Synopsis: The last in the series of seminal economics ideas discusses the Mundell-Fleming trilemma, its uses, and whether it actually stands the test of time.

Click here to read the original article.

Discussion:

What is international macroeconomics?

The Mundell-Fleming trilemma is rooted in international macroeconomics, which is the study of policymaking decisions that affect how global economies interact with one another. International macroeconomics deals with issues such as balance of payments, trade agreements, and capital controls.

What is the Mundell-Fleming trilemma?
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The Mundell-Fleming trilemma is described as the essence of international macroeconomics, according to Michael Klein from Tufts University. It states that, given the choice between monetary autonomy (explained under ‘Context’), free capital mobility, and a fixed exchange rate, an economy can only choose two of them. The trilemma is represented below.

​Two of the three corners of the triangle can be achieved by any economy; the third must be forsaken. Below is a table showing three different economies and which of the choices they surrendered.

Forsaking free capital mobility

For example, let’s take an economy that decides to maintain both monetary autonomy and a fixed exchange rate.

Assume the U.K. has its interest rate set at 2% a year, and its exchange rate is at parity with the U.S. dollar, i.e. $1 will get you £1. The U.K. decides to fix its exchange rate such that it is always at parity with the U.S. dollar.
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Given this scenario, U.S. investors convert $10,000 a day to £10,000 and invest it in the U.K. economy. Now, assume that the Bank of England wants to decrease interest rates in order to encourage British investment in the local economy: the interest rate falls to 1%.
U.S. investors now feel less inclined to invest as much money as their return has decreased by 1%. Thus, they want to convert fewer U.S. dollars into the British sterling, i.e. the exchange rate falls. This is illustrated below.

Originally, the Bank of England released an amount Ms of the British pound (GBP) in the international markets. The demand for the GBP, indicated by D1, resulted in an exchange rate of $1=£1. When the Bank of England reduced its interest rate to 1%, the demand for GBP fell from D1 to D2. Resultantly, the exchange rate fell to $0.8=£1. Because Britain has chosen to maintain both monetary autonomy (i.e. it will not increase its interest rate back to 2%) and a fixed exchange rate, it has to forsake free capital mobility by decreasing the money supply to Ms’. In other words, it cannot allow the amount of financial capital, including money flows, to be determined by external forces. Now, the exchange rate is back at $1=£1.

Forsaking a fixed exchange rate

If an economy decides it wants monetary autonomy and free capital mobility, it will have to give up control over its exchange rate. Assume that a certain event in the U.K., such as Brexit, has caused panic amongst international investors. They withdraw their financial capital (such as money) due to uncertainty over the future of the British economy, which depletes the U.K.’s reserves of foreign currency. Without the Bank of England’s increasing interest rates to encourage capital influx, foreign reserves stay low. Without these reserves, the U.K. cannot maintain a fixed exchange rate (explained under ‘Context’), and must allow its exchange rate to float.

Forsaking monetary autonomy

If an economy decides to maintain both a fixed exchange rate and free capital mobility, it must forsake monetary autonomy. To maintain a fixed exchange rate, the U.K. must have a certain level of foreign reserves, i.e. it has to ensure that foreign investors are incentivized to invest in the British economy, which would maintain the level of foreign reserves. If it wants to allow capital to move freely between borders, it must set an interest rate high enough to encourage a certain level of foreign investment. In other words, the U.K.’s interest rate must be determined by the amount of foreign reserves it requires to maintain a currency peg.

An example of a currency peg is the Hong Kong dollar, which, since 1983 has been pegged to the U.S. dollar at a rate of US$1 = HK$7.80. Between 1974 and 1983, the Hong Kong dollar was allowed to float. In 1974, the U.S. dollar depreciated, which encouraged capital influx to the U.S., and consequently, capital outflows from Hong Kong. As Hong Kong chose not to stem capital outflows, it had to choose between allowing its currency to float and forsaking monetary autonomy. Until 1983, it chose the former. To read more about the history of the Hong Kong dollar, click here.

The trilemma and the EU

The Euro was first launched in 1992, under the Maastricht Treaty. In order for an economy to participate in the Euro, it had to fulfill six conditions, one of which was to have an interest rate set close to the EU average. In the run-up to the establishment of the Euro, economies fixed their currencies to the Deutschmark (the currency used earlier in Germany) and allowed their capital to move freely across borders. The participating European economies then relinquished monetary autonomy and followed Germany’s interest rate closely. Wim Duisenberg, the head of the Dutch central bank, was dubbed “Mr. Fifteen Minutes” due to the alacrity with which he copied the interest rate decisions of the Bundesbank, the German central bank.

Today we can see the implications of a single interest rate in the EU. For economies that followed Germany’s business cycle back when the Euro was first established, such as the Netherlands, there was little impact of copying Germany’s interest rate. However, for economies that did not parrot Germany’s business cycle, such as Greece and Spain, interest rates were too low during booms, which caused major troubles when their economies faced busts.

After the Global Financial Crisis (GFC), the EU was hesitant to embark upon QE, a policy that necessitated lower interest rates across the common market. Even though it would have helped the suffering PIIGS (Portugal, Italy, Ireland, Greece, and Spain) economies by encouraging domestic investment, Germany voiced its hesitance, stating that it would leave Germany vulnerable to hyperinflation. Determining an interest rate that placates all members of a common market has proven to be nearly impossible.

The history of the trilemma

The first mention of some tension when it comes to international macroeconomic policymaking was by J.M. Keynes, who, in his 1930 essay “A Treatise on Money”, stated that “[preserving]… the stability of local currencies… and [preserving] an adequate local autonomy for each member over its domestic rate of interest and its volume [poses a dilemma]”.

This dilemma (Keynes assumed free capital mobility­) was the basis of Keynes’ criticism of the interwar gold standard: trade imbalances forced deficit countries to raise interest rates and lower wages to stop the hemorrhage of capital, which led to mass unemployment. If surplus economies increased their imports, this problem would be self-solving, but no surplus economy had any mandate to do so.

In the Bretton Woods conference, Keynes proposed a solution in which an international clearing bank (ICB) aids with deficits and dissuades surpluses. Unsurprisingly, this idea faced great opposition from America, which was an economy with a large trade surplus. The ICB was abandoned, but the idea of an international bank aiding deficit countries became the basis for the IMF.

Marcus Fleming was in touch with Keynes when he wrote his paper on the impotence of monetary policy in the face of a fixed exchange rate and freely-moving capital. Independently, Canadian economist Robert Mundell reached a similar conclusion, but was inspired by different circumstances.

Years after the Second World War, there were scarcely any countries that faced rapid and free capital mobility. Canada was an exception: it allowed capital to travel freely through its border with America. Because it valued monetary autonomy highly, it had no choice but to let its currency float from 1950 to 1962.

Maurice Obstfeld, the current Chief Economist of the IMF, was the first one to mention the term “policy trilemma” in a paper he published in 1997. Since then, the trilemma has become a centerpiece of macroeconomic textbooks, and a conversation piece for international policymakers.

Why the trilemma matters

International trade and globalized economic activity became increasingly commonplace after the Second World War. Economies that had to deal with sudden capital flight or influx, or struggled to maintain control over their currency, had to turn to a previously-ignored idea to not only understand why they did not have as much control over their markets as they did before the war, but also to understand how to deal with it and what the opportunity costs of choosing certain policies were.

The Mundell-Fleming trilemma paved the way for conversation about policymaking with reference to international economies. Today, we notice the impact of all policy decisions on global economic activity: divergence in terms of QE policies between the U.S. and Japan might lead to carry trade; China’s maintaining both monetary autonomy and a strongly-managed exchange rate means that it must employ capital controls; the Bank of England’s decision to continue with QE resulted in a depreciation of the GBP.

A criticism of the trilemma
A big critique of the Mundell-Fleming trilemma has been provided by Helene Rey, from the London Business School, who stated that an economy that allows both capital flows and a floating exchange rate will not necessarily have control over its monetary policy. To hear her lecture on why, click here.

Context

1. What is monetary autonomy?

Monetary autonomy denotes a central bank’s ability to choose its policies, especially interest rates, without taking into account the impact of its interest rate on international markets.
If a central bank has to take into account the reaction of international markets due to an interest rate decision, it would be because higher interest rates would encourage investors to purchase local government bonds, leading to capital influx. Alternatively, lower interest rates would lead to capital flight.

2. Why does a fixed exchange require lots of foreign reserves?

A central bank that wants to peg its exchange rate must meet decreased demand for its currency by lowering the stock of its currency in the forex market, and increased demand by increasing the stock of its currency in the forex market.

To increase the stock of its currency, a central bank must buy foreign currency using its own currency. Conversely, to decrease the stock, it must buy its own currency using foreign currency, which means  that it should have a stock of foreign currency to do so.

An economy must have enough foreign currency in its reserves to have the full flexibility to both buy and sell its own currency. Hong Kong, for example, has a large stock of foreign reserves to maintain its peg to the U.S. dollar. For this reason, speculators do not attack the Hong Kong dollar.

Synopsis: A quick summary on Brexit and an exploration of what the UK's future might hold.

Discussion:

The UK’s decision to leave the European Union (EU) surprised both Leave and Remain supporters alike - not to mention, the rest of the world. Whatever decisions the UK’s new prime minister will take, Britain will still be stepping into the unknown. With an unclear future ahead, everyone seems to be asking the question nobody has the answer to: what next?

A summary of Remain and Leave arguments

On trade and the economy:

1. Leave supporter Ian Duncan Smith promises £350 million per week contributed towards the EU budget would be redirected to the National Health Service should the UK leave. In fact, most of this £350 million is returned by the EU through various payments, and the Leave party has since reneged on its promise.
2. Leave cites an abundance of red tape due to the EU’s many product regulations as a barrier to trade.
3. Remain states that uncertainty and a reduction of trade if the UK leaves would result in decreased growth, if not a recession, a statement met with general agreement among economists.

On the free movement of labor:

1. Leave claims that EU members, especially the Poles, are taking away British jobs. Remain argues that it is free movement of labor that guarantees healthy competition and that only the more skilled workers get UK jobs.
2. Leave argues that without forced cultural assimilation, Britain will face more and more pockets of impenetrable cultural bubbles.

Voter demographics

The Financial Times highlights five key demographics.

1. Areas where more people had a degree voted to remain.
   
2. Areas with a small number of people in “professional occupations” voted to leave.
3. Areas where more people had passports voted to remain.
4. Lower income areas voted to leave.
5. Older people voted to leave.

Immediate reactions
After the shocking results of the EU referendum nearly a fortnight ago, it is no surprise that both UK and global financial markets reflected the sentiment of uncertainty. Most notably, the pound briefly dipped to a thirty-year low at $1.32 on June 27th, far below its pre-referendum high at $1.50. This drop is somewhat a relief as it dissuades imports and encourages exports in the UK. Equity markets, on the other hand, have bounced back above their pre-referendum levels. According to The Economist, this is due to the “oil and mining giants… [having] little to do with the British economy.”

Meanwhile, the Bank of England governor, Mark Carney, has tried to douse the sudden upsurge of uncertainty by announcing that the central bank will take “whatever action is needed to support growth”, most likely including some form of expansionary monetary policy. He warns that there is only so much the central bank can do. According to the Financial Times, two-year British government bond yields became negative for the first time following his statement.

Standard and Poor’s (S&P) downgraded Britain’s AAA rating to AA, and Fitch Ratings downgraded them from AA+ to AA. Moody’s has lowered its outlook for the UK from stable to negative.
S&P also lowered the EU’s credit rating from AA+ to AA.

What next?

Starting with the practical aspects, the BBC outlines the process for the UK to leave the EU.

Synopsis: What problems the EU will face with QE, when it will happen, and how it might come about.

Click here to read the original article.

Discussion:

This article discusses the likelihood of QE in the Eurozone, the necessity of QE, the problems it could face and the manner in which it would happen.

The Eurozone has faced persistent lowflation (which, for the countries in the periphery, means actual deflation). Hence, there has been a push from many countries for QE – “creating money to buy fiscal assets”.  The ECB faces strong opposition from Germany, whose nightmares about hyperinflation eclipse the need for QE to put a stop to sliding inflation.

Both core and headline inflation are slipping lower and lower – substantially lower than the ECB’s 2% target. The all in oil prices itself is a welcome relief for many countries, where the decrease in oil prices reduces their own costs of production. However, if the lower costs of production make people expect deflation (or even lower inflation), deflation will happen, true to its self-fulfilling nature.

Lowflation is equally as harmful as deflation, where the latter means an increase in the real value of debt (debt is in nominal terms), and the former means prices rising slower than what the government expected when they first borrowed money.

As the ECB can no longer decrease the interest rates (it is currently at 0.05%), they must try to expand their own balance sheet by buying sovereign bonds. They plan on expanding it by 1tn euros, although when this will happen is unknown.

Past attempts at increasing their balance sheet and pumping money into their economy was as not fruitful as the ECB had hoped – only 212bn euros of the 400bn euros was borrowed by banks from 2011-2012. One potential reason for this is that banks were not willing to borrow money during a stagnant economy.

Because Germany has its own reservations about the ECB’s buying sovereign bonds, the ECB is also buying covered bonds and asset0backed securities, neither of which is big enough to absorb the whole of the QE needed.

The ECB also has the option of borrowing corporate bonds, but even that market is not substantial.

The ECB, therefore, must buy public debt.

Whenever the ECB may enact QE, the program is unlikely to surpass 500mn euros, which may or may not be sufficient to aid the economy.

Context:

This post about the ECB and QE by Ambrosse Evans-Pritchard discusses similar things, and hence, is worth reading. Both articles reach a similar conclusion that the scale of QE the ECB plans to do is insufficient.

Synopsis:  The ECB and how it avoids QE.

Click here to read the original article.

Discussion:

This article discusses the fact that the ECB is taking negligible steps towards helping the Eurozone economy in terms of monetary policy.

The ECB is facing major opposition from Germany, which fears that the launch of large-scale and proper QE might result in uncontrollable hyperinflation – a repeat of pre-World War 2 German economy.

As opposed to the QE that was used by the Fed and is being used by the BoJ, the ECB is instead enacting ‘penance’ measures – more to put up a show rather than to improve the economy, according to Pritchard.

Mr. Mario Draghi, the head of the ECB, has hinted at a EUR 1tn spend. As much as it sounds similar to QE, it is not, for two major reasons:

1) Central banks that enact QE take the risk on their own balance sheet; this is to say, whatever happens to the value of the sovereign bonds they purchase, they deal with it. Instead of doing so, they are offering LTROs (explained in the article) to banks in exchange for collateral.

2) The ECB is spending nowhere near the EUR 1tn promise – rather, its spending amounts to about EUR 450bn, perhaps lower. This equates to roughly EUR 17.5bn a month (and this spending will not start until the end of the year), 10 times less than the spending by the Bank of Japan.

Many economists also say that the lowered interest rates will have a negligible effect on the overall market at this point, i.e. conventional expansionary monetary policy just does not work for the Eurozone as of now.

Key terms:

1) Deleveraging: Where banks lower the amount lent to the public so that banks can keep up with the capital adequacy ratio.

2) Capital adequacy ratios: To protect bank depositors, governments have come up with this concept. The idea is that a bank must have a certain amount of capital in its bank, so that if the bank incurs losses and cannot pay depositors back, the banks can use some of its own capital to cover the losses. Usually, when capital adequacy ratios are discussed, the Basel rules are mentioned as well. These rules (Basel I, Basel II and Basel III) dictate the amount of capital needed in the banks. The more, the better for the depositors.

Context:

One thing worth discussing is the sixteenth paragraph: “Nor is it clear… said Mr. Roberts from RBS”. The statement being made here is that unless the ECB takes on bad bonds, there is no point in bothering with QE in the EU. The problem with this statement is that no economy that has practiced or is practicing QE (Japan, USA and UK) has taken on bad bonds; they have only ever taken sovereign (government) bonds. Government bonds are steady and trustworthy, and very reliable bonds to purchase. For a long time, the government and the central bank of a country have been split, where it is the government’s job to take on bad loans and liquidate frozen banks. The central bank has two objectives: to maintain steady and reasonable inflation, and to reduce unemployment. If an economy were to be taking on “bad stuff”, as Mr. Roberts from RBS (quoted in that paragraph) says, it would be only from the part of the individual governments, not the ECB.

Discussion:
This article describes the influx of Chinese investment on Europe.  As part of its outbound investments model, Chinese investment has increased multifold.

One problem the Chinese are facing with investment abroad is the presence of labor and environmental laws. Usually, such laws are overlooked in China. Nonetheless, it is likely that investment in Europe will steadily increase.

Still, Europe may be getting in its own way, in that it might be discouraging the Chinese from investing in the EU. The EU has so far been benefitting with the influx of investment, especially into those countries who have been hit the hardest by the debt crisis (the PIGS countries – Portugal, Italy, Greece and Spain). But Europe is unwilling to sell China it’s more advanced technology and does not have much else to offer China.

Regardless, it is clear that private investors are entitled by the reduction in asset prices in Europe, and it is clear that Chinese investment in Europe will increase with time.