By Frances Coppola
The “trilemma” is a long-held theory of international economics showing that, when considering an individual country, free movement of capital and fixed exchange rates are not compatible with the fully independent monetary policy necessary to sound management of the domestic economy.2 So, for example, if a country wishes to raise or lower its domestic interest rates while maintaining a fixed exchange rate, it can’t have free movement of capital; there must be controls on the movement of capital across its borders. Absent such controls, a country that raises interest rates relative to its peers is likely to see a huge influx of capital to exploit the country’s higher rates; likewise, lower interest rates are likely to precipitate capital outflow seeking higher returns elsewhere.
Key to understanding the “trilemma” is the principle of uncovered interest rate parity. This principle states that if there is free movement of capital across borders and floating exchange rates, the difference between the interest rates of two countries should be equal to the difference in their currency exchange rates.3
For example, if the U.K. reduces interest rates while the U.S. raises interest rates, the GBP-USD exchange rate will fall, all other things being equal. To see this, imagine that to start with the U.K. and the U.S. both have short-term interest rates of 0.5 percent. The U.K. reduces its short-term interest rate to 0.25 percent, while the U.S. raises its short-term interest rate to 0.75 percent.
If there is free movement of capital, speculators will borrow in sterling and lend in U.S. dollars, profiting from the spread between the two interest rates – this is known as a “carry trade.”4 But if exchange rates are free to adjust, GBP-USD will naturally fall, eliminating the profit opportunity. When exchange rates are floating and capital markets are functioning efficiently, riskless arbitrage opportunities like these should be fleeting. In practice, however, capital markets aren’t completely efficient and carry trades can linger for some time, especially since the carry trade transaction itself – selling sterling and purchasing dollars – encourages the divergence to persist. But eventually, exchange rates should adjust fully.
But if the GPB-USD exchange rate were fixed, there would continue to be profit opportunities both from the carry trade itself and from outright speculation in both currencies. Speculators would short-sell sterling, thus putting the U.K. under pressure to devalue the pound, while dollar purchases would put the U.S. under some pressure to revalue the dollar. Because central banks can create infinite quantities of their own currency, the U.S. could easily prevent its exchange rate from rising by using newly created dollars to buy foreign currencies and foreign-denominated assets. But for the U.K., the story would be different.
To defend a fixed GBP-USD exchange rate, the U.K. would have to do one or more of three things:
Selling FX reserves and/or assets such as gold to buy back your own currency, thus reducing the quantity in the market and hence increasing its price, is often the preferred method of exchange rate defence. But because countries don’t have infinite quantities of FX reserves and assets, a country that burns through FX reserves to defend its exchange rate risks an FX crisis.
In an FX crisis, the country starts to run out of the money needed to settle external obligations such as debts denominated in foreign currencies and payment for essential imports. Defending the exchange rate becomes impossible, and the currency devalues sharply. If domestic companies and households have debts denominated in foreign currencies, the sudden devaluation can mean widespread debt default, bankruptcies and rising unemployment. In a country dependent on imports for energy and foodstuffs, severe shortage of foreign currency can cause deep recession and considerable hardship: some countries have been forced to borrow from the International Monetary Fund (IMF) to soften the impact of an FX crisis. Usually, countries devalue long before they come close to running out of FX reserves.
In the case described above, where the U.S. has raised interest rates relative to the U.K., rising U.K. interest rates sound attractive as an alternative to risking an FX crisis. But it would mean the U.K. had de facto relinquished control of domestic interest rates to another country. As the U.K.’s own history shows, defending a fixed exchange rate would instead become the focus of monetary policy, regardless of the needs of the domestic economy – and that does not always work.
In 1990, the U.K.’s Chancellor of the Exchequer, John Major, persuaded the Prime Minister, Margaret Thatcher, to take the pound into the European Exchange Rate Mechanism (ERM), a system of fixed exchange rates with narrow fluctuation bands similar to the Bretton Woods system that ended in 1971. When it joined the ERM, Britain pegged sterling to the German Deutschmark at 2.95 with fluctuation of 6 percent permitted in either direction.5
Maintaining the pound within its fluctuation band created problems. The U.K. entered deep recession in 1990 when a property price bubble burst. If the U.K. were in full control of monetary policy, it could have cut interest rates to support the economy.6 But at that time, Germany’s central bank was raising interest rates to counter expected inflation due to high government expenditure in the reunification of West and East Germany.7
To prevent the pound dropping out of the bottom of its fluctuation band, the Bank of England raised interest rates to 10 percent and reportedly spent nearly half its foreign currency reserves buying back its own currency.8 But FX traders, convinced that the pound’s exchange rate versus the Deutschmark was too high, mounted sustained speculative attacks. Noted investor George Soros’s short selling of sterling at this time is thought to have earned him over £1 billion in profits.9
On 16 September 1992, the short selling grew so intense that the Bank of England raised interest rates from 10 to 12 percent to try to persuade speculators to buy pounds. Later that day, the Bank raised interest rates again, to 15 percent. But traders continued to sell. At 7 pm that evening, the U.K. government announced that the pound would leave the ERM.10 The pound’s exchange rate versus the Deutschmark promptly fell freely, eventually stabilizing somewhere between 2.4 and 2.5.11 The following day, the U.K. cut interest rates back to 10 percent.
The U.K. never returned to the ERM and in due course also refused to join the euro, preferring to keep its own currency and maintain full control over monetary policy.12
Capital controls can be used to limit capital flight and thus help to maintain a fixed exchange rate. The IMF, long an advocate of free movement of capital, has suggested that capital controls could be useful when there are large unstable movements of capital, for example when there is a speculative run on a currency such as that on the U.K. pound in 1993.13
However, capital controls impede not only capital flight but capital investment, as well, because they make it difficult for foreign companies to repatriate funds. Thus they also make it difficult for domestic companies to obtain needed foreign investment, often leading to unfortunate long-term economic consequences, particularly for a developing country.
Capital controls also are notoriously “leaky,” as seen in China as it uses capital controls to help it manage the yuan exchange rate. Despite increasing measures to prevent controls being evaded, money continues to leave the country, putting downwards pressure on the exchange rate. China’s FX reserves are diminishing as capital flight and propping up the currency gradually erode them.14
For businesses, resolving the “trilemma” can seem a no-brainer: giving up independent monetary policy may be a small price to pay for the ability to do business anywhere in the world without encountering capital flow restrictions or FX risk. But history shows that the economic consequences of tying together the monetary policies of two countries with very different economic needs can be severe. In practice, countries tend to take different approaches to resolving their individual “trilemmas,” depending on their circumstances at the time.
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. “What is the Impossible Trinity?,” The Economist; http://www.economist.com/blogs/economist-explains/2016/09/economist-explains-economics-4
2. The Trilemma in History: Tradeoffs among Exchange Rates, Monetary Policies and Capital Mobility, Obstfeld, Shambaugh & Taylor, National Bureau of Economic Research; http://www.nber.org/papers/w10396.pdf
3. “Uncovered interest rate parity,” Investopedia; http://www.investopedia.com/terms/u/uncoveredinterestrateparity.asp
4. “Carry trade,” Investopedia; http://www.investopedia.com/terms/c/currencycarrytrade.asp
5. “The Trade of the Century: When George Soros Broke the British Pound,” Priceonomics; https://priceonomics.com/the-trade-of-the-century-when-george-soros-broke/
6. “Remember the last recession?” BBC; http://news.bbc.co.uk/1/hi/magazine/7686531.stm
7. “Interpreting the ERM crisis: country-specific and systemic issues,” Buiter, Corsetti & Pesenti, Department of Economics, Princeton University; https://www.princeton.edu/~ies/IES_Studies/S84.pdf
9. “The billionaire who broke the Bank of England,” The Telegraph; http://www.telegraph.co.uk/finance/2773265/Billionaire-who-broke-the-Bank-of-England.html
10. “1992: UK crashes out of ERM,” BBC On This Day; http://news.bbc.co.uk/onthisday/hi/dates/stories/september/16/newsid_2519000/2519013.stm
11. “British Pound to Deutschmark Spot Rates for 1992,” Poundsterlinglive.com; https://www.poundsterlinglive.com/bank-of-england-spot/historical-spot-exchange-rates/gbp/GBP-to-DEM-1992
12. Black Wednesday,Hélène Dury, Masaeyk University; https://is.muni.cz/el/1456/podzim2011/MPF_AFIN/um/27608616/27608949/Black_Wednesday.pdf
13. The Liberalization and Management of Capital Flows: An Institutional View,International Monetary Fund;http://www.imf.org/~/media/Websites/IMF/imported-full-text-pdf/external/np/pp/eng/2012/_111412.ashx
14. “China’s trilemma – and a possible solution,” Brookings Institution; https://www.brookings.edu/blog/ben-bernanke/2016/03/09/chinas-trilemma-and-a-possible-solution/