Wednesday, March 11, 2009

The trilemma problem will not go away

Nobel prize winner Robert Mundell described one of the most vexing issues in international finance and exchange rate regimes, the trilemma problem. A country cannot make three commitments at the same time, control the exchange rate, allow for free capital mobility, and control monetary policy or have economic autonomy. More countries are facing the problem as we move to economic extremes and the likely solution is a lack of exchange rate stability.

Looking back on the history exchange rate regimes we find that the trilemma problem is real and creates significant risks. The Bretton Woods regime focused on FX stability through fixed exchange rates with economic autonomy and restrictions on capital flows. As capital flows increased, the stability could not be maintained. FX stability declined. The three goals could not be reached. Now we have countries that want economic autonomy and no restrictions on capital markets, but who are concerned with exchange rate changes, but you cannot have it all.

Large open economies have free capital markets and economic autonomy but they have to accept the FX instability. This can describe the later part of the Bush Administration where more aggressive easing led to dollar declines. There was no strong dollar policy. The Obama Administration will like to continue the current policies of free capital flows and economy autonomy but if the dollar delevering is reversed we will be back in a situation where FX stability will not be able to be maintained and a fall-off will be expected.

For small open economies there is the attempt to maintain free capital flows and stable exchange rates, but the problem is that economic autonomy is lost and internal economics will be driven by global shocks. We are seeing the impact of this with some of the East Asian export-driven economies.

We cannot get away from the trilemma and have to accept that especially in a crisis we cannot have it all. Of course, the mantra of free capital flows may change which will lead to greater distortions in interest rates around the globe. Short of capital restrictions, foreign exchange volatility will continue to stay at high levels and there will be greater swings in exchange rates as economies try to maintain internal harmony with generally unfettered capital markets.

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