Empirical evidence on the monetary policy trilemma since 1970

Joshua Aizenman, Menzie D. Chinn and Hiro Ito from VoxEU:

"Against the backdrop of the most severe financial crisis since the Great Depression, the issue of the trilemma – the hypothesis that a country may only achieve at most two of three goals: monetary independence, exchange rate stability, and financial integration – seems rather distant. We would argue that, on the contrary, the way in which the trilemma has been addressed and how it will constrain future policy choices are questions that need to be answered in order to understand how the world economy has arrived at this juncture. In particular, reserve accumulation on the part of East Asian countries can be viewed as part of how the stage was set for the low interest rates that are blamed by some for the speculative excesses of the last few years.

Many have argued that the recent reserve accumulations are closely related to changing patterns of the trilemma among developing countries. There is now good empirical evidence on this. Calvo (1998) suggests that international reserves can reduce both the probability of a sudden stop and the depth of the resulting output collapse. Aizenman and Lee (2007) link the large increase in reserves holding to the deepening financial integration of developing countries and evidence that international reserve hoarding serves as a means of self-insurance against exposure to sudden stops. Cheung and Ito (2007) find that the explanatory power of financial variables as determinants of international reserves holding has been increasing over time while that of trade openness has been declining. Obstfeld et al. (2008) find that the size of domestic financial liabilities that could potentially be converted into foreign currency (M2), financial openness, the ability to access foreign currency through debt markets, and exchange rate policy are all significant predictors of international reserve stocks.

In a recent paper we study the development of trilemma configurations over the last four decades and find that developing countries, and particularly emerging markets, have moved towards greater exchange rate flexibility and deeper financial integration. More recently, since 2000, developing countries have converged towards managed exchange rate flexibility, monetary autonomy, and financial integration; all enabled by the accumulation of unprecedentedly large international reserves holdings. So far, the adjustment of emerging economies to the liquidity crisis has proceeded in line with this new trend –the real exchange rate and monetary policy have taken the first brunt of the adjustment. Given the magnitude of the disruption, the absence of deeper adjustment so far is a testament that the observation that the intermediate ground in the trilemma, combined with proper governance and management, allows for a softer landing.
In our paper, we also test and confirm the linearity of the three aspects of the trilemma. In other words, a rise in one trilemma variable should be traded-off with a drop of the weighted sum of the other two.

The trilemma framework

It shows that it is impossible to be simultaneously on all three vertexes of the triangle; a country choosing financial integration, for example, must either forego exchange rate stability to preserve a degree of monetary independence or forego monetary independence to maintain exchange rate stability. Over the last two decades, a growing number of developing countries have opted for hybrid exchange rate regimes – e.g., managed floats buffered by increasing accumulation of international reserves (henceforth “IR”). Despite the increasing pervasiveness of greater exchange rate flexibility, IR/GDP ratios increased dramatically, especially in the wake of the East Asian crisis (see Figure 2). Most of the accumulation has been in Asia.
(continue...)