‘Trilemma’: Currency Regimes Explained

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In economics, a trilemma refers to a decision-making theory. A play on the word “dilemma”, in which case implying a trade-off running along a dual spectrum, a “trilemma” refers to a scenario in which there are three competing trade-offs.

Often, the problem is conceptualized as needing to choose two of the three in order to best produce a solution the problem due to elements of mutual exclusivity. Trying to accomplish all three at once in a genuine trilemma scenario typically produces inefficient outcomes or the inability to stably manage the situation.

For example, the economics of healthcare is often conceptualized as a trilemma. You have the competing elements of quality/reliability, universality, and affordability. Generally speaking, pick two. If you want quality and affordability, it won’t be universal. If you want quality and universality, it won’t be affordable. If you want affordability and universality, it won’t be of very high quality or reliable (outside of the basics). Various public and private solutions can act to help supplement each other. If someone who can afford better care isn’t happy with the quality of what’s publicly available, he will typically look for a private plan.

This article is focused on the trilemma aspects of currency management policies. Big moves in currencies are often caused by shifts in how policymakers manage them.

Broadly speaking, policymakers have three options in terms of how to manage their currency policies. They have the elements of capital flows, the exchange rate, and the autonomy of the nation’s monetary policy.

They will typically try to choose whichever two of the three are the most important or logical in terms of managing the particular set of circumstances (at the expense of the third).

Autonomy refers to how well they can independently control their monetary policy without having to adjust to the policies associated with other central banks and other governmental institutions. Divergence in monetary policies will influence capital flows and relative exchange rates.

Capital controls represent any measure taken by a central bank, government, or regulatory body to restrict the flow of foreign capital going in and out of the domestic economy. This can include a mix of tariffs, taxes, legislation, and volume restrictions. They are more common in countries where capital reserves are volatile and in lower quantities. Capital controls normally scare away foreign investors and can lead to inadequate economic development.

Trilemma: 1) Capital flows, 2) Exchange rate, 3) Monetary policy autonomy

When countries are faced with this particular set of policy trade-offs, they may achieve one particular side of the triangle at any particular time illustrated by the diagram below:

trilemma

For Side A, a country can choose to fix its exchange with one or multiple countries and allow for the free flow of capital. If it chooses this option, it will forgo having an independent monetary policy. If it chooses to, the fluctuations in interest rates would cause capital to flow into one currency versus another in net terms. Currency pegs would therefore not be sustainable.

To run an independent monetary policy, it would need to drop its currency peg and shift to Side B of the triangle or it must take sufficient control over its capital account and move to Side C.

For Side B, a country can choose to have a free flow of capital while also having an independent monetary policy. In this case, as noted above, exchange rates cannot be reliably fixed.

For Side C, a country that wants a fixed exchange rate and autonomous monetary policy will need to restrict its capital account to prevent the free flow of capital. Allowing free capital flows would cause its currency peg to inevitably break unless such flows were insufficient in volume.

If a country cannot control its capital account and wants to maintain a fixed exchange rate then it must either give in to the reality that it will not have an independent monetary policy.

Restrictions on capital flows are typically done to support domestic banking systems. If a country’s banking system sees a run on its deposits, then it may face insolvency if loans cannot be called to cover deposit withdrawals. In 2015, Greece instituted a temporary bank holiday to forestall the prospect of a bank run. Domestic bank customers were not able to execute wire transfers out of the country.

Sometimes people will try to circumvent capital controls by moving their money into alternative assets such as gold. Accordingly, in various points throughout history, governments have banned the ownership of gold as an additional type of capital control. Alternatively, price and wage controls may be implemented. Typically, they don’t work very effectively and create distortions rather than mitigate problems.

These days, cryptocurrencies might be one alternative, off-the-grid asset that people might use to move their money “offshore”, or at least as a way to store their wealth in a place deemed safer than their domestic currency. Part of the risk associated with alternative digital currencies is that they may also be subject to legal and regulatory supervision or banned altogether.

If a government can’t adequately control cross-border capital flows and wants to maintain an independent monetary policy, then it must free float its currency.

These situations, when identified pre-emptively, can be big opportunities for currency traders.

Sometimes, currency peg removals will occur more or less unexpectedly and sometimes they will occur more predictably.

Examples of pre-devaluation scenarios

Is the country low on reserves? If its low on reserves, it will be much less likely to defend the peg because it will eventually run out.

Is the country’s growth suffering in combination with limited monetary policy options (e.g., rates at zero, quantitative easing less effective)? The next viable part of the toolkit is likely to be currency devaluations.

Is a country pre-paying its foreign-denominated debts? That might indicate that it’s about to devalue its currency. Debt denominated in a foreign currency becomes more expensive when its domestic currency decreases in value, thus incentivizing paying it down before a free-float occurs.

Government challenges

A government, notably the central bank, is forced to appropriately assess its situation and govern policy accordingly.

When a country is fully developed, it will tend to prefer being on Side B of the triangle. It can enjoy the advantages of an independent monetary policy, which will allow it to pull key levers in light of its current conditions. This, of course, assumes that policymakers have the ability and authority to do so. It will also have the ability to liberalize its capital account and let capital flow freely. The exchange rate will shift in light of this policy and broadly be determined by natural market forces.

The United States is an example of Side B.

The European Union, however, is aligned with Side A. The eurozone combines several different countries together as one general area and most share the same currency, the euro. It is essentially a peg that permits the free flow of capital.

In light of this situation, countries must necessarily forgo having an independent monetary policy. One of the chief concerns of the eurozone is the stress put on countries when they run into debt problems and cannot devalue their currency.

In 2012, Greece ran into a major debt problem. They were on the euro rather than the drachma, which they had left in 2002. Thus, they couldn’t devalue and spread these effects externally. Namely, because they did not have control of their own monetary policy, they could not offset the deflationary deleveraging forces associated with the necessary austerity and default requirements to bring nominal interest rates below nominal growth rates.

Instead Greece had to “internally devalue” and take the contraction in internal output. GDP contracted 40 to 45 percent.

Some EU member-states see distortions in their accounts because the exchange rate is too high or too low for them. The euro is too low for Germany, which shows up in its balance of payments, with a fiscal surplus and current account surplus. Other countries suffer because the EUR is too strong, notably on the periphery, which has a weaker economic situation. When output contracts 40 percent or more, as it did in the case of Greece, it can take 20 years of stable growth just to get back to where they were formerly. A “lost decade”, as the common term goes, can turn into multiple lost decades depending on the extent of the deleveraging necessary and the ability to handle it.

China is an example of Side C. It has a fixed exchange rate that it manages relative to what’s called the CFETS basket, which China (through its central bank and state banks) manages within a band. Due its high levels of debt, China needs an independent monetary policy so it can manage these debts by altering the interest rates and maturities (and who owns the debt) if and when it needs to.

China is still broadly a top-down, state-directed economy that wants stability in its exchange rate, so it desires a fixed exchange rate regime. To accomplish these dual objectives of an autonomous monetary policy and currency peg, it must take control over its capital account and regulate cross-border financial flows.

The Bretton Woods system in place from 1944 to 1971 was another example of Side C.

Currencies were pegged to the US dollar, though countries were allowed to set their own interest rates. In other words, they were allowed to pursue their own independent monetary policies. In order to effectuate the system, capital flows would either need to be restricted or small enough to be immaterial to ensure the system would be sustainable.

Because capital flows between countries were small enough for many years following the post-World War II period, the Bretton Woods system held up until the US unilaterally broke the peg with gold.

This established the US dollar as a free floating fiat currency, going from Side C to Side B. The US, in choosing to liberalize its capital account, necessarily had to liberalize its currency policy and free float the dollar.

Because this acted as an easing of monetary policy, US stocks were up 4 percent the following morning despite the common assumption that such a massive inflection point in the global exchange rate regime would be a volatility inducing shock that risk assets might react negatively to. While easier monetary policy from switching from Side C to Side B allowed the US to more effectively manage its own economic situation, policy remained too easy throughout the decade and resulted in high inflation until the early 1980s.

Several other developed market currencies followed the dollar thereafter in moving toward free floating regimes.

In the end, all pegged systems that are inconsistent with the fundamentals of the currency will eventually fail.

Conclusion

A trilemma refers to the situation of deciding between three different solutions or outcomes to a given problem. In the context of currency management decision-making, governments broadly have a trade-off between being able to control cross-border capital flows, pegging their exchange rate, and achieving an independent monetary policy.

Governments will typically target two of the three:

1) If a government wants to have an independent monetary policy such that they can adjust interest rates and the money supply in light of economic conditions and restrict cross-border capital flows, then they should strive to peg their currency.

2) If a government wants to have an independent monetary policy and have its currency free-floated on the international market, then it will need to liberalize its capital account and allow for cross-border capital flows. (This is typically the preferred option among developed markets.)

3) If a government want to have: a) a fixed exchange rate – typically because their economy is based on exports, resource extraction, and/or the selling of secondary goods (i.e., importing lumber and selling value-added products like wooden chairs) – and b) also wants to protect various industries by restricting capital flows (e.g., to support the banking system), then it will need to give up the notion that it can run its monetary policy independently from other countries. Otherwise its currency peg will eventually fail and/or it will not be able to restrict capital flows.

This route is typically followed in emerging and frontier markets. The euro zone, through the euro, also has given up the ability for its member-states to pursue an independent monetary policy.

Whatever a government decides to do will be a function of its specific set of conditions and its policymakers ability and authority to pursue the most appropriate measures.