Relevant or Irrelevant?
The highly integrated nature of the global financial system was amply demonstrated, if we needed any reminder, by the turmoil in emerging market currency and bond markets in the wake of Fed Chairman Bernanke’s statements regarding the normalization of U.S. monetary policy, i.e., the “taper tantrum”. Following close on the heels of complaints about unconventional monetary policy implementation in the preceding years, it is clear that – at a minimum – policymakers in emerging market economies perceive a high and increasing vulnerability to the whims of the global financial system.
The idea that the monetary policies of financial center countries have large spillover effects on the smaller economies is not new. During the mid-1990s, when advanced economy central bankers raised policy rates, after several years of negative real interest rates, similar complaints were lodged, and some may partly trace the financial crises in Latin America and subsequently in East Asia to the cycle in core country policy interest rates. One key difference is that in the earlier episode’s aftermath, the semi-fixed exchange rate regimes were tagged as a contributing factor. In contrast, countries adhering to a variety of exchange rate regimes all experienced challenges in insulating their economies in the most recent episode. This has led to a grand debate about the continued relevance of the “impossible trinity” or “monetary trilemma”.
Since Mundell (1963) outlined the hypothesis of the monetary trilemma, fundamental policy management in the open economy has been viewed as policy trade-offs among the choices of monetary autonomy, exchange rate stability, and financial openness (e.g., Aizenman, et al. (2010, 2011, 2013), Obstfeld (2014), Obstfeld, et al. (2005), and Shambaugh (2004)). The hypothesis and its extensions suggest a continuous trade off between the three trilemma dimensions, with the possibility that a fourth policy goal, financial stability, may augment it and turn it into a quadrilemma, where international reserves may play a role as buffers.
In contrast, in the aftermath of the global financial crisis (GFC), Rey (2013) concluded that the economic center’s (CE) monetary policy influences other countries’ national monetary policy mostly through capital-flows, credit growth, and bank leverages, making the types of exchange rate regime of the non-CEs irrelevant. In other words, the countries in the periphery (PH) are all sensitive to a “global financial cycle” irrespective of exchange rate regimes. In this view, the “trilemma” reduces to an “irreconcilable duo” of monetary independence and capital mobility. Consequently, restricting capital-mobility maybe the only way for non-CE countries to retain monetary autonomy. The recent experience of Brazil, India, Indonesia, South Africa, and Turkey – the “Fragile Five” – during the so called taper tantrum may make for many observers the “irreconcilable duo” view convincing.
In Aizenman, Chinn and Ito (2015) we investigate whether Rey’s prematurely predicted the end of the trilemma. Inferences based data drawn from times of heightened volatility emanating from the center might be modified once we examine how the propagation of large shocks from the CE can be affected by economic structures and measures of the trilemma variables. In a world of more than hundred countries, one ignores heterogeneity at one’s own risk. For instance, the trade-offs facing the OECD countries may differ from those facing manufacturing based or commodity based emerging markets economies and developing countries. Furthermore, large shocks arising from the EC during the global financial crisis and the Euro debt crisis may have altered the transmission dynamics, especially in comparison to the preceding decade of illusory tranquility.
