Very Interesting Economic Research - The Trilemma!

The title of the post seemed so unlikely. How can economic research be categorised as interesting? The working paper is entitled: SURFING THE WAVES OF GLOBALIZATION: ASIA AND FINANCIAL GLOBALIZATION IN THE CONTEXT OF THE TRILEMMA by Joshua Aizenman, Menzie D. Chinn and Hiro Ito. The hypothesis states that a country may simultaneously choose any two, but not all, of the following three goals: monetary independence, exchange rate stability, and financial integration.



This concept, if valid, is supposed to constrain policy makers by forcing them to choose only two out of the three policy choices. Given that Asian emerging market economies have collectively outperformed other developing economies in terms of output growth stability, it is possible that their international macro-policy management, determined within the constraint of the trilemma, has contributed to preparing these economies for higher output vulnerability possiblyexacerbated by recent globalization.

If the Asian economies do show robust and sustainable recovery while the advanced economies do not, that would have two implications. First, robust recovery is evidence for the Asian economies “decoupling” from the advanced economies. Second, it suggests that the Asian economies, most of which are quite open to international trade in goods and financial assets, are better prepared to cope with economic crises in a highly globalized environment.

History has shown that different international financial systems have attempted to achieve combinations of two out of the three policy goals, such as the Gold Standard system-guaranteeing capital mobility and exchange rate stability and the Bretton Woods system providing monetary autonomy and exchange rate stability. The fact that economies have altered the combinations as a reaction to crises or major economic events may be taken to imply that each of the three policy options is a mixed bag of both merits and demerits for managing
macroeconomic conditions.



Greater monetary independence could allow policy makers to stabilize the economy through monetary policy without being subject to other economies’ macroeconomic management, thus potentially leading to stable and sustainable economic growth. However, in a world with price and wage rigidities, policy makers could also manipulate output movement (at least in the short-run), thus leading to increasing output and inflation volatility. Furthermore, monetary authorities could also abuse their autonomy to monetize fiscal debt, and therefore end up destabilizing the economy through high and volatile inflation.

Exchange rate stability could bring out price stability by providing an anchor, and lower risk premium by mitigating uncertainty, thereby fostering investment and international trade. Also, at the time of an economic crisis, maintaining a pegged exchange rate could increase the credibility of policy makers and thereby contribute to stabilizing output movement. However, greater levels of exchange rate stability could also rid policy makers of a policy choice of using exchange rate as a tool to absorb external shocks. Prasad (2008) argues that exchange rate rigidities would prevent policy makers from implementing appropriate policies consistent with macroeconomic reality, implying that they would be prone to cause asset boom and bust by overheating the economy. Hence, the rigidity caused by exchange rate stability could not only enhance output volatility, but also cause misallocation of resources and unbalanced, unsustainable growth.



Financial liberalization is perhaps the most contentious and hotly debated policy among the three policy choices of the trilemma. On one hand more open financial markets could lead to economic growth by paving the way for more efficient resource allocation, mitigating information asymmetry, enhancing and/or supplementing domestic savings, and helping transfer of technological or managerial know-how (i.e., growth in total factor productivity).

Also, economies with greater access to international capital markets should be better able to stabilize themselves through risk sharing and portfolio diversification. On the other hand, it is also true that financial liberalization has often been blamed for economic instability, especially over the last two decades, including the current crisis. Based on this view, financial openness could expose economies to volatile cross-border capital flows resulting in sudden stops or reversal of capital flows, thereby making economies vulnerable to boom-bust cycles.

Thus, theory tells us that each one of the three trilemma policy choices can be a double-edged sword, which should explain the wide and mixed variety of empirical findings on each of the three policy choices.

Furthermore, to make the matter more complicated, while there are three ways of pairing two out of the three policies , the effect of each policy choice can differ depending on what the other policy choice it is paired with. Hence, it maybe worthwhile to empirically analyze the three types of policy combinations in a comprehensive and systematic manner.developing economies may have been trying to cling to moderate levels of both monetary independence and financial openness while maintaining higher levels of exchange rate stability. In other words, they have been leaning against the trilemma over a period that interestingly coincides with the time when some of these economies began accumulating sizable international reserves (IR), potentially to buffer the trade-off arising from the trilemma.

None of these observations is applicable to non-emerging developing market economies. For this group of economies, exchange rate stability has been the most aggressively pursued policy throughout the period. In contrast to the experience of the emerging market economies, financial liberalization has not been proceeding rapidly for the non-emerging market developing economies.The additional dimension is the role of IR holding. Since the Asian crisis of 1997-98, developing economies, especially those in East Asia and the Middle East, have been rapidly increasing the amount of IR holding.

China, the world’s largest holder of international reserves, currently holds about $2 trillion of reserves, accounting for 30% of the world’s total. As of the end of 2008, the top 10 IR holders are all developing economies, with the sole exception of Japan. The nine developing economies, including China, Republic of Korea (Korea), Russian Federation, and Taiwan, hold about 50% of world IR. Against this backdrop, it has been argued that one of the main reasons for the rapid IR accumulation is economies’ desire to stabilize exchange rate movement.

According to one perspective, economies accumulate massive IR to achieve a target combination of exchange rate stability, monetary policy autonomy, and financial openness only a handful of economies have achieved combinations of ERS (exchange rate stability) and IR that significantly reduce output volatility. Such economies include Botswana, China, Hong Kong, Malaysia, Jordan, and Singapore. However, the fact that three Asian economies are among the economies with large IR holding and great ERS may explain why Asian economies are often perceived to be currency manipulators although they are more of exceptions than the rule.if policy makers put greater weight on real exchange rate stability, it is better to pursue more exchange rate stability and greater financial openness (which implies lower levels of monetary independence), which could have a volatility-enhancing impact on investment and output, though the answer depends on the level of IR holding.

Due to that we have not seen the deluge of hot money frolicking in these markets over the past 10 years, the greater good or the lesser evil. One interesting outlier is China; its level of monetary independence is so high that it contributes positively to higher investment volatility despite having a combination of very high IR and ERS. Despite the high volatility-increasing impact of the trilemma configuration on investment, the volatility-reducing effect on the real exchange rate seems to be outweighing the former and contributing to lower output volatility although relatively it is not such an open economy.