Example Of Synergistic ‘trilemma’: A Systematic Analysis Of Economic Factors Research Paper
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1.0 Background and significance
In international finance, there exists a fundamental trilemma wherein three options are available but one of such options presents an inherent problem that any economy will always fail to harness should they decide to harness the economic potentials of the other two. This trilemma consists of opening up of the economy to international capital (free capital mobility), stabilizing the local economy through monetary policy (independent monetary policy), and stabilizing the local currency rate (fixed exchange rate) through central bank interventions (Mankiw, 2010; Rey, 2013). However, in the case of the United States dollar and the Euro, there seems to be a misinterpretation of the dynamics of the trilemma that may dispute that either two of the trilemma can give problems to the local economy or all may still work out.
The United States apparently chose two routes in handling the trilemma (the Americans allowed capital to enter and leave the domestic economy while adopt a policy of full employment and price stability) while letting the foreign exchange rate of the U.S. dollar to move according to the international market forces (Mankiw, 2010). Members of the European Union (EU), conversely, had followed different routes (opened itself up to international capital exchange and eliminated local currency fluctuation with the adoption of the Euro) as it forego its own domestic monetary policy-making freedom. However, at a closer look, the federal setup of the United States looks much the same as the European Union when looked at from the perspective of a European federalist framework.
The interaction of the three aspects of the trilemma may not be as untenable to synergy as generally presumed to be. Oftentimes, it is just a matter of refining the analysis of factors interplaying in this international economic game. This paper will investigate further the potential discrepancy of the current theory of the trilemma, and determine whether these factors are what they are viewed by current thinkers in international finance. Thus, it attempts to contribute a critical perspective over the theory of the trilemma in international finance, which may be useful in the future discussion of this topic.
2.0 Literature review
Helene Rey (2013) identified the three components of the international finance trilemma as free capital mobility (FCM), independent monetary policy (IMP), and fixed exchange rate (FER). FCM allows for international financial integration that mutually improves the economic activities of participating countries due to capital movement. IMP ensures free-determination of governments in managing their money supplies and their local economy. And, finally, FER provides a stable environment for commerce so that revenue and profit targets of exporters and importers, at least, are predictable and less subject to unexpected paper losses. These three components are supposedly “incompatible” together, unless without any one of them (Schoenmaker, 2011). Either one component had to be discarded as a government policy in favor of the remaining two.
Free capital mobility
Other writers refer to FCM as financial integration (FI) (Schoenmaker, 2011; Obstfeld, Shambaugh & Taylor, 2008; Mankiw, 2010). Capital may be in the form of investment funds or credits or both. As FCM increases, according to the trilemma theory, national policies become “less effective” (Schoenmaker, 2011). When using spread of banking activity as indicator, a home spread of close to 50 percent, as noted in the cross-border activities of European banks, is considered high FCM and, thus, an IMP will result to “coordination failure.” Disrupting this free capital flow, however, will forego its benefits, as Schoenmaker (2011) admitted. Conversely, credit flow follows global condition; thus, is pro-cyclical and expectedly volatile. Thus, excessive credit flow is the best indicator of an incoming financial crisis (Rey, 2013).
According to the neoclassical growth theory, capital flows to places with the highest concentrations of marginal product. This enables FCM to influence positively the efficient allocation of capital and improve risk sharing. However, Rey (2013) observed that these benefits are relatively so small compared to its effect in speeding up worldwide transactions towards a stable national economy. Conversely, American and Asian banks disregarded FCB in favor of internal capital mobility (ICM) (Schoenmaker, 2011), which indicates relative economic self-sufficiency within these regions.
Independent monetary policy
The IMP has been referred in other writings (e.g., (Schoenmaker, 2011; Obstfeld, Shambaugh & Taylor, 2008; Mankiw, 2010) as financial autonomy (FA). National autonomy allows a nation to protect itself against unexpected and unprecedented financial turmoil overseas. For instance, in a financial crisis wherein credit money stops flowing into a country, cutting down its capital level and its economic vitality as well domestic output and employment, financial autonomy empowers the government to adopt self-protective policy, such as conservation of foreign currency reserve. In fact, a foresighted administration normally initiates substantial accumulation of reserve to protect itself against a Sudden Stop (Calvo, Izquierdo & Loo-Kung, 2012). Reserves may be in the form of foreign currency stock or foreign-currency-denominated debts, such as Treasury bonds and bills. Moreover, reserve accumulation constitutes a critical tool in managing national economic instability as a consequence of FER (Obstfeld, Shambaugh & Taylor, 2008).
Fixed exchange rate
One policy used to fix the foreign currency exchange is reserve accumulation, or creating an optimal reserve of foreign currency, which is advantageous to the country for two reasons (Calvo, Izquierdo & Loo-Kung, 2012; Obstfeld, Shambaugh & Taylor, 2008). First, it avoids adjustment costs resulting from inadequate reserve level. Second, it protects the national economy against external volatility through central bank interventions.
3.0 Research methodology
This paper will utilize a systematic review of all published literature about the trilemma in the perspective of international finance. Published literature that will be reviewed shall cover peer-reviewed articles and news reports and articles of scholarly value, including those in newspapers written by authors of satisfactory and appropriate credentials.
Much of the theory of the trilemma rests upon the assumption of excess, or a policy of deregulation. An unregulated FCM can create credit imbalances in several countries, which expectedly result to net losses and, if enormous enough, can trigger a financial crisis (Rey, 2013). Conversely, an unregulated IMP, which allows so much national credit buildup, cooperates with unregulated FCM in bringing about both national and international financial crises. Moreover, an unregulated FER expected creates volatility in the money market and precedes economic instability.
However, should the FCM and FER are regulated through the agency of IFP, then all these three components of the trilemma can be utilized for the economic growth of the country. The key is synergistic regulation. Synergistic regulation, as a central expression of IFP, allows free but calibrated restraint of FCM and FER. The three components of the trilemma are still there. However, they no longer pose as problems or forces that cannot be reconciled. Instead, they are financial movements that can be wisely regulated independently by any country.
Regulation is not about unnecessary policies of financial constraints. It is about a dynamic supervision of the factors affecting international financial relations with a view of enhancing the synergy of positive factors and controlling negative ones. The interaction should be dynamic and free; but includes a regulatory safeguard to manage excesses. Economic growth may not be as explosive as should be when FCM is unregulated. However, volatility is largely within control together with the FER, while still exerting independence internal monetary policy.
Synergistic regulation also means actively managing the capital account of the country in order to control excessive capital inflows and leverage growth, which make a country highly vulnerable to global financial cycle (Rey, 2013). This in place, together with optimal reserve levels across currencies, then FER may be left to the international market forces but regulated internally to support trade supply-and-demand requirements.
Calvo, G.A., Izquierdo, A & Loo-Kung, R. (2012, Jul). Optimal Holdings on International
Reserves: Self-Insurance against Sudden Stop. [Working Paper 18219] Cambridge, MA: National Bureau of Economic Research; pp.28.
Mankiw, N.G. (2010). The trilemma of international finance. The New York Times 10 July.
Obstfeld, M., Shambaugh, J.C. & Taylor, A.M. (2008, Aug). Financial Stability, the Trilemma,
and International Reserves. [Working Paper 14217] Cambridge, MA: National Bureau of Economic Research; pp.48.
Rey, H. (2013). Dilemma not Trilemma: The Global Financial Cycle and Monetary Policy
Independence. Kansas City: Federal Reserve Bank of Kansas City.
Schoenmaker, D. (2011). The financial trilemma [Tinbergen Institute Discussion Paper No. 11-
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