EMU and the ‘Trilemma’

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The trilemma holds that economic policy must sacrifice one of the following three items: open capital flows, fixed exchange rate, monetary policy independence. For reasons that I won’t explain here, policymakers must forswear macroeconomic demand management completely (not just monetary policy) if they choose peg+open capital flows. And if they choose peg+independent macro management, then they will ultimately need to close not only the capital account (investment flows) but the trade account as well, because capital controls will be evaded via the trade account (e.g. through misstated invoicing).

If EMU-integrity is seen as a ‘Maginot line’ for the European project, then we have to be honest about the consequences. Will the citizens of a democracy put up with interminable austerity and rising unemployment? If not, and if EMU-integrity is sacrosanct, then the trilemma suggests that capital controls are the only option, because they can be combined with a fixed currency and internal demand-management policy (reflation). (‘Fixed-currency’ is relevant here despite having a unified currency, because a reflationary policy will require the emission of a parallel legal tender.)

Capital controls would by necessity have draconian ends, for the reasons already stated. But if EMU is seen as inviolable, it might be the unforeseen consequence. Sadly, Europe has been here before — in some respects, precisely here. But that’s another story.

One reply on “EMU and the ‘Trilemma’”

  1. The ‘other story’? Sure, that’s central Europe after 1931. They needed to keep their gold-standard pegs in order to repay debts in a ‘strong’ currency, but they couldn’t afford such overvalued exchange rates. Hence capital controls and, ultimately, ‘exchange clearing’ which was the jargon for draconian capital AND trade controls. Read ‘International Currency Experience’ by Ragnar Nurkse (Princeton/Geneva, 1944) for the gruesome details.

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