This week, “The Economist Explains” is devoted to the economy. Today is the last in a series of six explanations on a basic idea.

As the euro’s launch approached in 1999, aspiring members pegged their currencies to the German mark. As a result, they were forced to observe the monetary policy of the Bundesbank. For some countries, this monetary bondage was tolerable because their industries were closely linked to those of Germany and business conditions rose and fell in parallel. But some countries could not live with it. Britain was forced to abandon its monetary anchor with Germany in 1992 because it was in recession even as Germany was booming. Nowadays, China faces a related conundrum. It wants to be fully open to capital flows in order to create a modern financial system, in which market forces play a more important role. This past summer, it took a few small steps to achieve this. But doing so at a time of sluggish economic growth has raised fears that the yuan will plunge. As markets panicked, Chinese capital controls were quickly tightened.

Both of these difficulties were a consequence of the macroeconomic policy trilemma, also called the impossible trinity. He says that a country must choose between free mobility of capital, management of the exchange rate and an independent monetary policy. Only two of the three are possible. A country which wishes to fix the value of its currency and which also has an interest rate policy sheltered from any external influence cannot allow capital to flow freely across its borders. It was China’s trilemma. If the exchange rate is fixed but the country is open to cross-border capital flows, it cannot have an independent monetary policy. It was Britain’s trilemma. And if a country chooses free mobility of capital and wants monetary autonomy, it must let its currency float. This is the two-out-of-three combination that most modern economies choose.

To understand the trilemma, imagine a country that fixes its exchange rate against the US dollar and is open to foreign capital. If, to lower inflation, its central bank sets interest rates higher than those set by the Federal Reserve, it would attract foreign capital seeking higher returns. This in turn would put upward pressure on the local currency. Eventually, the anchor with the dollar would break. Likewise, if interest rates are lowered below the federal funds rate, the exchange rate would fall as capital has gone to seek higher returns in America.

Many emerging markets find it helpful to tie the exchange rate to a stable monetary anchor, such as the dollar. It’s a quick way to show serious intention to control inflation, for example. In fact, it was also the reason why Great Britain became attached to the D-mark in the early 1990s. The cost is a loss of monetary independence: interest rate policy is contingent on maintenance. anchoring and therefore cannot be used flexibly to stabilize the economy. Therefore, countries are generally advised to float their currencies once they have demonstrated their commitment to low inflation. In this way, the currency adapts to growth and declining capital flows, allowing interest rates to respond to the national economic cycle. In practice, many emerging markets are afraid of letting the exchange rate move sharply, so they choose to sacrifice either free mobility of capital (by introducing capital controls, or by increasing or depleting their foreign exchange reserves), or monetary independence, by giving priority to the stability of the currency over other objectives. China ultimately wants to liberalize its capital account as a springboard to a modern financial system. To do this, he will have to live on a volatile yuan. Three out of three is not possible, but two out of three is not bad.

Previously in this series



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