Policies and polities

MANY excellent economists have observed that globalization is a “golden straitjacket”. Many authors who have related openness to growth and so forth have discussed just how golden the jacket is. But how strait are the constraints imposed by financial openness on macroeconomic policies has not been equally accounted for. The “under-researched” situation of the trilemma emerges as a curiosum, but this state of affairs may partly explain – and be explained by – the fact that the trilemma itself seem to be disregarded by policymakers. Nevertheless, the new phase opened up by the pandemic and the U.S. elections leaves no room for mistakes regarding the critical mass the trilemma holds. In the words of Keynes, we are more in a world of international socialization of investments than in a world of national self-sufficiency, despite the U.S.-China quarrel that is here to last.


In a seminar held at Istanbul Bilgi University some years ago, Professor Walter Russell Mead from Yale, offered to a sizeable audience some interesting food for thought. I shall try to convey his views on the history of American foreign policy in a nutshell first, and I shall proceed with the “clinging associations” thereafter. Prof. Mead thought American foreign policy feeds its students with some simply construed and easily understandable constants, which also serve as historical landmarks. Accordingly, there are four periods: 1776-1823, 1823-1915, 1915-1947 and 1947 onwards. There are also four schools of thought: Hamiltonians, Wilsonians, Jeffersonians and Jacksonians. Hamiltonians are named after Alexander Hamilton, the secretary to George Washington. Jacksonians are so labelled because their foreign policy stance reminds us that of Andrew Jackson, the 7th President of the U.S. Jeffersonians and Wilsonians call for no particular explanation, I believe.


Hamiltonians thought the British world order – with the UK, standing as it was, as the world hegemon – was rational and appealing enough to the newly-born U.S. to be seen as an example to be followed. American interests could best be defended by accepting the supremacy of the UK and by giving a good fit to the international system Britain had already designed. Something like “commerce internationalism” would sufficiently justify this stance: Globalization of commerce would make everyone better off – a Pareto improvement – and other nations were bound to understand this fact and behave accordingly. The legitimacy of intervening in the world outside follows suit as a logical corollary, but this stance entails no fundamental beliefs and need not carry claims as to how other nations should be ruled. Some kind of post-modern revisionism and relativism could well fit into this rather pragmatic standing. In brief, a true Hamiltonian would utter “maintain the world order, promote international free trade, send troops afar if need be, but do not teach lessons to other people about how their public spheres ought to be organized”.


Wilsonians have, admittedly, stronger and far more substantive claims. They advocate universally valid –so they think – values that every nation should in the end be imbued with from a moral standpoint. Simultaneously, they would claim that anything short of a full admittance of a set of commonly defendable moral values could not possibly result in a situation that best serves American interests. Democracy, human rights, etc. should all become elements of a common denominator, beyond which evil lies. Wilsonians passed their formative period in the heyday of Leninist universalism. Bolshevism naturally shaped their outlook as the prime enemy and rival. They had to stick to a formidable set of fundamentally moral ideas and supply at least the semblance of a complete system of values capable of facing the appeal of communism squarely. As such, they are more ideologically motivated than the proponents of the other foreign policy schools, since their historical opponents were so.


Maybe Wilsonians are to American foreign policy what Trotskyites are to the Comintern, or at least this is the analogy provided by Prof. Mead. If we were to pursue this analogy, Jeffersonians would emerge as the Stalinists of the American foreign policy establishment. Jeffersonians are the “capitalism and democracy in one country” guys and they do not want to interfere with the affairs of the outside world. But, once they do, they would go to the end if need be. Jacksonians are alike in a sense, but they carry further ideological loads. The purely Jacksonian distinction between the “honorable” and the “dishonorable” enemies, for instance, may easily account for many an all-American political and military conduct, including the treatment of Japan in WWII and that of prisoners – suspected to be al Qaida contacts – held in Guantanamo after 9/11. Prof. Mead believed nothing substantial would change should any president lose the gambit in the forthcoming elections. The style might change, of course, and that is something, but the direction of American foreign policy would not and could not easily change. This is perhaps good advice, because the essential load and the directional derivative that carries it don’t go adrift as presidents from different parties alternate. The essence remains the same, and we now see signs of a return to the Obama Doctrine of 2014, albeit with small differences.


Then what? In the new international scene that admits less arbitrary decisions, the global economy and financial flows would also move accordingly. Indeed, after the outbreak’s first phase, a rule-based monetary order is a desideratum. Just as an example, a wide Turkish audience has already heard of a certain trilemma, notably from the writings of some economic journalists, though they are more often than not academic economists as well. Indeed, at the most general level, policymakers in open economies face a macroeconomic trilemma. Typically, they are confronted with three typically desirable, yet contradictory, objectives: (1) To stabilize the exchange rate; (2) To enjoy free international capital mobility; (3) To engage in a monetary policy-oriented way toward domestic goals. Because only two out of the three objectives can be mutually consistent, policymakers must decide which one to give up. This is the trilemma. If monetary policy activism (3) is taken to mean the ability to drive local interest rates away from the world rate, then arbitrage in open capital markets (2) and simple interest parity under a credibly fixed exchange rate (1) clearly defeat the objective. Despite the clarity and simplicity of this prediction, one is surprised by the frequency with which the lessons of the trilemma seem to be disregarded by policymakers, even today. This might reflect the lack of empirical studies showing how tight the constraints of the trilemma really are.


Monetary policy autonomy (3) can be viewed as either a quantity (money supply) or a price (interest rate) arrangement. Except Bundesbank’s well-known insistence on targeting money supply, partially reflected in the words – if not always the deeds – of the ECB, short-term interest rates suffice to characterize monetary policy. And it is the nominal rate of interest that is the policy instrument of central banks, not the real rate. Furthermore, the trilemma says that, under free international capital mobility, credibly fixed exchange rates imply that the nominal interest rate in the pegged country must equal that of the center country. This does not mean real interest rates ought to be equal, however. What the trilemma says is this: If capital mobility is allowed, a small open economy can only control one among the two rates; the nominal exchange rate and the nominal short-term (policy) rate of interest. If there are effective capital controls, a country can simultaneously maintain a hard peg and use the nominal interest rate as a policy variable. Then, the question would collapse to just how credible the peg is. If the capital account is open and the currency is pegged, the monetary policy autonomy is lost. But the question would be the same nonetheless: How credible is the peg? Only, in the former case there is no “hot money”; in the latter, there is.


Now, there are basically three episodes in the history of the international monetary system: The Gold Standard, the Bretton- Woods and the aftermath. The trilemma may have been an effectively binding constraint in all three, but more research is needed to document its operational efficacy over the long span. The Gold Standard was a period of fixed exchange rates, unfettered capital mobility and limited monetary independence. Bretton-Woods provided another fixed-rate system – fixed but adjustable – with ample monetary policy autonomy, a Keynesian feature. Therefore, capital mobility was strictly limited.


In today’s world, most countries have dismantled their post-WWII system of capital controls. Hence, they had to give up either the exchange rate or the interest rate as policy instrument. Some have chosen to float and enjoyed monetary independence whereas others have fixed and tied their hands. Those who vacillated under “soft pegs” lost credibility all too often and endured crises. Stop-go cycles or abrupt policy changes will be conducive to worse results in the near future.

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