The impossible third: why countries can’t have it all

VaselineSeptember 3, 2024

0 3 minutes read

The impossible trinity in international economics explains the challenges countries face when trying to achieve three key goals for economic stability.

The first objective is a fixed exchange rate, which means keeping the national currency pegged to another currency, such as the US dollar, or a basket of currencies. The second objective is the free movement of capital, allowing financial capital to flow freely across borders without restriction. The third objective is to maintain an independent monetary policy, retaining control over domestic interest rates and other monetary instruments to influence the national economy.

The essence of the impossible trinity is that a country can only successfully achieve two of these goals at a time.

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Why countries cannot achieve all three goals simultaneously

The effort to achieve all three results in economic instability and unsustainable policies. For example, if a country maintains a fixed exchange rate and allows free movement of capital, it cannot have an independent monetary policy because the need to defend the exchange rate requires aligning domestic interest rates with those of the currency to which it is pegged. This alignment reduces the country’s ability to meet its own economic needs.

Similarly, a country that maintains both a fixed exchange rate and an independent monetary policy must restrict capital movements to avoid destabilizing the exchange rate. Alternatively, if a country opts for free movement of capital and an independent monetary policy, it cannot maintain a fixed exchange rate because capital flows will cause fluctuations in the value of the currency.

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Past and present examples

The Bretton Woods era (1944–1971) is a classic example of the impossible trinity. During this period, 44 allied nations maintained fixed exchange rates by pegging their currencies to the US dollar, which was convertible to gold. However, to maintain these fixed rates and independent monetary policies, capital flows were heavily controlled. As different economies expanded at different rates over time, maintaining fixed exchange rates became increasingly difficult. Countries with consistent trade surpluses have amassed substantial dollar reserves, while deficit countries have experienced increasing pressure on their currencies. Maintaining fixed exchange rates became increasingly difficult, leading to the collapse of the system when the US suspended the convertibility of the dollar into gold in 1971.

Another significant example is the European Exchange Rate Mechanism crisis of 1992. The ERM was designed in 1979 to minimize exchange rate fluctuations in Europe, paving the way for the eventual adoption of a single currency, the euro. Member states have agreed to keep their currencies within a set range in relation to the European Monetary Unit.

In the early 1990s, Germany struggled with rising inflation and implemented a high interest rate policy to combat it. Instead, Britain was in a recession and eventually had to lower interest rates to stimulate its economy. However, the obligation of the United Kingdom to maintain the fixed exchange rate with the German mark required a match with that of Germany. Speculators began betting against the pound, leading to substantial capital outflows.

On 16 September 1992, a day known as Black Wednesday, the UK government left the ERM and allowed the pound to float freely. This decision allowed the UK to continue to allow free movement of capital while regaining control over its monetary policy, allowing for interest rate adjustments that better suited domestic economic conditions.

Today, the United States operates with free movement of capital and an independent monetary policy, allowing its exchange rate to fluctuate. Instead, eurozone countries have a common currency, eliminating exchange rate uncertainty and allowing free movement of capital, but sacrificing individual control of monetary policy to the European Central Bank.

China manages its currency within a controlled range and maintains an independent monetary policy, but imposes capital controls to avoid destabilizing capital flows. Hong Kong, on the other hand, pegs its currency to the US dollar and allows free movement of capital, but this limits its monetary policy independence as it must align with US interest rates.

Explaining why countries make the trade-offs they do

Emerging markets often face difficult choices as they must attract foreign investment through the free movement of capital while maintaining monetary policy autonomy, which often leads to volatile exchange rates and economic instability. In addition, the rise of cryptocurrencies and central bank digital currencies introduces new challenges to the framework, influencing capital flows, exchange rate stability and the effectiveness of monetary policy.

The impossible trinity remains a critical framework for understanding the trade-offs countries must make in today’s interconnected global economy. As nations navigate globalization, financial integration, and economic interdependence, the principles of the impossible trinity continue to guide their economic strategies and responses to global challenges.

The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice regarding your specific situation.

VaselineSeptember 3, 2024

0 3 minutes read

Vaseline

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