The emerging global financial architecture: Tracing and evaluating new patterns of the trilemma configuration

Abstract

This paper investigates how the trilemma policy mix affects economic performance in developing countries. We find that greater monetary independence can dampen output volatility, while greater exchange rate stability is associated with greater output volatility, which can be mitigated by reserve accumulation; greater monetary autonomy is associated with higher inflation, while greater exchange rate stability and greater financial openness is linked with lower inflation; pursuit of exchange rate stability can increase output volatility when financial development is at an intermediate stage. Greater financial openness, when accompanied by a high level of financial development, reduces output volatility. JEL Classification IntroductionAgainst the backdrop of the most severe financial crisis since the Great Depression, the issue of whether the trilemma -the hypothesis that a country can only achieve two, but not all three, goals of monetary independence, exchange rate stability and financial integration -seems rather distant. We argue that, on the contrary, determining the manner in which the trilemma has constrained policy choices is a question that needs to be answered in order to understand how the world economy has arrived at this juncture. East Asian reserve accumulation has been viewed as a contributing factor to the low interest rates blamed by some for the speculative excesses preceding the current financial crisis.A key message of the trilemma is instrument scarcity -policy makers face a tradeoff, where movement towards increasing the achievement of one trilemma policy goal, such as higher financial integration, induces a drop in the weighted average of the other two variables, i.e., lower exchange rate stability, lower monetary independence, or a combination of the two. 1In our previous paper (Aizenman, et al., 2008), we constructed indexes that measure the trilemma goals individually, for both industrialized and developing countries during the period 1970 to 2006. Using these indexes, we showed that the major crises -namely, the collapse of the Bretton Woods system, the debt crisis of 1982, and the Asian crisis of 1997-98 -caused structural breaks in the trilemma configuration. We also examined whether the three policy goals are "binding"; specifically, we tested the linearity of the indexes and confirmed that countries do face a trade-off among the three policy choices. This finding indicates that a change in any one of the trilemma variables induces a change with the opposite sign in the weighted average of the other two. With these results, we conclude that the present turbulence in global financial markets presents a serious challenge to the stability of the current trilemma configuration.A natural question follows: if policy makers are constrained to choose any two out of the three policy goals, what combination do they prefer? Hence, we test how each of the three policy choices as well as combinations of any two affect the economic outcomes policy makers focus on, such as output and infla...

Did the Indian Capital Controls Work as a Tool of Macroeconomic Policy?

“…In addition, emerging economies have also moved towards greater financial integration and lower monetary policy independence. In doing so, emerging economies have shown a preference for intermediate regimes (Aizenman et al, 2010).…”

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“…Like Gupta Sen (2010), Patnaik and Shah (2012, p 195), rightly criticise Chinn-Ito for "not adequately captur [ing] the gradual easing of capital controls, since it continues to give the same score unless all restrictions [in any dimension] 2 See Bernanke et al (2011); on capital controls, see Ostry et al (2010Ostry et al ( , 2011a and Magud et al (2011). 3 See Glick and Hutchison (2009), Aizenman et al (2010Aizenman et al ( , 2011, Kohli (2011), Hutchison et al (2012) and Patnaik and Shah (2012). 4 See Lane and Schmuckler (2007) and Aizenman and Sengupta (2011). Capital account openness of China and India: de jure and de facto measures Graph 1 Chinn-Ito indices of de jure openness International assets and liabilities (% of GDP)…”

Evaluating Asian Swap Arrangements

“…Recent studies dealing with the Trilemma (Aizenman, Chinn, and Ito 2010) are consistent with the notion that emerging market countries have moved towards the Trilemma middle ground, associated with greater exchange rate flexibility and limited but growing financial integration, buffered by sizable reserve holdings.…”

“…Applying data predating the crisis, Aizenman, Chinn, and Ito (2010) failed to find evidence that countries which pegged their currency to the dollar performed on average better than those that allowed controlled flexibility. During crises, many developing countries found that allowing the This has enabled them to retain a degree of monetary autonomy, even as financial integration has continued.…”