THE ETERNAL TRIANGLE
Explaining international financial perplexity
Anyone who has attended recent meetings of central bankers and finance officials, and who has enough cynicism to see through the mask of judicious confidence that is an essential part of such officials' wardrobe, has surely been struck by the air of unreality that pervades all discussions. On one side, nobody really believes that the rescue programs already in place or about to be put into effect will do more than stave off imminent currency crisis; prospects for a real recovery remain remote. Yet none of the proposals currently receiving serious discussion offers any realistic hope of changing the situation materially. Another $18 billion for the IMF? That wouldn't be enough to cope with an attack by a single hedge fund, let alone the massive capital flows that can result when not only hedge funds but domestic investors speculate against a currency. Credit lines for countries not yet under attack? The same. Voluntary standstill agreements by creditors, or even Chapter 11-type proceedings for countries? As I pointed out in an earlier note , these too are likely to be ineffective. Even Chilean-type restrictions on capital inflow - aside from being a conspicuous locking of the barn door long after the horse has gone - are not likely to do much to prevent future crises.
Why has international monetary discussion become such a matter of euphemisms, evasions, and well-meaning but ineffectual gestures? The deep answer, I believe, lies in the difficulty most officials and even private economists have in facing up to the unpleasant dilemma that is really involved in choosing an international financial "architecture". This dilemma is not new; on the contrary, the basic story has been the same for at least a century. But for a while a combination of good luck and special circumstances allowed us to forget about such unpleasantness. Now it's back, and leaders will either have to make hard choices, or find that the logic of events makes those choices for them.
The essence of the dilemma may be understood by remembering the catechism first suggested by the Bellagio Group, the famous official-academic international talk shop that flourished in the 1960s. In the world according to Bellagio, the problem of choosing an international monetary regime could be summarized as the effort to achieve Adjustment, Confidence, and Liquidity. Exactly what these terms mean is somewhat in the eye of the beholder; but my version goes as follows. Adjustment means the ability to pursue macroeconomic stabilization policies - to fight the business cycle. Confidence means the ability to protect exchange rates from destabilizing speculation, including currency crises. Liquidity basically means short-term capital mobility, both to finance trade and to allow temporary trade imbalances.
So what is the dilemma of international financial architecture? It is that, essentially because of the threat of currency speculation, you can't get everything you want. More specifically, insisting on having any one of the three desired attributes in an international regime forces the abandonment of one of the others. As a result, there is a limited menu of possible regimes - and each item on that menu is unsatisfactory in some important way.
The accompanying figure illustrates the problem schematically. Each vertex of the triangle shows one desirable feature of an international regime; each side of the triangle, which corresponds to the choice to have two of these three features, indicates a possible regime. As the figure suggests, over the past century we have tried all of the possibilities.
To get a sense of why the dilemmas refuse to go away, let's try choosing each of the vertices in turn and see why it requires abandoning one of the others.
- Confidence: Suppose that a country decides that it simply cannot accept an unstable currency, driven up and down by swings of investor sentiment (or, in the modern world, by the winding and unwinding of hedge fund positions). This means that it must either peg its exchange rate, or at least manage it strongly. But if it also tries to maintain liquidity - by allowing unrestricted flows of capital - then it will be subject to severe speculative attacks whenever the market suspects that stabilization concerns will lead to a devaluation. So a choice must be made. Either the country credibly forswears any future exchange rate adjustment - by adopting a currency board, or starting off down the road to monetary union - or it must restrict capital movement.
History offers clear examples of both choices. As Barry Eichengreen points out in his Globalizing Capital, the interwar experience was interpreted by the founders of Bretton Woods as compelling evidence that speculation was indeed destabilizing, and hence that confidence was necessary. But in the post-Keynes era, so was adjustment; and hence the early Bretton Woods system relied crucially on capital controls. Over time, those controls became (were allowed to become) less effective: the result was a "rigidification" of the system, with parity changes becoming rare.
- Adjustment: Alternatively, suppose that adjustment - the ability of governments to respond to recessions by reflating the economy - is regarded as being of paramount importance. If this kind of flexibility is combined with free movement of capital (liquidity), it exposes the economy to massive speculative capital movement whenever it is suspected that monetary policy will become looser. So a government that insists on maintaining the ability to adjust will necessarily be forced either to give up on confidence - which means going to a floating exchange rate, and accepting the idea that now and then the exchange rate will move 50 percent in a year or 15 percent in a week - or, again, to limit capital mobility. Again, history offers clear examples of both moves. The speculative attacks of the 1930s, driven by the efforts of some governments to fight recession and banking collapse, were met in some cases by the imposition of capital controls; the attacks of the early 1970s, driven by divergent macroeconomic policies, led to the collapse of Bretton Woods and the emergence of floating rates.
- Liquidity: By now the pattern should be clear. If the maintenance of free capital movement is a given - or if restrictions on capital movement are seen as infeasible - the government is driven inexorably either to a rigidly fixed rate regime, preferably a currency board or even a common currency, or to free floating.
So where are we now? Large advanced economies - the US, Japan, and Euroland - are reasonably comfortable for the time being choosing adjustment and liquidity, never mind confidence; that is, in letting their currencies float. The reason is that with small trade shares, little foreign-currency debt, and a deep-seated belief by investors in their long-term soundness, these economies can afford to ride out the ups and downs of the exchange rate. (We'll see if this complacency can survive the recent bizarre doings of the yen). Some smaller advanced countries - the U.K., Australia - also seem able to get away with this choice.
For emerging markets, however, this option is far less plausible. True, some economists - notably Jeffrey Sachs - still argue that if only the IMF would reassure markets instead of lecturing countries on their sins it would be possible for Brazil or South Korea to behave like the UK, setting monetary policy based on domestic goals and letting the exchange rate float. But the majority opinion right now seems to be that the burden of foreign currency debt and the risk of inflation from massive currency overshooting makes the flexible-rate side of the triangle unacceptable to many smaller economies.
But this means that these countries face a cruel choice: since they must choose confidence, that is, a stable exchange rate, they must either give up on stabilization policy - turning the clock back to pre-Keynesian fatalism - or try to restrict capital movement, with all the costs that entails.
Certainly there are many who regard this as an easy choice: they would cheerfully give up on stabilization. But they need to persuade the voters - and persuade the markets that they have persuaded the voters. As Eichengreen points out, as long as there were no effective voices on behalf of stabilization the gold standard was stable. But as soon as people began to demand that governments do something about unemployment, speculative attack became a recurrent problem and the system ceased to work. Indeed, he puts it even more brutally than I would have: "For several decades after World War II, limits on capital mobility substituted for limits on democracy as a source of insulation from market pressures."
This kind of reasoning is what led me to consider the possibility that the least bad option may lie on the other side of the triangle. Everybody knows how bad capital controls are for economic efficiency. But these costs must be compared with the alternatives. For example, Brazil's efforts to maintain both liquidity and confidence will probably lead to near-zero growth this year, something like -3 percent next year, in an economy that needs something like 5 percent growth to keep unemployment from rising. Think about it.
But of course at this point officials and those who want to stay close to them will not, indeed cannot, think about it. They cannot say bluntly that countries must give up on stabilization, that only a handful of First World central banks are allowed to have policies. Nor are they prepared to turn their backs on a generation of denouncing the evils of currency and capital controls.
Hence the strangely enervated tone of discussion. The current situation is unacceptable, and everyone knows that something has to give; but the policy ideas that the community of respectable opinion can allow itself to discuss are at best marginal, at worst irrelevant.