Yesterday, Greg Mankiw discussed the trilemma in international finance, noting that countries can trade off between capital mobility, monetary policy autonomy, and exchange rate stability, but cannot fully all three of those objectives at a given time. In this post, Hiro Ito cites work with Joshua Aizenman and myself, in which we quantified how countries have traded off these objectives over time (paper here).
Professor Mankiw argues that, given these tradeoffs, we should not be surprised if some countries pick configurations different from what the United States has — and he references China in this regard. I thought it of interest to show how China has made those tradeoffs over time.
Figure 1: drawn from Figure 4 in Aizenman, Chinn, Ito (2008).
Monetary autonomy is measured by the (lack of) interest rate correlation with base country interest rates, exchange rate stability by the inverse of the standard deviation of the monthly nominal exchange rate changes, and capital mobility by the Chinn-Ito capital account openness index. The international reserves/GDP serves as a buffer; accumulation/decumulation of reserves allows for a different set of tradeoffs, and is possible because the domestic financial system is somehow partly insulated from the international financial system.
The “diamond charts” show that China has behaved somewhat differently from the other emerging market Asian economies. It has moved substantially towards exchange rate stability. However, it is important to note that in this graph, even the latest subperiod ends with 2006, so that only about a year and a third of data from after China’s move to greater exchange rate flexibility in July 2005 is included.
The impact of those tradeoffs on macroeconomic performance is discussed in this post (also by Hiro Ito), and in this paper.
My own personal views regarding the optimality of China’s exchange rate regime choices are here. Resumed real appreciation on a trade weighted basis — although not a panacea — is what China, and the world, needs. And maybe we’ll even get it.
Too many <small>s!
Menzie: Thanks for this informative complement to Greg Mankiw’s NY Times piece.
Mankiw’s piece seems to willfully ignore the actual issue. Fixed exchange rates are one thing, dramatically misaligned exchange rates are another. Our old “fixed exchange rate” system provided for periodic adjustments. The U.S. position is not that China needs to adopt floating rates, but that it needs to align its currency’s value from its greatly undervalued level.
Prof. Mankiw said:
Moreover, the Federal Reserve sets monetary policy to try to maintain full employment and price stability. But a result of this decision is volatility in the value of the dollar in foreign exchange markets.
This is only conditionally true. Yes, during normal times the Fed sets monetary polcy and price stability; but this ain’t normal times and the Fed ain’t setting monetary policy and it ain’t controlling price stability, unless you consider a significant risk of deflation “price stability.” Monetary policy isn’t an effective policy tool right now, so why pretend that it’s a policy lever we should covet? Now if Bernanke has some new ideas to give monetary policy heretofore lost traction, then fine; but in the meantime maybe we need to rethink the exchange rate option. Once you recognize that a country doesn’t always have the opportunity to control any two of three policy levers, then the problem gets reduced to a dilemma. Policymakers need to learn what the Army refers to as “situational awareness.”
Pursuant to Mike Laird comment on The Enduring Trilemma By Hiro Ito
Why not at least a quadrilemna,since Central Banks do not share the same domain of definition,it should be stressed in the premises.
The US Fed mandate is aiming at, full employment, price stability and preservation of the payment system.The ECB has the same and a much looser definition where price stability and monetary policies should be supportive to the European Union endeavor to create full employment.
Federal Reserve Act 1977 as commented by governor Fed Mishkin April 10th 2007
“According to this legislation, the Federal Reserve’s mandate is “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” Because long-term interest rates can remain low only in a stable macroeconomic environment, these goals are often referred to as the dual mandate; that is, the Federal Reserve seeks to promote the two coequal objectives of maximum employment and price stability. In the remainder of my remarks today, I will describe how these two objectives are consistent with our ultimate purpose of fostering economic prosperity and social welfare. I will then talk about some important practical challenges in implementing these goals.
(By the way, I wish that I could also discuss the Federal Reserve’s role in promoting the stability of the financial system, another key objective of central banks, but unfortunately that would violate my own personal mandate of finishing this speech in the allotted time.)”
There are more than quadrilemna but in chasing them all, one may lose his Latin.
Framing the debate this way is much more useful then the approach used by our politicians, which is to label China a “currency manipulator.” In that regard, the U.S. is guilty of being an interest rate manipulator.
O.K. Now I’m torn between whether Mankiw’s piece displays “willful ignorance” or merely a lack of “situational awareness.”
Mankiw puts out a lot of good stuff on his site. Why was this piece chosen? And why was Krugman’s piece “Renminbi Runaround” not chosen? The latter is a much more important and accurate statement of the current situation vis-a-vis China’s currency peg.
The most important thing that Mankiw wrote is: “Americans shouldn’t be too harsh when other nations facing the trilemma reach conclusions different from ours. In this area of economic policy, as well as many others, there is room for reasonable nations to disagree.”
China chooses exchange rate stability with the US because the US chooses monetary manipulation over stability. But this angers the US because relative to China this take away the choice of the US. Every move made by the US to manipulate an economic advantage over China through monetary manipulation is countered by China’s choice of stability.
What China understands is that currency stability with its primary trading partner is more important than either capital mobility or monetary policy autonomy because foundationally money is simply a medium of exchange. When the exchange rates are volatile there is added cost to transactions resulting in reduced prosperity.
RicardoZ: “What China understands is that currency stability with its primary trading partner is more important than either capital mobility or monetary policy autonomy because foundationally money is simply a medium of exchange. When the exchange rates are volatile there is added cost to transactions resulting in reduced prosperity.”
This is a small consideration next to the problem of the greatly undervalued level of the renminbi. Would you say the same for the yen? How about the peso or the loonie?
A sufficiently misaligned currency will cause a very costly misallocation of resources. I don’t think we have had a good historical precendence to show us how the current episode will end.
Don,
Because of floating currencies and each country having a different was of dealing with exchange variances it is impossible to draw a general conclusion applicable to all currencies. The yen, peso, and loonie each have their own unique concerns.
But I will say that monetary stability makes trade between trading partners more efficient and lowers transaction costs tending to eliminate windfall losses from currency exchange. It doesn’t solve other problems such as fiscal errors.