Quarantine order makes sense in triangular way

PUBLISHED : Friday, 04 September, 1998, 12:00am
UPDATED : Friday, 04 September, 1998, 12:00am
 

The triangle depicted below comes courtesy of economics guru Milton Friedman, who once drew it on a blackboard to make a point about monetary discipline in a speech he gave in Hong Kong years ago.


His argument was that you can have any two points of this triangle, but if you try to get all three, you will instead get a collapse.


If you want open borders to capital flows and also want control of your interest rates then you must let your currency's exchange rates be determined by the market.


If you want open borders and control of exchange rates then you must let your interest rates be determined by the market. If you want to control both exchange rates and interest rates then you had best close your borders to capital flows and pretend you are on another planet.


A good example of the first way of doing things is the United States. Its borders are open to capital flows and its interest rates are controlled by the Federal Reserve Board. It therefore leaves US dollar exchange rates to be determined by market forces and everything works. The rules of the triangle have been observed.


A good example of the second way of doing things is Hong Kong. Its borders are open to capital flows and it has opted to control HK dollar exchange rates through a currency board link to the US dollar.


This requires that the authorities forswear attempts to control interest rates and that they leave them to be determined by the market.


It does not always work as well as the US model, because occasionally, there are panics about whether the link will hold and then interest rates go through the roof, which, as we all have reason to know, can be very unsettling.


But it is a viable way of doing things and it observes the rules of the triangle.


A good example of the third way is now Malaysia. Exchange rates and interest rates are controlled but the borders are closed to capital flows.


It is a workable solution. The rules of the triangle are still observed. The problem is only that, if you practise it, you force your economy to rely on domestic financial resources alone. This would be all very well centuries ago when there was not much cross-border capital flow in any case, but modern Malaysia does not exist in such a world.


Its exports alone are equivalent to more than 90 per cent of its gross domestic product. As just one contrast to this, the equivalent figure for Japan is only 10 per cent. Malaysia also relies heavily on foreigners for technology and investment to keep its economy moving.


So, as another notable economist, Paul Krugman, points out in an open letter to Malaysian Premier Mahathir Mohamad, which was published in this newspaper yesterday, the controls which Malaysia has adopted are defensible in crisis times but they had best be temporary ones, because the dangers of maintaining them are acute.


Worse, however, than what Malaysia has done is what Thailand did to bring itself into its present crisis. It controlled both exchange rates and interest rates while leaving borders open to capital flows, a clear defiance of the triangle.


The result was enormous inflows of foreign capital to take advantage of high Thai interest rates under an illusion that there was no currency risk and a huge bubble with money pouring into a grossly overbuilt property sector and the consumer whims of Thai yuppies. It collapsed because it had to.


Malaysia is also guilty of having played this game a little, hence its present troubles. But if Dr Mahathir has sinned against the laws of economics with his controls, this latest sin isn't necessarily a cardinal one.


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