Question

1. Explain why the “impossible trinity” has its name. (In other words, why is it impossible for a country to have all three conditions at the same time?)

2. Describe the main elements and results of the Asian Financial Crisis.

Answer 1

1. In the run-up to the launch of the euro, in 1999, aspiring members pegged their currencies to the German mark. As a consequence they were obliged to shadow the Bundesbank’s monetary policy. For some countries, this monetary serfdom was tolerable because their industries were closely tied to Germany’s, and business conditions rose and fell in tandem. But some countries could not live with it. Britain had been forced to abandon its currency peg with Germany, in 1992, because it was in recession even as Germany enjoyed a boom. In the present day, China faces a related conundrum. It would like to open itself fully to capital flows in order to create a modern financial system, in which market forces play a bigger role. Last summer it took some small steps towards that end. But doing so at a time of sluggish economic growth raised fears that the yuan would dive. As markets panicked, China’s capital controls were swiftly tightened..

Both predicaments were a consequence of the macroeconomic policy trilemma, also called the impossible trinity. It says a country must choose between free capital mobility, exchange-rate management and an independent monetary policy. Only two of the three are possible. A country that wishes to fix the value of its currency and also have an interest-rate policy that is free from outside influence cannot allow capital to flow freely across its borders. That was China’s trilemma. If the exchange rate is fixed but the country is open to cross-border capital flows, it cannot have an independent monetary policy. That was Britain’s trilemma. And if a country chooses free capital mobility and wants monetary autonomy, it has to allow its currency to float. That is the two-from-three combination that most modern economies choose.

To understand the trilemma, imagine a country that fixes its exchange rate against the American dollar and is open to foreign capital. If in order to bring down inflation its central bank sets interest rates above those set by the Federal Reserve, this would attract foreign capital in search of higher returns. That would in turn put upward pressure on the local currency. Eventually the peg with the dollar would break. Equally, if interest rates are cut below the federal funds rate, the exchange rate would fall as capital left to seek higher returns in America.

Many emerging markets find that tying the exchange rate to a stable monetary anchor, such as the dollar, can be useful. It is a speedy way to show a serious intent to control inflation, for instance. Indeed this was also the reason why Britain tied itself to the D-mark in the early 1990s. The cost is a loss of monetary independence: interest-rate policy is subordinated to maintaining the peg and so cannot be used flexibly to stabilise the economy. That is why countries are generally advised to float their currencies once they have demonstrated a commitment to low inflation. That way, the currency adjusts to the waxing and waning of capital flows, allowing interest rates to respond to the domestic business cycle. In practice, many emerging markets are fearful of letting the exchange rate move sharply, so they choose to sacrifice either free capital mobility (by introducing capital controls, or by adding to or depleting their foreign-currency reserves) or monetary independence, by giving priority to currency stability over other targets. China wants eventually to liberalise its capital account as a stepping stone to a modern financial system. To do so, it will have to live with a volatile yuan. Three out of three ain’t possible, but two out of three ain’t bad.

2. Asian financial crisis, major global financial crisis that destabilized the Asian economy and then the world economy at the end of the 1990s.

The 1997–98 Asian financial crisis began in Thailand and then quickly spread to neighbouring economies. It began as a currency crisis when Bangkok unpegged the Thai baht from the U.S. dollar, setting off a series of currency devaluations and massive flights of capital. In the first six months, the value of the Indonesian rupiah was down by 80 percent, the Thai baht by more than 50 percent, the South Koreanwon by nearly 50 percent, and the Malaysian ringgit by 45 percent. Collectively, the economies most affected saw a drop in capital inflows of more than $100 billion in the first year of the crisis. Significant in terms of both its magnitude and its scope, the Asian financial crisis became a global crisis when it spread to the Russian and Brazilian economies.

The significance of the Asian financial crisis is multifaceted. Though the crisis is generally characterized as a financial crisis or economic crisis, what happened in 1997 and 1998 can also be seen as a crisis of governance at all major levels of politics: national, global, and regional. In particular, the Asian financial crisis revealed the state to be most inadequate at performing its historical regulatory functions and unable to regulate the forces of globalization or the pressures from international actors. Although Malaysia’s controls on short-term capital were relatively effective at stemming the crisis in Malaysia and attracted much attention for Prime Minister Mahathir bin Mohamad’s ability to resist International Monetary Fund (IMF)-style reforms, most states’ inability to resist IMF pressures and reforms drew attention to the loss of government control and general erosion of state authority. Most illustrative was the case of Indonesia, where the failures of the state helped to transform an economic crisis into a political one, resulting in the downfall of Suharto, who had dominated Indonesian politics for more than 30 years.

The early neoliberal triumphalist rhetoric, however, also gave way to a more profound reflection about neoliberal models of development. Perhaps most of all, the 1997–98 financial crisis revealed the dangers of premature financial liberalization in the absence of established regulatory regimes, the inadequacy of exchange rate regimes, the problems with IMF prescriptions, and the general absence of social safety nets in East Asia.

Echoing these concerns were those who saw the crisis as a function of systemic factors. In contrast with neoliberal theorists who focused on technical questions, however, critics of neoliberalism focused on political and power structures underlying the international political economy. Mahathir’s characterization of the financial crisis as a global conspiracy designed to bring down Asian economies represented the far extreme of these views, though his views did have some popular appeal in East Asia.

Mostly, the widely held perception that IMF prescriptions did more harm than good focused particular attention on the IMF and other global governance arrangements. The IMF was criticized for a “one size fits all” approach that uncritically reapplied prescriptions designed for Latin America to East Asia, as well as its intrusive and uncompromising conditionality. Fiscal austerity measures were criticized as especially inappropriate for the East Asian case and for prolonging and intensifying both economic and political crises. In addition to the criticism leveled at the technical merits of IMF policies, the politics of the IMF and the general lack of transparency of its decision making were also challenged. Limited East Asian representation in the IMF and World Bank underscored the powerlessness of affected economies, as well as their lack of recourse within existing global governance arrangements. Combined, the criticisms of the IMF diminished the prestige, if not the authority, of the IMF, resulting in heightened calls for a new international architecture to regulate the global economy.

The Asian financial crisis also revealed the inadequacies of regional organizations, especially the Asia-Pacific Economic Cooperation (APEC) and the Association of Southeast Asian Nations (ASEAN), generating much debate about the future of both organizations. Criticism focused especially on the informal, nonlegalistic institutionalism of both organizations. However, though ASEAN displayed greater receptiveness to institutional reform, informal institutionalism remains the norm with respect to regional forums in East Asia.