different options to sacrifice. China, for example, has never opened its capital account. The United States, in pursuing quantitative easing, has basically chucked fixed exchange rates under the bus, no matter how many times Tim Geithner utters he "strong dollar" mantra in his sleep to reporters.

So far so good -- although I'd emphasize more than him that it is possible to do any two of those three, so the choice is which one to neglect, not which one to pursue -- and he's honing in on an important dimension of IPE right now: what happens when the major economies disagree about which two to prioritize? Bretton Woods I emphasized #s 1 and 3; Bretton Woods II emphasized #s 2 and 3 (see graph above). Right now there doesn't appear to be a consensus.

As Drezner notes, right now the U.S. is letting the exchange rate float (which is nothing new; it has been official policy since the early 1970s), China maintains a closed capital account, Brazil is trending towards that direction, the E.U. has sacrificed independent monetary policy within its borders and fixed exchange rates beyond them, the U.K. is allowing sterling to float, Japan is also eschewing a fixed exchange rate, while open exporting economies like S. Korea and Switzerland have worked to protect their exchange rates. Right now nobody is stressing too much about maintaining capital account openness, but this is a relatively new development.

The interesting part of this, to me, is that divergent policies could put states, especially major trading partners, at cross-purposes. This could under-cut the effectiveness of states' domestic policy goals, which could lead to confrontation and instability. Unfortunately Drezner ultimately neglects the question of why different countries will prioritize different policies, and what the implications of those choices are for the macro system. Instead, he argues that we'll see "a lot more capital controls". That's true, but we'll also probably see a lot more central bank activity and a lot more exchange rate manipulation, depending on the domestic political incentives of states. We've already seen increased management along all of these dimensions recently. In other words, I think we should expect a more active role overall for states in managing their economies in the coming decade that in the past one, but different states will prioritize different goals.

What intrigues me is how the financial sector responds to a situation in which their freedom of action in emerging markets becomes more and more constrained. It's possible that they could pressure the Fed to change its position in the future. It's also possible, however, that big firms could see these controls as a useful barrier to entry for new firms.

My money is on the former response, however.

Or they could revert to their default position: the Washington Consensus. The major criticism from the advanced economies of emerging economies prior to the Asian financial crisis was the persistence of capital controls. The major IPE controversy from 1973-2000 or so was the use of the IMF to break those controls down. It's definitely possible that that debate flares up again in the coming years, precisely because capital owners in emerging countries benefit from a more-closed financial system while capital owners in developed countries benefit from a more-open financial system.

We'll have to wait and see, but the longer it takes the global economy to rebound, the stronger these pressures will become.


The Effect of the Unholy Trilemma on the International System




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