Sunday, June 12, 2011

More on why domestic central banks still setting interest rates are now outdated artefacts

This follows my post where I said central banks should get out of the rate-setting game. Three years ago, I wrote this in a post: Capital mobility is now global. With more inter-connectedness among nations, it is now increasingly imperative that each individual nation's monetary policies be coordinated to ensure smooth economic results system-wide.

1. With global capital mobility, if one country hikes its interest rate to contain domestic inflation, it can attract more capital from overseas, nullifying the hike. Similarly, if the country cuts rates to spur investment, capital might leave the economy for better rates elsewhere.
2. An aggressive money supply policy in one country can spill over excess liquidity into the global system, spreading inflation globally.
3. One country’s active currency management policies artificially inflates/devalues free floating currencies.
4. Because of points 1, 2, and 3, one Central Banker’s monetary policies to cure domestic unemployment might be rendered ineffective.
5. Financial crisis that start in one country can easily spread to other economies.
6. That’s because the same toxic financial security can now have multiple listings in different markets.
7. They can be placed in multiple markets, or owned, by multi-national banks looking for arbitrage opportunities created globally by, among other things, uncoordinated Central Bank policies.
8. Conversely, a domestic bank can itself own multinationally-issued investments.
9. There’s been an explosion in cross-border money laundering.
10. Multinational corporations now also cross-lend funds borrowed elsewhere among subsidiaries located in different jurisdictions.

At the time, I didn't know I was hitting on a trilemma identified much earlier by Mundell and Fleming. Mundell and Fleming’s economic trilemma posits that you can only achieve two of three objectives desired outcomes in monetary policy: open capital markets, domestic control over monetary policy, and fixed as opposed to floating exchange rates.

Wikipedia mentions that Paul Krugman has stated: "The point is that you can't have it all: A country must pick two out of three. It can fix its exchange rate without emasculating its central bank, but only by maintaining controls on capital flows (like China today); it can leave capital movement free but retain monetary autonomy, but only by letting the exchange rate fluctuate (like Britain – or Canada); or it can choose to leave capital free and stabilize the currency, but only by abandoning any ability to adjust interest rates to fight inflation or recession (like Argentina today, or for that matter most of Europe). "

Three years ago, I wondered whether we needed a global central bank. But now I'm thinking that with a global free market, a domestic central bank still setting interest rates is already an outdated artefact, and sure to cause more harm than beneficial results. If a Central banker really doesn't fully control his domestic monetary policy, whatever he does is sure to cause unintended effects, both for his domestic situation and for those abroad. With global capital mobility, a central banker needs to either give up control over interest rates, or give up all pretension that he has any relevant control over domestic policy. At best, given that whatever a domestic central banker of a nation like the US does affects the international capital markets, whether rate-setting or non-traditional quantitative easing, such as QE2, monetary policy and rate-setting is only useful as a trade war weapon. Just witness what's happening to China's economy now, as it tries to maintain a fixed peg.

Here is a still relevant related discussion on central banks over at David Smith's EconomicsUK.


Min said...

"Mundell and Fleming’s economic trilemma posits that you can only achieve two of three objectives in monetary policy: that is, open capital markets, domestic control over monetary policy, and fixed as opposed to floating exchange rates."

Pardon my ignorance, but why are open capital markets and floating exchange rates objectives of monetary policy?

Thanks. :)

Rogue Economist said...

Min, my bad. A more precise wording is 'open capital markets and floating exchange rates are 'possible objectives' of monetary policy'. Or, put another way, economic planners can only successfully achieve two of three desired outcomes simultaneously - open markets, floating exchange rates, and domestic control of policy. Their objectives may not necessarily involve open capital markets or floating exchange rates, in which case,and particularly, if they choose closed capital markets, it would be easier to control domestic monetary policy.

Detroit Dan said...

Excellent post! There might be some confusion in the last comment by RogueEconomist with regard to fixed v floating exchange rates. But the point is that central banks don't really have much power to fix national economies. This is a problem, and the answer would seem to require regulation of capital flows. But I hsven't thought about this much and would be glad to hear Rogue Economist's ideas on what is the best way to run monetary policy so that a country cannot be victimized by private capital flows (arbitrage) or mercantile currency manipulation...

Rogue Economist said...

Dan, the only way I can think of to prevent being victimized by capital flows is to control it. Otherwise, especially if you're a small economy, your monetary policies will be undermined and controlled by speculators.

Min said...

Thanks, R. E. !

I misspoke myself, writing floating exchange rates instead of fixed.

My questions had to desirabilty, anyway. Like, how desirable are open capital markets when foreigners take over your agriculture and water supply? Or why are fixed exchange rates desirable? (As opposed to not too volatile rates?) I have heard that Great Britain got into trouble "defending the pound" back in the 70s.

Rogue Economist said...

Min, well, according to the Washington Consensus, open markets with freely floating exchange rates lead a nation towards economic prosperity. We can now see how those initiatives turned out. Open markets and flexible exchange rates are only good for everyone when there are also open borders.