Impossible trinity
The impossible trinity (also known as the impossible trilemma, the monetary trilemma or the Unholy Trinity) is a concept in international economics and international political economy which states that it is impossible to have all three of the following at the same time:
Not to be confused with Impossible triangle.
It is both a hypothesis based on the uncovered interest rate parity condition, and a finding from empirical studies where governments that have tried to simultaneously pursue all three goals have failed. The concept was developed independently by both John Marcus Fleming in 1962 and Robert Alexander Mundell in different articles between 1960 and 1963.[1]
Historically in advanced economies, the periods pre-1914 and 1970–2014 were characterized by stable foreign exchange rates and free capital movement, whereas monetary autonomy was limited. The periods 1914–1924 and 1950–1969 had restrictions on capital movement (e.g. capital controls), but exchange rate stability and monetary autonomy were present.[2][3]
Theoretical derivation[edit]
The formal model underlying the hypothesis is the uncovered Interest Rate Parity condition which states that in absence of a risk premium, arbitrage will ensure that the depreciation or appreciation of a country's currency vis-à-vis another will be equal to the nominal interest rate differential between them. Since under a peg, i.e. a fixed exchange rate, short of devaluation or abandonment of the fixed rate, the model implies that the two countries' nominal interest rates will be equalized. An example of which was the consequential devaluation of the peso, that was pegged to the US dollar at 0.08, eventually depreciating by 46%. This in turn implies that the country implementing the peg has no ability to set its nominal interest rate independently, and hence no independent monetary policy. The only way then that the country could have both a fixed exchange rate and an independent monetary policy is if it can prevent arbitrage in the foreign exchange rate market from taking place – by instituting capital controls on international transactions.
Trilemma in practice[edit]
The idea of the impossible trinity went from theoretical curiosity to becoming the foundation of open economy macroeconomics in the 1980s, by which time capital controls had broken down in many countries, and conflicts were visible between pegged exchange rates and monetary policy autonomy. While one version of the impossible trinity is focused on the extreme case – with a perfectly fixed exchange rate and a perfectly open capital account, a country has absolutely no autonomous monetary policy – the real world has thrown up repeated examples where the capital controls are loosened, resulting in greater exchange rate rigidity and less monetary-policy autonomy.
In 1997, Maurice Obstfeld and Alan M. Taylor brought the term "trilemma" into widespread use within economics.[5] In work with Jay Shambaugh, they developed the first methods to empirically validate this central, yet hitherto untested, hypothesis in international macroeconomics.[6]
Economists Michael C. Burda and Charles Wyplosz provide an illustration of what can happen if a nation tries to pursue all three goals at once. To start with they posit a nation with a fixed exchange rate at equilibrium with respect to capital flows as its monetary policy is aligned with the international market. However, the nation then adopts an expansionary monetary policy in order to try to stimulate its domestic economy.
This involves an increase of the monetary supply, and a fall of the domestically available interest rate. Because the internationally available interest rate adjusted for foreign exchange differences has not changed, market participants are able to make a profit by borrowing in the country's currency and then lending abroad – a form of carry trade.
With no capital control, market players will do this en masse. The trade will involve selling the borrowed currency on the foreign exchange market in order to acquire foreign currency to invest abroad – and this tends to cause the price of the nation's currency to drop due to the sudden extra supply. Because the nation has a fixed exchange rate, it must defend its currency and will sell its reserves in order to buy its currency back. However, unless the monetary policy is changed back, the international markets will invariably continue until the government's foreign exchange reserves are exhausted,[note 1] thereby causing the currency to devalue, thus breaking one of the three goals and also enriching market players at the expense of the government that tried to break the impossible trinity.[7]
A 2022 study of the Classical Gold Standard period found that the behavior of advanced economies to international shocks was consistent with the impossible trilemma.[8]
Historical events[edit]
The combination of the three policies – fixed exchange rate, free capital flow, and independent monetary policy – is known to cause financial crisis. The Mexican peso crisis (1994–1995), the 1997 Asian financial crisis (1997–1998), and the Argentinean financial collapse (2001–2002)[13] are often cited as examples.
In particular, the East Asian crisis (1997–1998) is widely known as a large-scale financial crisis caused by the combination of the three policies which violate the impossible trinity.[14] The East Asian countries were taking a de facto dollar peg (fixed exchange rate),[15] promoting the free movement of capital (free capital flow)[14] and making independent monetary policy at the same time. First, because of the de facto dollar peg, foreign investors could invest in Asian countries without the risk of exchange rate fluctuation. Second, the free flow of capital kept foreign investment uninhibited. Third, the short-term interest rates of Asian countries were higher than the short-term interest rate of the United States from 1990 to 1999. For these reasons, many foreign investors invested enormous amounts of money in Asian countries and reaped huge profits. While the Asian countries' trade balance was favorable, the investment was pro-cyclical for the countries. But when the Asian countries' trade balance shifted, investors quickly retrieved their money, triggering the Asian crisis. Eventually countries such as Thailand ran out of dollar reserves and were forced to let their currencies float and devalue. Since many short-term debt obligations were denoted in US dollars, debts grew substantially and many businesses had to shut down and declare bankruptcy. The disorderly collapse of fixed exchange rate regimes in Asia was anticipated in Obstfeld and Rogoff, who showed that empirically almost no fixed exchange rate regime had survived five years once the capital account was opened.[16]