The problems at hand lend themselves rather neatly to the logical form of the trilemma. While a dilemma is an either/or situation, in a trilemma only two of three available options can possibly apply at any given time. One option must be sacrificed. To illustrate, consider the mordant trilemma that made the rounds in the former Soviet Union: you could be a party member, or intelligent, or honest. Obviously, ran the joke, you could not be all three at once!
We see a trio of problems shaping economic developments in 2011, and below we explain the costly trade-offs they will inevitably entail. First, the three trilemmas:
• Emerging Markets and to a lesser extent the European Monetary Union: unrestrained capital flows, a fixed exchange rate, and independent central banks.
• The Eurozone: a supranational entity (the EU) made up of sovereign nation states that practice democracy and share a common currency.
• America: the conflicting aims of running a trade surplus and balanced budget with buoyant consumers.
In each trilemma, one element has to give way, and this choice will tell the economic story in 2011.
The Emerging Markets trilemma
Textbook economics calls this the "impossible monetary trinity:" an independent monetary policy, freely moving international capital flows and a pegged exchange rate. Only two of these conditions can prevail at the same time. How emerging markets respond to this trilemma will be one of the biggest economic stories of 2011, and beyond.
It is not surprising that the first official to use the term “currency war” was Brazil’s Finance Minister, Guido Mantega. After their financial crisis of the late 1990s, many countries in Asia and other emerging markets pegged their currencies to the US dollar. Staggered by bouts of high inflation, overheated economies, current account deficits and currency crashes, they understandably sought some form of monetary stability.
The dollar peg, later called “Bretton Woods II,” was quite successful. Emerging market currencies grew steadily cheaper when in fact they should have appreciated. They enjoyed strong exports and healthy current account surpluses, building up vast foreign exchange reserves. China alone has managed to increase its foreign exchange reserves to a whopping USD 2.6 trillion.
At first, Bretton Woods II seemed to deliver the best of all possible worlds to both the emerging markets and the US. The emerging markets exported and saved; America got the cheap goods and credit it craved to finance its consumption and housing booms.
But the model was inherently unsustainable, as the recent financial crisis made clear. By binding their exchange rates to the US dollar, emerging markets lack their own independent monetary policies. This was not an issue as long as US monetary policy was stable. But with the Fed first slashing interest rates to zero and then launching its quantitative easing programs – effectively printing money – many emerging markets are now wedded to a monetary policy that is far too expansive for their economies.
Overheated economies, inflation surges and asset bubbles – especially in real estate – are the ugly potential consequences that emerging markets now fear because of their forced adherence to America’s loose monetary policy. Emerging markets face a stark and difficult choice: Either they abandon the dollar peg and see their currencies appreciate sharply, or they maintain the peg and await an inevitable jump in inflation.
One strategy to counter an inflation surge would be capital controls to limit funds entering the asset markets of these countries, something that Brazil has recently implemented. By preventing surplus US liquidity from flooding into their economies, emerging markets can at least soften the choice between currency appreciation and inflation. However, history has shown that capital controls are difficult to maintain if goods and services still move freely.
Textbook economics calls this the "impossible monetary trinity:" an independent monetary policy, freely moving international capital flows and a pegged exchange rate. Only two of these conditions can prevail at the same time. How emerging markets respond to this trilemma will be one of the biggest economic stories of 2011, and beyond.
It is not surprising that the first official to use the term “currency war” was Brazil’s Finance Minister, Guido Mantega. After their financial crisis of the late 1990s, many countries in Asia and other emerging markets pegged their currencies to the US dollar. Staggered by bouts of high inflation, overheated economies, current account deficits and currency crashes, they understandably sought some form of monetary stability.
The dollar peg, later called “Bretton Woods II,” was quite successful. Emerging market currencies grew steadily cheaper when in fact they should have appreciated. They enjoyed strong exports and healthy current account surpluses, building up vast foreign exchange reserves. China alone has managed to increase its foreign exchange reserves to a whopping USD 2.6 trillion.
At first, Bretton Woods II seemed to deliver the best of all possible worlds to both the emerging markets and the US. The emerging markets exported and saved; America got the cheap goods and credit it craved to finance its consumption and housing booms.
But the model was inherently unsustainable, as the recent financial crisis made clear. By binding their exchange rates to the US dollar, emerging markets lack their own independent monetary policies. This was not an issue as long as US monetary policy was stable. But with the Fed first slashing interest rates to zero and then launching its quantitative easing programs – effectively printing money – many emerging markets are now wedded to a monetary policy that is far too expansive for their economies.
Overheated economies, inflation surges and asset bubbles – especially in real estate – are the ugly potential consequences that emerging markets now fear because of their forced adherence to America’s loose monetary policy. Emerging markets face a stark and difficult choice: Either they abandon the dollar peg and see their currencies appreciate sharply, or they maintain the peg and await an inevitable jump in inflation.
One strategy to counter an inflation surge would be capital controls to limit funds entering the asset markets of these countries, something that Brazil has recently implemented. By preventing surplus US liquidity from flooding into their economies, emerging markets can at least soften the choice between currency appreciation and inflation. However, history has shown that capital controls are difficult to maintain if goods and services still move freely.
The European trilemma
The age of globalization has given rise to complex political and economic challenges that often involve competing demands. The Eurozone is learning firsthand just what that means.
Harvard's Dani Rodrik has described the structural tensions facing the Eurozone as "the political trilemma of the world economy:" economic globalization, sovereign nation-states and political democracy. They cannot all flourish simultaneously. At least one element will have to give way. Like the emerging markets’ impossible monetary trinity, the political trilemma has a particularly strong impact on one region: the Eurozone.
Many of the Eurozone’s recent crises and tensions can be traced to clashes among these three elements. For example, many observers saw the recent strikes in France as a refusal to acknowledge that the French pension system is severely underfunded. And, incidentally, the funding situation will not improve much, even with the retirement age lifted to 62. But, I would argue, much of the anger triggered by raising the retirement age was because the change was imposed upon the population, without the usual lengthy debate that characterizes the French democratic process.
The early stages of the Irish crisis showed another facet of the trilemma. The Irish government initially refused any bailout from the European Union, fearing this would mean surrendering some of its hard-won sovereignty. The country’s ultra-low corporate tax rate came under especially harsh scrutiny from its Eurozone partners, and the government saw that accepting aid would seriously compromise its capacity to resist this pressure.
The fundamental clash of economic globalization, nation-states and democracy offers a neat framework for considering the future of the Eurozone. If nation-states were forced to give way, we would see a Federal Republic of Europe, that is, a democratic, integrated Europe with common fiscal, economic and social policies. If economic globalization – represented by the European Monetary Union as a supranational entity – were to give way, the Eurozone would break up, with all the disruption such a scenario would entail.
Finally, if democracy were to give way, we could see further integration imposed against the will of the people. The austerity measures being implemented in the heavily indebted countries at Europe's periphery, which are strongly opposed locally, can be seen as the prototypes of centralized political power. If the European Central Bank were to start printing money to mitigate the sovereign debt crisis, while at the same time fueling inflation fears in Germany, for example, this could also be seen as undermining democracy.
We see many examples of democracy giving way as the Eurozone attempts to muddle through, dealing with its systemic problems case by case. However, as Ambrose Evans-Pritchard wisely observed in The Telegraph, in the aftermath of the Greek crisis, “No democracy will immolate itself on the altar of monetary union for long.”
The age of globalization has given rise to complex political and economic challenges that often involve competing demands. The Eurozone is learning firsthand just what that means.
Harvard's Dani Rodrik has described the structural tensions facing the Eurozone as "the political trilemma of the world economy:" economic globalization, sovereign nation-states and political democracy. They cannot all flourish simultaneously. At least one element will have to give way. Like the emerging markets’ impossible monetary trinity, the political trilemma has a particularly strong impact on one region: the Eurozone.
Many of the Eurozone’s recent crises and tensions can be traced to clashes among these three elements. For example, many observers saw the recent strikes in France as a refusal to acknowledge that the French pension system is severely underfunded. And, incidentally, the funding situation will not improve much, even with the retirement age lifted to 62. But, I would argue, much of the anger triggered by raising the retirement age was because the change was imposed upon the population, without the usual lengthy debate that characterizes the French democratic process.
The early stages of the Irish crisis showed another facet of the trilemma. The Irish government initially refused any bailout from the European Union, fearing this would mean surrendering some of its hard-won sovereignty. The country’s ultra-low corporate tax rate came under especially harsh scrutiny from its Eurozone partners, and the government saw that accepting aid would seriously compromise its capacity to resist this pressure.
The fundamental clash of economic globalization, nation-states and democracy offers a neat framework for considering the future of the Eurozone. If nation-states were forced to give way, we would see a Federal Republic of Europe, that is, a democratic, integrated Europe with common fiscal, economic and social policies. If economic globalization – represented by the European Monetary Union as a supranational entity – were to give way, the Eurozone would break up, with all the disruption such a scenario would entail.
Finally, if democracy were to give way, we could see further integration imposed against the will of the people. The austerity measures being implemented in the heavily indebted countries at Europe's periphery, which are strongly opposed locally, can be seen as the prototypes of centralized political power. If the European Central Bank were to start printing money to mitigate the sovereign debt crisis, while at the same time fueling inflation fears in Germany, for example, this could also be seen as undermining democracy.
We see many examples of democracy giving way as the Eurozone attempts to muddle through, dealing with its systemic problems case by case. However, as Ambrose Evans-Pritchard wisely observed in The Telegraph, in the aftermath of the Greek crisis, “No democracy will immolate itself on the altar of monetary union for long.”
The American trilemma
The last of our three trilemmas that will shape 2011 is a super-sized American specialty: the Hollywood dream of a trade surplus, buoyant domestic consumers and a balanced government budget. It’s a big story and plenty of drama is guaranteed.
There are two ways to evaluate a country’s trade balance. The usual method subtracts the value of total imports from total exports. The less traditional approach subtracts the value of total consumption from total production. Applying the second measure, a country with a trade deficit lives beyond its means, consuming more than it produces. Sound familiar?
We can make a useful distinction here between the private sector and the government. This lets us reformulate America’s trilemma in even starker terms: If the private sector consumes more than it produces and the government does the same, a trade surplus is an accounting impossibility. There is simply no way around that cold fact.
Economists refer to America’s problem as the income-balance trilemma, but it may be better known as the tale of the twin deficits: a deeply negative trade balance and a government budget awash in red ink. These two black holes grew cavernous in the 1980s, when Ronald Reagan’s sharply higher government deficits were accompanied by a nose-diving trade balance.
The income-balance trilemma will affect the US in two profound ways in 2011, and beyond.
First, the noisy debate between Democrats and Republicans on whether fiscal stimulus can be achieved through government spending or via tax cuts will be rendered increasingly irrelevant. The towering US budget deficit can no longer be ignored in any serious economic discussion. Even if US consumers snap out of their coma, the budget deficit will still weigh heavily on America’s trade position.
Second, negotiations between the US and China on their bilateral trade relations are a dialogue of the deaf. The US insists that China let its currency appreciate, thus favoring the exports-minus- imports definition of the trade balance. Meanwhile, China points to America’s excessive consumption and low savings rate, using the production-minus-consumption definition. One is talking apples, the other oranges, so we see little hope for progress here.
The income-balance trilemma holds the key to America’s macroeconomic future. To return to growth, either its overly indebted consumers must resume living beyond their means, or public debt must massively expand. There is a third possibility that may comfort optimists: The country as a whole may finally acknowledge that austerity, both personal and public, although unhelpful to short-term growth, is the only possible way to achieve sustainable long-term growth and the much-desired trade surplus. That would truly be a Hollywood happy end.
The last of our three trilemmas that will shape 2011 is a super-sized American specialty: the Hollywood dream of a trade surplus, buoyant domestic consumers and a balanced government budget. It’s a big story and plenty of drama is guaranteed.
There are two ways to evaluate a country’s trade balance. The usual method subtracts the value of total imports from total exports. The less traditional approach subtracts the value of total consumption from total production. Applying the second measure, a country with a trade deficit lives beyond its means, consuming more than it produces. Sound familiar?
We can make a useful distinction here between the private sector and the government. This lets us reformulate America’s trilemma in even starker terms: If the private sector consumes more than it produces and the government does the same, a trade surplus is an accounting impossibility. There is simply no way around that cold fact.
Economists refer to America’s problem as the income-balance trilemma, but it may be better known as the tale of the twin deficits: a deeply negative trade balance and a government budget awash in red ink. These two black holes grew cavernous in the 1980s, when Ronald Reagan’s sharply higher government deficits were accompanied by a nose-diving trade balance.
The income-balance trilemma will affect the US in two profound ways in 2011, and beyond.
First, the noisy debate between Democrats and Republicans on whether fiscal stimulus can be achieved through government spending or via tax cuts will be rendered increasingly irrelevant. The towering US budget deficit can no longer be ignored in any serious economic discussion. Even if US consumers snap out of their coma, the budget deficit will still weigh heavily on America’s trade position.
Second, negotiations between the US and China on their bilateral trade relations are a dialogue of the deaf. The US insists that China let its currency appreciate, thus favoring the exports-minus- imports definition of the trade balance. Meanwhile, China points to America’s excessive consumption and low savings rate, using the production-minus-consumption definition. One is talking apples, the other oranges, so we see little hope for progress here.
The income-balance trilemma holds the key to America’s macroeconomic future. To return to growth, either its overly indebted consumers must resume living beyond their means, or public debt must massively expand. There is a third possibility that may comfort optimists: The country as a whole may finally acknowledge that austerity, both personal and public, although unhelpful to short-term growth, is the only possible way to achieve sustainable long-term growth and the much-desired trade surplus. That would truly be a Hollywood happy end.
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