The Other Trilemma: Governing Global Finance

Courses in international economics usually introduce students to the impossible trinity, also known as the trilemma of open-economy macroeconomics: namely, that a fixed exchange rate, free cross-border capital flows, and discretionary monetary policy are incompatible. Why? Because, in the presence of free capital flows under a fixed exchange rate, private currency preferences (rather than policymakers) determine the size of the central bank balance sheet and hence the domestic interest rate. We’ve highlighted this problem several times in analyzing China’s evolving exchange rate regime (see here and here).

While many students learn that a country can only have two of the three elements of the open-economy trilemma, few learn that there also exists a financial trilemma. That is, financial stability, cross-border financial integration, and national financial policies are incompatible as well. The logic behind this second trilemma is that increases in financial integration reduce the incentives for national policymakers to act in ways that preserve financial stability globally. Put differently, as the benefits from financial stability policies spread beyond borders, the willingness to bear the costs of stabilizing the system at the national level decline. This has the important implication that, if we are to sustain increasing financial integration, then we will need greater international coordination among national financial regulators (see here, or for a much broader case for international economic governance, see Rodrik)....

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Is China's devaluation a game changer?

Since 1978, China has engaged in an unprecedented and wildly successful experiment, moving gradually from a command economy to one based on markets; in small steps transforming a system where administrators controlled the goods that were produced to one where prices allocate resources. There were surely miscalculations along the way. But, even big blunders could largely be concealed. Until now!

What has changed in recent months? The day has come for China to become more closely integrated into the global financial system, and this has a number of implications. The most important is that as prices and quantities of financial assets (rather than goods) are determined in markets, bureaucrats lose a great deal of control. But, as recent events very clearly demonstrate, Chinese authorities are reluctant to let go....

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