The Trilemma in International Politics: Fixed Exchange Rate, Sovereign Monetary Policy, and Open Capital Flows

1. International Politics Week 7:The Trilemma Instructor: James Raymond Vreeland, Professor 2.0

2. Remember, remember the 5th of November

4. 1st: A reminder of The Inconsistent/Unholy Trinity Or “Trilemma”

6. The Trilemma

7. Fixed Exchange Rate

8. Sovereign Monetary Policy

9. Open Capital Flows

10. Free Capital Flow Inconsistent/Unholy Trinity Or “Trilemma”: a country can only have 2 out of 3 of these Fixed Exchange Rate Sovereign Monetary Policy

13. Fixed Exchange Rate The Trilemma Open Capital Flows Sovereign Monetary Policy

14. Why would you want… • Free Capital Flow? • Draw on the savings of the rest of the world • Investment opportunities abroad • Fixed Exchange Rate? • Reduce uncertainty in trade & other international transactions • Sovereign Monetary Policy? • Address inflation & unemployment

15. Examples?

16. Fixed Exchange Rate Eurozone countries Switzerland PRC The Trilemma Open Capital Flows Sovereign Monetary Policy

17. Free Capital Flow USA PRC Inconsistent/Unholy Trinity Or “Trilemma”: a country can only have 2 out of 3 of these Fixed Exchange Rate Sovereign Monetary Policy

18. Why did we ever need the IMF?A puzzle Degree of global capital mobility Fixed exchange rates + Capital controls Floating exchange rates + Open capital flows 1971-3 1944

19. Conclusion: Cannot maintain (global) fixed exchange rates in the presence of high capital mobility…?

20. Why did we ever need the IMF?A puzzle Degree of global capital mobility * Fixed exchange rates + Capital controls Floating exchange rates + Open capital flows 1971-3 1870 1944

21. A puzzle:Why were countries able to maintain fixed exchange rates with high capital mobility in the late 19th century? Fixed exchange rates + Open capital flows Degree of global capital mobility Fixed exchange rates + Capital controls Floating exchange rates + Open capital flows 1870 Interwar period 1971-3 1944

22. GLOBAL FINANCIAL INTEGRATION (World external assets as % of GDP) Source: WEO 9/02, 4/05 and 10/07

23. Why?

24. Another answer: Democracy & Labor Unions Growing #’s of democracies Few democracies Fixed exchange rates + Open capital flows Degree of global capital mobility Fixed exchange rates + Capital controls Floating exchange rates + Open capital flows 1870 Interwar period 1971-3 1944

25. Under democracy, • The “pocketbook voter model” • people vote according to changes in their income • http://www.youtube.com/watch?v=loBe0WXtts8 • http://www.popmodal.com/video/13134/Michael-Reagan-talkes-with-Meygn-Kelly-about-his-dads-question-Are-You-Better-Off-Now-than-You-Were-4-Years-Ago

28. Nixon ends Bretton Woods http://www.youtube.com/watch?v=iRzr1QU6K1o http://www.popmodal.com/video/8803/Nixon-Ends-Bretton-Woods-International-Monetary-System

29. Why? • So, why do fixed exchange rates pose a problem for democracies in the face of highly mobile capital?

30. Pure gold standard • Country A imports from Country B • Gold moves from A to B (re-coined/minted) • Less money in A  lower prices • More money in B  higher prices •  Country B imports from Country A • Balance is restored

31. With paper money • Central Banks intervene by adjusting interest rates • So gold doesn’t actually flow • Gold Standard  strict discipline!

32. What is “discipline”? • What do “lower prices in Country A” mean? • Supply of money down • More expensive to borrow • Jobs cut! • People don’t eat!

33. Under authoritarianism: Let them eat cake Under democracy: Incumbents lose elections People don’t eat

34. Fixed exchange rates + Open capital flows • No problem under authoritarianism • (no problem for governments) • Big problem under • Democracy • Labor Unions

35. What was the IMF supposed to do? • Soften the blow • Lend to “Country A” deficit-countries so that adjustment can be gradual

36. Stylized history so far… • Late 19th century: • Mobile capital, authoritarian governments • Interwar years: • Mobile capital + democracy  beggar-thy-neighbor Still to come… • Bretton Woods (1944-1971/3): • Capital controls + democracy • Post Bretton Woods: • Floating exchange rates

37. Meanwhile, the Trilemma saga continues… The story of the contemporary international monetary system is the story about the search for the elusive ideal-balance between domestic economic autonomy and exchange rate stability.

38. The point of the unholy trinity – you can’t have it all… • “The point is that you can't have it all: A country must pick two out of three. It can fix its exchange rate without emasculating its central bank, but only by maintaining controls on capital flows (like China today); it can leave capital movement free but retain monetary autonomy, but only by letting the exchange rate fluctuate (like Britain--or Canada); or it can choose to leave capital free and stabilize the currency, but only by abandoning any ability to adjust interest rates to fight inflation or recession (like Argentina today, or for that matter most of Europe).” • – Paul Krugman http://slate.com/id/36764

39. The European Monetary System • 1979 • Fixed but adjustable • The Bundesbank (Germany) used monetary policy to keep inflation low, and other countries engaged in foreign exchange market intervention to fix their currencies to the German mark

40. French-German fight in 1981-3

41. Or: François tests the Adele-hypothesis • Is the trilemma wrong? • Can we have it all?

42. French-German fight in 1981-3 • Mitterand – socialist president – believed German monetary policy was strangling • Expansionist monetary policy (e.g., lowered interest rates) • French inflation began to rise • Called on Germany to lower their interest rates • 18 month stand-off… the French backed down

43. 1988-2002: Monetary Union • 1988: Planning begins • Gradually moved towards fixing their currency XR’s (1999 – “permanently” fixed) • Jan 2002: The Euro! • Why union? • High degree of economic openness across Europe  • Sacrificed monetary autonomy for XR stability

44. To fix or to float?

45. Open capital flows lead to imbalances How do governments deal with these imbalances? • Fixed exchange rate  sacrifice monetary policy OR: • Floating exchange rate sacrifice certainty in international exchanges Trade-off between • exchange rate stability versus • domestic price stability with monetary policy autonomy

46. What will governments choose?Society-based models of monetary & XR politics • Electoral models • Partisan models • Sectoral models

47. Assuming free capital flows… • Governments must choose between • monetary policy autonomy • XR stability

48. 1. Electoral models • Prediction: Democracies choose floating XR  • monetary autonomy used to manipulate political-business cycles • If there is a fixed XR  • commitment may not be credible before elections (elections like the Sirens!) • Pocketbook voter model – people vote according to changes in their income • http://www.youtube.com/watch?v=loBe0WXtts8 • Sociotropic model – voters consider macro performance (economic growth, unemployment, inflation) • http://www.douglas-hibbs.com/HibbsArticles/Welt-am-Sonntag-2008-08-22.pdf

50. 2. Partisan models • Left-wing parties are “pro-employment” • Tied to organized labor • Right-wing parties are “anti-inflation” • Tied to business interests • Prediction: • Right-wing governments more likely than left-wing governments to establish & maintain a fixed XR • It is possible to connect this to the electoral model: • Voters choose left-wing parties during recessions & right-wing parties under inflation • Some partisan models suggest, however, *convergence* of party positions (specifically in 2 party systems)