Friday, March 19, 2010


A reader writes:
Would you explain how the impossible trinity comes into play in current US-China relations?

It's actually relatively simple at the macrolevel.

To recap, the impossible trinity states that a country cannot have the following simultaneously:
A fixed exchange rate
An open capital account
An independent monetary policy

The US has the following:
A floating exchange rate
A open capital account
An independent monetary policy

China has decided to have the following:
A fixed exchange rate
An closed capital account
An more-or-less independent monetary policy

The decisions for these things are political, but also driven to some extent by underlying economic factors. The US is the most developed nation in the world with deep capital markets and the reserve currency. We can deal with the fluctuation that comes from a floating exchange rate and an open capital market. The US is so big that billion dollar shifts aren't really felt.

China, on the other hand, along with many other developing nations, decide to close the capital account (i.e. regulate what money comes in and out of the country) and peg the exchange rate. As impressive as China's growth has been, her financial system couldn't deal with tens of billions of dollar swings. I wrote more-or-less independent monetary policy because the Chinese have to sterilize all the money that comes into the country.

Personally, I don't think there is anything particularly wrong with the way China has chosen to go about this. It's a legitimate political decision and given their stage of development when they chose to do it, it made sense. However, it may be that at this point they need to shift towards a more flexible regime for their own economy's sake as well as the rest of the world.

But that is problematic. First, as I mentioned above, their banking system sucks. A weak banking system is extremely vulnerable. Second, the Chinese government, in the aftermath of communist failure, bases it legitimacy on technocratic ability. Shifting to a flexible regime is fraught with peril. Indeed, if done poorly could be an existential threat. Nevertheless, it seems that China realizes this cannot continue forever. Indeed, they let the currency "float" and appreciate since 2005.

I have little patience for American politicians grandstanding about China's "manipulation." Moreover, I have little patience for Krugman's argument that because we are in a liquidity trap right now that the problem is China's system. I'll concede that it is a problem right now. Indeed, I'll concede it may have negative consequences in general, but you shouldn't change from a closed to open system on a dime based on present circumstances. These are medium to long-term decisions on how to manage an economy in the international economic environment. It's entirely imprudent and somewhat stupid to say to the Chinese, "Hey, we know you've had a long-term policy, but it's hurting us especially bad in these highly unusual economic times. Therefore, you are bad and need to risk destabilizing your entire economy and possibly toppling your political regime over the next few years when we still have domestic monetary options available."

The take away here is that from FLG's perspective the international spat is silly. As with most things in the international economic arena, the biggest determinant of your country's economic growth is still domestic economic policy and to the extent that international forces play a role their potential impact is also the subject of domestic political decisions about how to deal with the impossible trinity.

In general, if you are talking about "to competing in the global economy" you are already on the wrong path. Education policy shouldn't be driven by the desire to compete in the global economy. It should be for domestic political reasons. Likewise, economic policy shouldn't be to compete in the global economy, but focused primarily on the domestic economic circumstances. Worrying about competing leads us to zero sum thinking, which leads to protectionism, which makes us worse off.

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