T C A Srinivasa-Raghavan: The horns of the trilemma

OKONOMOS/Does the problem overstate the helplessness of central banks?

Most people can do only one thing at a time. A few can do two. But blessed are those who can do three things at the same time.

Central banks are no exception. Most of them manage to do two things simultaneously, like pursuing a fixed exchange rate and an autonomous monetary policy.

But add in a third dimension, namely, open capital markets, and they start to fumble. We have been seeing this happen in India in recent years, although not in the degree seen elsewhere.

Economists call this the open-economy trilemma. In two recent papers*, Maurice Obstfeld, Jay C Shambaugh and Alan M Taylor have tried to show from inter-war data that "the trilemma is a central feature of the macroeconomic world we have lived in for a century or more."

This proposition has been challenged, of course. Some historians and political scientists have argued, not without reason, that the trilemma overstates the helplessness of central banks.

This column agrees. It has pointed out in the past that while the exchange rate and the interest rate are point variables, an open economy is really a range variable. As such it is in the nature of an operating environment "" like a cricket pitch, for instance "" and should not, for purposes of analysis, be treated in the same way as the other variables are treated. If you grant this, the trilemma ceases to exist in the way economists have formulated it.

Not so, say Obstfeld, Shambaugh and Taylor. It is true, they write, that "the real world content of the trilemma does deviate from the simplistic idea of full international interest rate equalisation, but only in degree." In other words, any autonomy that the central banks have in an open economy with flexible exchange rates is fleeting.

The authors use a term from quantum physics to describe this impermanence "" half-life. Thus, "the half-lives of interest rate deviations can be counted in months and interest rate pass-through is strong whether before or after World War I, or even today."

The issue then is whether "such meagre room for manoeuvre can offer any significant scope for purposeful macroeconomic management." The answer is no.

If central banks want real autonomy in monetary policy, they have to give up one of the other two. So "Spanning, as it does, a century or more of experience, our empirical work in this and other papers highlights the enduring power of this principle. In this sense, we would argue that the trilemma is alive and well. Despite recent challenges to the trilemma as a concept, we see its lessons borne out over a long span of modern economic history."

How helpful is this analysis to governments who have to determine policy in respect of the three variables? The loss of freedom to steer the economy is likely to daunt even the stoutest of political hearts. So in practice, all three variables are manipulated in varying degrees, either openly or surreptitiously.

Central banks intervene in the currency markets, either directly by buying and selling or by talking the market up or down to establish the exchange rate to their choice.

They also fiddle in the money market through open market operations to influence the level of interest rates. And governments decide precisely how open the capital markets will be at any point in time.

These measures are often mistakenly viewed as being somehow dishonest. In reality, the objective is to minimise volatility. Like batsmen, it is not the bounce that businessmen mind. It is variable bounce that annoys them.

Which rather negates the central thesis of these two papers, namely, that if the room for manoeuvre is tight, there is not much scope for purposeful macroeconomic management. The history of the past 50 years suggests otherwise.

*Monetary Sovereignty, Exchange Rates, and Capital Controls: The Trilemma in the Interwar Period, NBER Working Paper No. 10393, March 2004
The Trilemma in History: Tradeoffs among Exchange Rates, Monetary Policies, and Capital Mobility, NBER Working Paper No. 10396, March 2004