The “Trilemma” Runs the World

Today we’re considering the real environmentthat determines economic conditions.

It has nothing to do with short-term data, Fed policy, conventional economic models or other factors most economic commentary focuses on.

Instead, it has to do with the “trilemma,” identified in the 1960s by economist Robert Mundell.

Mundell identified three critical policy variables that nations face: the central bank policy rate, the exchange rate and open capital accounts. He said that nations could control any two of these variables, but not all three at once.

If you want to control the policy rate and the exchange rate you can, but you have to close your capital account. Otherwise, if your policy rate is high and your capital account is open, capital will flow in and make your exchange rate higher than you want.

Or if you have a set exchange rate and open capital account, you have to let your policy rate float along with other central banks to avoid the exchange rate pressure.

In the first case, you control the policy rate and have an open capital account, but you lose control over exchange rates. In the second case, you control your exchange rate and have an open capital account, but you lose control of your policy rate. The only way to control the policy rate and the exchange rate is to close the capital account.

As Mundell explained, you can control two of the three factors, but not all three.

If you try, you will fail — markets will make sure of that. A country that attempts to have all three will fail in one of several ways including a reserve crisis, an exchange rate crisis or a recession.

Freedonia Can’t Escape the Trilemma

Consider the case of a country — call it Freedonia — that wants to cut its interest rate from 3% to 2% to stimulate growth. At the same time, Freedonia’s main trading partner, Sylvania, has an interest rate of 3%.

Freedonia also keeps an open capital account (to encourage direct foreign investment).

Finally, Freedonia pegs its exchange rate to Sylvania at a rate of 10-1. This is a “cheap” exchange rate designed to stimulate exports from Freedonia to Sylvania.

In this example, Freedonia is trying the impossible trinity. It wants an open capital account, a fixed exchange rate and an independent monetary policy (it has an interest rate of 2% while Sylvania’s rate is 3%).

What happens next?

The arbitrageurs get to work. They borrow money in Freedonia at 2% in order to invest in Sylvania at 3%. This causes the Freedonia central bank to sell its foreign exchange reserves and print local currency to meet the demand for local currency loans and outbound investment.

Printing the local currency puts downward pressure on the fixed exchange rate and causes inflation in local prices.

Eventually something breaks.

Country Freedonia may run out of foreign exchange forcing it to close the capital account or break the peg (this is what happened to the U.K. in 1992 when George Soros broke the Bank of England).

Or country Freedonia will print so much money that inflation will get out of control forcing it to raise interest rates again.

The exact policy response can vary, but the end result is that country Freedonia cannot maintain the trilemma. It will have to raise interest rates, close the capital account, break the peg or all three in order to avoid losing all of its foreign exchange and going broke.

This shows you how powerful the trilemma is as an analytic tool.

The Trilemma Explains the Strong Dollar

The major economies today all have mostly open capital accounts (although China does impose some restrictions), which means they can control interest rates or exchange rates, but not both.

Most major economies fix short-term interest rates, which means they lose control over exchange rates.

This means the interest rate and the exchange rate have to be thought of as a pair. A higher interest rate generally results in a stronger currency. That’s exactly what the U.S. is experiencing today where sharply higher interest rates have resulted in a stronger dollar.

The ability of central banks to pursue any interest rate policy they might prefer is further constrained by conditions in the real economy.

Central banks target policy rates intended to produce maximum real growth, low unemployment and price stability.

As noted above, if maximum potential real growth in the U.S. is about 3%, the Fed will target a neutral rate of interest (also called r*) that will produce 3% growth, which is consistent with price stability and should optimize employment at the same time.

If the Fed guesses at a neutral rate that is too high, they will slow the economy, hurt job growth and cause disinflation or deflation. If the Fed guesses at a neutral rate that is too low, they will cause the economy to run hot, tighten labor markets and cause inflation.

Since the Fed is guessing, they are likely to guess wrong. Sooner than later, the Fed’s incorrect guess shows up in economic data.

Still, the result of trying to hit a neutral rate means central banks will wander high or low while trying to converge on the unseen target. Other central banks are doing the same.

This neutral rate targeting combined with Mundell’s trilemma shows us that all major central banks with reserve currency status are not really free agents but are highly constrained by the need to hit the neutral rate, avoid inflation or deflation and maintain reasonably stable exchange rates.

This is a highly imperfect process with many errors committed along the way, but it does provide a framework for forecasting international monetary policy using just a few key factors.

The One Big Exception to the Trilemma

By the way, there’s historically been one big exception to the trilemma. That’s the United States.

The U.S. sets interest rates independently and has an open capital account. The U.S. does not officially peg the dollar to any other currency (thus technically not breaking the trilemma). But it does work with other countries to allow them to informally peg to the dollar.

Why hasn’t the U.S. suffered adverse consequences? Because the U.S. doesn’t need foreign exchange.

The dollar is still the leading reserve currency in the world (about 60% of global reserves and close to 90% of global foreign exchange trades), so the U.S. can never run out of foreign exchange to pay for things. It can just print more dollars!

This is what the French called the dollar’s “exorbitant privilege” in the 1960s.

Now you see why so many trading partners like the BRICS nations are trying to escape from a dollar-denominated global system (among other reasons, like escaping dollar-based sanctions).

The game is rigged against other countries, and in favor of the U.S.

This is why the game won’t last — and why King Dollar’s days are numbered.

The Daily Reckoning