The Currency Trilemma

Morgan Stanley has an interesting piece out today, arguing there is  no ‘currency war’… yet. Win Thin made some points on this score yesterday, pointing to real effective exchange rates in developing countries. Morgan Stanley’s Manoj Pradhan has a different take, citing the lack of emerging market retaliation.

Brazil’s Finance Minister, Guido Mantega, recently sparked a lively discussion by saying that an ‘international currency war’ has broken out. Most EM currencies have been appreciating throughout 2010…

However, one crucial ingredient that would suggest we are in a currency war still seems to be missing – retaliation. Rather, these currency movements and the understandable policy response are symptomatic of a two-track global economy where low-growth and über-easy monetary conditions in DM has led to capital flows seeking to benefit from the robust domestic demand-led recovery in EM, which in turn has helped EM risky assets to outperform. EM policymakers have, as a group, deployed similar tools this year when faced with similar issues in a synchronized but not necessarily retaliatory fashion. There is a parallel here with how the Fed, ECB, BoE and BoJ responded to the events of late 2008 by allowing their balance sheets to expand in a synchronized but not necessarily coordinated fashion (see Global Monetary Analyst: QE2, March 4, 2009).

I disagree with Pradhan here because there most certainly is a currency war in the developed markets between the US, the euro zone, Japan, the UK, and Switzerland. I understand that Pradhan and Thin are more focussed on emerging markets. And it was the Brazilian finance minister’s comments which started the focus on this issue. But it is the developed markets where the retaliation has already begun. Japan and Switzerland have already intervened to stop their currencies from appreciating. Meanwhile quantitative easing in the US is almost certainly coming by November 3 when the Federal Reserve next meets. Can the UK be far behind? And what will the euro zone do given the stress their appreciated currency puts on its periphery?

However, Pradhan does raise an important topic: the currency trilemma or what is commonly known as the Impossible Trinity. During the last period of economic weakness, this was also a main point of contention within Europe. In February 2009, I wrote:

I would break the Europe down into four distinct spheres: The Eurozone, the non-Eurozone West (like the UK, Sweden and Denmark), the EU East (like Poland, Hungary and Latvia) and the non-EU East (like Ukraine and Croatia). The problems and potential outcomes in each of these regions is different. The crux of the matter is the Impossible Trinity of a fixed exchange rate, independent monetary policy and free movement of capital. You can have two, but you cannot have all three. Paul Krugman says it best in an article from 1999:

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).

–The European problem

This was a problem for the euro zone. You’ve heard the term dollarization for Latin American countries that use US dollars as the circulating currency.  These economies are dollarized. The euro zone operates as a ‘euro-ized’ economy with the national currency are pegged to the euro. That’s what a currency union effectively is. But that means they have an internal fixed exchange rate and free movement of capital. Naturally, then individual countries have no monetary autonomy then. Greece and Italy cannot devalue vis-a-vis the Deutschemark any more.  And to the degree you have a peg to the euro as you do in the Baltics, this means you also have lost monetary authority unless you impose capital controls – one reason internal devaluation and depression were the austere method the Baltics have taken to weather the crisis.

Pradhan believes that this is also an issue for emerging markets vis-a-vis developed markets in a two-track global economy. He writes:

For EM countries, the combination of rapid capital inflows, a need to tighten monetary policy, and the desire to keep currencies from appreciating suggests that EM policymakers are battling the Trilemma – a three-way dilemma whereby policymakers can choose only two policies out of a trio of: pegged or managed exchange rate, free flows of capital, and independence of monetary policy. The Trilemma has troubled policymakers for the better part of a century (Obstfeld, Shambaugh and Taylor, The Trilemma in History, 2004), and is exasperating them again now. If the tensions caused by the trade-offs above are exacerbated much further, however, we believe there is a potential risk that policymakers could yet become aggressive and retaliatory enough to engage in a ‘currency war’.

The cost and risks of not getting it right are particularly high for EM policymakers at this stage of a still-fragile global economic recovery. Structural forces of high productivity growth in EM economies mean that there is sustained upward pressure on domestic inflation or currency values or both (the Balassa-Samuelson effect). The additional short-run appreciation pressures from a two-track global recovery are effectively compounding the problem. Too much temporary inflation may be politically undesirable, and too much currency appreciation could lead to another round of rapid ‘hot money’ flows, overshooting, and a painful correction later on, especially if global fundamentals change. Such is the price of success.

This is what Mantega was complaining about: If emerging markets are growing faster and the developed markets are debasing their currencies by every means they can, hot money enters the emerging markets and creates bubbles.  Joseph Stiglitz has also made comments to this effect. For the developed economies, forget about domestic demand, it’s China or bust.

Because the emerging markets have yet to retaliate except for some minor capital controls, Pradhan doesn’t believe the currency war for emerging markets is on yet. But he believes it could be coming and gives a few ways to avoid it.

Source: No ‘Currency War’…Yet – Manoj Pradhan, Morgan Stanley