Assessing the Emerging Global Financial Architecture: Measuring the Trilemma’s Configurations over Time
NBER WP # 14533
While the epicenter of the present liquidity crisis has been the US, the growing financial integration and the deepening globalization implies that the claim for the “decoupling” of developing countries from the rapid deterioration of the economic climate in the US is wishful thinking. Indeed, developing countries that on average benefited from the growth bonus of growing international trade, and improving terms of trade, are facing now the darker side of globalization – the rapid decline in trade, sudden stops and capital flight, propagated by the flight to quality and the unwinding and deleveraging of past financial inflows to developing countries. While there is no way to avoid the need to undergo the stabilization blues, the hope is that the stronger initial position of developing countries would allow them a softer landing. A key dimension of this position is the choices countries make with respect to the Trilamma — exchange rate flexibility, monetary independence and capital mobility. In a recent paper, we develop a methodology that allows us to characterize in an intuitive manner the choices countries have made with respect to the trilemma during the post Bretton-Woods period. We find that since 2000, measures of the three trilemma variables have converged towards intermediate levels characterizing managed flexibility, using sizable international reserves as a buffer, thus retaining some degree of monetary autonomy. Using these indexes, we also test the linearity of the three aspects of the trilemma: monetary independence, exchange rate stability, and financial openness. We find that the weighted sum of the three trilemma policy variables adds up to a constant, validating the notion that a rise in one trilemma variable should be traded-off with a drop of the weighted sum of the other two.