Friday, June 22, 2012

Currency Intervention and the Myth of the Fundamental Trilemma

On Monday I linked to an article from VoxEU about the fundamental trilemma of international finance to display the recent massive increase in the Swiss National Bank’s (SNB) monetary base and foreign assets.
“The fundamental trilemma of international finance maintains that a country cannot simultaneously peg an exchange rate, maintain an independent monetary policy, and permit free cross-border financial flows (Feenstra and Taylor 2008).”
A conclusion of that article, which I accepted at the time, was that the SNB had given up control over its monetary policy in order to maintain a currency floor against the euro. Switzerland therefore provided a modern example of support for the trilemma.

The same article was posted over at Angry Bear earlier today. After thinking about the topic for a couple days and following comments by Philip Pilkington, I’m persuaded that my initial acceptance of the article’s conclusion was, in fact, incorrect. This view, in part, hinges on how one defines “monetary policy”, which I interpret as control over interest rates, and an “exchange rate peg”, which I take to include setting a currency floor. As Philip notes:

They could easily maintain control over interest rates by paying a set rate of interest on reserves, just like the US/UK/Japan do with their base rate.
As long as the SNB is willing to acquire unlimited amounts of foreign assets, it CAN “simultaneously peg an exchange rate, maintain an independent monetary policy, and permit free cross-border financial flows." The fundamental trilemma is therefore not fundamental at all, but simply another misunderstanding of our modern monetary systems.

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