By Frances Coppola
The “economists’ trilemma” says that a country has monetary sovereignty if:
If all three conditions are satisfied, this theory says, the central bank can use interest rates and other monetary tools such as quantitative easing (QE) to control inflation, unemployment and economic growth. The resultant economic stability can make a country a good place to do business.
But there are many examples of countries that have monetary sovereignty according to the trilemma, but don’t have economic stability. Argentina, for example, meets all three criteria yet recently experienced a foreign exchange crisis and was bailed out by the International Monetary Fund (IMF).1 It seems that monetary sovereignty may be more complex than the trilemma suggests.
In a Bank of England (BoE) discussion paper, the economist Kristin Forbes identifies “exchange rate pass-through” as a potential explanation for why the trilemma appears to apply better to some countries than others. Exchange rate pass-through is the degree to which changes in the exchange rate are directly reflected in import prices and domestic inflation, and it varies both between countries and, over time, within countries.2
When exchange rate pass-through is high, a sudden fall in the exchange rate causes import prices and inflation to rise sharply. This forces businesses and households to cut back spending, causing economic growth to slow. At the same time, rising yields on government and private sector debt make it more expensive for government and local businesses to raise money in international capital markets. At the extreme, the country can find itself shut out of capital markets, leaving it with few options other than default and/or an IMF program—the feared situation known as a “sudden stop.”
Sudden stops have historically been much more common in developing countries than developed ones. In fact, until the Eurozone crisis of 2012-14, many economists believed that sudden stops were exclusively a developing country problem. The BoE paper shows that, in general, developing economies have higher exchange rate pass-through than modern developed countries. But why should higher exchange rate pass-through make a country more vulnerable to a sudden stop?
Fund manager Toby Nangle uses Forbes’ data to show that developed countries have what he terms “developed market privilege.” When a global economic shock such as the fall of Lehman Brothers occurs, investors typically dump riskier investments and move their money into “safe assets.” Nangle shows that investors tend to regard the government debt of countries with low exchange rate pass-through as “safe,” but that of countries with high exchange rate pass-through as “risky.” And he further argues that this is the essential distinction between developed and developing (or “emerging”) markets. As Nangle puts it, when reducing risk “I buy your sovereign debt if you’re developed-market and sell your debt if you’re emerging-market.”3
Thus, the attitude of investors to a country’s government debt determines whether that country has full monetary sovereignty. If investors regard the government debt as a “safe asset,” they will continue to invest in it after an economic shock even if the central bank is actively pursuing policies that ordinarily would discourage inward investment, such as lowering interest rates. Given this, the group of countries whose government debt is regarded by international investors as “safe assets” can lower interest rates, do QE and increase government spending in response to economic shocks— with impunity. By and large, those countries are the major reserve currency issuers: the U.S., the U.K., Germany (for the Eurozone), Japan, Switzerland, Canada, and Australia.4
But for countries whose debt is regarded by investors as risky, responding to a shock by lowering interest rates and increasing government spending can intensify capital flight and even trigger a sudden stop. Nangle says that for these countries, protecting the exchange rate may be the higher priority.5 In such countries, central banks may raise interest rates sharply to prevent the exchange rate falling even if the country is going into a severe economic recession.
Other economists say that monetary sovereignty is a “spectrum” ranging from complete sovereignty to no sovereignty at all.6 At one extreme might be North Korea, whose currency is not convertible and whose capital account is completely closed: North Korea has total monetary sovereignty, but this makes it extremely difficult for it to trade with the outside world. At the other extreme might be Ecuador, which uses the U.S. dollar as its currency: Ecuador’s monetary policy is in effect set by the Federal Reserve, and its fiscal policy is determined by its ability to obtain U.S. dollars. Most countries fall somewhere between these two extremes.7
Among developed countries, the U.S., as the issuer of the world’s premier reserve currency, is perhaps the closest to full monetary sovereignty. But as discussed above, other reserve currency issuers also have a high degree of monetary sovereignty due to the “safe asset” status of their government debt.8
Outside the reserve currency club, monetary sovereignty tends to be diminished by thinner FX markets, less developed capital markets and cross-border trade restrictions, as well as lack of “safe asset” status and the ever-present risk of exchange rate volatility and sudden stops.9 Many countries run fixed or managed exchange rate regimes to protect themselves from inflation due to exchange rate volatility. However, this approach diminishes monetary sovereignty because holding an exchange rate peg obliges the country to follow the monetary policy of the country to which the currency is pegged. Additionally, a fixed or managed exchange rate regime can raise the risk of FX crisis if the FX reserves needed to defend the peg are inadequate.10
Ever since the Asian financial crisis of 1997, many developing countries have run persistent trade surpluses to build up FX reserves, thus giving themselves greater monetary sovereignty and better protection from sudden stops. But this strategy is not without its problems. The next piece in this series will discuss the causes of the Asian financial crisis, the world’s response to it, and the effects of it that still linger on the world economy.
“Developed market privilege” may explain why the world’s major reserve currency issuers have such a high degree of monetary sovereignty. Investors view their debt as “safe assets,” which enables them to reduce interest rates and do QE after a major economic shock without triggering capital flight and a sudden stop. For other countries, the need to protect exchange rates from sudden collapse may make counter-cyclical monetary and fiscal policy after an economic shock impossible. However, building up large FX reserves by running persistent trade surpluses can provide some degree of protection from shocks.
With 17 years experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.
1. “Argentina and the lure of dollars,” Forbes; https://www.forbes.com/sites/francescoppola/2018/10/31/argentina-and-the-lure-of-dollars/#705254d46cc6
2. “Shocks versus Structure: explaining differences in exchange rate pass-through across countries and time,” Bank of England; https://www.bankofengland.co.uk/-/media/boe/files/external-mpc-discussion-paper/2017/explaining-differences-in-exchange-rate-pass-through
3. “Developed Market Privilege,” PrinciplesAndInterest; https://principlesandinterest.wordpress.com/2019/08/30/developed-market-privilege/
4. “Rethinking Government Debt,” Coppola Comment; http://www.coppolacomment.com/2015/09/rethinking-government-debt.html
5. “Developed Market Privilege,” PrinciplesAndInterest; https://principlesandinterest.wordpress.com/2019/08/30/developed-market-privilege/
6. “Monetary sovereignty is a spectrum: modern monetary theory and developing countries,” Real-World Economics Review, Bonizzi, Kaltenbrunner & Michell; http://www.paecon.net/PAEReview/issue89/Bonizzi-et-al89.pdf
7. “The myth of monetary sovereignty,” Coppola Comment; http://www.coppolacomment.com/2018/11/the-myth-of-monetary-sovereignty.html
9. “Monetary sovereignty is a spectrum: modern monetary theory and developing countries,” Real-World Economics Review, Bonizzi, Kaltenbrunner & Michell; http://www.paecon.net/PAEReview/issue89/Bonizzi-et-al89.pdf
10. “The myth of monetary sovereignty,” Coppola Comment; http://www.coppolacomment.com/2018/11/the-myth-of-monetary-sovereignty.html