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

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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:  The ECB and how it avoids QE.

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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.

Synopsis: The abysmal state of the Italian economy and how it can recover.

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Discussion:
This article discusses the dismal state of the Eurozone, focusing on Italy, and stresses the importance of QE as a means of recovery.

Many economies are doing abysmally, such as France, Germany and Italy, all of whoom had great hopes of recovery. As GDP in Italy slows down to 0.1% and debt rises, the debt/GDP ratio rises to 145%.

The high debt/GDP ratio worry many, and the writer, Ambrose Evans-Pritchard, calls upon Mario Draghi (the head of the ECB) to start QE in a serious way, as opposed to the timid plans that are being discussed by the ECB.

Italy is now practicing contractionary fiscal policy to lessen its high debt.

Zolt Darvas, quoted in the article, rom the Bruegel think tank in Brussels, warns that relying on additional lending by ECB will do minimal good. Instead, QE, in the form of asset purchases, is needed to stimulate the economy.

Whether or not Italy’s current prime minister, Matteo Renzi, will “meekly” participate in further austerity and fiscal cuts, one thing is clear: only if the ECB begins QE in a meaningful way will the Italian economy be saved.

Key words:
1. Primary budget surplus (paragraph 10): This is where the Italian government is in surplus when the government pays back the principal borrowed, but not the interest. Once the Italian government pays the interest back to its lenders, it is facing a deficit. The solution to this is austerity measures, which allows them to stop borrowing but maintain some reasonable level of government revenue through the collection of taxes. A good analogy is found here.
2. Debt trap (paragraph 12): A debt trap is where a country borrows to pay back interest. For example, if Italy borrowed 10 billion euros with 2% interest rate per annum (not real figures), and Italy pays back the 10 billion euros at the end of the year but not the 200 million euros interest, it will borrow more money to pay back the interest. The new loan will come with its own interest rate, which Italy must pay back by borrowing from somewhere else. Ultimately, Italy will spiral into uncontrollable debt.
3. Anglo-Saxon QE (paragraph 15): U.K. and U.S. QE
4. Austerity measures: This is contractionary fiscal policy, which means an increase in tax rates and a decrease in government spending. This is usually used to reduce the debt level in a country.

Context:
1. Internal vs. external devaluation: Neither of these terms is explicitly said in the article, but both ideas are mentioned. External devaluation is when an economy’s currency is devalued, which will encourage exports and hopefully increase production in the economy. Italy, being a part of the EU cannot devalue its currency as it does not have its own currency to control. Hence, exports cannot be encouraged through external devaluation. What Italy can do is devalue its economy internally. In paragraph 17, Evans-Pritchard writes, “If Italy slashes wages and deflates the economy to further regain lost competitiveness…” This is internal devaluation. By slashing wages, there will be less for Italian citizens to spend. Because of this, the price of commodities will drop. This drop in price of commodities might encourage other countries to import goods from Italy. It is a risky game, because it increases unemployment. Hence, internal devaluation is always a second-resort option; most economies prefer external devaluation.
2. Debt/GDP ratio: this is the ratio between debt and GDP. No economy ever looks at debt on its own, because it must be in relation to its economy. Imagine Country A with $100 debt and Country B with $200 debt. While it seems like Country A is doing better, this might not always be the case. Country A has only made $10 GDP, while Country B has made $100. So, Country A’s debt is ten times the amount of its GDP but Country B’s is only twice. On this scale, Country B is doing much better. This is why debt is always taken as a ratio of GDP.

Synopsis: Qualitative easing and its effects on quantitative easing.

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Discussion:
This article discusses the reasons behind the success of QE, stating that, in theory, QE (buying long-term treasury bonds) shouldn’t have any effects, as it only shifts government debt from cash to treasury.  However, this shift is what made QE1 successful; investors preferred the cash.  In QE2 and QE3, when financial markets were mostly back to normal, what made the difference is the confidence the Fed injected back in the market.  The public and markets felt comforted by the fact that the Fed would do whatever it takes to ameliorate the economy.  This injection of economic confidence is a lesson the Bank of Japan and the ECB should learn in their own efforts to make QE successful.

This article was specifically chosen to show the effect of qualitative easing, which is essentially a bank’s use of forward-looking statements to reassure the market and provide stimulus. This is a prime example of the fact that sometimes, economics hinges on not only theory, but also on the psychological aspect of humans.

Synopsis: How long will it take for the Fed to raise the interest rates after the end of QE?

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Discussion:
This article talks about the U.S. Federal Reserve’s (Fed’s) next steps after the end of its bond-buying program. Quantitative easing (QE) is ending in October, and this begs the question of when interest rates will increase. The Federal Open Market Committee (FOMC) had said that this will happen in “considerable time”, which can be perceived to mean between April and June, i.e. six months after QE stops. However, speculation has it that Yellen was speaking “dovishly”, and that it may not increase after a “considerable time”; interest rates will rise after the six-month window.

Why is the Fed speaking so dovishly? What is “considerable time”? The use of this phrase is a part of the Fed’s attempt at qualitative easing, i.e. the use of forward-looking statements about interest rates to reassure the market and to provide a stimulus. To read another article and commentary on qualitative easing and its impacts on the U.S. market, click here.

The Fed has always spoken dovishly so as to allow itself some “wiggle room”, as the article calls it. Resultantly, is not one to renege on its words, so if they do want to withdraw the “considerable time statement” it will have to be done around December so as not to shake consumer confidence.

Context:
There are three steps to ending QE, and the Fed is on the second step.

1. Tapering (bringing down the level of new bond purchases)
2. Maintaining the stock of bonds on the Fed balance sheet
3. Letting the bonds mature and the stocks run down

Key words:
Dovish – to speak with a tone that implies that no immediate action will be taken.
Hawkish – the antonym of dovish, to speak with a decisive tone