The links of international reserves, exchange rates, and monetary policy can be understood through the lens of a modern incarnation of the “impossible trinity” (aka the “trilemma”), based on Mundell and Fleming’s hypothesis that a country may simultaneously choose any two, but not all, of the following three policy goals: monetary independence, exchange rate stability, and financial integration. The original economic trilemma was framed in the 1960s, during the Bretton Woods regime, as a binary choice of two out of the possible three policy goals. However, in the 1990s and 2000s, emerging markets and developing countries found that deeper financial integration comes with growing exposure to financial instability and the increased risk of “sudden stop” of capital inflows and capital flight crises. These crises have been characterized by exchange rate instability triggered by countries’ balance sheet exposure to external hard currency debt—exposures that have propagated banking instabilities and crises. Such events have frequently morphed into deep internal and external debt crises, ending with bailouts of systemic banks and powerful macro players. The resultant domestic debt overhang led to fiscal dominance and a reduction of the scope of monetary policy. With varying lags, these crises induced economic and political changes, in which a growing share of emerging markets and developing countries converged to “in-between” regimes in the trilemma middle range—that is, managed exchange rate flexibility, controlled financial integration, and limited but viable monetary autonomy. Emerging research has validated a modern version of the trilemma: that is, countries face a continuous trilemma trade-off in which a higher trilemma policy goal is “traded off” with a drop in the weighted average of the other two trilemma policy goals. The concerns associated with exposure to financial instability have been addressed by varying configurations of managing public buffers (international reserves, sovereign wealth funds), as well as growing application of macro-prudential measures aimed at inducing systemic players to internalize the impact of their balance sheet exposure on a country’s financial stability. Consequently, the original trilemma has morphed into a quadrilemma, wherein financial stability has been added to the trilemma’s original policy goals. Size does matter, and there is no way for smaller countries to insulate themselves fully from exposure to global cycles and shocks. Yet successful navigation of the open-economy quadrilemma helps in reducing the transmission of external shock to the domestic economy, as well as the costs of domestic shocks. These observations explain the relative resilience of emerging markets—especially in countries with more mature institutions—as they have been buffered by deeper precautionary management of reserves, and greater fiscal and monetary space.
We close the discussion noting that the global financial crisis, and the subsequent Eurozone crisis, have shown that no country is immune from exposure to financial instability and from the modern quadrilemma. However, countries with mature institutions, deeper fiscal capabilities, and more fiscal space may substitute the reliance on costly precautionary buffers with bilateral swap lines coordinated among their central banks. While the benefits of such arrangements are clear, they may hinge on the presence and credibility of their fiscal backstop mechanisms, and on curbing the resultant moral hazard. Time will test this credibility, and the degree to which risk-pooling arrangements can be extended to cover the growing share of emerging markets and developing countries.
“Reform” in the economics literature refers to changes in government policies or institutional rules because status-quo policies and institutions are not working well to achieve the goals of economic wellbeing and development. Further, reform refers to alternative policies and institutions that are available which would most likely perform better than the status quo. The main question examined in the “political economy of reform” literature has been why reforms are not undertaken when they are needed for the good of society. The succinct answer from the first generation of research is that conflict of interest between organized socio-political groups is responsible for some groups being able to stall reforms to extract greater private rents from status-quo policies. The next generation of research is tackling more fundamental and enduring questions: Why does conflict of interest persist? How are some interest groups able to exert influence against reforms if there are indeed large gains to be had for society? What institutions are needed to overcome the problem of credible commitment so that interest groups can be compensated or persuaded to support reforms?
Game theory—or the analysis of strategic interactions among individuals and groups—is being used more extensively, going beyond the first generation of research which focused on the interaction between “winners” and “losers” from reforms. Widespread expectations, or norms, in society at large, not just within organized interest groups, about how others are behaving in the political sphere of making demands upon government; and, beliefs about the role of public policies, or preferences for public goods, shape these strategic interactions and hence reform outcomes. Examining where these norms and preferences for public goods come from, and how they evolve, are key to understanding why conflict of interest persists and how reformers can commit to finding common ground for socially beneficial reforms. Political markets and institutions, through which the leaders who wield power over public policy are selected and sanctioned, shape norms and preferences for public goods. Leaders who want to pursue reforms need to use the evidence in favor of reforms to build broad-based support in political markets. Contrary to the first generation view of reforms by stealth, the next generation of research suggests that public communication in political markets is needed to develop a shared understanding of policies for the public good.
Concomitantly, the areas of reform have circled from market liberalization, which dominated the 20th century, back to strengthening governments to address problems of market failure and public goods in the 21st century. Reforms involve anti-corruption and public sector management in developing countries; improving health, education, and social protection to address persistent inequality in developed countries; and regulation to preserve competition and to price externalities (such as pollution and environmental depletion) in markets around the world. Understanding the functioning of politics is more important than ever before in determining whether governments are able to pursue reforms for public goods or fall prey to corruption and populism.