Balance of payments and the trilemma

On 16 September 1992 the British government raised its base rate from 10% to 12%, announced a further rise to 15% before the afternoon was out, and by the evening had abandoned the policy the rises were meant to defend. Nobody involved was stupid. They had been trying to hold three things at once, and only two of them fit.

The three things

A country would like a stable exchange rate, because it makes trade and borrowing predictable. It would like free movement of capital, because foreign money funds investment and residents resent being told where to keep their savings. And it would like its own interest rate, set for its own economy rather than somebody else's.

Each is reasonable. Any two are achievable. The third is not available, and the reason is arbitrage rather than politics.

Suppose the exchange rate is fixed and money can move freely. Now set a domestic rate below the anchor currency's. Anyone holding the local currency can sell it at the guaranteed rate, buy the anchor, and earn more, with no currency risk because the rate is fixed. That is a free lunch, and free lunches get eaten until they are gone. Money leaves until the central bank runs out of reserves or gives up the rate. Fixing two corners has priced the third.

Try to hold all three

Turn on the two you want. Then reach for the third and watch what it costs you.

The switches are not decoration. Turning on a third forces one of the others off, and the one that gives way is whichever was committed to longest ago, because that is how it tends to go: the oldest promise is the one that has stopped being defended.

Base rate moves on 16 September 1992 are recorded in the Bank of England's official Bank Rate history, available free at bankofengland.co.uk. The 15% rise was announced and never took effect.

The identity underneath

The trilemma sits on top of an accounting fact that is worth separating from it. A country's current account and its capital account sum to zero, by construction rather than by policy.

If a country imports more than it exports, it has handed foreigners more of its currency than it took back. That currency has to go somewhere, and the only somewhere is claims on that country: its bonds, its companies, its property. A current account deficit is therefore the same event as a capital account surplus, described from the other side. They are not two outcomes that happen to correlate. They are one transaction counted twice.

This is why "we should stop running a trade deficit and also attract foreign investment" is not a policy, it is a contradiction. The investment is the deficit.

What each choice actually costs

• Give up the fixed rate. The currency moves, sometimes a long way and quickly. Exporters and anyone holding foreign earnings carry that risk rather than the government carrying it for them. Most large economies chose this after 1973.
• Give up free capital. The peg survives and the domestic rate stays yours, at the cost of telling residents and foreigners where money may go. It works, it is not costless, and the cost compounds: capital that could be stopped from leaving is capital that thinks twice about arriving.
• Give up your own rate. The rate is set elsewhere, for conditions that are not yours. This is the euro, and it is the choice that feels cheapest until the two economies need opposite things.

What to do with this

When you meet a currency story, find the two corners first. If a country has a managed rate and controls, its rate decisions are about its own economy and you can read them that way. If it has a peg and open capital, its rate is not really its own and its central bank is following somebody else.

And when a country holds a peg while cutting rates into a downturn with the capital account open, you are watching something that is going to end. The trilemma will not tell you when. It will tell you that there is no version of this where all three survive.