The Impossible Trinity, or, Why Latin America Hates QE2

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The Impossible Trinity, or, Why Latin America

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Posted Jan. 19, 2011 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com

Latin America Up in Arms over QE2

Latin America is up in arms over the Fed’s program of quantitative easing, known as QE2

Brazil and Chile, among the most affected countries, have undertaken actions to protect their economies

Why the harsh reaction, when most people in the United States view QE2 as a purely domestic policy designed to reboot a faltering economic recovery?

“This is a currency war that is turning into a trade war.”

—Guido MantegaFinance Minister of Brazil

Photo source: Agencia Brasil, http://commons.wikimedia.org/wiki/File:Guido_mantega.jpg



Making Waves

Fact No. 1: There is no such thing as purely domestic monetary policy in today’s world

Central bank actions of even the smallest countries create ripples in the global financial system

The Fed’s actions can create bigger wavesPhoto source: Malene Thyssen, http://commons.wikimedia.org/wiki/User:Malene


http://commons.wikimedia.org/wiki/User:Malene


How QE2 Affects the Global Economy

The Fed’s purchases of longer-term Treasury securities under QE2 tend to reduce yields on those securities

Paying for the purchases increases bank reserves, putting additional downward pressure on US interest rates

When US interest rates fall, some investors look for better opportunities abroad

Countries like Brazil, Chile, and others experience increased financial inflows

The Federal Reserve Building in Washington, D.C.Photo source: AgnosticPreachersKid, http://commons.wikimedia.org/wiki/File:Marriner_S._Eccles_Federal_Reserve_Board_Building.jpg


The Impossible Trinity

According to the “impossible trinity,” a country can choose only two of the following three:

An independent monetary policy

An open capital account A fixed exchange rate


Effects of Financial Inflows: Variant 1

If a country chooses an independent monetary policy and an open capital account, it must have a floating exchange rate

An increase in financial inflows will cause its exchange rate to appreciate

Consumers and other buyers of imported goods will benefit, but exporters and manufacturers that compete with imports will suffer

If the political influence of exporters and import-competitors is disproportionately great, as is often the case, then the political reaction to currency appreciation will be mostly negative



If a country chooses a fixed exchange rate and an open capital account, it loses independent control of monetary policy

When financial inflows increase, the central bank must buy foreign currency in order to prevent exchange-rate appreciation

It pays for the foreign currency with newly created domestic money

The increased money supply causes inflation, which, in turn, undercuts the competitiveness of exports

This combination of a fixed nominal exchange rate plus inflation can also be described as real appreciation of the country’s currency



A country can maintain fixed exchange rate and use its monetary policy independently to control inflation if it closes the capital account and blocks unwanted financial inflows

Orthodox economics has tended to frown on this option because cutting off financial inflows can deprive the economy of a vital source of capital

In that case, stability of the exchange rate and the price level comes at the expense of slow economic growth


Compromise policy: Partial capital controls

Some countries, including Brazil and Chile, have tried a compromise policy that partly restricts financial inflows without completely closing the capital account

The idea is to filter out unwanted, short-term, speculative “hot money” while allowing inflows of growth-promoting, long-run direct foreign investment

These controls may help in the short run, but they may lose their effectiveness over time


Compromise policy: Sterilization

Another possible compromise, currently being used by Chile, is to “sterilize” foreign exchange market intervention

A central bank is said to sterilize when it buys foreign currency to resist appreciation, and then neutralizes the monetary effects by selling bonds or other non-monetary financial instruments

However, sterilization can be very expensive and may not work well for more than short periods


Why South America Hates QE2

The impossible trinity makes it easier to see why South American finance ministers and central bankers do not like QE2

QE2 causes increased financial inflows, which cause unwanted inflation and exchange rate appreciation

Countermeasures can be taken, but because of the impossible trinity, all countermeasures involve costs and compromises

Photo source: NASA, http://commons.wikimedia.org/wiki/File:South_America_satellite_plane.jpg


But QE2 is Only Part of the Problem

However, QE2 is only one among many sources of Latin America’s problems

As this chart shows, the trend toward real exchange rate appreciation was underway long before QE2

Other causes of currency appreciation in Latin America: Dynamic, well-managed economies that

offer many investment opportunities Increases in world commodity prices

during recovery from the global financial crisis


The Bottom Line: Ripples, but not a Tsunami

The bottom line: QE2 may make life a little harder for Latin

American policy makers, but they have other problems as well

QE2 is making ripples in the world financial system, but hardly a tsunami

QE2 is not the start of a global currency war; It is a domestic program with moderate but unavoidable external effects

In the long run, if QE2 works to speed recovery, US trading partners everywhere will benefit

Business

The Impossible Trinity, or, Why Latin America Hates QE2