'Impossible trinity' teaches us to learn to let go

These three objectives are exchange-rate stability, monetary autonomy (from external, not just political influence), and free capital flow. And as experience shows, the smaller your economy is, the more bite this trade-off has on your economy and the higher the cost of failure for not listening to Mundell’s advice.

The idea of the “impossible trinity” is simple, now that our understanding of how an economy works is much deeper than during Mundell’s time.

Imagine a central bank that wishes to pursue all three objectives together, that is, a stable exchange rate, monetary autonomy and financial-market openness.

If the performance of the economy is better than the global average, funds will start pouring in, causing the currency to appreciate. However, if its central bank desires to keep a stable exchange rate, it must devote its resources to fighting the appreciation, either through intervening in the market or cutting the interest rate to reduce the currency’s attractiveness to the carry trade. Either choice will tie the hands of the central bank in controlling the pace of the fast-growing, if not overheating, economy.

The Asian crisis in 1997 is a good example. Thailand was trying to manage its domestic risk while fighting the downward pressure on the baht under fully open capital accounts. The rest is indeed history, while the present is also in the making.

What Thailand faces today is quite different from 1997. For one thing, the exchange-rate pressure is shooting in a different direction – investors want to see the baht appreciate, while the government wants to see it depreciate. The bitterness of exporters pressures the government, which in turn pressures the Bank of Thailand to slash the policy interest rate by a whopping 100 basis points. That suggestion would bring the rate close to the level of the 2008 crisis, when stimulus was needed to save the economy.

But do we have other choices? Sure we do. But as Jean-Paul Sartre would say, “We are our choices.”

“Impossible trinity” also teaches us that a choice must be made in regards to fighting the recent strengthening of the baht. If we want a stable exchange rate, we must let go of either monetary autonomy or financial-account openness. In this context, the suggestion from the government to use the policy rate to fight the baht’s appreciation is a suggestion to surrender monetary autonomy to save the exchange rate and the free flow of capital.

But whether that choice is correct is of course questionable. If capital flows are “hot money” speculating on the baht, why should we continue to let the activity run amok? Since all sides agree that the baht’s recent appreciation has been out of sync with economic fundamentals and that rapid capital flows have put the Thai economy at risk, it would make more sense to curb capital flows, the root of the problem, instead of letting monetary-policy autonomy succumb to the pressure of large economies.

Choices here also have another interesting dimension. Of the three objectives, the free flow of capital is the one we could most easily tinker with in terms of various degrees of adjustment. In contrast, monetary-policy autonomy is typically all or nothing, while exchange-rate stability also has a varying degree, but our ability to control it is very limited. So tinkering with the level of free flow of capital would be a more manageable choice where authority has a range of varying instruments, from the most conservative to the most liberal.

This is by no means the first and definitely not the last piece on impossible trinity. The importance of the concept is not from pointing out what we cannot do, but in the trade-off we must face. All things in life have choices, and monetary policy is no exception. 

 

Benjarong Suwankiri, head of TMB Analytics, the economic analysis unit of TMB Bank, can be reached at [email protected]. The views expressed herein are those of the author and not of TMB Bank or its executives.