Something did come out of the Federal Reserve conference in Jackson Hole, Wyoming this year, but it was not anything that was expected, nor was it from any of the "main" players in the world of monetary policy and finance.
The something that came out of Jackson Hole this year that seems to be catching everyone's attention and is being written about and talked about "literally" throughout the world, is the paper written by a London Business School professor, Hélène Rey. This paper takes on the received knowledge of the economic world referred to as the "trilemma" problem.
The "trilemma" problem concerns the situation that exists in international economics relating to the free, international movement of capital, fixed exchange rates, and the independence of a country's monetary policy. The conclusion reached by economists in this discussion is that a country cannot maintain all three of these objectives. It is possible for a country to achieve only two.
John Maynard Keynes, although he did not state the specifics of this problem, developed a policy for the post-World War I environment that minimized the free movement of capital between in the world while keeping fixed exchange rates. This allowed him to assume that a country could follow an independent monetary policy that could be used to maintain full employment in the country and prevent England, and other countries, from being taken over by the revolutionary ideologies floating around at the time, which he was so afraid of.
This idea was later adopted at the Bretton Woods conference that created the post-World War II international monetary system. (See the review of an important new book discussing the creation of the Bretton Woods system, "The Battle of Bretton Woods.")
The Bretton Woods system was finally brought down as the 1960s saw a resumption of international capital flows that eventually resulted in the United States floating the US dollar in August of 1971 in order to be able to maintain its monetary independence.
Since this time, the global economic scene has basically allowed the developed nations to conduct their own independent economic policy by working in a world of floating exchange rates that permitted the free flow of capital between countries.
Now, Ms. Rey is challenging this working model as it impacts emerging nations. Her research has led her to the conclusion that the free flow of capital may inevitably result in the loss of monetary policy independence in these countries. The problem for these emerging nations is really a "dilemma" and not a "trilemma."
This is the apparent difficulty. When a country, like the United States, conducts a monetary policy independent of the monetary policies of all other countries, international capital flows can cause problems to these other countries. But, for emerging countries the international capital flows can be so large relative to the capital markets in the countries themselves that the flow of money can overwhelm the emerging markets.
For example, it is argued, that as the United States conducted a monetary policy that lowered its interest rates relative to those in other countries, especially relative to the interest rates in some emerging countries, large capital flows left the United States and went into these emerging nations because of their higher interest rates. These large capital flows can cause the currencies of these emerging countries to rise in foreign exchange markets, hurting their exports, while still creating "credit bubbles" that cause dislocations of economic resources.
The central banks can attempt to intervene in the foreign exchange markets to keep in order to "neutralize" the inflows of money chasing the higher interest rates, but "credit bubbles" are still created. And, this situation can even occur in cases where fixed exchange rates are used.
That is, the behavior of the Federal Reserve System attempting to stimulate the US economy and get the country back to higher levels of employment can overwhelmingly flood the world with US dollars so that emerging nations are impacted and cannot conduct their own independent monetary policy regardless of the foreign-exchange rate system in place.
The downside problem is that if the United States moves in the opposite direction, the situation reverses itself with international capital flows moving in the opposite direction.
The relevance of this argument is that the appearance that Federal Reserve System is considering moving to a "less expansive" stance in its monetary policy. The idea here is that if expectations are for the Federal Reserve to purchase $85 billion in securities each and every month and that this policy is underwriting the economic activity in the emerging nations, a reduction in purchases will mean that the Federal Reserve is "tightening" up on its monetary policy. This creates, in the mind of investors, that we are now moving into what I called in the last paragraph the "downside problem."
As a consequence, the Indian rupee has plunged by 23 percent against the US dollar since early May. The Indonesian rupiah has fallen 16 percent over the same time period while the Turkish lira has dropped by 15 percent. This is all consistent with the research of Ms. Rey and it is why her paper has received so much attention.
The problem seems to be that the relative size of international capital flows that have resulted from Federal Reserve actions have overwhelmed the global financial system. According to the "trilemma" problem, a rise in international capital flows with floating exchange rates would result in the exchange rates changing to levels that would eliminate these flows.
As a result of the Asian financial meltdown in the late 1990s, almost all Asian countries moved to abandon fixed exchange rates. Yet, the situation here in 2013 indicates that even with floating exchange rates, the overwhelming size of the capital flowing out of the United Stats into Asia…and elsewhere in the world…have not resulted in exchange rate fluctuations large enough to offset the flows. And, in several cases, central bank interventions into foreign exchange markets may have kept foreign exchange markets from clearing.
This has all made the imposition of capital controls attractive to many monetary officials and economists. There is more talk now about how bringing back monetary controls might be able to allow for continued country independence in terms of the conduct of monetary policy. This is a conclusion that is drawn from the work of Ms. Rey where the only choice is between an independent monetary policy and free international flows of capital.
There might be one other point to address, however. This point leads to the following question: Does a country that can create such massive international flows of capital that it can disrupt the economies of other countries have any responsibility to conduct its affairs with sufficient discipline so that it does not harm these other countries through its independent actions?
I have written many posts over the past five years discussing how the United States government, over the past 50 years, has conducted a policy of credit inflation that has resulted in the breakup of the Bretton Woods system and the value of the US dollar being almost 30 percent lower today than it was forty years ago. And, yet it still is the world's reserve currency. To me, the problem Ms. Rey's research points to is that the United States can do just about anything it wants to in the area of economic policy regardless of how it impacts other nations. If the United States wants to inflate the world…damn the consequences on the rest of the world. If the United States wants to "taper" the purchases of its central bank…then like it or lump it. We'll do what we like!