Dealing with the Monetary Policy Trilemma

Notes for an informal economic discussion

Keywords: Macroeconomics & Money;

While pursuing my primary research interest of globalisation, a recently read paper reminded me of the ‘fundamental’ dilemma of monetary policy of an open economy, also called the ‘trilemma’ or the ‘irreconcilable trinity’.[1]

While nations may have three goals of
– currency convertibility (freedom of cross-border capital movements);
– a stable exchange rate; and
– an independent monetary policy oriented towards domestic objectives such as price stability;
the theory argues that an economy can attain only, at most, two out of three of them.

New Zealand monetary policy is predicated on the trilemma. In December 1984 we removed capital controls, and in March 1985 we floated the currency. Since then we have gone for the independent monetary policy and currency convertibility pair of objectives. As a result the exchange rate has had to fluctuate.

The strategy makes life difficult for the tradeable sector which exports and competes against imports, and whose success is at the heart of the growth process in a small open multisectoral economy like New Zealand. We compounded the difficulty by running an over-valued exchange rate, but even had we not, the profitability of the sector suffers from fluctuations in the rate. Buying exchange forward is some protection, but that costs money, lowering the exporter’s return. In any case, for every purchase of foreign exchange someone is selling it.

Is it possible to avoid the trilemma? If we did not care about one of the goals, there is no dilemma. An option might be to abandon full currency convertibility. A number of economists have condemned total convertibility for ‘hot money’ – short term capital movements – including James Tobin and Jagdish Bhagwati. Note they are not advocating restricting foreign domestic investment. Perhaps some time in the future, restraints on hot money will be internationally normal. Is there anything we can do in the interim?

Like many so-called ‘generalities’, the trilemma has underlying institutional assumptions, reflecting an American perspective that monetary policy bears all the weight of macro-policy, because the US constitution was constructed long before economic management was conceivable.

In other countries there are other policy instruments. A guided wage path is no longer possible here, given the weakness of the union movement, although unions still need to be responsible in their wage settlements. But fiscal policy can share the weight when pursuing domestic objectives. Insofar as it does, monetary policy can contribute to a stable and competitive exchange rate.

For as long as I can remember neither the Reserve Bank nor the Treasury have commented on the other’s macroeconomic responsibility. Even in the 1970s and 1980s, when fiscal management was disgraceful, the Bank made no public comment. As far as I know, there is no systematic thinking in either of the two institutions about how monetary and fiscal policy might be co-ordinated, although I welcome their macro-economic forecasting cooperation of recent years.

I appreciate why neither publicly comments on the other and how, given the Official Information Act, it is hard to have a rigorous internal discussions on macroeconomic co-ordination. Alas no New Zealand university is a centre of macroeconomic policy expertise, and a lack of research funding has undermined the NZIER’s traditional role as a macroeconomic thinktank.

The assumption that optimal monetary and fiscal policy can be separated is a nonsense, both empirically and theoretically. The trilemma exists in New Zealand as long as we fail to address how we might coordinate fiscal and monetary policy.

[1] M. Obstfeld and A.M. Taylor, “Globalization and Capital Markets” in M.D. Bordo, A.M. Taylor and J.G. Williamson Globalization in Historical Perspective (NBER/University of Chicago Press, 2003).