The unholy trinity in open economy macroeconomics is pretty simple. It's impossible for a country to do the following three things at the same time:

1) Maintain a fixed exchange rate

2) Maintain an open capital market

3) Run an independent monetary policy

One of the issues with macroeconomic policy coordination right now is that different countries have chosen different options to sacrifice. China, for example, has never opened its capital account. The United States, in pursuing quantitative easing, has basically chucked fixed exchange rates under the bus, no matter how many times Tim Geithner utters the "strong dollar" mantra in his sleep to reporters. 

These  policies are generating a fair amount of blowback from the rest of the world, forcing President Barack Obama to defend the Fed's actions. And it appears that the developing countries are mostly following China's path towards regulating their capital account to prevent exchange rate appreciation and the inward rush of hot money.  

How does this end? I think it's gonna end with a lot more capital controls for a few reasons:

1) It's the political path of least resistance;

2) Capital controls are seen as strengthening the state;

3) The high-growth areas of the world don't need a lot of capital inflows to fuel their continued growth. 

What intrigues me is how the financial sector responds to a situation in which their freedom of action in emerging markets becomes more and more constrained. It's possible that they could pressure the Fed to change its position in the future. It's also possible, however, that big firms could see these controls as a useful barrier to entry for new firms. 

My money is on the former response, however.

Developing…

Europe's debt crisis is not going away anytime soon, which means that the crisis over European monetary union won't be going away either. As it turns out, the European Commission is on this, proposing things like "excessive deficit procedures" and the like. 

Will this work? Well … let's go to the Economist's explanation for why the previous set of rules failed to prevent this from happening:   

The “stability and growth pact” was supposed to limit each country’s budget deficit to 3% of gdp and public debt to 60% of GDP. It failed, in part because France and Germany refused to abide by it -- and even rewrote the rules when they breached the deficit limit.

In contrast, the problems that arose because different economies responded differently to the zone’s common monetary policy were underestimated. The sudden drop in real interest rates on joining the euro in Greece, Ireland and Spain fuelled huge spending booms. (Portugal had enjoyed its growth spurt in the late 1990s in anticipation of euro membership.) Rampant domestic demand pushed up unit-wage costs relative to those in the rest of the euro area, notably in Germany, hurting export competitiveness and producing big current-account deficits.

The euro allowed these internal imbalances to grow unchecked and now stands in the way of a speedy adjustment, because euro-area countries whose wages are out of whack with their peers’ cannot devalue. 

So, what is to be done? In the past, European integrationists have been quite adroit at using periods of crisis and malaise to jumpstart further integration efforts. It's possible that this could happen again. 

In this case, however, integration efforts are going to be very costly. The Economist explains:

[T]here are three ways for a country to restore competitiveness: devaluation (which reduces wages relative to those in other exporting countries), wage cuts or higher productivity. In the euro area, the first option is out. The other two rely on easing job-market rules so that pay matches workers’ efficiency more closely, and workers can move freely from dying industries and firms to growing ones.

I'm thinking unions will develop breakout nuclear capabilities aren't going to be big fans of that second option. The third option seems like the ultimate political dream, except it involves eliminating regulations that likely benefit a lot of entrenched interest groups. 

Another possibility is greater fiscal centralization. The Economist is not keen on this, but that's besides the point -- as Mary Sarotte points out at Foreign Affairs, there's a Very Important Country that's not going to go along with the move:

The challenge now is governance reform, not expulsion of member states. Reverting to national currencies would drive the values of reissued southern currencies into the ground and the deutsche mark into the sky, thereby undermining Germany's export competitiveness and job market, to say nothing of the collateral damage to the European Union and the single market. The eurozone crisis should not signal the end of the euro but rather the start of a long-overdue overhaul. The idea of a European Monetary Fund, endorsed by Wolfgang Schäuble (an elder statesman from the days of German unification and now a subordinate of Merkel), faded after Merkel dismissed it but deserves broader support. Germany also needs to reconsider its calls for painful fiscal discipline on the part of the weakest countries until their economies regain footing. Ideally, but perhaps not realistically, Merkel should return to previous German form and spearhead a revision of the Maastricht Treaty, leading a fresh effort to do for political union what Kohl and Mitterrand did for monetary union.

The unlikelihood of such a move exemplifies a fundamental problem within the whole European Union: there exists a built-in tension between the lofty goals of integration and member states' collective unpreparedness to think through the consequences of their ambitious project. The great achievement of the past has been to reconcile these contradictory impulses by focusing on practical agreements. It is time to do so once again and realize that the necessary consequence of monetary union is greater political union.

In some ways, what happens from here on out will be an excellent test of whether economic interdependence really alters national incentives. As I blogged a few months ago, "When going backwards isn't an option, and muddling through is no longer viable, the only thing left to do is move further along the integration project." 

Of course, the European have spent the past few months muddling through some more. Given current trends, however, that option is going to disappear sooner rather than later. 

Developing …

This week Japan has provoked the ire of the United States and Europe by unilaterally intervening in currency markets to depreciate the yen against other major currencies. Japanese Prime Minister Naoto Kan has responded to these criticisms by telling the US and EU to go suck a lemon stating that further "resolute actions" would be taken on this front. 

This comes on the heels of mounting U.S. frustration with China's "go-slow" policy on letting the yuan appreciate against the dollar. [What do you mean by "go slow"?--ed. Let's put it this way: the tortoise thinks that China is being pokey on this question.]

So, is this the beginning of beggar-thy-neighbor? Will other countries start intervening in foreign exchange markets to gain a competitive advantage for their export sectors? 

The New York Times' Hiroko Tabuchi thinks not, because Japan can't unilaterally devalue its currency like in the old days:

It is unlikely, though, that intervention by Japan alone will sway currency markets in the long term. The global volume of foreign exchange trading has grown rapidly in recent years, which prevents intervention by a single government from countering bigger market trends.

Other countries are unlikely to help Japan’s cause, because they need to keep their own currencies weaker to bolster exports. A weak currency makes a country’s exports more competitive and increases the value of overseas earnings.

Much of the yen’s weakening came from investors selling the currency on expectations that the Japanese government would be more active in keeping the yen in check. Japan did not disclose how much it had spent in currency transactions, but dealers put the initial amount at 300 billion to 500 billion yen ($3.5 billion to $5.8 billion).

But as Switzerland found this year, a single government’s efforts to weaken its currency can prove futile. Switzerland abandoned that effort, after its central bank had lost more than 14 billion Swiss francs ($14 billion) in foreign currency holdings in the first half of the year, after a fall in the euro’s value ate into the bank’s reserves.

The Swiss franc is also seen by investors as a relative haven and has also strengthened amid global financial unrest. This month, the franc hit a record high against the euro.

Hmmm.... maybe. Japan's economy is much larger than Switzerland, so I'm not sure the comparison holds up. The real problem, however, appears to be that countries perceived of as "safe havens" wind up with overvalued currencies. 

This little parable also makes me wonder whether we might see beggar-thy-neighbor policies in a different guise this time around. This is going to sound a little crazy, but here goes: rather than explicit exchange rate intervention, what if countries decided to play fast and loose with Basle III and other measures to strengthen financial integrity? 

This really does sound crazy -- it suggests that governments would be willing to tolerate a higher risk of domestic banking collapse in order to avoide being a "safe haven" status for capital. That said, think of how much Europe benefited from the depreciation of the euro due to the Greek crisis. Basle III, by taking so long for banks to meet standards allow those countries with more insolvent financial institutions **cough** Germany **cough** to take their own sweet time in having them meet new capital adequacy standards.  This would allow Germany to have the euro stay relatively cheap without abandoning its anti-inflationary zeal. 

Now, in all likelihood, not even the Germans would purposefully do this. This is crazy talk. What I'm suggesting, however, is that there is more than one way for a country to have its currency depreciate, and these policies are substitutable. Looking only at explicit exchange rate intervention might be just a bit too narrow. And if more countries find more ways of keeping their currency undervalued, well then, the days of beggar-thy-neighbor would have arrived.

Developing....