Sunday, May 29, 2011

Another note on the 'looming' currency war

I wrote this post on the potential for a currency war a while back, arguing that nations ought not to get involved. Since then, few significant headlines have cropped up. With the renminibi steadily rising against the dollar, Europe steeped in greecier bigger problems, and emerging economies faring much better than a year ago, it seems as if the guns have been muffled. Nonetheless, Krugman wrote a post two weeks ago that I think is worth reposting/discussing.

A central tool for understanding monetary policy and foreign exchange rates is the 'impossible trinity' or the trilemma, as I like to call it...

As it says in the middle of the triangle, a country cannot pursue all three policy goals at the same time.

The example in the picture is pertinent, but an equally appropriate starting point is the situation in the US right now.

The US has free capital flows and retains control over its monetary policy, control it is wielding ardently at the moment for the purposes of stimulating the post-financial-crisis economy.

The problem is, with rock bottom interest rates and increasing amounts of US dollars floating around, emerging markets (such as Brazil) are faced with appreciating exchange rates against the dollar. This spells trouble for economies that export massive amounts to the US, and even more trouble for economies with high interest rates that can't easily manage massive short term capital inflows coming from the US. 

...historically speaking, big trouble. On page 14 of this section of this section of the OECD Economic Outlook you can see that one in ten of the 268 countries that have faced a similar episode have fallen into either a banking crisis or a currency crisis.

So, Brazil has three choices, 1) either accept the appreciation of the reál against the dollar (making sales to the US less likely, and capital to flow freely to Brazil), 2) pursue an equally expansionary monetary policy (relinquishing independence and causing unsolicited domestic inflation), or 3) restrict the increase in capital flows and risk scaring away coveted long term foreign investment.

Luckily for countries like Brazil, the IMF has learned, after years of pigheadedness, that capital controls are useful for stemming exactly this type of short-term-investment-fueled boom and bust cycles. In fact, the IMF has been meeting in Rio over this past week to discuss exactly which are the appropriate measures to place on capital in the effort to mitigate the destructive and destabilizing effects of this flighty capital.

As you can see, this poor set of choices that emerging markets face are a direct result of the US trying to save its economy. So, to argue that the US shouldn't put other countries in this position is to argue that the US should give up their independent monetary policy. This will simply not happen. Brazil should know this and stop asking.