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International Politics Week 7: The Trilemma. Instructor: James Raymond Vreeland , Professor 2.0. Remember, remember the 5 th of November. 1 st : A reminder of. The Inconsistent/Unholy Trinity Or “Trilemma”. The Trilemma. Fixed Exchange Rate. Sovereign Monetary Policy.
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International Politics Week 7:The Trilemma Instructor: James Raymond Vreeland, Professor 2.0
1st: A reminder of The Inconsistent/Unholy Trinity Or “Trilemma”
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
Fixed Exchange Rate The Trilemma Open Capital Flows Sovereign Monetary Policy
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
Fixed Exchange Rate Eurozone countries Switzerland PRC The Trilemma Open Capital Flows Sovereign Monetary Policy
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
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
Conclusion: Cannot maintain (global) fixed exchange rates in the presence of high capital mobility…?
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
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
GLOBAL FINANCIAL INTEGRATION (World external assets as % of GDP) Source: WEO 9/02, 4/05 and 10/07
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
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
Nixon ends Bretton Woods http://www.youtube.com/watch?v=iRzr1QU6K1o http://www.popmodal.com/video/8803/Nixon-Ends-Bretton-Woods-International-Monetary-System
Why? • So, why do fixed exchange rates pose a problem for democracies in the face of highly mobile capital?
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
With paper money • Central Banks intervene by adjusting interest rates • So gold doesn’t actually flow • Gold Standard strict discipline!
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!
Under authoritarianism: Let them eat cake Under democracy: Incumbents lose elections People don’t eat
Fixed exchange rates + Open capital flows • No problem under authoritarianism • (no problem for governments) • Big problem under • Democracy • Labor Unions
What was the IMF supposed to do? • Soften the blow • Lend to “Country A” deficit-countries so that adjustment can be gradual
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
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.
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
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
Or: François tests the Adele-hypothesis • Is the trilemma wrong? • Can we have it all?
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
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
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
What will governments choose?Society-based models of monetary & XR politics • Electoral models • Partisan models • Sectoral models
Assuming free capital flows… • Governments must choose between • monetary policy autonomy • XR stability
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
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)