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 look at Japan’s economy and a discussion about how best to improve it

​Click here to read the original article.

Discussion:

This article discusses the ways in which Japan could improve its economic situation, chiefly through fiscal and monetary policy.

Krugman highlights aspects of the Japanese economy that are encouraging: “Output per working-age adult has grown faster than in the United States since around 2000, and at this point the 25-year growth rates look similar”, and “… Japan is closer to potential output than we are”. Nevertheless, Japan is struggling to escape from deflation. Why has Abenomics not worked as well as people hoped?
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The main ideas in his article are best portrayed through a flow chart:

1. According to Krugman, the two biggest issues are Japan’s over-reliance on fiscal expansion (which leads to a high debt-to-GDP ratio) and its chronic deflation. Fiscal consolidation may be called for to balance the debt-to-GDP ratio and to reduce Japan’s reliance on fiscal expansion, but Japan has no way of offsetting the effects of fiscal consolidation through QE; after all, the interest rates are already as low as can be.

2. It follows that one of the only solutions is to raise inflation such that real interest rates fall. This way, QE can happen alongside fiscal retrenchment. Krugman adds as a side note that raising inflation would also reduce the value of debt.

Krugman describes how Japan may be facing a negative Wicksellian rate (explained under ‘key terms’) as a permanent condition. He points out that even if the Bank of Japan were to promise greater QE, it is ultimately consumer expectations of future inflation that will determine inflation (more about this will be explained under ‘context’).

Krugman’s solution is to combine monetary policy with a burst in fiscal stimulus. The fiscal stimulus will raise the inflation, and the increase in inflation leaves room for more QE. Only when more QE is enacted can fiscal consolidation occur, which would cut down the debt-to-GDP ratio.
The question, then, is how high should inflation be? While the answer does not have a certain numerical value currently (i.e. it has to be high enough to allow QE to occur), it is clear that Japan’s 2% inflation is not enough.

Krugman emphasizes the problem of fiscal consolidation alone: it may cause an economy slump, in which case Abenomics may be beyond redemption. He says that the only measure left is for Abe to engage in aggressive austerity and QE together to increase inflation.
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Key terms:

1. Wicksellian rate (a.k.a. natural rate of interest): Kurt Wicksell was a leading Swedish economist who was best known for his idea of the natural rate of interest. The theory suggests that there is a long-run natural rate of interest, and if the current rate of interest is higher than said natural rate, there will be deflation, and if the current rate is lower than the natural rate, there will be inflation. When the current interest rate equals the natural rate of interest, there is equilibrium in the commodity market and price levels are stable. To read more about this (and how it pertains to modern-day economics), click here.

Context:

1. To understand this article, it is important to understand what Abenomics is. Abenomics is a portmanteau of the words economics and Abe – Shinzo Abe being the Prime Minister of Japan. His plan is to fire three ‘arrows’ to stimulate economic recovery. The first arrow is expansionary monetary policy in the form of QE, the second is fiscal stimulus, and the third is structural reforms, mainly through strengthening the Japanese army.

While these three arrows seem like feasible ways to revive the economy, Japan is still faced with lacklustre inflation, and many attribute this to the fact that Abe is not aggressive and hawkish in any of his three tactics, or arrows. Paul Krugman discusses what Abenomics’ next steps are.

2. How does future inflation determine inflation today? Consider this situation: a consumer in an economy wants to buy a new phone. She believes that inflation will increase in the future, i.e. the price of the phone will be higher in the future than it is currently. For this reason, she buys the phone today. Many consumers in the economy also believe that future prices will be greater than current prices, and buy the goods and services today instead of waiting for the price to increase. The aggregate demand in an economy suddenly increases, and producers increase the price of the goods and services in an economy as a response. This increase in prices of goods and services is, in fact, inflation. Deflation works in a similar way. In this way, inflation (or the lack thereof) is a self-fulfilling prophecy.
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3. In my opinion, there are a few problems with Krugman’s proposed solution. The first is that despite years of fiscal expansion by the Bank of Japan (BoJ), deflation still persists. Even aggressive fiscal expansion, which is what Krugman suggests, has its problems. Firstly, there is no telling when the aggressive expansion will result in a sufficient level of inflation; it could take much longer than the BoJ can afford, and it will exacerbate the debt-to-GDP ratio greatly. Secondly, even when the BoJ deems the inflation level in Japan as healthy enough to allow fiscal retrenchment to happen, they have to be wary of consumer expectations. Either the BoJ will have to execute fiscal consolidation so slowly that it now faces high inflation and a high debt-to-GDP ratio, or it will have to carry out fiscal consolidation quickly enough to avoid inflation from becoming a worry. The problem with the latter is that consumer, investor and producer confidence in the market is shaky enough as it is; fiscal consolidation may scare them enough to revert the economy back into the original state of deflation where people are hesitant about consumption, production and investment.

Synopsis: A debate between Larry Summers and Ben Bernanke about why US interest rates are so low.

Click here to read the original article.

Discussion:

This article by Greg Ip details a debate between former Federal Reserve Chairman Ben Bernanke and former Treasury Secretary Larry Summers about why interest rates in America are so low. While Summers argues that it is due to secular stagnation, Bernanke disagrees, citing “cyclical and special factors” as the reason for low interest rates.

Secular stagnation includes low growth, low inflation and low interest rates and lasts a substantial amount of time. As Ip points out, it is the real interest rate (nominal interest rate – inflation) that is important. It is the real interest rate that balances savings and investments. More about this will be explained under ‘Context’.

Summers states that the “real rate needed to balance desired saving and investment may actually be negative”, a key factor of secular stagnation.

Bernanke disagrees that the real rate may be negative and details a scenario to illustrate his point. The rough idea is that if the real interest rate was always negative, then all investments would be profitable. Due to an increase in demand for investments, the real interest rates would increase.

Greg Ip further illustrates this point by outlining a scenario with stock dividends, where, if the real interest rate were 0%, the value of the stock would theoretically be infinity, and if the real interest were negative, the equation becomes nonsensical. This will also be explained under ‘Context’.

Summers retaliates by showing that, according to Summers, “rates in America have been negative at least 30% of the time”. His reasoning behind this is that “negative real interest rates are a phenomenon that we observe in practice if not always in theory”.

How is that possible? There are a few reasons for this.

1) While government bonds, or risk-free bonds, are negative, private borrowers would often pay a positive due to the higher risk involved in giving private borrowers loans. Further, investors may demand an “even higher hurdle, especially if they expect the project’s profits to grow quite slowly in a stagnant economy”.

2) Bernanke agrees that real rates can be negative temporarily, not permanently. (Here, Ip points out that Summers never argued that the interest rate was permanently low, it could just be for a 10-15 year time period).

Even if the real rate was not negative, secular stagnation could still be a culprit in low interest rates as secular stagnation does not need rates to be negative, just low.

Next, Bernanke faults Summers for downplaying the international element of the argument. If it were true that there was a lack of profitable investments in the US, the savings would go abroad, increasing interest rates in the US. Bernanke believes that the weak recovery of 2002-06 was due to a global savings glut, as opposed to Summers’s belief that the weak recovery was due to secular stagnation. China and other countries with large trade surpluses “saved more than they invested and exported the rest to the US”. Therefore, the lack of US growth, according to Bernanke, was because imports were displacing domestic production. Since then, China’s trade surplus has decreased while Europe’s has grown, but Bernanke thinks this is a “cyclical, temporary problem”.

Paul Krugman questions Bernanke’s theory that open capital markets would not depress real interest rates by citing Japan as an example. Bernanke however argues that while interest rates were extremely low, inflation was lower, causing real interest rates to be slightly higher than that of the US.

Greg Ip then cites a few reasons why he believes interest rates are so low:

1) Worldwide monetary policy. When QE ended in the US, which had brought real rates worldwide down, ECB’s QE began, keeping the real rates down.

2) Supply side factors – slower growing labour and productivity.
a. Slowing labor can be classified as slower population growth, which depresses the supply of workers and investment, as a smaller workforce need less machinery and other equipment. It also depresses demand, as retirees consume less and aging workers save more for retirement.
b. Productivity has also slowed down worldwide, partly due to the residue of the financial crisis on capital spending, which will eventually fade. However, it also reflects a lack of innovation. And firms may invest less because they see “fewer payoffs to new technology”.  Robert Gordon, a famous economist in the productivity field, also cites education attainment no longer increasing as why growth is slowing down.

Key terms:

1. Financial bubbles: where there is an unsustainable increase in asset prices such as stocks, houses, property and even land.

2. Risk-free interest rate: The interest rate acceptable to a lender when he believes that the borrower will not default on the loan. In practice, this refers to the interest rate on US treasuries, which are considered the safest investment.

3. Hurdle: The minimum expected rate of return from a project, below which the investors will not go ahead with it.

Context:

1. Economists care about real interest rates rather than nominal interest rates. As inflation erodes the purchasing power of the interest earned by the lender, he will make lending decisions based on interest rate after deducting the inflation; in other words, the real interest rate.

2. An important idea to understand from this article is the relationship between real interest rates, savings and investments. As stated in the article, investments can be considered demand for savings, while savings can be considered supply of savings. The diagram below illustrates the relationship.

At real interest rate R2, investment is at I2 and savings is at S2, i.e. they are equal at an equilibrium point. If the real interest rate decreases from R2 to R1, investment would increase to I1 and savings would drop to S1. Similarly, if the real interest rate increases from R2 to R3­, investment would decrease to I3 and savings would increase to S3. This relationship shows that as real interest rates increase, investment decreases and savings increase.

3. Nominal interest rates cannot be negative. Given the equation that real = nominal – inflation, real can still be negative, if inflation > normal.

4. Gary Ip’s discussion of stock dividends:  A stock is worth the sum of its future dividends, discounted at an appropriate interest rate to bring them to today's present value. In other words:

Stock value = D/(1+i) + D/(1+i)^2  + D/(1+i)^3 + D/(1+i)^4 + D/(1+i)^5 ... 
(assuming that the stock pays a fixed divided of D every year and i is the interest rate).

As you can see, as the value of i falls,  the stock value increases; if the value of i reaches zero, the stock value is infinity; if the value of i goes below -1, then the equation turns nonsensical.

5.  Larry Summers states that “negative real rates are a phenomenon that we observe in practice if not always in theory”. This is an allusion to Bernanke’s earlier statement that quantitative easing works in practice if not always in theory. More about that can be read here.

6. There is a discussion about the 2002-2006 weak recovery. The context of this is that, during that time, China exported high volumes of goods to the US, and used the resulting surplus to invest back in America, which led to low real interest rates, and displaced domestic production in America.

7. One important thing to consider is why there is persistent low growth in America, as that is reason for QE and low interest rates in the first place. Some reasons for low growth to persist are:
a. The benefits of technology adoption are finished. Tyler Cowen, a professor at George-Mason university, is famous for discussing this concept in his book “The Great Stagnation”, the gist of which is that the low hanging fruits have already been plucked.
b. Retirement of baby boomers.
c. Long left over effects of the Great Financial Crisis (GFC).
d. Ageing population.

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.