Most economic concepts are pretty dry, but the Impossible Trinity sounds like one of those dilemmas where you are in a burning house and can only save two out of three people. The term refers not to religion (that Trinity is impossible in its own way) but international trade and how governments can only two out of three options, each of which is desirable in its own way. The three options are fixed exchange rates, independent monetary policy and free movement of capital. If they don’t sound that exciting, they are crucial to understanding the crisis with the Euro and what we can do about it.
First things first, fixed exchange rates. Generally speaking, the less these change the better. International trade is a highly uncertain business with a huge amount of variables. This uncertainty dissuades most people dealing abroad, so anything that can provide some certainty is beneficial to trade. Let’s say for example you buy something for $900 and plan to sell it Euro and convert this back into, say $1000. Let’s say the exchange rate changes so instead of making a profit, you only make $800. Unless they are large corporations with large reserves, these swings can destroy a business. Therefore businesses want to know that when they are planning a deal, that it is actually beneficial and profitable. Governments want to promote trade as much as possible and so aim for fixed exchange rates. By saying that £1 will equal $1.50, now and for the foreseeable future, businesses can trade with certainty and not be blown off by the winds of random changes.
Next there is independent monetary policy. This is the most obviously desirable option as every country wants to control its economy. This makes sense on both nationalist and economic fronts. Governments are wont to give up power or be held responsible for actions they can’t control. Having an independent national central bank means control over interest rates, which can be adjusted to suit the specific needs of the economy. So if the economy is in a recession or a slow down, interest rates can be lowered to give the economy a boost. Or if the economy is overheating or in a bubble with too high inflation, interest rates can be raised. In other words, interest rates can be used to attempt to fine tune the economy.
Thirdly, there is capital mobility. This means freedom to move money to other countries and invest easily. For obvious reasons, governments want to make easy for companies to invest in their country, setting up factories and employing people. This is linked to the general trend towards free trade and globalisation. By making global movement as easy as possible, money can move to the places where it is needed the most and can make the best return (the two points are often considered the same). This is also the most ideological of the three aims, with conservatives putting particular emphasis on this “freedom” and opposition to government control of where a company can or cannot spend its money. In recent years this has been the policy of the Western World with advocating restrictions on capital mobility seen as almost Socialist.
So far so good. All three aims seem desirable with their own advantages and it would be good to have them all. But why is this called an Impossible Trinity? Why can we only have two of the three?
Well imagine a country has free capital mobility and an independent monetary policy. It would be impossible to have fixed exchange rates as if interest rates were lowered to boost the economy, capital would leave the country to get a better return. This would put pressure on the exchange rate causing the central bank to either deplete its reserves or change the exchange rate (thereby losing the advantage of a fixed stable exchange rate). Thus a government must choose between defending the exchange rate or keeping control over interest rates. If they choose to let the exchange rate float (that is to let the market set the price and not the government) then businesses lose the certainty of a fixed rate but money can still be invested easily and interest rates can be kept low. The exchange rate is now free to swing in price (sometimes wildly) making life difficult for exporters and importers. If the government persists in keeping a low interest rate then capital will leave the country which will cause the currency to depreciate (lose value) making imports more expensive (but exports cheaper). In essence, the government will be able to boost the economy but at the cost of higher inflation.
If instead the government has free capital mobility and a fixed exchange rate then an attempt to boost the economy by lowering interest rates would cause a capital flight. Companies naturally want to get the best return on their investment and will therefore move to where they can get this. For this reason a capital flight will happen, putting pressure on the exchange rate. If the government wants to keep the value of the currency fixed, then it will have raise interest rates again. Therefore capital flight would nullify the government’s attempt to boost the economy and leave them in the same that they started. If the government raised interest rates to combat inflation, capital would pour into the country, boosting the economy and cancelling out the fall in inflation. In other words freedom of capital mobility with fixed exchange rates severely hampers a government’s attempts to fight recessions. It also means the interest rate can be out of sync with the rest of the economy, leading to the possibility of high interest rates during a recession (which would make the problem worse) or low interest rates during a boom (which would also make the problem worse).
Let’s consider the third option, where capital controls allow fixed exchange rates and independent monetary policy. Capital controls would prevent destabilising capital movements that would put too much pressure on the exchange rates, making it easy to keep it fixed. It would therefore also be easy to combat recessions by lowering interest rates or combat inflation by raising interest rates. This option gives the most power to the government, which is both the best and worst part of it (depending on your point of view). If you think the government should do something to fight recessions, then this is appealing. However, if you the government as a threat to individual liberties and deny it any right in the running of the economy, then this level of control is appalling. By making it difficult to move capital in and out of the economy, it is less attractive for companies to invest in the country leading to the danger of capital shortages.
So those are the three options and why we cannot have the full trinity. Hopefully it wasn’t too confusing and you’re still following me. Now let me explain how this links to the current state of the global economy. Since the 1980s, developed economies have all prioritised free capital mobility to the extent that the only major economy that still practices capital controls is China. The idea of free trade and faith in the magic of the market has lead to a continual shrinking of the power of the government. International trade is viewed as the prerogative of corporations and not something for governments to manipulate. There is also a general movement away from fixed exchange rates too with most countries (such as America and the European Union) optioning for option number 1 (independent monetary control and free capital mobility). Ireland (and technically each individual Eurozone member) has capital mobility and fixed exchange rates (the Euro in a way keeps the exchange rate fixed between say, Ireland and France) but no control over its interest rates.
The story would have ended here if it wasn’t for the global financial crisis. Suddenly, the freedoms of the market and lack of government control meant there was no one to prevent a major crisis and worldwide recession. Capital mobility meant investment could pour into countries and overheat their boom (Ireland, Greece, Spain etc) leading to inflation and unsustainable growth. It also meant that when the bubble burst, capital was free to leave the country, destabilising the economy and leading to severe recessions. The lack of an independent monetary policy has been widely bemoaned in Ireland as it led to interest rates that were out of kilter with our economy. During the boom interest rates were low to help core countries like France and Germany but which exacerbated the boom in peripheral countries like Ireland and Spain. It is likely that rates will rise soon to prevent inflation in core countries despite the peripheral countries being still mired in the depths of a recession. It is for this reason that there have been calls for Ireland and other peripheral countries to leave the Euro and re-establish their own currencies so that they can better manage their economies (in other words switch from option 2 to option 1 by trading fixed exchange rates for an independent monetary policy)
It is over the question of capital mobility that the biggest change can be seen. Capital controls had been seen as Socialist methods supported by only a diminishing handful of countries. Capital was supposed to be free and beyond the control of governments. Telling capital it could not leave the country was as unacceptable as telling people they could not leave. However, the financial crisis (and the Asian Financial Crisis of 1997) showed the dangers of unrestricted capital movements. Booms were unsustainably boosted into bubbles much greater than they otherwise would have been, while the inevitable crash was made far worse by capital flight. Capital mobility was destabilising economies and making them more extreme. Economists are beginning to reconsider their using and advocating some limited use of them. Paul Krugman and Joesph Stiglitz are leading the charge and over 250 economists signed an open letter calling for capital controls. Studies of banking crashes have found that they are often preceded by a large influx of capital and followed by capital outflows. Rogoff and Reinhart therefore conclude that capital controls are useful in preventing banking crashes. Even neo-liberal institutes such as the World Bank and the IMF acknowledge that there are occasions when capital controls are beneficial. The bailouts of Iceland and Cyprus signalled a milestone as they included the introduction of capital controls.
So in conclusion, no country can have all three parts of the Impossible Trinity. Which two they chose has an important effect on the economy. A major explanation for the Financial Crisis and why it effected Ireland so badly was because we had free capital mobility and no control over our interest rates. This meant we were unable to dampen the boom or boost ourselves out of recession. There is now widespread questioning of whether or not we made the right choice and if there is a better option. Economists are questioning the taboo over capital controls which can stabilise the economy and prevent the extremes of the 2000s from being repeated. There are many who would have an automatic repulsion from this level of government control, but now is not the time for impulses or taboos. If we want to escape from this recession we must challenge the old beliefs that got us into this mess. It does not matter where ideas came from or whether they make us feel uncomfortable, we are in dire straits and need a solution.
We need option 3 (fixed exchange rates and independent monetary policy backed by capital controls) in order to restore balance to the economy and prevent the wild swings of recent years from re-occurring. The economy has shown that left to roam wild, it does not lead to prosperity, but rather chaos. Wild markets are hotbeds of speculation, bubbles and uncontrollable swings. We have all seen the damage down when people’s lives are left at the mercy of speculators. A stable economy makes business decisions easier and allows the economy to run smoothly without the wild swings from boom to bust and flood to drought. We may not like capital controls, but we need them. It is only with fixed exchange rates that exporters and importers can have the certainty they need to take risks and make investments. It is only with an independent monetary policy that we can lower interest rates to boost the economy (and raise them to prevent another bubble). It is only with the combination of all three that we can end the recession, recover from the Euro crisis and return to prosperity.