Economic Roundup, December 14, 2018

Economic Environment

  • New Reserve Bank of India (RBI) Governor

  • Elections in 5 states

  • US-China trade tensions and global growth

How are the Indian and global economic environments affecting the financial markets?

  • The government has quickly appointed Shaktikanta Das as Urjit Patel’s replacement after his sudden resignation. Signals of business continuity at the RBI from the new governor have prevented market anxiety. Given that annual inflation in November is well below RBI inflation target and October industrial production has surged, RBI policy is expected to be status quo on interest rates.

  • In the run up to the general election in 2019, 5 states have gone to the polls on December 07. The results announced on December 11, despite the loss in all 5 states of the ruling BJP, have not led to any unusual volatility in the markets which have, in fact, welcomed the winners’ promises to deal with youth unemployment and farmer sentiments as a sign of support for the economy.

  • The primary concern for the markets has been uncertainty about US-China trade which they have linked to the slowing global growth. The global markets, with India taking cues from their reaction to developments in the US-China trade situation, want a resolution to the trade tensions to alleviate their concern about any possible global economic slowdown. However, it is unlikely to be resolved within the next 90 days unless China meets US demands on bilateral trade. The global markets, as a result, will remain somewhat volatile through the end of the first quarter of 2019.

    What to expect from the markets next week?

Indian financial markets will continue to takes cues from global markets on global growth though they could breathe a sigh of relief because of expected slower pace of Fed rate increases due to probable slowing of US growth at around the Fed’s inflation target and the RBI status quo, despite a new governor, but with a watchful eye on Indian economic growth outlook also at around the RBI’s inflation target.

Economic Roundup, December 07, 2018

Economic Environment

  • Reserve Bank of India (RBI) monetary policy

  • US-China trade uncertainty

  • The Organization of the Petroleum Exporting Countries (OPEC) and Russia

  • Global growth

How are the Indian and global economic environments affecting the financial markets?

  • The RBI left interest rates unchanged given the slowdown of the Indian economy in the July-September quarter and lower than target inflation while maintaining its stance of ‘calibrated tightening’. This decision by the RBI was widely expected though the markets also expected a change in the RBI’s stance to ‘neutral’. The reaction of the Indian equity markets was bearish because of the RBI signal that it is not bullish on the economy. Some deterioration in the macro situation was also reported by the government with the Indian fiscal deficit exceeding the fiscal year target with the year still one quarter away from being completed. It must be noted here that the trade deficit is also increasing and is highly sensitive to the oil price. The twin fiscal and trade deficits do not bode well for the strength of the rupee. If inflation holds at or below target, we expect the RBI to return to ‘neutral’ stance with a bias of lowering interest rates next year depending on economic growth to boost the economy though we also expect the RBI not to act on lowering interest rates because of inflation concerns until Indian gross domestic product (GDP) growth rate falls to about 6.5% in 2019. Therefore, given the forecast of 7.2% for GDP growth rate in 2019, we expect, on balance, the RBI to maintain status quo on interest rates through the end of the fiscal year 2018-2019.

  • Indian equity market reaction to US-China trade uncertainty was mixed despite a sharp fall in US markets. It is still unclear how the US-China trade dispute would be resolved while noting that India, in fact, stands to benefit from both US and China should their trade dispute continue.

  • OPEC and Russia agreed on Friday to together cut oil production by 1.2 million barrels-per-day for the next 6 months to prop up the oil price. It is unclear to what extent they would succeed in doing so given rising US production which will only stand to benefit from propped up oil prices. This, however, is not good news for India because higher oil prices will only cause the trade deficit to rise and pressure the rupee.

  • Concerns about global growth have caused all the major advanced and emerging equity markets to fall. The International Monetary Fund (IMF) has clarified that it only expects global growth to slowdown without the risk of a recession.

    What to expect from the markets next week?

Indian financial markets will continue to takes cues from global markets on global growth though they could breathe a sigh of relief because of expected slower pace of Fed rate increases because of probable slowing of US growth at around the Fed’s inflation target and the RBI status quo but with concern about Indian economic growth outlook also at around the RBI’s inflation target.

Monetary Policy of India and Economic Development

India, since liberalization in 1991, has depended on foreign institutional investment (FII) and foreign direct investment (FDI) to bulk up its foreign exchange reserves, even as it built its services exports sector that depends on outsourcing primarily from the United States and Europe. Unlike China, India paid little attention to the development of domestic infrastructure and manufacturing, remaining as a primarily agricultural economy. The challenges, as a result, India continues to face are hightened poverty, among the highest in the world, and inability to create jobs commensurately to the number of young people, about a million, entering the job market every month.

On the path toward becoming the most populous country in the world by 2050, India, being a democratic polity and a mixed economy founded on Fabian socialist principles, must position itself to reap the demographic dividend in the upcoming three decades. If leveraged well, India, with its large English-speaking population, can create the needed jobs by aiming to become a global center for services similar to but beyond Singapore and by transforming its infrastructure with smart cities, “Make in India” and “Digital India” programs. This would also have a dramatic effect on poverty reduction which has not happened as one would expect after 1991. The government programs are there but the question remains about how they can be funded at the scale that is needed for India’s economic transformation.

Monetary policy of China, says Li Yunqi, a Chinese research scholar associated with the People’s Bank of China (PBOC), has always been about economic development. Industrialization, in particular infrastructure related, has been the focus of PBOC, together with, of course, expanding the exports sector. Both infrastructure and exports, which contributed to significant and sustained increase in real investment have propelled China to be the second largest economy in the world when measured by nominal gross domestic product (GDP) and the largest in purchasing power parity (PPP) terms.

Blessed with fertile land and fresh water perennial rivers both in its north and south, India is an economy waiting to happen on the world stage powered by all three of the economic sectors: agriculture, industry and services. Road, rail, electricity and water are the primary infrastructure areas that are ripe for transformation. With urban areas growing, the government’s smart cities initiative should be able to accommodate the migration from rural to urban areas without over-burdening the existing cities by expanding or building new cities along major highway or railway corridors.

China printed money for investment in the expanding infrastructure and exports sectors of its economy, thus raising the potential growth rate which also thereby managed inflation despite occasional, short bouts with high inflation. This created millions of jobs and dramatically reduced poverty in the three decades since 1978 when China began its market socialist reforms. Though China, as Li Yunqi points out in his 1991 Asian Survey article “Changes in China’s Monetary Policy”, has to deal with the paradoxes of a burgeoning market economy and a socialist state that intervenes in it, and also with finding growth drivers as infrastructure and exports wane, its management of monetary policy holds important lessons for its neighbor to the south, India.

The Reserve Bank of India (RBI) should expand money supply for targeted funding of economic transformation initiatives. Money supply targeted to investment and growth initiatives only raises the potential growth rate but does not cause inflation. India is not yet an economy whose monetary policy can behave as if it is a developed economy.

The Trump Trade

There have been two trends since toward the end of 2016. The election of Donald Trump as president of the United States in large part due to his promises to boost economic growth and bring jobs back to the country and the turning of the corner by the Chinese economy returning it to consuming once again the world’s natural resources for its infrastructure and manufacturing sectors. Both of these trends have lifted the global economy out of deflationary pressures by reflating while investors in the financial markets are carefully watching their sustainability.

Trump’s election brought into focus the U.S. personal and corporate tax regimes, burdensome business regulations, deteriorating infrastructure and America’s trade policies that have proven to be detrimental to its economy. Promised reforms to all these determinants of the health of the U.S. economy greatly encouraged the equity markets on Wall Street which are eager for the expected reforms to become law. The president’s ongoing difficulty with members of his own political party in negotiating health care reform to end Obamacare is raising doubts about his ability to pass major economic reforms into law. If he cannot deliver, the markets could be deeply disappointed which could lead to a 10% drop or a correction in the major equity indices.

As China – the world’s largest economy by purchasing power parity (PPP) and the second largest in nominal terms – navigates the stabilization of its economy at a lower level of growth, transitioning, according to conventional wisdom, to a services and consumption-based economy from a manufacturing and exports-based model in its attempt to move up the economic value chain, a closer examination of China reveals that it wants to strengthen all four – manufacturing, services, consumption and exports. It is climbing up the manufacturing ladder to more innovative and higher-end manufacturing from simply being an assembler of imported components, building up the services sector, raising domestic consumption, and aggressively seeking and building markets for its exports with initiatives such as “One Belt, One Road.”

China intends to primarily import natural resources and food it is deficient in, make in China using Chinese producers for the Chinese market and for export. It is not a country that is open to foreign firms who wish to make in China for Chinese consumption even as it is beginning to expand the global footprint of its own corporations to produce for the consumption of others within their countries. When faced for some time – nearly four decades – with such globalization that takes advantage of the current global free trade regime not only by China, but by other aggressive exporters such as Germany and Japan, the United States cannot stand still without adjusting its global trade posture of playing the unsustainable consumer of global exports which is costing America jobs. This makes the sustainability of the Trump Trade all the more critical – an imperative. The president must succeed in passing economic reforms in America.

Any future success of the expected reforms in the United States will have a significant impact on the world. Lowering personal income taxes for the middle class while expanding the tax base with taxes on consumption (as India is doing) would economically strengthen the society. Cutting corporate taxes and facilitating repatriation of foreign profits of American firms at a low tax rate will increase business investment in the U.S. Streamlining regulations and making regulations smart will reduce the cost of compliance of firms, create a business-friendly environment and increase the ease of doing business while reducing the chances of events such as financial crises. Investing in infrastructure reduces business inefficiencies. Most importantly, a local, global and sustainable model of international trade which encourages local production by multinational corporations and local companies for sustainable local consumption while importing only natural resources and food items a country is deficient in will lead to global economic development by creating and developing local markets and political and economic institutions. All these reforms will be emulated by other countries once they become operational in the United States, pushing less open countries such as China and Japan to become reciprocally more open.

The American president may be lending his name to real estate projects around world but he may not have anticipated branding the global economy. The Trump Trade signals a paradigm shift in the structure of the world economy. It not happening will be a costly disappointment.

Will There Be a Banking Crisis in India?


Indian banks are creaking with non-performing assets (NPAs) which are typically defined as loans made by a financial institution on which interest or principal payment is past overdue for more than 90 days. This problem has gotten progressively worse in the past 5 years in most public sector banks (PSBs) in India, where, by one estimate, a total of at least INR 3.6 trillion needs to be infused into the PSBs to clean up their balance sheets, with the gross NPAs constituting, on average, 10% of the total assets of a PSB.

While private sector banks carry the risk of failing if they do not conduct their business soundly, PSBs carry the moral hazard of government guarantee against failure. In this sense, PSBs can never fail because of the guarantee that the government will provide the required cash infusion to prevent the PSBs from failing, with the tax payer bearing the losses due to the NPAs. The issue then becomes one of resolving this moral hazard to avert market failure.

There are two approaches to the problem of the resolution of NPAs on the balance sheets of PSBs: one, to prevent the NPAs and if not preventable, two, once the NPAs reach worrisome levels because they could not be prevented, the PSBs can be rescued with tax payer funds on the condition that the rescued funds would be paid back to the government by the financial institutions after they return to normal health or from the management of the NPAs by the government.

Preventing NPAs requires thorough due diligence of the borrower on the part of PSBs when lending to ensure that the moral hazard presented by the PSBs is not being taken advantage of by the borrower who could take out a loan with the intent of defaulting on it from the outset which is difficult to prove. PSB bankers in India often face pressure from the business lobby and politicians to lend despite due diligence concerns. The government must set up checks and balances so that loan quality is not compromised by nepotism and corruption.

Ex post accumulation of NPAs, which poses systemic threat to the financial system as is the situation now, despite arguments that the PSBs are the best judges of their lending and that, therefore, they should resolve their own bad loans, a “bad bank” as done by Sweden in 1991-’92 should be established by the government and the NPAs must be transferred to the bad bank at a discounted price. The bad bank must then resolve the NPAs either by (a) liquidating the collateral assets; or (b) strategically restructuring the debt by converting their loans to equity and taking a stake in the firm to oversee its management (along the lines of the private equity model); or (c) restructuring the loan terms so that the borrower can service the loan. The proceeds from the resolution of NPAs will all flow to the government and the tax payer expense of resolving the NPAs would then at least be neutralized.

Most importantly, because the institutions being bailed out are banks which come under the regulatory authority of the Reserve Bank of India (RBI), the RBI can infuse the required funds into the PSBs directly rather than the government by increasing the money supply and set up the bad bank.

Sustainable credit growth is an important factor in the growth of any free market economy. Unsustainable credit in countries such as Italy, China and India could, in the best case, hamper economic growth and, in the worst case, result in a systemic crisis such as bank failure spreading across many banks in the economy which have a high percentage of NPAs. If the problem of the growing menace of NPAs in India’s PSBs is not resolved in a timely manner, both PSB asset growth and economic growth in India could be adversely affected as PSBs provide credit to businesses, small and large, which is the lifeblood of the Indian economy.

What Demonetization Can Buy for India


The independent think tank and leading business information company Center for Monitoring Indian Economy (CMIE) estimates that the combined cost of demonetization to enterprise, households, banks, and government (including the Reserve Bank of India) is about INR 1.3 trillion or about USD 20 billion.

Economists often use the concept of opportunity cost to understand what has to be given up in order to get what one wants: India has given up USD 20 billion, which could have been put to other uses, to get in return an economy with an expectedly far less unaccounted for cash, or in other words, India is expecting to “purchase” with USD 20 billion a far less corrupt economy.

Some estimates of India’s gross domestic product (GDP) for the period October-December 2016 say that nearly 1% could be shaved-off GDP growth. Are India’s prime minister Narendra Modi’s efforts to significantly reduce corruption by first clamping down on the cash unaccounted for by the tax authorities, or “black money” as they call it in India, worth the cost to the economy due to the demonetization drive and the consequent short term hit to GDP and the financial markets especially when interest rates are expected to rise in the United States after the election of Trump triggering capital flight from India and depreciation of the rupee just as it did previously during the taper tantrum when the U.S. Fed gradually ended its policy of quantitative easing?

The shock of about 86% of cash being taken out of circulation to remove, as economics Nobel Laureate Amartya Sen has pointed out, only 6% of black money that is actually in cash could, on the surface, seem excessive, but to disagree with Sen, there is no other alternative to demonetization to end the hoarding of ill-gotten gains. The government, in contrast to Sen’s labeling of it as being despotic in its actions, has, in fact, twice allowed the holders of hoarded cash to come forward voluntarily to convert it into white money by depositing in banks and paying the taxes with the penalties due on it. The INR 500 and 1000 notes continue to be legal tender as long as they are deposited in banks or exchanged for the newly designed INR 500 and 2000 notes within a prescribed timeframe: the government is indeed honoring its currency as legal tender. It is not despotic to ask cash holders to exchange old design notes for new design notes within a timeline.

At issue really is whether demonetization can actually end black money and other ill-gotten assets in the future. This is why it appears that it is a mistake to introduce two new currency notes of large denominations – the INR 500 and 2000 notes. Despite the government’s sound intent to convert what is a cash-based society into a digital society, the introduction of these notes poses the danger of recidivism. Moreover, once the circulation of cash attains normalcy again, the momentum gained toward a digital economy during the period of demonetization could be lost as people may tend to revert back to transacting in cash. It would, therefore, be good to see INR 500 and 2000 denomination notes demonetized with INR 100 becoming the largest denomination. Further, given that only a small percentage of black money is in cash and the rest of it lies in foreign currencies typically in Swiss bank accounts or offshore, gold, financial assets such as stocks, and real estate, it is unclear at this time how the government can account for all of it though the government needs to chart a clear course for it to forever end the shadow economy.

India is a highly desirable market to the extent that foreigners are willing to transfer technology to India to get a share of the Indian market. It is large enough not to depend on the comings and goings of foreign investment to be continually concerned about the depreciation of the rupee because of temporary domestic events such as demonetization or foreign happenings such as the election of Donald Trump in the United States. “Make in India” for the Indian market is a worthy goal to pursue for both foreign investors and Indian investors to reduce the reliance of the Indian economy on exports (and hence a cheaper rupee) as much as export competitiveness is necessary. More importantly, India can reduce imports, except of natural resources such as oil and gas and other minerals India does not possess, if it makes in India, boosting the Indian manufacturing sector. There is no reason at this time for the Indian rupee to depreciate against the dollar but for fleeting market sentiment about the prospect of higher US interest rates. India continues to be an attractive country for foreign direct investment (FDI) and foreign institutional investment (FII).

Strengthening the domestic market thus makes the rupee optimally strong at all times, similar to the US dollar, charting a path for the full convertibility of the rupee in the near future and its use as one of the reserve currencies in international trade. And all of this does not require dependence on cash because investment in India by both domestic and foreign investors can happen digitally and the economy can be steadily pushed to attaining the goal of all digital transactions by giving incentives to market participants and instituting laws to digitize especially when the technology to do so for all transactions, small and large, is readily available.

Digitization of the currency is the way to go and if the opportunity cost to achieving it is a small, short term, and temporary hit to Indian GDP and the Indian rupee, so be it.

Could the Recovery After the Great Recession Have Been Quicker?


The party of nearly uninterrupted growth since the Reagan economic recovery of 1983 with the exception of two small recessions in 1990-1991 and 2002-2003 in the United States ended with a thud, culminating in the financial crisis of 2007-2008 and the Great Recession of 2007-2009. Unemployment had risen to double digits and inflation fell raising fears of deflation as in Japan. Therefore, interest rates were cut deeply by the Federal Reserve to the zero bound and money supply was further expanded through bond purchases and purchases of mortage-backed securities (MBSs) in three episodes of quantitative easing. Yet the economic recovery since 2009 has been sluggish. All that money supply perhaps achieved was to put a floor under inflation but not accelerate real investment through the credit channel of monetary policy transmission.

It has taken 7 years to nearly halve the unemployment rate with little to say about the quality of employment created. Rise in wages has been slow and people have not been able to find employment and incomes comparable to what they have been before the Great recession. Economists have cited technology and trade as two reasons for the plight of the average American as gains from both technical change and international trade have gone disproportionately to the top 10%, and more so to the top 1%. Innovation in all sectors, including in finance, was encouraged with little regulation. Technical change and trade have become dogmas whose critique was forbidden. As a result, populism and protectionism are now on the rise around the world as can be seen from Brexit in the United Kingdom and the election of Donald Trump for president in the United States.

The blame for the rising populism and protectionism must squarely be laid on the lack of substantive discussion among policymakers about how to safeguard jobs amidst technical change in manufacturing – a key employment sector of the economy – and how global trade must be structured for its benefits to be equitably distributed among the population. More importantly, under the grave threat of deflation after the onset of the Great Recession, monetary and fiscal policies have not been commensurately radical in a timely manner.

There was much deliberation whether to cut interest rates to zero during the initial period of the financial crisis, then it was followed by further deliberation whether quantitative easing should be adopted. Monetary easing occurred in an environment of fiscal tightening or austerity, a contradictory approach to macroeconomic policy making. While fiscal policy was constrained from acting through austerity measures, there has been no discussion on how monetary expansion can be conditioned on real investment rising to direct money to those sectors of the economy where it is most needed.

The extremely radical approach of the central banks in developed countries directly funding government budgets with the central banks forgiving all new government debt so that fiscal space can be increased to raise real investment to create jobs (“helicopter money”) has largely been left to opinion articles by former central bank policymakers and academics when the required global infrastructure spending alone is estimated to be USD 57 trillion by 2030. All of this has needlessly prolonged the economic recovery: money is being hoarded at central banks in the form of excess reserves and in cash by corporations instead of being invested in the real sector.

Predicating economic recovery on money from central banks trickling down into the economy and into sectors decided solely by market forces has made monetary policy less activist than it should have been for the recovery to be quicker. It is still not too late.

Demonetization, Jan-Dhan Yojana, and Digital India


The surprise demonetization of large (INR 500 and 1000) denomination currency notes (to be replaced by newly designed notes later) and restrictions on automated teller machine (ATM) and bank withdrawals of cash have indeed affected day-to-day commerce in India that depends mostly on paper money and coin. This will, therefore, prove to be an inconvenience to a large part of India’s population and, according to the government, may continue to do so for about 60 days from the date of demonetization but has major implications for the future of base money in India.

The primary motive for India’s demonetization of currency notes of large denominations has been to ferret out the money that has not been accounted for as income for the purposes of taxation. This money, also known as “black money” that runs a shadow economy, is estimated to be as high as about one-fifth or 20% of India’s gross domestic product (GDP) or about USD 500 billion, larger than the economies of some countries.

Typically, hoarders of unaccounted for cash in India use that money to engage in all-cash transactions to buy – unknown to the tax collectors – real estate, stocks and other financial assets, foreign currencies, and gold. India also has a long list of people who have intentionally defrauded the banks by not paying back large sums of loans and also those who have stashed away gold and cash in secretive Swiss bank accounts. Forcing black money into light through demonetization and future digitization of financial transactions ends the underground economy.

Sweden, the first country to introduce paper money in the 17th century, is already contemplating becoming the first country to issue digital money because in Sweden, and in the Nordic countries in general, using paper money is fast going out of fashion, with people shifting mostly to all electronic transactions, both large and small, which can be traced and tracked and fully accounted for. This could be a trendsetter for the rest of the world for both convenience and to severely limit criminal activity such as money laundering and money unaccounted for by the tax authorities of governments.

India is a dreamscape for financial technologies (fintech) given the sheer volume of monetary transactions especially as the economy grows in size in the future. Paytm (short for “Pay through mobile”), a fintech e-commerce company, took out a full page advertisement in India’s major newspapers the day after India’s prime minister Narendra Modi announced the demonetization. The advertisement thanked the prime minister for pushing the country more towards the use of electronic monetary transactions and moving the country away from the paper currency-based economy.

The penetration of mobile phones in India has reached an astounding 1 billion mobile subscribers in a country with a population of about 1.3 billion. When so many people can use mobile phones with ease, it is only a matter of time before they also learn to transact using mobile technologies such as the Unified Payments Interface (UPI) which can transfer money between bank accounts using a text (Short Message Service, SMS) message between mobile phones. SMS simply uses the wireless phone signal and does not require internet access.

Even if some mobile applications (also known as “apps”) require internet access and smart phone use, the smart phone market is a rapidly growing market in India and telecommunications companies such as Reliance Industries with initiatives such as Jio are pricing telephone and data wireless internet services at a rate that can be afforded by the common man. Soon Reliance’s competitors will catch on and catch up in the market place.

Another initiative of the government, Jan-Dhan Yojana, which literally means People’s Money Scheme, aims at massive financial inclusion of the many unbanked poor and rural population of India. As many of them have access to mobile phones, with technologies such as UPI it is only a small next step to avail electronic banking and other financial services for amounts small and large.

Demonetization, Jan-Dhan Yojana and Digital India are mutually consistent government initiatives which are moving India in the right direction.

Is a Banking Crisis in Europe in the Offing?

While all attention is being focused on China’s growing indebtedness and its ability to stave off a debt crisis, another series of bank failures could be in the coming in Europe. The cause of any possible debt crisis in China and any impending bank failures in Europe is at the core the same: slowing and weak economies. Return on lending by banks, given the monetary policy environment, is low and financial institutions are finding it difficult to remain profitable especially in the regulatory environment in the aftermath of the 2007-2008 financial crisis.

China, because of its political system that permits significant state intervention, can make nimble decisions to shutter some unprofitable state run enterprises, consolidate others and capitalize banks which have lent to the unprofitable state run enterprises to prevent any serious crisis from taking hold. Besides, Chinese financial institutions, as of yet, are not globally systemically important. This, however, is not true of European banks.

In Europe, both German in the north, despite expectations to the contrary, and Italian banks in the south are not faring well either with regulators or with investors. Deutsche Bank’s minimum capital ratio versus regulator requirement is severely short. The International Monetary Fund (IMF) has released a report saying that Deutsche Bank “appears to be the most important net contributor to systemic risks in the global banking system” as can be seen from the picture below.


The bank has been fined USD 14 billion by the United States Department of Justice for mis-selling mortgage-backed securities and at the current share price Deutsche Bank is barely worth more than the fine. Deutsche Bank hopes that the fine can be negotiated down to smaller number giving it breathing room to implement its restructuring strategy for 2020. Information is circulating that the German government, despite Deutsche Bank being its only major global player, does not intend to come to its rescue. The bank has said that it would not be needing a government bailout nor should it get one. Deutsche Bank should be allowed to fail if it comes to that in an orderly manner by the regulators by putting up its assets for sale to be acquired by other companies in the global banking industry and by saving its depositors.

Recent stress tests – designed to show how banks would weather a severe economic crash – highlighted weaknesses in Italy’s financial firms UniCredit and Monte dei Paschi di Siena (MPS). Italian banks are burdened by non-performing loans and as a result they are not intent on lending more which is holding back the economy. Italian economy has ground to a halt with zero growth reported in the second quarter of 2016.

The vicious cycle of a slowing economy and poor bank performance is plaguing Europe. It is important for the markets to keep an eye on European banks under stress, German and Italian in particular, for any signs of a cascade of bank failures which, if mishandled, can be to the detriment of the global financial markets and the global economy at this sensitive stage in the global economic recovery. Acquisitions by other global banks of underperforming European banks are a better way to go than government bailouts.

No financial institution should be “too big to fail.”

The Trilemma in International Economics and Large Open Economies


As World War II was coming to an end, at the conclusion of the Bretton Woods talks about exchange rate arrangements between countries after the war, the United States insisted that the currencies of the parties to the talks be pegged to the U.S dollar and that the U.S dollar would be pegged to gold. Thus the U.S. dollar became the currency of choice for global trade – the reserve currency or the currency that other countries keep in reserve for international transactions denominated in the U.S. dollar – ending the dominance of the British pound. The gold peg of the U.S. dollar where Americans and countries could convert their U.S. dollars to gold was an arrangement that continued until Nixon shocked the world in 1971 by ending the convertibility of the U.S. dollar to gold.

From Bretton Woods in 1944 to the abandonment of the fixed exchange rate Bretton Woods agreement between 1971 and 1973, the United States had a fixed exchange rate regime with the U.S. dollar pegged to gold, minimal controls on capital flows into and out of the United States, and sovereign central banking. This American experience violates the Impossible Trinity or the Trilemma in international economics that says that a country cannot simultaneously have all three – fixed exchange rate, open capital markets with free capital movement into and out of the country, and sovereign monetary policy. It can only have two out of the three and must give up on the third.

The Impossible Trinity is based on the Mundell-Fleming model which describes the workings of a small open economy. In fact, Robert Mundell, who won the Nobel Prize for his work on international economics, and Marcus Fleming used their model to describe the small open economies of Switzerland and Belgium. To develop their model they had assumed a small open economy with perfect capital mobility where the interest rate in the country is equal to the world interest rate over which the country has no control. This is a key assumption. To apply the model, the model implies that a small open economy has perfectly open capital markets and no control over its monetary policy. This means, according to the Trilemma, it must have a fixed exchange rate along with open capital markets because it gave up the sovereignty of its monetary policy.

A key insight of this article is that all small open economies – small because they cannot set their own interest rate but their interest rate is equal to the world interest rate – according to the Mundell-Fleming model, should be characterized by fixed exchange rate, open capital markets and non-sovereign monetary policy.

It is interesting that the academic literature in international economics has generalized the Trilemma to apply to all countries including large open economies such as the United States which have a significant influence over the world interest rate because the currencies of large open economies are the reserve currencies in international trade. Therefore, it is a useful question to ask whether the Trilemma applies to large open economies: can large open economies have fixed exchange rate, open capital markets and sovereign monetary policy as was the case with the United States for nearly 30 years after World War II?