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On the trinity for the economic agnostics

Published at: 25-01-2019

Posted on: January 25th, 2019 by RaduC No Comments

“Somebody asked me the other day if I saw a threat of a self-induced crisis in Romania despite a stable international environment. A legitimate question because, in my opinion, if the 2008 world crisis hadn`t happened Romania might have been carried on with the massive current account deficit at the time. Because capital inflows would have continued for a while sustained by investors` exuberance. The moment that made everybody realize that “the emperor had no clothes” came with the crisis which stopped the capital flows financing our deficit.

As a result, I don`t think that there is an imminent danger in the current situation as long as the external environment remains favorable, despite the clearest negative internal tendencies: inflation goes up, foreign deficits go up as well, the currency devalues, and the economy “is roaring” far beyond its potential. These are circumstances where the NBR has to apply the brakes. This takes me to the main scenario which could cause possible economic deviations likely to throw the economy into a crisis in the absence of an external one: the NBR losing its independence and, implicitly, it’s ability to brake in time.”

This is a comment which I made 10 months ago in   a post entitled “The Fed and the NBR undermine the economy”. And here we are, in a situation where the independence of the NBR [the Romanian central bank] is heavily tested. The 2% benchmark interest rate for the interbank market (ROBOR) recently set by the government to apply irrespective of economic circumstances, based on which banks will be charged a tax, pushes the central bank into a corner. Any rate hike by the latter makes a system crisis across the overly taxed banking system more likely, as an increased ROBOR interbank rate is set against the 2% benchmark decided by the government. To put it differently, the monetary policy stopped being independent, and is now contingent on a fixed interest rate set by the government. This amounts to a de facto amputation of the monetary policy.

But things do not stop here. The government wants a more stable foreign exchange rate as well by using, when needed, the central bank`s foreign-exchange reserves. The utopia is having the NBR maintain the stability of both the foreign exchange rate and interest rate, no matter where the government`s fiscal or economic policies are headed.

The bad news for the economic agnostics is that there is a trinity that they will have to take into account, sooner or later. It goes by the name of “the impossible trinity” and it is an economic concept which states that a country cannot have a fixed foreign exchange rate, an independent monetary policy and free capital movement at the same time.

A country, such as Bulgaria, with a Monetary Council that pegged the Lev to the Euro, allows interest rates to fluctuate freely, and automatically absorbs shocks caused by capital inflows and outflows. The vast majority of economically mature countries have, however, central banks with independent monetary policies which goes hand-in-hand with foreign exchange fluctuations against a backdrop of free capital movement.

This is a concept that I teach at my Macroeconomics class which unfortunately is not attended by those who take macroeconomic decisions. The Romanian economic agnostics are either ignorant, or seem not to believe in the “impossible trinity” and push to take control over two of the three variables. This will only be possible if free capital movement comes to an end (one of the prerequisites which allowed Romania to be deemed a functional market economy) or if the foreign-exchange reserves are used up.

The actual application of any of the two options is unthinkable. There have been other countries playing with this fire and got badly burned. The only option left is a return to normal: leave the NBR to set the interest rates as it sees fit, and have the foreign exchange rate reflect the economic performance. Let us not break the mirror just because we don`t like what it shows us.

Have a nice weekend!

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