China Battles “Impossible Trinity,” by Jim Rickards

A country can’t have an open capital account, fixed exchange rate, and an independent monetary policy at the same time. It can have two out of three, and as the Meat Loaf song says, two out of three ain’t bad, but trying for three out of three can lead to disaster. From Jim Rickards at dailyreckoning.com:

Just because something is inevitable does not mean it cannot be postponed.

The popular name for this is “kicking the can down the road,” which is a perfectly good description.

I prefer more technical terms such as dynamic systems in “subcritical” and “supercritical” state space, but it amounts to the same thing.

A financial crisis can be a long time in the making, but it will definitely erupt. When it does, there will be huge losses for those who ignored the warning signs.

China is in a pre-crisis situation today.

It is confronting the harsh logic of the “Impossible Trinity.”

The Impossible Trinity theory was advanced in the early 1960s by Nobel Prize-winning economist Robert Mundell. It says that no country can have an open capital account, a fixed exchange rate and an independent monetary policy at the same time.

You can have one or two out of three, but not all three. If you try, you will fail — markets will make sure of that.

Those failures (which do happen) represent some of the best profit-making opportunities of all. Understanding the Impossible Trinity is how George Soros broke the Bank of England on Sept. 16, 1992 (still referred to as “Black Wednesday” in British banking circles. Soros also made over $1 billion that day).

The reason is that if more attractive total returns are available abroad, money will flee a home country at a fixed exchange rate to seek the higher return. This will cause a foreign exchange crisis and a policy response that abandons one of the three policies.

But just because the trinity is impossible in the long run does not mean it cannot be pursued in the short run. China is trying to peg the yuan to the U.S. dollar while maintaining a partially open capital account and semi-independent monetary policy. It’s a nice finesse, but isn’t sustainable.

To continue reading: China Battles “Impossible Trinity

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