Horns of a trilemma

How can emerging economies protect themselves from the rich world’s monetary policy?
Source: The Economist Aug 31st 2013

SINCE the beginning of May the Indian rupee has plunged by 23% against the dollar. The Turkish lira fell by 15% in that time, and the Indonesian rupiah by 16%. Headlines warn of a replay of the Asian crisis of the late 1990s. Complaints from emerging-market officials that rich-world monetary experiments are to blame for the trouble look like sour grapes. But new research presented to the world’s top central bankers at their recent gathering in Jackson Hole suggests they may have a point.

At issue is how the flood (and ebb) of foreign capital affects economies. The traditional rule has been that countries face a “trilemma”: they must choose between free capital flows, a fixed exchange rate and an autonomous (independent) monetary policy.

“The impossible trinity” sounds like new-age theology (religious truth) but simply posits (presents) that an economy can choose at most two of these three. An economy open to free movement of capital can keep a fixed exchange rate, for example, only by subjugating monetary-policy goals to its defence—by raising interest rates sharply, say, when capital outflows put downward pressure on the currency. Yet the trilemma also implies that an economy can enjoy both free capital flows and an independent monetary policy, so long as it gives up worrying about its exchange rate.

Emerging-market leaders have long been sceptical of this notion. The Asian crisis led much of the developing world to abandon fixed exchange rates. Yet many emerging-market central banks still intervene in foreign-exchange markets, partly to neutralise inflows of “hot money” from rich countries. Footloose capital generates bubbles as it rushes in, some complain, only to generate crises when it later retreats