Jay Shambaugh on the Macroeconomic Trilemma, “The Impossible Trinity”

Sticking to the “Macroeconomic Trilemma” principle is an important task to help maintain macroeconomic stability, as any major deviation may lead to a financial catastrophe.

Jay Shambaugh is a professor of economics and international affairs at The George Washington University and a former member on the Council of Economic Advisers (CEA). Jay joins Macro Musings to discuss his work on the “Macroeconomic Trilemma” (or “Impossible Trinity”): the problem that a country cannot maintain a fixed exchange rate, free movement of capital, and an independent monetary policy all at once. He also shares stories from his time at the CEA as well as thoughts on current monetary policy both for the U.S. and the Eurozone. 

Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].

David Beckworth: Jay, welcome to the show.

Jay Shambaugh: Thanks very much. It's great to be here.

Beckworth: We're glad to have you on. We've followed your work over the years, and I would like to know, how did you get into economics, and particularly, into international economics?

Shambaugh: I think how I got into economics, my dad worked in the finance industry some. And I think, as a kid, just talking to him about unemployment and inflation. And so it's late seventies, early eighties, and topics of what's going on with inflation or why is unemployment so high were very much things you saw in the news. I think how i got to international economics was I was always interested in the international affairs side of things. I actually don't know that I intended to be an economist. I was always interested more from the international affairs angle, and then some combination of interest and comparative advantage kept always drawing me over more towards economics. And so I found myself always kind of fascinated with watching currencies move around. But less so the financial industries side of that as much as the who's making the choice that's driving these things. What are the fundamental policy choices being made, and how is it having all these big effects in the world were always things that seemed to interest me and then eventually I went and got a PhD to study them and think about them more.

Beckworth: I think you're right. And it's hard to understand the world without understanding economics.

Shambaugh: Yeah, no, and I think that was... I, in some ways, almost tried to avoid getting a PhD in economics because I was enjoying kind of just thinking about it and studying these issues, and then eventually realized if I really wanted to work on them in detail, I needed to go and kind of tool up and get the training to be able to think about these issues. So I think you meet some people in econ PhD programs who they're in some sense applied mathematicians looking for a subject. And then there are people who come from the other direction, which is definitely where I came from, which was the you're interested in a topic, and you're getting the skills and the tools to be able to think about it more deeply.

Beckworth: Well, let's talk about your time at the Council of Economic Advisors. Tell us about the roles you played there, what topics did you cover, and what was the interaction with policy makers?

Experience with the Council of Economic Advisors and QE2

Shambaugh: So I had two stints at the CEA. I was there from 2009 to '11. I came in on staff as a senior economist, which is kind of where they bring in people who are either assistant or associate professors usually. You come in, you spend one year, you're kind of dedicated to a topic. So mine was international econ, which meant I covered kind of all of international macro and international trade. So academics makes you specialize very narrowly, and when you get to the CEA, you realize you are the person who's covering this very broad portfolio. And then I stuck around and did a second year at the chief economist, where I kind of had a broader portfolio. And then I came back for the last year and a half of the administration as a member. Where there you have a much bigger portfolio, just because they're only... There's a chair and two members, so the kind of two members as deputies basically divide the world in half. And so I had kind of this broader portfolio of things like international and macro and competition and housing and energy, environment, things like that.

Beckworth: Well, while you were there, what international issues were at the forefront? What were simmering?

Shambaugh: So I think all along, trade policy, there's always issues, questions of... They can be incredibly minute as the kind of 30-year fight over bananas between the U.S. and the EU rolls on, things like that, where you think, "This doesn't seem very important," but then you realize it's all precedence and it's all about are you enforcing the rules or not. And so there were a lot of issues along those lines. And then on the international macro side, certainly our relationship with China was always in some sense front and center. When I was first there, China had re-pegged and had... They had been allowing a slow appreciation against the dollar and then they'd re-pegged during the crisis and that was something that was making everyone very nervous, the question of how would... Was China expecting to go back directly to kind of the old growth model of purely export live growth, just depend on the U.S. consumer as an engine. And we were sitting there trying to say, "You're a much bigger country now. That's not really a viable growth model for you, and it's not sustainable for us." And I think actually over time that message did sink in on both sides that we're not going back to the mid-2000s. That's not a growth model for the world that works, and not a growth model for China and the U.S. that works.

Shambaugh: And then, interestingly, on the flip side coming back, I got back just a couple weeks after China had tried to change their exchange rate regime in some way and how they were setting the overnight rate that led to a lot of uncertainty in the markets and led to fairly persistent depreciation of the RMB against the dollar, which then had its own flip side of discomfort in the U.S. It's this kind of a deliberate competitive attempt or is this they really have lost control here, in which case the markets would occasionally flare up and you'd see things in August or in January 2016 where everyone was very nervous in the markets, and you start worrying, is this going to spill over much more broadly. So there were always interesting questions there.

Shambaugh: Europe was, of course, always the other thing going on. In some ways, it was always this thing where we had thoughts and opinions, and we would share them, but and sometimes I think they were shared and really listened to. I think how much Europe wanted to hear from the U.S. varied over the course of the last seven years and how much they were just entirely trying to deal with disagreements within European governments.

Beckworth: And the Eurozone crisis is a tough nut to crack. We'll talk more about that later. But during your first stint, was QE2 going on? Because I remember that created some international tension. Did you have to deal with that?

Shambaugh: Yes. So only to the extent that at various international meetings, whether it was at the OECD or whether when we'd have dialogue with China, CEA was often the people sitting next to the fed. And so if they started yelling at the fed, we would basically duck and quite literally.

Beckworth: Incoming.

Shambaugh: Yes. And, frankly, they wanted us to. From our perspective, the White House was not going to comment on monetary policy, and for that matter, the White House wasn't going to comment on exchange rate policy. That was being left to... Treasury Secretary was the person who talks about the dollar, and the fed is the person who talks about monetary policy.

Shambaugh: Actually, for me, as someone who studies international macro and currency, it was often a somewhat ironic position that the only things I wasn't allowed to talk about were the things that I felt like in some sense I knew the most about. And everything else was fair game. But certainly QE2 was something that the fed was taking flak for while we were there at times. The question of you're debasing your currency and you're exporting inflation and things like that was something we were certainly hearing a lot of. The fed would obviously then take the position we're gearing at our domestic economy, that's our job, that's what we're doing. If there's spillovers, that's not what we're focused on. We're not doing this to deliberately make the dollar cheaper, we're doing this to stimulate the economy. And they would argue the spillovers from that were frankly more positive to the rest of the world then whatever the other spillovers were.

Beckworth: I wonder what your take is on the effect QE2 had on China's real exchange rate in the sense... So before the crisis, as you mentioned earlier, the big criticism was China was undervaluing its currency and today we think it's where it should be or maybe even a little higher than it should be. But between that period there's some adjustment taking place. Did QE2 force that inflation into China and cause a real appreciation at all?

Shambaugh: I actually don't think it did too much of that. And I think where you really see it is where they started to face trouble was when in some sense most of the accommodative policy ended in the United States. And the run-up from mid 2014 to early 2016 and the dollar was just something that basically a year in they look around and realize, "Well, we've been staying basically flat with the dollar, but we've appreciated ten percent or more on a trade basis." And that's what eventually led them to try to switch the exchange rate regime and say, "Well, we've got a de-link from the dollar. We can't have all the focus be on the dollar/RMB because sometimes we don't want to ride with the dollar. And I think they correctly could see that the fed was going to be tightening before everyone else, and they didn't want to go for that ride. Of course, they'd already caught most of it by then. And they were trying to, in some sense, unwind a lot of that.

Shambaugh: So in some ways, despite, when other countries would complain about the QE policies or things like that, from China's perspective, there are some advantages, right? They can stay constant with the dollar and get cheaper against the world, or they could even crawl up slightly against the dollar, which made our loculars in the United States very happy, and they weren't getting any more expensive against the rest of the world. And so it was when that ended, and all of a sudden they were going the other way with us that I think it really became a challenge for them.

Beckworth: That's a fair point. I've brought that up with previous guests too, that appreciation from mid 2014 up until the end of 2015, and there's been some up and down. It's kind of plateaued. But that's almost over 20 percent appreciation in the dollar, which is really rapid rise, and China was tied to that, which is mind blowing. They have their own internal problems, and on top of that, they were going to tie themselves to the dollar ship and be pulled up.

Shambaugh: Yeah, we used to drop interest and say there were kind of three great waves of dollar appreciation you've seen since 1973, and this was one of them. No, this is not a blip. This was a real and concerted and very rapid rise in the dollar. And any country that was pegged to the dollar for that run was suddenly finding themselves a lot more expensive against their trading partners. And so I think that's why China wanted to both de-link a little bit from the dollar, but also I think they somewhat quite clearly wanted to get some of that back. That they weren't comfortable just staying flat on a trade weighted basis. They felt like they had run up too much and they wanted to unwind some of that. And so they allowed that to happen.

Beckworth: Let me ask you about this. This is a nice diversion into Fed policy and its international reach. So I think one of the key reasons that it went up is the Fed started talking up rate hikes. Janet Yellen comes in. I think she needs to prove herself. She's talking up rate hikes. Also the economy. I mean, there's some fundamentals. The Fed kind of following the fundamentals to some extent. And so they're talking up rates. Meanwhile, the ECB and the Bank of Japan are talking down. They're going negative. So you have this big diversion, the expected path of interest rates between the U.S. and the other two big money centers are diverging rapidly and that drives up the dollar. And there's all these concerns with this. Number one, there's a large number of countries that are loosely or tightly or in between pegged to the dollar, right? The dollar block. China's one of them you just mentioned. That's one thing. So whatever the Fed does, they kind of have to go along for the ride. If Fed does tighter monetary policy, they take it.

Beckworth: The other concern is the BIS, the Bank for International Settlements reports there's about ten trillion dollars or so of dollar denominated debt out there, outside the U.S. that foreigners have to bear the liability. So if the dollar goes up and their currencies don't keep up with it, the real debt burden for them goes up as well. So there's many stresses through which the Fed policy can affect the world. I think Governor Brainard has been mindful of this.

Shambaugh: Yes.

Beckworth: But my sense is as a whole, and maybe I'm being unfair. Push back on this. And I know they have a domestic mandate, but the extent to which when they set monetary policy they really are messing things up in the global economy.

Recent Fed Policy and the Global Economy

Shambaugh: I think they are aware of it. I think the way you see that they're aware of it is that the hikes they did were nowhere near the pace they expected to be. And so they're aware of it to the extent that that the feedback kicks in and that affects the things that they are quite carefully looking at. So the dollar gets stronger, commodity prices go down, and they suddenly find themselves with much, much, much less pressure on prices than they were expecting. They say, "Well, boy, unemployment's low. The economy seems like it should be hitting the point where you start to see pressure, but there was no pressure in inflation." And so they did. And in some sense to their credit, they deviated from the path they had laid out and said, "We don't need to go as fast." And I think you see that... I mean, the one thing I will say about the ten trillion dollars in liabilities abroad, there are a lot of assets too, right?

Beckworth: That's a fair point. Yeah.

Shambaugh: And so one of the differences I think today versus, say, 1997, this is work I've done with Philip Lane back when he was an academic. He's now the head of the Central Bank of Ireland. But is looking at the currency composition of balance sheets of countries. And if you go back far enough, emerging markets were just incredibly short foreign currency, right? They borrowed in foreign currency. They had no assets. But over time, they built up a lot of assets. And they started taking on more debt not in foreign currency. There's still a lot of it, but they've taken some FDI and equity that's effectively local currency. And so one of the things you saw in this crisis was countries depreciated and didn't turn into basket cases immediately. And that was really important. You saw in some sense both in 2008 and '09 and then again in the Taper tantrum. You saw big moves in currencies at times.

Shambaugh: And then in some sense the other shoe didn't drop. There wasn't some massive financial crisis where all of their banks were insolvent because they'd borrowed so much in foreign currency and had no assets. You actually saw the emerging markets do better than... They were in some sense dragging along the U.S., Euro, Japan, slow growth regions during the crisis. So I think it's out there and it's got huge impacts in some countries where they are short foreign currency or frankly, in a lot of cases, they're not short foreign currency, but they're short dollars. And so when the dollar runs differently from everyone else, that has real impacts.

Shambaugh: But I do think it winds up being kind of this complicated set of things where it's also sometimes you can have banks in China short dollars, the government's got three trillion of them. So their assets are suddenly worth a lot more. Now you have to figure out, "What do we do within our economy?" We've got some either institutions or the government with assets that are appreciating and others where their liabilities are appreciating and do you just wash those out together or do some go bankrupt and some not? And so I think that's where it certainly has big effects. And I think dollar movements and fed policy has big impacts on the rest of the world.

Beckworth: Well, that's encouraging because I get the impression, which may be a poorly informed one, that this is a big deal. But what you're saying is it's not as big of a deal because balance sheets are better diversified and you don't see the problems you saw in the emerging market crisis.

Shambaugh: I don't want to say it's not a deal because, frankly, when we were being asked, "What are the things that scare you?" When I was at CEA, we would talk about rapid credit growth in some countries and the extent to which a lot of it was dollar based. And so that was something that made us nervous. I guess what I'm saying is that I think the headline numbers don't mean the same thing they used to, in the sense that there are... Yes, there are liabilities, but there are assets in some cases, too. And, again, sometimes there aren't. Sometimes it's Indian multinationals who can borrow in New York, and then they turn around and invest locally and they're basically doing carry trades. And that's really dangerous.

Beckworth: Right, right.

Shambaugh: It's the old picking up nickels in front of steamrollers story. And that's all well and good, as long as you're faster than the steamroller.

Beckworth: So going back to the Fed just briefly here. So you make a fair point that the Fed failing up to its four hikes that it had promised was either a direct or an indirect recognition by them that their policies do have global ramifications.

Shambaugh: Yeah.

Beckworth: So and maybe to be fair to them as well, maybe they are very aware of the feedback effect, but given their domestic mandate, they can't say, "Hey, we're not going to raise rates because things around the world are blowing up." They've got to say they're doing things because of domestic inflation or domestic activity.

Shambaugh: Yeah, and I think that's even something that you've seen through the G7 and the G20. Everyone encourage everyone else to behave this way. There was a lot of pressure on Japan at times to say, "Look, if you want to... If Abenomics means a rapid increase in the money supply, that's fine. And if all of us sitting around the table can do the math and say a rapid increase in the money supply is going to lead to yen depreciation, we're not going to say anything about that. But if you start saying you're targeting yen depreciation or if you start talking down the yen because you're trying to make it move, that we have a problem with."

Shambaugh: And I think you've seen in a lot of the statements from the G7 and especially statements along the lines of we'll use domestic tools for domestic purposes. And as long as the fed is saying, "Hey, we're looking at our mandate," that doesn't mean you don't think about how the international channels feed into your mandate, but probably is from a global perspective, something they'd prefer not to make the front and center thing to say, "Boy, the dollar's expensive, we're not going to hike." I think is something that would make everyone else around the world uncomfortable. And then they'd sit there and say, "Well, then, why can't I target my exchange rate and try to become cheap?" And so I think the view is the spillovers are there. And it may be the case that sometimes they don't anticipate the spillovers as much. And maybe that's why they laid out the course that was more aggressive than they eventually followed. And it wasn't until they saw how much it moved the dollar and how big an effect that was having that they had to say, "Boy, we need a different rate path here."

Beckworth: Yeah.

Shambaugh: But I think we'll see it again. They're forecasting a couple more hikes. If the dollar responds to that and kind of picks up again, I would wonder how much they can continue that path because, again, it'll slow down inflation, it'll slow down the U.S. economy. It will wind up doing the things the rate hikes were supposed to do, and they may not need as many rate hikes as they thought.

Beckworth: Yeah. Very interesting. Well, let's move on to some of your research that you've done. Fascinating conversation. I could go on a long time on that. But let's move to some of the work you've done. And you've done a lot of work on the macroeconomic trilemma.

Shambaugh: Yes.

Beckworth: And I want to get into it. Before we get into what it is and the work you've done, I want to even make sure I have the name right. So I've heard it called just the trilemma, the macroeconomic trilemma, and also the impossible trinity. Is there a proper term? Which one should I use of those?

Shambaugh: So I historically have always used trilemma? I've noticed lately people coming up with other trilemmas. And so I think that has led people to try to be a little more clear and say, "I mean, the macroeconomic trilemma here when say it." People used to call it the impossible trinity. I think in some sense just because of my... Maurice Obstfeld and Alan Taylor kind of named it the trilemma and since I've written with them a bunch, I'm almost contractually obligated to continue referring to it that way. I don't know if it was a discomfort with the religious overtones or something that made people look for a more secular term. I'm not sure.

Beckworth: Nice. Yeah, okay.

Shambaugh: But, yeah. I tend to just call it the trilemma.

Beckworth: Trilemma. Okay. Fair enough. Well, why don't you describe for our listeners, what is the trilemma?

Defining the Macroeconomic Trilemma and Its Historical Context

Shambaugh: So the basic idea is there are three things the government might want to do. And we don't have to stipulate they want to do all of them, but they might want to, and that's have exchange rate stability, open financial markets where money can move across borders, and have some ability to use monetary policy for domestic purposes that we'll often refer to as domestic monetary autonomy. An the idea of the trilemma is you can't have all three, that you can at most have two of these three things. And the most basic idea behind it is if I peg my currency to you and money can flow across borders. If I try to lower my interest rates relative to you, then people are... Money's going to flow away from my country, because people say, "Well, gee, I can get a better interest rate over there. And the act of them kind of selling my currency and buying yours is going to start to make my currency depreciate. And if I've said I want exchange rate stability, then I can't do that, and so I have to make a choice between changing the interest rate or keeping the currency stable."

Shambaugh: And the idea is the other option I would have would be to throw out the capital controls, not let the money move across borders, in which case I could fix the currency where I want, move my interest rates up and down however I want. But basically I have to pick some combination of these. If you wanted none of them, you certainly could. You could close your financial markets, let the exchange rate bounce all over and never move interest rates. But the point is, if in theory, all of these have some advantage to them, you can't have all three.

Shambaugh: I think at its fundamental core, what it's really about is trade-offs. And so, in that sense, you don't have to pick purely two and none of the other. It's saying if you want more of one you've got to give up some of one of the other. And so if I want a little more exchange rate stability, I can maybe buy that with a little less capital mobility. Or if I'm open and I'm pegged, and I want a little bit of ability to move my monetary policy around, well, I can maybe loosen the bands on the exchange rate. Let it bounce around up and down five percent instead of up and down one percent. Or I can throw some sand in the wheels of financial flows.

Shambaugh: I think if you look at China most recently, that's clearly the choice they made that they didn't want to always have to follow the Fed necessarily. And they were uncomfortable with the extent the exchange rate was moving. And so they tightened capital controls quite severely in the last year. And that's one way... And so you can kind of play these levers against each other.

Beckworth: Yeah, so I want to go through some countries, and you tell me which ones they're doing, but you mentioned China, so let's go there first. So China, one can make the argument, they're kind of... I like the idea of a tradeoff, so it's not all or nothing, you can on the margins. But one of the implications of this is that it's not sustainable to do all three in a pronounced manner, right?

Shambaugh: Absolutely.

Beckworth: At some point, it will come home to bite you in the rear and have a financial crisis. So is China at that point? Are they trying to do too much?

Shambaugh: So I think they... In some sense they were. So China actually, once in a while, some officials would come out and say, "We've solved the trilemma."

Beckworth: Really?

Shambaugh: Explicitly and say, "We've beaten it." Now, in some sense, there's this fourth element out there that I didn't mention which is intervention in currency markets with reserves, right? And the implication is unless you have some capital controls, that's just not going to be effective on a sustained basis. But I think China, through a combination of kind of following the fed but not really, having some capital controls, but they were getting looser and looser. And then, yeah, they were pushing that envelope a little too far and the currency was moving more than they were comfortable with. And they had, even, despite intervention, and after a trillion dollars reserves intervention, they said, "This is more than we want," and they tightened the capital controls quite a bit.

Beckworth: So they were maybe cheating on the margin and they felt the pressure so they backed off.

Shambaugh: And they felt the pressure and had to back off in some way.

Beckworth: So we do have any country that truly completely blocks capital flows? I mean, North Korea is the only one...

Shambaugh: North Korea's a great example.

Beckworth: That's the only one that comes to mind.

Shambaugh: Yeah, I mean, I think with capital controls, there's a real continuum. And so there are the countries that it's kind of hard to move money across the border in any kind of quick way, and then there are the countries that by and large just... There might be rules. There might be some macro prudential controls from the central bank. But by and large if money's going across borders, they're not interfering with it, and you've basically got a spectrum in between that. It's certainly a hard one to measure, and so the empirics of this get tricky. Different people measure it in different ways. But you're certainly right that there's no one that really was all the way on the closed side usually today. If you go back in history, you certainly see it. And so the first paper I wrote with Maury and Alan, it was called The Trilemma in History, and we found that one of the nice things about going back historically is you have almost much more stark choices in it.

Shambaugh: So you go to the gold standard, there aren't really capital controls across the major economies at all. They just, in some sense, hadn't really thought of doing it. You were allowed to put gold on a boat and move it if you wanted to. That's one. And then on the other hand, they're perfectly fixed. They're on the gold standard. There's a rigid, fixed exchange rate system. And so it wasn't in some sense countries choosing their solution to the trilemma, it was broadly the system. There was an international monetary system that was open financial markets, fix exchange rate. No ability to use interest rates for monetary autonomy at all. And in some sense, there really wasn't an ethic of doing so at the time, so it wasn't really seen as much of a cost.

Shambaugh: You come through the Depression where people decide, "Boy, there's really a cot to not having that monetary policy tool," and they decide to swing to the other direction, and you get the Bretton Woods arrangement where you've got fairly tight capital controls. Money was really not moving, especially in the first decade or two after World War II. Still fixed exchange rates, but because you've got the capital controls, now there's a lot more monetary autonomy and countries can move their interest rates differentially from the U.S. because they can. There's nothing stopping them. And so you get those two periods where you can really see it start.

Beckworth: Interesting.

Shambaugh: And how much countries are following what we would call the base country interest rate is just very, very sharply different in those two periods despite the fact that the exchange rates are fixed in both and the difference is the capital controls. And then you can come out the other side and find a lot of countries in the last four decades or so who have floating exchange rates and open financial markets and, again, seem to be able to move their interest rate differentially from the U.S. or other large countries.

Beckworth: That's a fascinating historical case study. Can you use the trilemma to also make sense of why these things ended or why they blew up? For example, you mentioned earlier, if you try to do all three in a pronounced level, at some point things are going to blow up. So I think like the inner war gold standard. France began to sterilize gold inflows. And so was France trying to do all three?

Shambaugh: No, I mean, in some sense you ran in... The inner war years, we wound up actually not using them in the first paper because it's so messy we just wrote a separate paper just on that one, that episode. And in some sense, it's you run into this thing where the big countries who... The U.S. and France in particular were acting in a way where gold was flowing into them and it's putting pressure on everyone else. And everyone else either has to ride with France and the U.S. and tighten monetary policy, or blow up the gold standard. And you really do see in some sense this fracturing where countries make different choices. You've got a block of countries that say, "We're still on gold," but they've instituted really rigid exchange controls, kind of the exchange control block in Europe.

Shambaugh: You've got other countries that just give up on gold. And there are those neat pictures you can draw that show as soon as a country gives up the gold standard, they tend to reflate and get out of the Depression faster. And so in many ways, it was countries just saying, "I want the monetary autonomy. The gold standard's not worth it to me. I'm out." And so they didn't close their capital markets. They just gave up on being rigidly pegged to gold at that rate that they were. And that lets them use their lower interest rates, kind of print more money, and try to reflate out of the Depression.

Beckworth: Well, I know that Doug Irwin has an interesting paper on...

Shambaugh: Yeah.

Beckworth: And it's interesting. Blame the French and the U.S. for making the Great Depression what it was. And I may be wrong here, but take this framework and let's apply it to the U.S. in particular.

Shambaugh: Sure.

Beckworth: So they had the fixed exchange rate, they're on the gold. Capital is allowed to flow, right? But they were also tinkering with interest rates. So didn't they adjust their rates to help Great Britain and to nip the stock market boom? So really violating all three. Did this contribute?

Shambaugh: So the gold standard's kind of a funny thing because there's no one base country.

Beckworth: Oh, okay.

Shambaugh: So you've all got in some sense a gold cover ratio. So it's much easier to tell the story when you've got everyone's pegged to one country and they have to follow that one country. In the gold standard, there's no center country. And instead everybody's got to watch their own gold cover ratio. And what it does is it puts the surplus countries in a big advantage because gold is flowing into them. And as you said with France, you can sterilize that and still be pegged on the gold standard whereas the deficit countries are in trouble because they're the ones who are about to break the rules. And so in the gold standard, you can raise rates and gold flows in, and as long as you are able to sterilize that, that's fine. And that in some sense is one of the flaws of it was that raising rates and sterilizing works out okay for you.

Beckworth: For whoever's doing it, right.

Shambaugh: It's just that everyone else that is kind of stuck in this situation.

Beckworth: That added some clarity then with the use of the trilemma. I mean, this kind of goes back to this question of the gold standard itself, right? So it worked relatively well with the classical gold standard period, like from 1870 to 1914, but it was a big disaster in the inner war period. So Barry Eichengreen tells a story, and I think it's a common one, but I'd like to hear your thought son it that it worked well back then... I think his key argument is it worked well back then because people were less enfranchised that they had no expectation that a politician would care about domestic stability. And the beauty of it of course then is you had international... I mean, you didn't have big sustained deficits because gold would flow across the borders. But once we get to the inner war period, people do care. And so I've heard another version of this story is by the time you get to that point central banks are actively managing the gold standard whereas they weren't before. But the reason they're managing it is because there's domestic political pressure to do something. Is that reasonably historic?

Shambaugh: Yeah, I mean, I think I've seen the argument that after World War I the franchise gets extended a lot more broadly and suddenly people not just have an expectation but a voice to drive that expectation. But I think we shouldn't overestimate how well the classical gold standard worked. If you go back and think of the Populist Movement in the United States. What was their chief target? Their chief target was the gold standard because in particular the farmers are facing falling prices. And debtors aren't really fond of falling prices. And so if you've borrowed for your farm equipment or for your seed or whatever it is, you're in trouble if prices are falling. And so you get the Williams Jennings Bryan "You shall not crucify man on this cross of gold," famous convention speech.

Shambaugh: And I think but the U.S. was unusual in that the franchise was a lot broader in the U.S., then it was in a lot of other countries pre World War I. And so I think you do see that there always were some tensions in that you were gearing your monetary policy at this external target. You weren't paying attention at all to anything internal, and that can lead to some frustrations. Prices were probably more flexible.

Beckworth: I was going to ask...

Shambaugh: And I think that matters, right?

Beckworth: Okay, yeah.

Shambaugh: So prices were downwardly flexible in ways that they over time became less so. And I think that mattered to this so that you could get away with it more in the gold standard. And then honestly, the gold standard may have blown up earlier if we hadn't found gold in Alaska. So the whole Populist Movement that wanted free coinage of silver and wanted to get away from the gold standard, then we find gold. And so you loosen monetary policy because you found a lot more gold. And so in that sense there was this stroke of luck that kept some of those tensions from boiling over than they were at the time.

Beckworth: There's a lot of arbitrariness, if that's a word, to the gold standard.

Shambaugh: Yes.

Beckworth: In the sense that who sets the initial exchange rates, right?

Shambaugh: Right.

Beckworth: Isaac Newton. And then it's changed later. Andrew Jackson. Is that right? And a lot of this is just due to politics, by luck. The fact that the U.S. became a gold standard and not a silver standard was because of the fluctuating exchange rates, right?

Shambaugh: Yeah.

Beckworth: So I appreciate the enthusiasm for the gold standard in the sense people want the price stability. And they're thinking about the classical gold standard. But I think there's also a bit of history there that's underappreciated, that it wasn't always a clean, well thought out exercise, right?

Shambaugh: Well, I also think that the price stability is very much overrated. So you look at U.S. prices fell I think it's something like 40 percent from the time we got on the gold standard until you strike gold in Alaska. So you've got growing output, but the money supply is really not moving very rapidly and so prices are falling. And, again, if prices are more flexible because you have fewer written contracts and you don't have long-term contracts and things like that, maybe you can get away with it some, but it certainly was something that was an issue. I always say when people talk about the price stability is you've got this idea, you're making one price stable, the price of an ounce of gold. All of the other prices are moving depending on the relative price of the price of gold.

Shambaugh: So you can look at the price of milk over the last forty years in terms of gold or in terms of dollars. It's a lot more stable in dollars than it is in gold because you get big fluctuations in the price of gold relative to dollars. And so you kind of have the choice. You could have the central bank target one price, or you could have the central bank target a basket of prices. Now, targeting one price has the advantage it's perfectly visible. There's no question as to whether the central bank has successfully achieved its target, and so that's something I think people like about it. On the other hand, it's not clear. I care about the price of an ounce of gold being stable, but I have a lot more interest in the price of the basket of goods and services I buy being relatively stable.

Beckworth: Well, I'm a nominal GDP targeter kind of guy, but let me play the Devil's advocate here just because the listeners out there are pulling their hair out right now. It's true that you're targeting the gold, but if you look at price level measures, they were relatively stable over long periods of time. And even I know the Postbellum period, you do see that decline, but it was a gradual...

Shambaugh: It was gradual. Yeah.

Beckworth: So it was expected. It's not kind of the unexpected Great Depression deflation, right?

Shambaugh: No.

Beckworth: So I think they would say, "Well, yeah, there were ups and there was downs, but on average a relatively stable price level. Whereas when we moved to fiat, we had this massive explosion in the sixties and seventies." So I think there's something to the argument there was this discipline, but I think as we said, it came at a cost that's underappreciated maybe today by the advocates of gold standard.

Shambaugh: Well, I think it clearly has... What it does is it disciplines the central bank. So if you think your primary concern is that you can't make your central bank act responsibly, then there's a strong appeal to something like the gold standard. It's also why countries in many cases fix the exchange rate. It provides the exact same nominal anchor. Instead of picking the price of an ounce of gold, you pick the price of a given currency and stabilize that. It's visible. Every morning in Argentina, I could wake up and see, "Oh, it's still one peso for one dollar. The central bank hasn't cheated in the last 24 hours." But on the other hand, if you think that you can find a different way to discipline your central bank, if you can come up with an institution that follows a certain broad set of rules of structures or incentives that you think is able to provide broad price stability for a basket of goods, I think that's probably preferable.

Shambaugh: If you don't trust them, if you don't think you can do it, then you say, "Well, no, I don't want the fiat currency. I need this nominal anchor. I need something tangible and real." I think you look at the last 40 years of central banking, and it suggests that if you want, you can get central banks to keep the CPI relatively growing at the rate you tell them you want it to grow at and therefore stabilizing relative to one asset price is probably not what we want.

Beckworth: Yeah, no, I think ultimately the issue is credibility of our institutions, right?

Shambaugh: Yeah.

Beckworth: It's not gold standard. It's not inflation targeting. It's whether they are committed to price stability or nominal stability. And I think that's another point maybe that some people miss is just returning to the gold standard is not going to suddenly change everything. I had to review a book once of an individual who's been beside himself since the 1970s when Nixon took us off gold. And he goes as far as to make arguments that civilization has suffered and would be restored suddenly back to the heights of glory. And what I wrote in the piece was, "Look, I think the real issue here is deeper institutional quality and commitments to..." Gold standard it's just a commitment of mechanism, but so is inflation targeting, right?

Shambaugh: Yeah.

Beckworth: It's just a different form. And, yeah, we had a period where we really messed up in the mid sixties, seventies, early eighties. That was kind of the learning curve for fiat. I'm a big advocate of nominal GDP level targeting. But that's a different discussion. But I do think, going back to the one point you made about increased price rigidity, I do think that makes it a tougher argument, a tougher sell for gold standard. I mean, and that's why I think the managed stocks are important and that's why I'm a fan of nominal GDP targeting.

Shambaugh: Yeah.

Beckworth: Well, let's move on. These are fascinating conversations, but we're talking about the trilemma here.

Shambaugh: Sure.

Beckworth: You have many papers on this. You mentioned some of them. But you went through one. Let me see if I have the name here is The Trilemma in History: Trade Offs among Exchange Rates, Monetary Policy, and Capital Mobility. And you went through and basically tested this idea over 130 years, right?

Shambaugh: Right.

Beckworth: And what did you find?

Shambaugh: Well, we found basically that the trilemma broadly held. That if you look in the gold standard era, countries are following British interest rates. If you look in Bretton Woods, there's a lot more freedom from the capital controls. And you look post Bretton Woods, where you've got what in later work my coauthor and I Michael Klein referred to it as the modern era because it was almost like the modern era of painting when painters were doing lots of different styles all in one era. You get that now. It's not that the system has picked the solution. Now countries are picking their own solution. And within that modern era or post Bretton Woods era, you can find the countries that are pegged seem to follow the base country interest rate a lot more than the countries that aren't pegged. The advantage of the modern day era is there are different bases. So it's not like we're all following the dollar or all following the gold interest rate or whatever. Now some countries are clearly more linked to the euro and some countries were linked to former colonial powers and some are linked to the dollar and increasingly more linked to the dollar. And you can see very clearly. You can see very clearly Ireland following British interest rates until 1979 switchover where they're now part of the EMS and they're suddenly following German interest rates. And you can see this notion that you have to follow whoever you are pegged to, you follow their interest rate. And so that's what we found in kind of this variety in these papers.

Beckworth: So the big lesson is you've got to stick to it. Again, there's some marginal trade off, but you got to stick to this principle, the trilemma or else you will face some kind of financial blow up at some point.

Shambaugh: Yeah.

Beckworth: And let me ask. So when I first actually came across this idea, it was in the late nineties when the emerging market crisis was going off, so is that a useful framework to view what happened in South Korea, Thailand, Indonesia during that time.

Shambaugh: I think those are more in some sense almost more the blowup is coming from the financial sector from kind of excess credit buildup and things like that. I think it's much more... It's trying to describe to policymakers where the constraints are. And like I said, I think sometimes there's a misnomer where people say, "Well, you've got to pick one corner." You've got to kind of have two sides and none of the other.

Shambaugh: And I think in subsequent work, we had a paper called Rounding the Corners of the Trilemma, Michael Klein and I did, where we were trying to see if kind of subtle gradations mattered, where, hey, what if instead of keeping my exchange rate rigidly fixed, I just try to keep it kind of fixed. I try to not let it move too much and, well, lo and behold, you seem to follow the base country a little less. And what if I have some capital controls? Well, that seems like that may help a little bit. Maybe not quite as much, but some. And so I think this idea that you're making tradeoffs all the time. And I think you're right in terms of the blowup issue it's if you try to do all three simultaneously, it's not going to end well. Eventually you're going to...

Beckworth: You build excesses up.

Shambaugh: You build excesses up.

Beckworth: I guess my impression like '97 and '98, Asia, Russia, Brazil. There were these other financial imbalances that built up, but to what extent was the creation of those imbalances the result of these countries doing too much on all three corners?

Shambaugh: I think it may some, right? And I think in particular you get if you're pegged and people think they can take out loans in foreign currency because you've told them the exchange rate's never going to change, right? What are they supposed to do? You told them it'll never change. And so you can get excess borrowing and buildups in these situations where maybe you should've headed them off earlier and raised interest rates but that's hard because you're pegged and if you raise the interest rates you may appreciate. And so you wind up being unable to use monetary policy in a way you probably should. In somewhat sense, it's almost you're not violating the trilemma but you're not doing with monetary policy what you probably should to head off the future crisis because of the constraints of the trilemma. And then, well, you let excess credit built up in your system and it doesn't usually end well.

Beckworth: Well, let's move to international reserve growth. You have several papers on this. I look at one, The Financial Stability, the Trilemma and International Reserves 2010.

Shambaugh: Yeah.

Beckworth: So what is behind the rapid growth of emerging market reserves?

The Growth of Emerging Market Reserves and the Safe Asset Angle

Shambaugh: So I think people had often been telling two stories, one of which is pure mercantilism. I'm trying to stay undervalued because I want to run big current account surpluses and grow. And I think export leg growth's my route, so I'm going to try stay undervalued, and as part of that, I just have to keep intervening to buy more and more reserves to keep my currency cheap. That's one story in some sense. And there's another one of it was all self-insurance. Countries saw the Asia crisis, they didn't like the way it went, and they didn't want to have to go hat in hand to the IMF so they wanted to purely self insure.

Shambaugh: And I think we didn't want to discount either of those stories. I think there's something going on with both of those. But we thought there was another story going on that we weren't seeing discussed as much, which was this idea that if you have a growing banking... Central banks who have some preference for exchange rate stability. Not a pure peg even necessarily, but they don't want to just let the exchange rate move too much. If you have open financial markets, one of the things you're worried about is in some sense, your money supply leaking out of the country in a panic. You worry about a bank run not just on a bank, but on your country in a sense. And so one of the things you do about that is you build up a big stock of reserves.

Shambaugh: And so I think that's one of the things that you saw countries doing is seeing while their banking system is growing... So what we found just empirically was if you were open and you had a relatively fixed exchange rate, when M2 was going up, you let your reserves go up too, because you were in some sense trying to back your banking system. And if you go back to the gold standard, we saw plenty of discussion of people way back in the central banking literature and the gold standard just talking very explicitly about this that, "Well, of course the central bank needs gold to back the financial system because if there's a run on the banking system out of the country, they'd have to break the standard unless they had enough gold to back the currency."

Shambaugh: And this became, in some sense, a similar story. If you want to be able to deal with a bank run without causing your currency depreciate, you're going to need foreign currency. And so what we found was just empirically, it seemed like this motivation was there too. It's not that there was no mercantilism motivation in some countries. Actually, interestingly, we kept finding we could trace China's reserve growth really, really clearly until around I think it was 2003. And then it started leaving the regression line. They were getting more and more reserves than we would have thought they needed.

Shambaugh: And so I think it's a useful perspective because sometimes people would talk just about, "Can you buy six months of imports with your reserves so in case you suddenly faced a crisis?" And we didn't see that at all in the data anymore. Other people would say, "Well, can you back a certain amount of short-term external debt?" And, again, it was just hard to see that was the motivation, whereas this idea if you've got a growing banking system, you may need more reserves, that did seem to have some explanatory power and help us understand why some countries had growing reserves. Now, again, there are some countries who have grown way beyond even what that story would tell you where you do look and you say this does seem like they're trying to stay undervalued at a certain point in time and maybe for different types of reasons. But it at least struck us as something as kind of a missing story that was out there.

Beckworth: Well, let me throw in another story, and maybe this is a part of the self insurance story, maybe it's a part of the one you just said. But I think it might be distinct. And that is the demand for safe assets from the following perspective. So assume there have been no emerging market crises, so it wasn't necessarily a self insurance motive. But let's assume that these emerging markets are growing rapidly, right?

Shambaugh: Mm-hmm (affirmative).

Beckworth: They're growing really rapidly, and they're growing faster than their institutional quality.

Shambaugh: Yeah.

Beckworth: So they don't have the deep capital markets, the rule of law. And so as they get wealthier, they're going to just by nature want to demand more safe assets. And they look around the world, they come to the U.S. and they find treasuries, maybe some from Europe as well. Is that part of the story? Is that different or is that the same?

Shambaugh: I think it's similar in the sense that if it were purely private individuals who wanted more of the safe assets it wouldn't show up as the reserves growth necessarily because the reserves it's purely in the central bank. But to the extent that you think the central bank wants to hold a safe asset to back the banking system and assets produced domestically aren't safe enough to be that reserve you could use in a crisis, that I think is the place it becomes very similar where you say in a crisis they are going to want something that is highly liquid and that they can sell and that their own assets don't fit that bill. And so if the banking system grows, they're going to need even more and more of that same asset to back it.

Beckworth: So it's a similar story.

Shambaugh: So it becomes I think... I think it has a lot of parallels.

Beckworth: It's this demand for liquid very safe assets whether it's the private or the public sector that's recording them.

Shambaugh: Exactly.

Beckworth: In the time we have left, I want to jump to the Eurozone crisis. You had a really great Brookings paper on it, The Euro's Three Crises. And you lay out there was a banking crisis, a sovereign debt crisis, and then the growth crisis.

Shambaugh: Yeah.

Beckworth: So maybe summarize those for us as they relate to Eurozone.

The Euro’s Three Crises

Shambaugh: Sure. So I think the idea behind that paper was just trying to get across that at times people kept referring to it as strictly a sovereign debt crisis and there was a great quote from the German finance minister that there is no Euro crisis, there is a debt crisis in some European countries and trying to say this has nothing systemic to it and nothing broader. And I think this was trying to say, look, there are three things that are very interconnected and the interconnections matter because the obvious policy solutions to one may make the others worse. And if you try to think of it just as one at a time, you might make things worse. And so the idea was, look, you've got a banking crisis. Your banks are close to insolvent. And one of the things making that worse is the growth crisis. Your economy's not growing, you're getting more non-performing loans because of that and that's hard for the banks.

Shambaugh: On the other hand, the fact that the banks are in trouble is bad for the growth because they're not lending. And then on the other hand, the sovereign debt crisis means on the one hand people are worried that your government can't back... Stop the banks if necessary and on the other hand, when the banks are going under, that's taking down the sovereign. That's why you have a sovereign debt crisis in many cases. And then lastly the growth is causing the sovereign debt crisis because your revenues are going down. And problematically, the solution to the sovereign debt crisis austerity was making the growth crisis and the banking crisis even worse. And so I think that was the idea was to try to say you need to look at these things wholistically and not make two worse whenever you fix one.

Beckworth: Yeah. Well, let me throw in another story, one that I like. I don't know if you're familiar with it, but my argument is that the ECB played a large role in affecting it, particularly that growth one which may fit into the other ones and even making austerity worse is they actually raised rates in 2008. I've been critical of the fed for not doing enough in 2008, but it could've been worse. It could've been the ECB. And then moreover, so everyone through the Great Recession and the ECB had a even more adverse reaction to inflation than the fed did, but in 2011, they raised rates twice.

Shambaugh: Yeah. That was one of the great owned goals of monetary policy making history I think. Yeah. So, no, I actually very much agree with your work on this. That I don't think I would lay it all at the feet of the ECB, but in the paper when I was trying to say, "Well, what would make things better," front and center was looser monetary policy would help all three of these. And that's a solution that is dealing with the wholistic problem. And the, in some sense, flip side to that is tighter monetary policy was making all three of these worse and that this was a real problem.

Shambaugh: And I think there were fiscal problems especially in Greece, and there were banking system problems, and kind of structural buildups of imbalances across the Euro area, but tightening monetary policy in the face of those...

Beckworth: On top of all that. Yeah.

Shambaugh: Was just, in some sense, triggering a bigger and bigger crisis.

Beckworth: Yeah, I guess talking about the paper I wrote on this, but when I wrote that one of the referee reports was, "Well, isn't the fundamental problem the Eurozone itself?" It was never really a truly optimal currency area, and therefore you're going to have these structural problems build up. And, yeah, monetary policy was bad, but you're walking into a minefield already.

Shambaugh: I mean, I think there was a minefield, but the rate hikes just made it much, much worse. And so, to me, there were huge structural flaws. You had banks that were backstopped by the national governments despite the fact that they were real European banks, and so they... We think our banks are big. But it's a share of GDP. Many European banks dwarf the country. How on earth is the country supposed to adequately backstop that bank in a crisis? It can't. Ireland had something like 30 or 40 percent deficit to GDP in one year because they backstopped the banks in that year.

Beckworth: Amazing.

Shambaugh: And then we would never ask Delaware or Washington to backstop the banks that are chartered in those states. They're U.S. banks. And so I think in the same way, Europe had all these structural flaws. But I would agree that the policy choices, if you had had looser monetary policy and less austerity, the structural flaws are still there, but you come through looking a lot better. And the adjustments that needed to take place with the imbalances would have been much, much less painful in a world with looser monetary policy. You needed relative price changes across Europe. You can do that with one percent inflation in Germany and negative four in Spain, Portugal, and Greece or you could do it with one percent inflation in Spain, Portugal, and Greece, and five percent inflation in Germany. That latter one is a lot less painful.

Beckworth: That's fascinating. Yeah, see, I was going to ask this question. So inflation has been really low in the Eurozone so the ECB's had a harder time than the fed in hitting its target. And I've heard this argument made, and I've echoed it, and it may not be accurate, but let me run it by you. If the ECB had higher inflation, even if it's a temporary overshoot, they maintain the long run target, but what would have happened is that the core countries which had... That were close to full employment would have seen inflation go up first.

Shambaugh: Yep.

Beckworth: Greece, Spain would have seen very little inflation. You would have that scenario you just described where because they're at full employment, inflation goes up quickly there. Thus you have the real exchange rate adjustments that are needed. Greece and the periphery is much better off. Is that a reasonable story?

Shambaugh: I think it's an absolutely reasonable story. And I think related to that is when you're in a solvency crisis, the denominator matters. And the denominator here is nominal GDP. And I think people often forget the first word there, that it's nominal GDP that counts here. And so having falling prices in Greece or Spain is just making their debt crisis worse. It's making it worse for the individuals who see either their assets or their salaries going down and they've still got the same nominal debt. It makes it worse for the country that has a shrinking nominal GDP but they still have these fixed nominal debts out there.

Shambaugh: And so I think it might solving these crises a lot harder that the root to solving them that was expected was to have literally falling price levels in some of these countries as opposed to saying, "Look, the right answer out of this is we at minimum..." Setting aside whether they could have lifted the inflation target, they could have at least just hit it. That would have been progress. And I mean that not only joking, but had the European central bank hit two percent for the last seven years, I actually think you would have seen a markedly different outcome in these countries than instead constantly falling short of it and being close to zero at times which was just I think made it really, really hard for countries that were on the kind of the deficit side to come out of this.

Beckworth: So my question is can the Eurozone really work? Because part of the way I look at the problem... I know there's the banking problem. There's these other deep structural problems. But I think monetary policy itself is always going to have a challenge. You think of a Taylor rule for all the different countries. Well, the Taylor rule that the ECB follows seems to be more closely made for Germany and the core countries. It works relatively well and that's I think reasonable because it's a big part of the Eurozone. So the ECB's looking at these aggregated inflation. They don't look at regional just like the Fed doesn't look at Texas or Florida. And so they're always going to be this one size fits all monetary policy which may be way off for the periphery. So are you hopeful they can work through this or is it a systemic problem that will continue?

Is There a Systemic Problem?

Shambaugh: I think it's a problem that continues, but I think that doesn't mean it continues as bad as it is right now. I think in some ways, the optimist in me looks back at that paper I wrote at the end of 2011 or early 2012, and I had some things that people were telling me to take out of the paper because that's crazy. They're never going to do that and you just look like a loon by putting that in. And they've done some of those things. Not because I suggested them. That was trying to distill some of the conventional wisdom out there. And there were things that looked politically difficult. I don't think you could have forecasted in 2010, that Draghi would step forward and say, "Whatever it takes. I'll buy whatever you need me to buy. The liquidity counter is going to be open if needed." That's crazy for the ECB to be saying that. And they got there by 2012.

Shambaugh: The banking union, they are making progress there. It's hard because there are legacy issues. I mean, as someone said to me once, "Look, if you tell me there's European federal deposit insurance, I can pass a law tomorrow that says all my homeowners are allowed to default on their mortgage, my banks are insolvent, and Europe has to bail them out." And so there are real issues of sovereignty and institutional structure that are hard to fix, but they are making halting progress there. I think the thing that has made it harder... I do think honestly a combination of austerity, ideology and tight money ideology at the ECB has just made all this harder.

Shambaugh: So it's not as institutionally permanently flawed as you might worry. I do think, look, it's not as good an optimal currency area as the United States. It's just not. The economy has more diverse shocks than the United States has. It doesn't have the labor and mobility and the United States has and it doesn't have the fiscal federalism the United States has where fiscal policy cushions shocks across regions. That's going to make it a lot harder to run one monetary policy. It doesn't make it impossible. It just means you're going to have more pain at times. And so if they've made the choice that the pain is worth it, I think they can get through this.

Shambaugh: But I do think you're right. There are going to be times where the tailor rule is screaming, "Raise rates for Ireland as it was in 2006 and 2007," and they weren't because you had Germany and France that didn't meet it. And there are going to be times like now where the tailor rule is saying, "Go sharply negative." And the ECB is stuck at zero, when frankly Germany would probably rather they raise rates. So I think you're going to face problems like this across countries with asymmetric shocks.

Beckworth: Very interesting. Well, our time is up. Our guest today has been Jay Shambaugh. Jay, thank you for being on the show.

Shambaugh: It's been a real pleasure. It's a fun conversation.

About Macro Musings

Hosted by Senior Research Fellow David Beckworth, the Macro Musings podcast pulls back the curtain on the important macroeconomic issues of the past, present, and future.