Monetary Sovereignty and Trilemma Stability Data Now Available

Our new paper (with Helen Popper and Graham Bird) entitled "Trilemma Stability and International Macroeconomic Archetypes" is out soon in the European Economic Review.

The paper uses the simple geometry of the classic, open-economy trilemma to introduce a new gauge of the stability of international macroeconomic arrangements.  The new stability gauge reflects the simultaneity of a country's choices of exchange rate fixity, financial openness, and monetary sovereignty.  So, the new gauge is bounded and correspondingly non-Gaussian. We use the new stability gauge in nonlinear panel estimates to examine the post-Bretton Woods period, and we find that trilemma policy stability is linked to official holdings of foreign exchange reserves in low income countries. We also find that the combination of fixed exchange rates and financial market openness is the most stable arrangement within the trilemma; and middle-income countries have less stable trilemma arrangements than either low or high-income countries. The paper also characterizes international macroeconomic arrangements in terms of their semblance to definitive policy archetypes; and, it uses the trilemma constraint to provide a new gauge of monetary sovereignty.

Link to full text (on ResearchGate)

Data on monetary sovereignty and trilemma stability for 180 countries are available. A file with both variables in stacked form (for panel analyses) can be found here. 

A Scottish Currency

The Scottish Government is keen to form a "Sterling Area" with the UK post-independence. Ironically, under this arrangement, an independent Scotland would not have an independent monetary policy: the Bank of England would still be responsible for setting the Area's policy interest rate. In contrast, a Scottish Government would have the ability to affect the country's output and employment through its own independent taxing and spending decisions.

However, that very same fiscal policy independence would present a potential risk for the Area as a whole. For example, a substantial increase in Scottish debt could lead to significantly higher borrowing costs. In turn, these could derail the country's budget. Solutions at that stage would be economically and politically painful. The options would entail either an unpopular bailout by the UK (which, no doubt, would come with austere conditions) or a potentially messy exodus from the stirling area in order to boost competitiveness. 

Such dilemmas have been recently faced by countries in the eurozone and Scotland should heed the lessons. Entering a currency union with the UK will require a credible and strict fiscal framework to prevent a future exchange rate crisis. Westminster is unlikely to agree to a currency union without appropriate fiscal brakes, otherwise it will be exposing the UK to risks emanating from Scottish fiscal policies. If Scotland is unwilling to sign up to that, it should bite the bullet and create its own freely-floating currency. That will also be more commensurate with the aim of political independence.  

Some Lessons for Investors by Aesop, the Ancient Storyteller

I sometimes read Aesop's fables so that I can provide lessons to my children without appearing to preach too much. But as I read, I realise that Aesop's stories have more valuable lessons for us, the adults.

So, here are two of them:

On greed...

"A man and his wife had the good fortune to possess a goose which laid a golden egg every day. Lucky though they were, they soon began to think they were not getting rich fast enough, and, imagining the bird must be made of gold inside, they decided to kill it in order to secure the whole store of precious metal at once. But when they cut it open they found it was just like any other goose. Thus, they neither got rich all at once, as they had hoped, nor enjoyed any longer the daily addition to their wealth."

(The Goose that Laid the Golden Egg, translated by V. S. Vernon Jones for Wordsworth Classics)

I guess that in terms of the theory of finance this couple would have a utility function with a convex shape. In other words, their utility would increase at an increasing rate as their level of wealth increases... It would look something like this:

They would be risk-loving. Of course the risk of killing the bird did not pay off! Luckily, modern financial theory assumes investors whose utility increases at a decreasing rate as wealth increases. Investors are risk-averse or 'moderately greedy'...

On Investment Styles...

"A hare was one day making fun of a tortoise for being so slow upon his feet. 'Wait a bit,' said the tortoise; 'I'll run a race with you, and I'll wager that I win.' 'Oh, well' replied the hare, who was much amused at the idea, 'let's try and see'; and it was soon agreed that the fox should set a course for them, and be the judge. When the time came both started off together, but the hare was soon so far ahead that he thought he might as well have a rest: so down he lay and fell fast asleep. Meanwhile the tortoise kept plodding on, and in time reached the goal. At last the hare woke up with a start, and dashed on at his fastest, but only to find that the tortoise had already won the race."

(The Hare & the Tortoise, translated by V. S. Vernon Jones for Wordsworth Classics)

Choosing good companies (tortoises) and holding on to them may be a better strategy than jumping on bandwagons (hares) for long-run races (investment returns). There was a story recently at the Wall Street Journal discussing the case of an old fund (structured in 1935) invested in 'boring' companies which has outperformed recent and more 'dynamic' allocations. Have a look here.

EuroDigest

EuroDigest is my data-based report summarising EURUSD performance for the first six months of 2012.

Document available here

If you read one thing today... (and you are interested in the EZ)

The President of the Council of Europe has published his proposals ahead of the European summit this Thursday and Friday.

The document does present a roadmap to further integration that should underline the strength of the union in the long run.

It mentions explicitly integrated financial, budgetary and economic policy frameworks.

There is no time frame but it is suggested that this could be agreed in December.

I suspect that the markets are getting impatient for something concrete and will not react with enthusiasm.

But the EZ leaders have shown that they do not want to be (seen to be) swayed by the financial markets' short term reactions.

Democratic accountability and legitimacy also mean that the proposals will have to be sufficiently discussed and approved at the national level.

I think that these proposals are in the right direction.

Of course a lot (all) depends on what Germany thinks it can do.

And further integration presents a challenge not only for those who want to be part of it but also for those who are sceptical or hostile (e.g. the UK).

Does the EZ have time to contemplate these proposals?

I think it does, as long as Italy can borrow at reasonable rates.


Just in case you missed it the document is here.

Greece's Memorandum of Understanding with the "Troika"

For those who haven't had the chance to browse through the MoU that Greece has signed with the troika (ECB, IMF and the European Commission) here is a link to a document (IMF Country Report No. 12/57) that includes it (page 152 onward).

The actual document is entitled "Greece: Request for Extended Arrangement Under the Extended Fund Facility—Staff Report; Staff Supplement; Press Release on the Executive Board Discussion; and Statement by the Executive Director for Greece" and contains more or less everything one needs to know about the greek economy, its assessment by the IMF staff, and the MoU that has been signed.

It will, of course, be interesting (and consequential at so many levels) to see whether the greek people decide to renege on, or abide by, their commitment to the terms of the bailout at the elections of June the 17th, 2012. 

They really have to choose between a rock and a hard place... 

Rock: Sticking to the terms of the bailout, achieving some concessions from the troika, staying in the EZ. Recession continues for 2-3 more years, ceteris paribus. 

Hard place: Reneging on the MoU, missing the next loan instalment, defaulting on debt, returning to the drachma. Massive uncertainty.

Problem with the Rock: this option is favoured by the same old parties that have been ruling Greece since the end of the civil war (except for seven years of military rule), and are responsible for the current drama.

Problem with the Hard Place: this option is favoured (implicitly) by a radical Left party that has never been in government, let alone having the responsibility of steering a nation to safe waters during a cataclysm. 

Today the greeks progressed in the euro 2012 football competition's quarterfinals against all expectations. Can they produce another surprise by returning to some sort of economic and social normality? It will take much more than the 90 minutes of a football game but it requires the same kind of spirit.

Greece must hang on?

Exploring the possible economic effects of Greece's election.

Phone interview with Dukascopy TV. Click here for Dukascopy's page or, for a direct YouTube link, click here