Monthly Archives: November 2015

Dilemmas, Trilemmas and Difficult Choices

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.

Growth in the Emerging Market Economies

In recent decades the global economy has been transformed by the rise of the emerging market economies. Their growth lifted millions out of poverty and gave their governments the right to call for a larger voice in discussions of international economic governance. Therefore it is of no small importance to understand whether recent declines in the growth rates of these countries is a cyclical phenomenon or a longer-lasting transition to a new, slower state. That such a slowdown has wide ramifications became clear when Federal Reserve Chair Janet Yellen cited concerns about growth in emerging markets for the delay in raising the Fed’s interest rate target in September.

The data show the gap between the record of the advanced economies and that of the emerging markets. I used the IMF’s World Economic Outlook database to calculate averages of annual growth rates of constant GDP for the two groups.

2001-07 2008-09 2010-15
Advanced 2.46% -1.62% 1.82%
Emerging and Developing 6.62%  4.48% 5.47%
Difference: (Emerging + Developing)               – Advanced 4.16%  6.1% 3.65%

The difference in the average growth rates was notable before the global financial crisis, and rose during the crisis. Since then their growth rates have fallen a bit but continue to exceed those of the sclerotic advanced economies. Since the IMF pools emerging market economies with developing economies, the differences would be higher if we looked only at the record of emerging markets such as China, India and Indonesia.

And yet: behind the averages are disquieting declines in growth rates, if not actual contractions, for some members of the BRICS as well as other emerging markets. The IMF forecasts a fall in economic activity for Brazil of -3.03% for 2015 and for Russia of -3.83%, which makes South Africa ’s projected rise of 1.4% look vigorous. Even China’s anticipated 6.81% rise is lower than its extraordinary growth rates of previous years, and exceeded by India’s projected growth of 7.26%. The IMF sees economic growth for the current year for the emerging markets and developing economies of 4% , a decline from last year’s 4.6%.

What accounts for the falloff, and can it be reversed? The change in China’s economic orientation from an economy driven by investment and export expenditures to one based on consumption spending has slowed that country down. The decline in that country’s demand for raw materials to transform into finished goods for export is rippling through the economies of the major commodity exporters, such as Australia and Brazil. The Economist has claimed that the resulting fall in commodity prices constitutes a “great bear market.”

This downturn may be aggravated by a failure in institutions. Bill Emmott writes that emerging markets need political institutions that “…mediate smoothly between competing interest groups and power blocs in order to permit a broader public interest to prevail.” He specifically cites the leaderships of Brazil, Indonesia, Turkey and South Africa as examples of governments that have not been able to achieve that task.

The basic model of economic growth, the Solow-Swan model, predicts that income in the poorer countries should catch up with those of the advanced economies as the former countries adopt the advanced technology of the latter. This basic result is modified if there are higher population growth rates or lower savings levels, which can lead to lower per capita income levels. On the other hand, the Asian countries used high savings rates to speed up their economic growth while their birth rates fell.

But convergence has not been achieved for most economies despite periods of rapid growth. Some economists have postulated the existence of “middle-income traps.” Maria A. Arias and Yi Wen of the St. Louis Federal Reserve Bank describe this phenomenon in a recent issue of the institution’s publication, The Regional Economist. They explain that while income rose close to U.S. levels in the “Asian Tigers” (Hong Kong, Singapore, South Korea and Taiwan) as well as Ireland and Spain, per-capita income shows no sign of rising in Latin American economies such as Brazil and Mexico. There may also be a “low-income” trap for developing economies that never break out of their much lower per-capita income.

Why the inability to raise living standards? Arias and Wen, after discussing several proposed reasons such as poor institutions, compare the cases of Ireland and Mexico. They claim that the Irish government opened the economy up to global markets slowly in earlier decades, and encouraged foreign direct investment to grow its manufacturing sector. This allowed the country to benefit from the technology embedded in capital goods. Mexico, on the other hand, turned to foreign capital markets to finance government debt, which left the economy vulnerable to currency crises and capital flight. Arias and Wen conclude that governments should manage the composition of capital inflows and control capital flows that seek short-term gain rather development of the manufacturing sector.

But there may be a more basic phenomenon taking place. In 2013 Lant Pritchett and Lawrence Summers of Harvard presented a paper with the intriguing title, “Asiaphoria Meets Regression to the Mean.” They examined growth rates for a large number of countries for10 and 20 year periods, extending back to the 1950s. They showed that there is ”…very little persistence in country growth rate differences over time, and consequently, current growth has very little predictive power for future growth.” While acknowledging China and India’s achievements, they cautioned that “…the typical degree of regression to the mean imply substantial slowdowns in China and India relative even to the currently more cautious and less bullish forecasts.” They drew particular attention to the lack of strong institutions in the two countries.

If growth does slow for most emerging market economies, then the recent buildup of corporate debt in those countries may be a troubling legacy of the recent, more robust period. Debt loads that looked manageable when borrowing costs were low and future prospects unlimited are less controllable when that scenario changes. While there may not be a widespread crisis that afflicts all the emerging markets, those countries with extended financial sectors are vulnerable to international volatility.