Based on the theory (Feenstra and Taylor, 2016), three key conditions faced by open economies: a fixed exchange rate that can enhance stability in trade and investment, free international capital mobility that can promote integration, efficiency, and risk-sharing, and monetary policy autonomy that can provide control over the economy’s business cycle. The trilemma suggests that open economies can only achieve two out of three of these desirable policy goals simultaneously, leading to three scenarios: a fixed exchange rate and international capital mobility with no interest equality, international capital mobility and monetary policy autonomy with no fixed exchange rate (floating exchange rate), or a fixed exchange rate and monetary policy autonomy with no international capital mobility (capital control), resulting in differences between domestic and foreign returns. Essentially, it is impossible to have free capital mobility, fixed exchange rates, and independent monetary policy all at once, and only a floating exchange rate can enable monetary policy independence in the presence of free capital flows. The trilemma also assumes uncovered interest parity (UIP).
However, it is possible that a country may not fit completely into one of the three scenarios presented earlier, as the degree of fixed exchange rates, capital mobility, and monetary policy independence may be partial rather than absolute. Additionally, in practice, the global financial cycle can be influenced by a country’s monetary conditions and changes in risk aversion and uncertainty. Rey (2013) argues that the assumption of uncovered interest parity (UIP) may not always hold true. When capital is mobile, fluctuating exchange rates cannot protect economies from the global financial cycle. Thus, the trilemma becomes a dilemma, where independent monetary policies can only be possible if the capital account is managed, regardless of the exchange rate regime. In other words, capital control is necessary for monetary policy autonomy, making it a dilemma rather than a trilemma.
Rey (2015) has proposed various policy options to tackle the “dilemma” and the global financial cycle. One option is to use targeted capital controls. However, it is challenging to evaluate their effectiveness on financial stability and their side effects because they have only been implemented in specific low-income countries with unique characteristics. Temporary capital controls on credit flows and portfolio debt during a boom phase may be useful in preventing an excessive exchange rate appreciation, such as through the imposition of taxes on capital inflows. Capital controls may also be necessary when there is extensive cross-border lending, and the banking system can be circumvented. It is important to note that macro-prudential policies can also help reduce the link between domestic monetary policy and capital inflows, without the need for capital controls. For instance, by controlling excessive credit growth during boom times, the Central Bank can discourage banks from borrowing externally when domestic monetary policy tightens.
The second approach involves addressing the global spillovers resulting from the monetary policy of the dominant countries. These spillover effects are currently not being internalized, so the central banks of the major economies should consider the collective impact of their policies on the rest of the world. One practical method, as suggested by Eichengreen et al. (2011), would be to create a small group of systemically significant central banks that meet regularly under the auspices of the Committee on the Global Financial System of the Bank for International Settlements (BIS). This group would evaluate and discuss the effects of their policies on global liquidity, leverage, and exposures, as well as the appropriateness of their joint money and credit policies concerning global price, output, and financial stability. However, implementing this policy option presents difficulties, as international cooperation on monetary spillovers may conflict with the domestic mandates of central banks.
The third option to deal with the challenges posed by the dilemma and the global financial cycle is to prevent excessive credit growth. Macro-prudential tools, such as countercyclical capital cushions, loan-to-value ratios, and debt-to-income ratios, can be used to limit excessive credit growth. It is also necessary to monitor lending standards and trading strategies during high credit growth periods. However, the timing of the intervention needs to be determined carefully. Automatic rules based on the credit-to-GDP ratio can be used to determine the timing of intervention, which is more robust to lobbying from interested parties and overcomes the bias towards inaction during good times. Stress testing the balance sheet of the financial sector is another option. However, stress testing is a challenging exercise, and estimating second-round effects is particularly difficult. This option is also unpopular with market participants and requires careful communication policy and fiscal backstop strategies to guarantee the credibility of the stress testing.
The fourth option involves limiting the ability of financial intermediaries to amplify the effects of global financial conditions through stricter regulations on their leverage. This would structurally reduce their capacity to be excessively pro-cyclical. Implementing tougher leverage ratios is a reasonable approach to reduce the significant costs of errors of judgment without burdening costs on the real economy (Haldane, 2012).
Given that excessive leverage and credit growth are the main problems, a combination of macroprudential policies based on rigorous stress testing and stricter leverage ratios is necessary. Depending on the source of financial instability and institutional context, capital controls could be considered a partial alternative to macroprudential measures. In general, the policy choice may also depend on domestic mandates and economic conditions. For instance, Indonesia has implemented automatic rules based on the credit-to-GDP ratio, intervening when the threshold of 60% is exceeded. While each option has its benefits and drawbacks, the choice of policy will depend on country-specific factors.
References
Eichengreen, B. et al. (2011). Rethinking Central Banking, Committee on International Economic Policy and Reform, Brookings Institution.
Feenstra, R.C., and Taylor, A. M. (2016). International Macroeconomics (4th ed.). Worth Publishers
Haldane, A. (2012). The Dog and the Frisbee, given at the Jackson Hole 36th economic policy symposium.
Rey, H. (2013). Capital flows: assessing the costs, hunting for the gains, presented at the IMF research conference on Rethinking macroeconomic policy, Washington DC.
Rey, H. (2015). Dilemma Not Trilemma: The Global Financial Cycle and Monetary Policy Independence. NBER Working Paper 21162
hope. 