Yet another 60 second clip from the Open University (there are only 6, so the last will be up tomorrow).

Whatever else is going on, there are usually three big topics of conversation on the government criticism table:

  • The Exchange Rate (it’s either too weak or too strong)
  • Interest Rates (are either too high or too low)
  • Free Capital Flows (it’s either money coming in or money going out)

And all of those are linked to the fact that people trade.

The trouble is: empirically, trying to manage all three is a fail.

Let me try and articulate this into examples. Let’s say that you’re a small African country that has recently seceded from Sudan. You’re new on the map, but you have plenty of oil reserves and you’re preparing your debut onto the world stage. You invent a new currency (the pound), and you appoint a new minister of finance who has to make some decisions.

Playing With Exchange Rates and Interest Rates

Let’s say that he decides to fix the pound at 1:1 to the US dollar (fixed exchange rates), and fixes the interest rate at 2% in order to encourage investment spending by the new residents of this country (after all, it needs to be built up). That’s two members of the awkward trilemma. What would happen to the swathes of foreign money?

If I was a foreign investor, I would say: “A 2% return on my money¬†in a new country that’s just come out of civil war and completely lacks infrastructure?!” That would be a hell no, and I just would not lend my money to South Sudan’s government.

Meaning that the country would be left without vital foreign capital, which makes for extraordinarily slow economic growth. After all – oil reserves are wonderful, but if there are no roads and running water, then those oil reserves suddenly became extraordinarily expensive to access.

So the Minister says: “no, I’d prefer to try and keep foreign money here, so let me rather allow the interest rate to float freely.”

Managing Exchange Rates and Capital Flows

If I was a foreign investor, and I was looking at a new country that’s just come out of a civil war and lacks infrastructure, and I saw that it wanted my money and was prepared to negotiate on interest rates, what would happen? I would demand really high interest rates to compensate me for the risk.

Which would result in crippling government debt (and it’s what happened to many of the newly-liberated African countries in the 1960s, 70s and 80s).

Also: it might result in speculation against the currency (see Bruno Iksil: the Volkermort of JP Mogwarts for a brief explanation of how George Soros broke the pound).

So the new finance minister eventually declares: “Bugger it – we’ll just set interest rates.”

Managing Interest Rates and Capital Flows

The government sets interest rates, and allows the movement of foreign capital to determine the exchange rate (ie. a floating exchange rate regime).

Which has a delightfully free market flavour that makes it the trilemma choice that most countries make.

However, it does make a country particularly vulnerable to sudden movements of hot money (speculator money).