For Emerging Economies, a Dilemma Becomes a “Trilemma“

Vladimir Putin says we’re hooligans; Brazil accuses the United States of engaging in “currency wars”; and the Chinese are, well, being their usual charming selves.

But what’s going on in the international currency scene?

I don’t know why I didn’t think to put it this way before — and I don’t know if anyone else is saying this — but what we have here is a classic example of the Mundellian impossible trinity, also known as “the trilemma,” which says that you can’t simultaneously have free movement of capital, a stable exchange rate and independent monetary policy. So, how does this apply to current issues?

Advanced countries, very much including the United States, are weighed down by the aftereffects of the 2008 financial crisis; this has led to low investment returns.

Meanwhile, emerging markets are in much better shape, so capital wants to go there.

And this creates a problem for emerging markets. They don’t want their currencies to rise sharply; Brazil, for example, is not at all happy about this. But not letting a currency rise would be inflationary — that is, Brazil doesn’t want to give up on its independent monetary policy. So what’s the answer?

All those accusations of hooliganism and currency wars are in effect demands that the trilemma be resolved by requiring America to give up having an independent monetary policy — basically, that the Federal Reserve give up on trying to stabilize the United States’ economy so that emerging markets aren’t faced with the uncomfortable tradeoff between massive appreciation and imported inflation. But this shouldn’t, and won’t, happen.

The alternative, trilemma analysis suggests, is capital controls. China already has these, but they’re looking a bit porous.
Brazil has been making some efforts in this direction, but they obviously haven’t been enough.

But to come back to the issue of monetary policy, what this analysis tells us is that the hard choices emerging markets are facing don’t reflect any kind of spectacular misbehavior on the part of the United States.

All that we’re seeing is the classic set of tradeoffs that any currency regime faces — and it’s not the business of the Fed to save other countries from the necessity of making choices.

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Paul Krugman joined The New York Times in 1999 as a columnist on the Op-Ed page and continues as a professor of economics and international affairs at Princeton University. He was awarded the Nobel in economic science in 2008.

Mr Krugman is the author or editor of 20 books and more than 200 papers in professional journals and edited volumes, including “The Return of Depression Economics” (2008) and “The Conscience of a Liberal” (2007). Copyright 2011 The New York Times.