China’s pursuit of economics’ ‘impossible trinity’ is a sure path to disaster
A claim by China’s central bank that it has achieved the ‘impossible’ – a stable yuan, open borders and control of its own interest rates – is nonsense
The mainland’s central bankers have done the economically “impossible”, finding a way to have a stable yuan, a free market and effective monetary policy.
That is the assessment of two central bank researchers who claimed in a paper published on the People’s Bank of China website yesterday that Beijing would continue to realise the “impossible trinity.”
– SCMP, March 31
And I claim to have invented a perpetual motion machine. It’s easy. I just did what these two so-called “researchers” did. I published a paper. You hold it in your hands. Hey Presto, the impossible achieved.
I once saw the late economist Milton Friedman deal with the particular impossible trinity that these two say the PBOC has made possible. It was at an informal lecture that he delivered here at the Academy for Performing Arts in Hong Kong.
He sat alone on the stage on a chair that was unfortunately a little too high for his short stature so that his shoes barely touched the floor, a huge contrast with his stature as an economist. Someone asked him what he thought of China’s monetary policy, whereupon he hopped off his chair and drew on a whiteboard a triangle representing the elusive trio of factors.
It’s simple, he said. A country can have any two of the three points of this triangle and maintain a workable monetary system but it cannot have all three as it then invites an economic and financial crisis.
Thus if a government wants control of its domestic interest rates and wants its borders open to trade and capital flows it must give up control of its currency by allowing the exchange rate to be freely determined by the market. This is the United States model.
Alternatively, if a government wants control of its exchange rate and wants its borders open to trade and capital flows, it must give up control of its domestic interest rates and allow these to be market determined. This is the Hong Kong model with our currency peg to the US dollar.
The third option is to control both exchange rate and domestic interest rates. If a government chooses this option it must close its borders to capital flows. This is the North Korea model. It works, not well, but it complies with the rules of the Impossible Trinity and can be maintained indefinitely.
Choose all three, however, Friedman said, and you get a pressure cooker with a disabled safety valve. It is simply not sustainable. He did not say that he was speaking of China but the message was clear.
What China has done in recent years is stumble between the three, with the PBOC never making up its mind just what it wants.
Twelve years ago it decided (well, partially) to go for the US model and let market forces take control of the yuan’s exchange rate as a price for keeping open borders and maintaining control of interest rates.
Then, more recently, it decided that it did not really like what the market was doing to the yuan and adopted (well, partially) the Hong Kong model in which it took firmer control of the exchange rate but looked the other way as informal lenders took control of interest rates.
And now, since about mid-2016, China has decided that the North Korea model has its attractions. It has thus (well, partially) choked off capital flows at its borders while once again trying to get its hands firmly on both the exchange rate and interest rates.
It’s not a realisation of the impossible trinity. It’s just a muddle of confused bouncing back and forth from one to the other, of monetary policy held hostage to whatever scream of distress happens to be loudest at the time.
And, yes, it’s a pretty sure path to an eventual financial crisis.