In 2013 Hélène Rey of the London Business School presented a paper at the Federal Reserve Bank of Kansas City’s annual policy symposium. Her address dealt with the policy choices available to a central bank in an open economy, which she claimed are more limited than most economists believe. The subsequent debate reveals the shifting landscape of national policymaking when global capital markets become more synchronized.
The classic monetary trilemma (or “impossible trinity”) is based on the work of Robert Mundell and Marcus Fleming. The model demonstrates that in an open economy, central bankers can have two and only two of the following: a fixed foreign exchange rate, an independent monetary policy, and unregulated capital flows. A central bank that tries to achieve all three will be frustrated by the capital flows that respond to interest rate differentials, which in turn trigger a response in the foreign exchange markets. Different countries make different choices. The U.S. allows capital to cross its borders and uses the Federal Funds Rate as its monetary policy target, but refrains from intervening in the currency markets. Hong Kong, on the other hand, permits capital flows while pegging the value of its currency (the Hong Kong dollar) to the U.S. dollar, but forgoes implementing its own monetary policy. Finally, China until recently maintained control of both its exchange rate and monetary conditions by regulating capital flows.
Rey showed that capital flows, domestic credit and asset prices respond to changes in the VIX, a measure of U.S. stock market volatility. The VIX, in turn, is driven in part by U.S. monetary policies. Consequently, she argued, there is a global financial cycle that domestic policymakers can not resist. A central bank has one, and only one, fundamental choice to make (the “dilemma”): does it regulate the capital account to control the amount and composition of capital flows? If it does, then it has latitude to exercise an independent monetary policy; otherwise, it does not possess monetary autonomy.
Is Rey’s conclusion correct? Michael Klein of the Fletcher School at Tufts and Jay Shambaugh of George Washington University have provided a thorough analysis of the trilemma (working paper here; see also here). Their paper focuses on whether the use of partial capital controls is sufficient to provide monetary policy autonomy with a pegged exchange rate. They find that temporary, narrowly-targeted controls–“gates”– are not sufficient to allow a central bank to both fix its exchange rate and conduct an independent policy. A central bank that wants to control the exchange rate and monetary conditions must impose wide and continuous capital controls–“walls.” But they also find that a central bank that forgoes fixed exchange rates can conduct its own policy while allowing capital flows to cross its borders, a confirmation of the trilemma tradeoff.
Helen Popper of Santa Clara University, Alex Mandilaras of the University of Surrey and Graham Bird of the University of Surrey, Claremont McKenna College and Claremont Graduate University (working paper here; see also here) provide a new empirical measure of the trilemma that allows them to distinguish among the choices that governments make over time. Their results confirm, for example, that Hong Kong has surrendered monetary sovereignty in exchange for its exchange rate peg and open capital markets. Canada’s flexible rate, on the other hand, allows it to retain a large degree of monetary sovereignty despite the presence of an unregulated capital market with the U.S.
The choices of the canonical trilemma, therefore, seem to hold. What, then, of Rey’s challenge? Her evidence points to another phenomenon: the globalization of financial markets. This congruence has been documented in many studies and reports (see, for example, here). The IMF’s Financial Stability Report last October noted that asset prices have become more correlated since the global financial crisis. Jhuvesh Sobrun and Philip Turner of the Bank for International Settlements found that financial conditions in the emerging markets have become more dependent on the “world” long-term interest rate, which has been driven by monetary policies in the advanced economies.
Can flexible exchange rate provide any protection against these comovements? Joshua Aizenman of the University of Southern California, Menzie D. Chinn of the University of Wisconsin and Hiro Ito of Portland State University (see also here) looked at the impact of “center economies,” i.e., the U.S., Japan, the Eurozone and China, on financial variables in emerging and developing market economies. They find that for most financial variables linkages with the center economies have been dominant over the last two decades. However, they also found that the degree of sensitivity to changes emanating from the center economies are affected by the nature of the exchange rate regime. Countries with more exchange rate stability are more sensitive to changes in the center economies’ monetary policies. Consequently, a country could lower its vulnerability by relaxing exchange rate stability.
Rey’s dismissal of the trilemma, therefore, may be overstated. Flexible exchange rates allow central banks to retain control of policy interest rates, and provide some buffer to domestic financial markets. But her wider point about the linkages of asset prices driven by capital flows and their impact on domestic credit is surely correct. The relevant trilemma may not be the international monetary one but the financial trilemma proposed by Dirk Schoenmaker of VU University Amsterdam. In this model, financial policy makers must choose two of the following aspects of a financial system: national policies, financial stability and international banking. National policies over international bankers will not be compatible with financial stability when capital can flow in and out of countries.
But abandonment of national regulations by itself is not sufficient: International banking is only compatible with stability if international financial governance is enacted. Is the administration of regulatory authority on an international basis feasible? The Basel Committee on Banking Supervision seeks to coordinate the efforts of national supervisory authorities and propose common regulations. Its Basel III standards set net capital and liquidity requirements, but whether these are sufficient to deter risky behavior is unclear. Those who deal in cross-border financial flows are quite adept in running rings around rules and regulations.
The international monetary trilemma, therefore, still offers policymakers scope for implementing monetary policies. The financial trilemma, however, shows that the challenges of global financial integration are daunting. Macro prudential policies with flexible exchange rates provide some protection, but can not insulate an economy from the global cycle. In 1776, Benjamin Franklin urged the members of the Second Continental Congress to join together to sign the Declaration of Independence by pointing out: “We must, indeed, all hang together, or most assuredly we shall all hang separately.” Perhaps that is the dilemma that national policymakers face today.