Selected Topics of Financial Architecture

Term Paper, 2000

35 Pages, Grade: A-

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2.1 The impossible trinity
2.2 The trade-off situation
2.3 Effects on Euroland

3.1 Currency board
3.2 Issue Analyses

4.1 Different Canada
4.2 China's controls
4.3 Argentina's fear

5.1 "Fix or float" dilemma and "Impossible trinity"

6.1 "Free banking" as financial architecture
6.2 E-money and Impossible trinity

7.1 Mutual funds and E-money



This 32 page term paper discusses issues raised in the course assignment. We thereby focus on the questions asked, which are for the convenience of the reader repeated below, and establish key arguments around them:

1. According to the Economist’s Survey of Global Finance an “impossible trinity” underlies the instability of today’s international financial architecture. What is it? Why is it impossible? The survey maintains that “politicians are not prepared to choose only two out of three objectives” involved. “The best hope in the short term, therefore, lies in improving the trade-offs between them. (Chapter II). In this context, what trade-off did the Euroland countries make by introducing the Euro? Is it an improvement as compared to the previous trade-off? What types of companies benefit the most from the new situation? Of the three objectives to which The Economist refers, which objective did the Euroland countries give up for the time being. What types of companies are thereby hurt? (Chapter II, 2.3)
2. Explain how monetary nationalism has already - and could again - threaten the stability of current institutions. (Chapter III)
3. Give examples of other countries or regions in which trade-offs different than the one in Euroland have been made. Do these countries or regions thereby gain benefits that Euroland does not enjoy? What are the costs of these other trade- offs? Are there specific companies that do relatively well in these other countries? (Chapter IV)
4. Refer to Lawrence White’s article, “Fix or Float? The International Monetary Dilemma”. Is White’s dilemma the same as the “impossible trinity”? If Richard Rahn is correct, will such “dilemma” or “impossible trinity” still exist in the future? (Chapter V)
5. According to The Economist (referring to work by Harvard’s Benjamin Friedman) what will be necessary in order for e-money to eliminate central banks as a source of instability? Explain. (Chapter VI)
6. Rahn and The Economist discuss the possible displacement of banks by mutual funds? What might be causing this to happen? What are its implications for financial stability? Is risk being eliminated, or is it simply shifted from one set of people to another? Explain. (Chapter VII).

Last but not least we will draw a conclusion in chapter VIII.


The founders of the Bretton Woods institutions more than half a century ago were right to recognize that there could be no successful global integration without financial stability within countries and a well-functioning system for the flow of capital between them.

This was the painful lesson of the 1930s, when the absence of an effective international response to financial panics helped pave the way for deflation and depression - and ultimately, World War II. The same lesson has been taught again and again in the postwar period.

While that insight remains valid today - indeed, has been pointed up by recent events in Asia and elsewhere - a great deal in the global economy has changed since Bretton Woods. The framing new reality of the late 20th century global financial system is that the private sector is the overwhelming source of capital for growth1.

2.1 The “impossible trinity”:

The Bellagio Group - a famous academic talk shop that flourished in the 1960, was the first to propose the concept of the "impossible trinity". Robert Mundell then enforced it.

The basic parameters of the "impossible trinity" according to Paul Krugman are2:

- Adjustment: The ability to pursue macroeconomic stabilization policies and to fight the movements of the business cycle.
- Confidence: the ability to protect exchange rates from destabilizing speculation and the resulting currency crises.
- Liquidity: Basically refers to short-term capital mobility, both to finance trade and to allow temporary trade imbalances.

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An adjustment of the concept shown above is presented in The Economist’s “Survey On Global Finance”3. It names three other points that are the basis of today’s efforts to draw an architectural blueprint for the ideal international financial architecture:

- Financial market control: Financial markets that are regulated supervised and cushioned vs. free financial markets based on discovery procedures.
- National Sovereignty: Central bank regime and monetary policy on national level vs. monetary union or pegged exchange rates.
- Global financial market integration: Regionally operating financial markets vs. benefits of integration of a regional financial market into a broader global system, harmonization of financial institutions and invention of new products.

The dilemma of international financial architecture lies in the incompatibility of the factors involved. By insisting on having any one of the three desired attributes in financial system blueprints, it consequently forces the abandonment of one of the others. As a result, there are a limited number of possibilities - and each of them is unsatisfactory in some important way, and any policy pursued must take these trade-off situations into account.

2.2 The trade -off situation:

Adjustment / Financial market control:

“Alternatively, suppose that adjustment - the ability of governments to respond to recessions by "reflating" the economy - is regarded as being of paramount importance. If this kind of flexibility is combined with liquidity” (free movement of capital, global financial market integration), “it exposes the economy to massive speculative capital movement whenever it is suspected that monetary policy will become looser. So a government that insists on maintaining the ability to adjust will necessarily be forced either to give up on confidence” - a floating exchange rate -“or to limit capital mobility.”4

The same principle is true for the control of financial markets. A high degree of involuntary regulation correlates positively with Confidence - as governments tend to set central bank actions or invent other forms of cushions against system failures, so called crises - which itself may cause “moral hazard” situations.

But regulation on the other hand contradicts the goal of global market integration. It deprives individuals or banks to make the most efficient use of their funds. Especially it does not allow strengthening a weak financial market with the assistance of foreign institutions or investors. The latter will always look for better opportunities based on their maximizing principle.

Confidence / National Sovereignty:

Suppose that a country decides that it simply cannot accept an unstable currency, driven up and down by swings of investor sentiment or, in the modern world, by the winding and unwinding of hedge fund positions (the case of free financial markets and global integration).5

Solutions to solve the issue are either to manage the exchange rate strongly - which will only work in case of committed institutions with commensurate reserves and acting power - or peg the countries' exchange rate - as Austria did with the Schilling when it was linked to the Deutsche Mark.

If the country decides to maintain liquidity and opens to integration on a global basis it may become target for international speculators as soon as the market suspects trends towards devaluation. So the room for maneuver offers a twofold option: It can escape a future volatile exchange rate situation by introducing a currency board, or - as it is the case in Europe - it can go the way of a monetary union. Alternatively it can only restrict capital movement and regulate the financial market strictly, which may lead to monetary nationalism in consequence.

Liquidity / Global financial market integration:

If free capital movement and global integration is the given status quo or if restrictions of these fields are not feasible, the government has several options. It either needs to fix the exchange rate, install a currency board or opt for a managed common currency or in contrast accept a flexible exchange rate system with freely operating financial markets with no regulations imposed.

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No national sovereignty

The recent situation of instability of the international financial architecture has raised a lot of concerns about the future direction, in which such architecture needs to head. Volatility and downward trends infected especially capital markets in emerging economies as if it were a contagious disease.

But the main decision-makers are politicians and officials. The Economist Survey maintains that those “politicians are not prepared to choose only two out of three objectives” involved. “The best hope in the short term, therefore, lies in improving the trade-offs between them.6 In our opinion, in today's world politicians simply are not able to choose all three policies at the same time. If they ever do it this would bring instability and they would lose in the next elections.

So the large industrialized economies as the U.S., Japan and Euroland turned to adjustment and liquidity with confidence set aside. And these counties perform relatively well. This is also true for even the smaller countries as the U.K. - at present not an EMU member. The reason of success of this choice is that with small trade shares, little foreign-currency debt, and a strong belief by investors in their long-term soundness, these economies can withstand the ups and downs of the exchange rate. But politicians had to invest a great deal of efforts into persuading the voters and the markets to make this architecture happen.

For the emerging economies the situation is less obvious. Following the path of the industrialized countries, as an example, has proven unsustainable as frequent speculative attacks occurred. So at this point officials cannot think about it. They cannot say bluntly that countries must give up on stabilization, that only a handful of First World central banks are allowed to have policies. Nor are they prepared to turn their backs on a generation of denouncing the evils of currency and capital controls. So the choice of some of them consequently fell on stability and liquidity. However, some developing countries choose to increase regulation and capital controls. Limits on capital help protect economies from market pressures mobility thus avoiding limiting democracy.

It is also true that there is no common understanding of the interrelated functions of the “impossible triangle” in politics. And there are different subjective values attached to each item of the triangle that do have different meanings for different people and more for each political party. So it comes that Tony Blair proposes a “new Bretton Woods for a new millennium”, while Alan Greenspan favors to change “the patchwork of arrangements”7.

The current situation where the best hope is short-term tradeoffs is unacceptable. But the blue prints for designing the financial markets architecture under discussion in the community are irrelevant. It seems that the past and recent problems have not been severe enough to make mankind to arrive at a common startup point.

2.3 Effects on Euroland:

As mentioned earlier, the introduction of European Monetary Union (EMU) in the Maastricht Treaty and its start on 1 January 1999 paved the way for a focus on two out of three possible parameter of the “impossible trinity” in Euroland: adjustment and liquidity. The third item, confidence has been set aside.

For a single EMU-country the parameters are liquidity and confidence. Omitting national sovereignty is a remarkable change because it used to have high importance for the national states, of course, while resulting in a downturn in one of the other fields.

This new trade-off situation for Euroland members (EU-11)8, the prospective candidates to EU membership and related regions such as Northern Africa and the Baltic States that peg their currencies to the Euro is mainly linked to the issue of stability. Robert Mundell discusses the stability issue and chances for the Euro to become an international currency and relates it to the optimum currency area model.9 The following key characteristics determine whether a currency will remain stable10:

Inflation and unemployment: First consider a currency area with a common currency and two members (A, B). They are initially in full employment and balance of payment equilibrium. Money wages and prices cannot be reduced in the short run without causing unemployment. Central banks act against inflation. What happens if demand is shifted from B to A? A shift in demand from B to A will increase unemployment in B (decline in output as prices and wages remain stable) and cause pressure on inflation in A. So unemployment in a deficit region can only be corrected on behalf of inflation of a surplus region. The target of full employment in a multi-regional economy with a common currency therefore contradicts inflationary targets.

Mundell says that: “The fault lies not with the type of currency area” - either multicurrency or multi-regional -“but with the domain of the currency area.” The optimal currency area is not the world. It is the region. Optimality is defined here in terms of the ability to "stabilize national employment and price levels”11. It has still to be proven that EMU can achieve this goal and live with this major trade-off.

Oppositely it can be seen that in the previous "before EMU" trade-off situation EU countries have not dealt with unemployment and inflation at the same time. So restraining prices in the surplus country had recessively affected the world economy when the exchange rates were fixed or had put pressure on deficit countries under the system of flexible rates.

Size of transaction domain: The larger the transaction domain, the more capable is a currency to act as a cushion against crises. The size is relative and one will have to look at the comparable currency blocks. That is the dollar zone and the yen zone. The Euro is even larger which tends to be favorable.

Stability of monetary policy: The Maastricht Treaty is unambiguous in making price stability the main target of monetary policy. So the latter will not be used to reduce unemployment - at least in theory. But political activities such as the “Bündnis für Arbeit” (= alliance for work) may raise some doubt, especially if the Socialist influence on European level increases further.

The approach of ECB towards transparency as collective noun for predictability and consistency of the monetary policy shall be comparable to those of other central banks and therefore shall not be considered an advantage or drawback.

Problems remain with monetary targeting. As monetary aggregates (M1, M2, M3) cannot be used to steer central bank action, because it lacks historic data, and globalization leads to the invention of many new financial products, that are not comprised in the arbitrarily defined aggregate terms, ECB uses inflation targeting instead.

Absence of controls: Although one can confirm some "dirigisme" historically, both in Euroland and in the areas mentioned above (dollar and yen area), no exchange controls are in effect at present and can be seen in the future.

Strength and continuity of the issuing state: Sound monetary policy is affected by its political background. Strong international currencies have always been backed by strong central states. EMU seems to be irrevocable. But the EU-15 has always had internal discussions, and the British position towards the Euro reinforces this. So no one can make predictions what will happen to the unity in case of violent economic crises. This fact can be seen as a disadvantage compared to central state backed currency areas.

Fallback value: In the past currencies were metallic (gold, silver) themselves or at least convertible. Modern paper currencies so called "fiat currencies" lack this quality, with the exemption of the dollar that gained international significance. In case of any great political emergency, there will be a run on Euro that is not backed at all. Long-term securities to finance government debt would not be accepted in this case. This parameter will work against a stable Euro under states of emergency.

Advantages and drawbacks of the present and previous tradeoffs:

On the basis of these stability criteria the chances for the Euro to become a stable international currency stand pretty good. Large currency domain, stability of the monetary policy and absence of controls are corresponding positive signals. The strength of the issuing state and the fallback value may be seen negative in this context. But an overall judgment is hard to make. Whether the present situation compared to previous tradeoffs can be seen as benefit or disadvantage depends on one’s confidence in the respective monetary authorities to use monetary policy wisely.

Nevertheless one point of justified criticism centers around the problem of inflation, unemployment and the different levels of economic growth in Euroland, that makes setting an optimal economic policy (monetary policy, fiscal policy) very difficult. Optimal in the sense that it suits all members of EU-15 to achieve the set goals - namely, stable prices, sustainable economic growth, full employment and a balance of payments equilibrium.

EU-11 gave the power to pursue monetary policy in the ECB’s hands, giving up national sovereignty to adjust it according to national needs. Thus, economic policy on the national level is restricted to fiscal policy (tax policy and deficit spending), which does not influence money supply. And even the use of fiscal policy is limited as the Maastricht criteria for budget deficits (3% of GDP max.) prohibit large deficit spending activities and reduces the options to tax measurements. The latter again is a subject to harmonization tendencies within the EU. The remaining possibilities seem to be very few compared to the power of centralized EU institutions.

In this context Mundell makes the point that the optimum currency area is the region. Based on Ricardo school, he argues with factor mobility, let it be labor or capital. So we would like to conclude that Euroland is no optimum currency area and that the future will show, whether the monetary experiment proves to be successful to achieve the economic goals.

Euroland for companies:

The Euro is by definition of the internal exchange relations is stable in its inside value. This inner stability has positive impacts compared with situation before EMU. Among the manifold advantages cited we can name three important ones:

- Fixed basis for business transactions, not only within EU-11 but to some extent also in Euroland as a whole.
- Reduction of transaction cost in European trade, as cost for covering exchange risk or transferee losses are reduced or eliminated.
- Common base for regional or European marketing (Euro-pricing)

In its external relationship the Euro floats against non-EU currencies. It devaluated approx. 25% against the dollar since its start on 1 January 1999. The Euro devaluation in this respect represents the relative strength of the U.S. economy compared to Euroland.

What types of companies benefit the most from the new situation? On the one side, companies that operate on the European continent are better off due to the reasons listed above, i.e. minimization of transaction cost and elimination of currency risk. Especially those companies will benefit the most that do business in more than one member country compared to those having only single locations. But these factors become true also for the trade with possible EU- candidates. This happens due to their pre-access harmonization efforts.

Externally the presently weak Euro favors European exporters as their goods and services become cheaper for third country buyers and therefore increase demand. But this situation can in time change of course because the currencies involved can flow “freely” - for example, if ECB and Fed interventions are assigned to this term.


At the beginning of the 21st century, globalization with the liberalization of financial and trade flows is in danger. Volatile short-term capital movements are identified as the problem and even the well-known economist as Krugman and Eichengreen consider capital controls (under certain circumstances) as solution.12 13 In our opinion, this way is based on a wrong diagnosis and will lead to monetary nationalism and the type of economic situation, which has frequently occurred in the past.

We found a statement by Judy Shelton that indicates, why it is so important to look at the topic closely: “But there's an even more compelling reason to care about exchange rate turmoil and the manipulation of currencies. Wars have been triggered by monetary nationalism. Look at the '30s, when governments attempted to undercut the ability of other nations to sell products in world markets by engaging in competitive devaluation of their currencies. Instead of boosting global demand and employment, it led to a downward spiral of increasingly isolationist economic policies that raised the level of political tensions and set the stage for World War II.”14

3.1 The currency board:

Again one lands at the start-off point - the “impossible trinity” or eternal triangle, especially in emerging economies. Which direction is more prone to the problem right now? Liquidity and confidence is the chosen menu to cope with volatile markets and crises. The free float would not work in many cases, as the Asia, Russia and South America crises demonstrated in the past.

Therefore, the only way to avoid such a catastrophe for emerging economies is to peg their currencies to stronger ones or by replacing a national currency with a strong foreign currency (official dollarization, building of a multi-region currency area) or by establishing a currency board.

Currency board is a monetary institution, which can only issue notes and coins, when they are fully backed by a foreign reserve currency and convertible into the reserve currency at a fixed exchange rate on demand. In addition, a currency board cannot act as a lender of last resort, does not regulate reserve requirements for commercial banks, only earns seignorage from interest on reserves, and does not engage in hedging operations.

3.2. Issue analysis:

Governmental regulation in any form including central bank activity, and this is our key point in context with monetary nationalism, also limits personal freedom and in consequence liberty. While global integration of financial systems on freely operating markets with the background of i.e. currency boards as guidelines, fosters individual responsibility, personal freedom and thus liberty.

On practice, from our point of view, The Economist delivers a good guess on how the emerging economies will develop in terms of their exchange rate regimes.15 It is likely that two groups will develop: the first group with a system of floating exchange rates but a low level of global integration (= higher level of regulation or control), and the second group that binds their currency by the mentioned measures.

Even the skeptics have admitted that currency boards are not trouble-free. They cannot cope with external shocks; that they are vulnerable to surges in inflation triggered by capital inflows; and that with limited lender of last resort capacities, they cannot deal effectively with financial emergencies.

But they work as guidelines not as stiff regulations and are therefore clearly the better option to sustain free markets and liberty.


As already mentioned, a country can fix its exchange rate without emasculating its central bank, but only by maintaining controls on capital flows (like Bretton Woods in the past, and China today). Or it can leave capital movement free but retain monetary autonomy, but only by letting the exchange rate fluctuate (like collapse of Bretton Woods and emergence of floating rate regime in Europe in the past, or Britain, USA, Canada or EMU today). And in the third scenario, it can choose to leave capital free and stabilize the currency, but only by abandoning any ability to adjust interest rates to fight inflation or recession (like Argentina and single EMU-countries today).

4.1 Different Canada

In 1960 almost all countries had fixed exchange rates with their currencies pegged to the U.S. dollar. International movements of capital were sharply limited, partly by government regulations, partly by the memory of defaults and expropriations in the '30s. And most economists who thought about the international monetary system took it for granted, explicitly or implicitly, that this was the way things would continue to work for the foreseeable future16.

But Canada was different. Controlling the movement of capital across that long border with the United States had never been practical; and U.S. investors felt less nervous about putting their money in Canada than anywhere else. Given those uncontrolled movements of capital, Canada could not fix its exchange rate without giving up all control over its own monetary policy. Canada would have used money supply not for stimulating or slowing down the economy but to sustain the exchange rate during relative changes in the investment attractiveness of Canada and USA. Unwilling to become a monetary ward of the Federal Reserve, from 1949 to 1962 Canada made the almost unique decision to let its currency float against the U.S. dollar.

In global terms the Canadian economy is performing well. Inflation is relatively low. Growth in 1999 was the second highest among the top seven industrial economies (G7), after America. And in the year 2000 it may come join first. When federal, provincial and local accounts are added up, the nation’s total government balance is in surplus. And unemployment has been falling, from a peak of almost 12% of the workforce at the end of 1992 to around 7% today. The Canadian dollar’s purchasing power is well above its value on the foreign-exchange markets, giving Canada the lowest cost of living in the G7; housing is cheap; and health care and schooling are good.

However, ten years ago a Canadian dollar was nominally worth around 84 US cents. Today it is worth about 68. In our opinion, a weak Canadian dollar reflects relatively low economic potential of Canada. It reflects the dramatic decline in net foreign investment in Canada - in businesses and real estate, and in stocks and bonds. If a weak currency were good for an economy, the U.S. would be in recession and Brazil, Turkey and Russia would be booming. The strength in the U.S. dollar in recent years has mirrored the strength in the economy. The recent appreciation in the yen and the Euro from rock-bottom levels has been the result of early signs of a recovery in economic activity.

But the Canadian economy is growing rapidly now, thanks to robust exports to the U.S. Cross-border flows of foreign direct investment (FDI) have more than doubled since 1984, the year Canada declared itself open for business. Canada allocates more of its Gross Domestic Product (GDP) to business investment than any other G-7 country, except Japan, giving it an excellent base for further growth. Canada has experienced substantial growth in the area of real plant and equipment investment. From 1979 to 1989, it demonstrated the second highest rate of growth of all G-7 countries, next to Japan. Investment in machinery and equipment enhances Canada's productivity and competitiveness and has been increasing as a proportion of total business investment, from 51.2% in 1983 to 65.4% in 1989. However even with the surge in some resource sectors this year, foreign investors are afraid that exchange-rate losses could offset stock market gains.

The fact that interest rates in Canada are so much below those in the U.S. is also not necessarily such a good thing. It is symptomatic of a lackluster, tax-burdened economy. If low interest rates were necessarily a good thing, the high-rate jurisdictions of the U.S. and the U.K. would not have been the global growth leaders in the 1990s - both posting enormous job growth and generation-low unemployment rates. Conversely, lowinterest-rate countries such as Japan and Switzerland would have been economic stalwarts instead of laggards. Often interest rates are low because the economy has under-performed and the rate of return on capital is low.

For the moment the Canadian dollar has become stronger. So Canadians can buy more foreign goods and are richer than a year ago. But Canadian exporters will have to be more competitive vis-à-vis U.S. manufacturers. Since 1989, the Canadian dollar has fallen by 2.4% a year and this drop has hidden many of economy's shortcomings, such as lower productivity growth and rising costs. Lower dollar has allowed Canadian manufacturers to avoid controlling their costs relative to their ability to improve their productivity17. Also high levels of taxation on payrolls and businesses have added to manufacturing costs, stifled innovation and retarded productivity growth. As the protection afforded by a low dollar is peeled away, so the uncompetitive impact of Canada's higher taxes will become clearer and more disabling.

Fortunately the government has started recently to improve Canada's business and investment climate. This includes the deregulation of the transportation, energy, telecommunications and financial sectors; the privatization of 25 government-owned corporations; and reforms to the unemployment insurance, competition and bankruptcy laws. Other changes include: increased protection for intellectual property; making Canada more attractive for the headquarters of international shipping companies through tax reforms; and amendments to national policy regarding international investment in Canada's oil and gas sector. Several international companies are currently using Canada as a test-market site for their North American operations. This strategy allows them to establish a North American base, and organize systems, channel members and branding strategies. Also, once companies become comfortable with their Canadian operations, they use Canada as a North American head office from which they target the much larger (roughly 10 times the size) U.S. marketplace.

4.2 China's controls

China’s stability results in part from the strength of its currency, the renminbi. China’s nominal exchange rate vis-à-vis the U.S. dollar has been virtually unchanged since early 1995. The stability of the nominal dollar rate contrasts with the sharp appreciation of China’s trade-weighted real exchange rate. China’s large foreign exchange reserves have helped insulate it from the worst effects of the Asian crisis. The total foreign reserves (less gold) have risen sharply since 1994, as China’s central bank accumulated foreign exchange to offset pressure for a nominal appreciation. At the end of 1998, China had about $149 billion in total reserves less gold (including about $145 billion in foreign exchange). The growth in foreign reserves has slowed since late 1997. However, reserves began increasing again at the end of 1998. This increase presumably reflects primarily revaluation stemming from substantial yen appreciation in October 1999. The increase may also reflect the effects of new controls aimed at stemming capital flight. For example, authorities have ordered state enterprises to repatriate offshore holdings of foreign exchange and have tightened inspection of trade documents. Given China’s reserves, its sizeable external debt remains manageable. China reported external debt of $130 billion in mid-1998.

China’s capital controls played a considerable role in contributing to stability. They take various forms, including restrictions on foreign borrowing by Chinese entities, restrictions on portfolio outflows by Chinese citizens and inflows by foreigners, and a ban on futures trading in the Renminbi. Foreigners are largely excluded, restricted to the less attractive “B”-share market, denominated in foreign currencies. Nevertheless, the amount of foreign investment jumped by 27% in the first three months of 2000.

Regardless of their adverse effects, capital controls prevented Chinese financial institutions from borrowing excessively abroad, and hence helped keep the external fundamentals strong. The financial market indicates an increased risk premium associated with China. This increased risk premium is likely to lead to reduced capital inflows. To the extent that reduced inflows include foreign direct investment (FDI), reforms also become difficult, since FDI provides an important source of financing for the more dynamic non-state sector.

In the recent past it was the fear of uncontrollable surges across the exchanges that have kept China’s capital account closed. Now, reformists are promoting the idea of allowing foreign institutions to invest in “A”-shares. China wants the expertise that foreigners can bring, particularly in the area of institutional fund-management, more than it wants their money. To that end, it hopes that foreign fund-managers will form joint ventures with local companies to launch open-ended funds and other forms of collective investment. Currently local managers offer a mere ten closed-end investment trusts, each with no more than 2 billion yuan ($240m) to invest. The next logical step is to allow foreign stockbrokers to form joint ventures. Undertakings China made to get into the World Trade Organization will allow foreigners to underwrite Chinese securities.

Given China’s strong balance of payments position and substantial foreign reserves, it is unlikely that external pressure on the currency will provoke a crisis. However, growth is gradually slowed down by continued declines in exports and non-state investment, an overhang of inventories, and widespread consumer unwillingness to spend. Although exports are doing relatively well, China’s economy is driven mainly by domestic demand and investment, and exports, in the long run, play only a supporting role. Moreover, private companies mostly produce them. Such a slowdown would raise the likelihood that foreign investors become less willing to invest and lend; bank runs would also become more likely as Chinese citizens attempt to evade capital controls and invest abroad.

Chinese authorities appear aware of the risks, but the problems are inherently difficult. China is attempting to balance conflicting concerns—a desire for short-run stability and growth (which tends to slow reforms) versus a need for long-run improvements in the allocation of resources (which requires that reforms move forward). Following the success of East Asia's newly industrialized economies in the 1970s and 1980s, China has been following an export-led growth strategy. Government policies included mainly decentralization of the trade management system, the regional targeting policy, and the sectoral targeting policy. The targeting policies used instruments such as tax breaks, foreign exchange retention privileges, government provision of cheap materials and credits, and duty-free imports. As a part of China's regional targeting policy, the strategy of combining openness toward foreign investment with export orientation in the special economic zones and open coastal cities has been particularly successful. Among the targeted regions, Guangdong Province has been a model for developing a foreign investment based and export-led development strategy.

Without clear signs of new household spending and business investment, China’s progress will depend upon exports. Exports have recently been driven by strong demand in Europe and America. China may be seriously affected if the demand declines. Moreover, facing weak growth and downward pressure on the currency, China might choose to devalue in an attempt to increase exports and avoid losing foreign exchange18.

Argentina's fear

Argentina has been the role model for those who believe that a credibly stable currency is all you need to promote prosperity. And its troubles - especially the contrast with the unexpectedly good news from Brazil - are therefore a reminder that a strong currency and a strong economy are by no means the same thing19. Now, Argentina does, by law (the so-called "convertibility law"), have an undeniably strong currency. A peso is worth one U.S. dollar, and that promise is made credible by the legal requirement that every peso in circulation be backed by a dollar's worth of foreign exchange reserves. In other words, short of actually abandoning its own currency in favor of the U.S. dollar - a measure that has been discussed quite a bit lately - Argentina has done everything possible to make that currency credible and secure. This "currency board" system was introduced in 1991, when hyperinflation was a recent memory and most people expected it to return in due course. It is also argued that fear of currency speculation, not the desire for efficiency, has led Argentina to talk seriously about replacing pesos with dollars and made dollarization at least a topic of discussion elsewhere in Latin America.

The problem is that the same rules that prevent Argentina from printing money for bad reasons - to pay for populist schemes or foolish wars - also prevent it from printing money for good reasons such as fighting recessions or rescuing the financial system. Argentina came very close to financial collapse in 1995 when it turned out that the convertibility law left no leeway to rush cash to troubled banks. It has since established various questionably strong safety nets to prevent a repetition of that crisis.

Since the late 1980s the bulk of foreign investment in Argentina has been in the large privatized, formerly state-run, industries. Although these include such industrial production as steel, the main privatized industries participated in by outsiders have been the former monopolies operating the extractive sectors, utilities, and services: oil and gas, mining, telecommunications, water and sewers, energy, transportation, financial services, ports and port services. Foreign investments for the period 1994-98 totaled US$ 6.0 billion in oil and gas, US$ 6.5 in telecommunications, US$ 5.7 billion in energy, US$ 5.2 billion in banks and insurance, and US$ 1.7 billion in mining. Following investment in these privatized sectors, the next largest area has been portfolio investment in securities.20

Remaining direct foreign investment has been made largely in manufacturing, with the automotive industry as the primary target sector. For the period 1999-2002, the oil industry will be the area to receive more investment, followed by telecommunications, supermarkets and distribution, automotive industry, energy, construction, banks and insurance, chemicals and food industry.

There are currently no restrictions on foreign ownership, but in some industries there are regulations to the entry of companies of any national origin (including Argentines). In some cases, typically depending on the state of the market, the only entry form accepted is the acquisition of an existing firm, for example in insurance, fishing. These restrictions have nothing to do with nationality but with limited licenses, safety, and natural resource control.

And now the country faces what is basically a garden-variety recession, the sort of thing that happens to every economy now. It cannot try to cushion the slump by lowering interest rates and pushing more money into the system. They cannot even borrow money for some employment-generating public spending, because fiscal indiscipline would undermine the peso's hard-won credibility. Argentina is a resource-rich nation, a long way from anywhere, with no dominant Northern Hemisphere trading partner. Economic logic suggests that in the long run such countries, if they can put their inflationary histories behind them, have no business adopting the currency of a faraway country, which will not take their interests into account21.


5.1 "Fix or float" dilemma and "Impossible trinity"

It should be clear by now that this exchange rate dilemma deals with the alternative financial architectures described above. We believe that it can be considered the most important element of "impossible trinity" concept. However in order to present a true and full picture it should be complemented by analysis on how the level of capital controls influences the choice of architecture. Why is it vital? Because capital controls could be very bad for economic efficiency. But these costs must be compared with the alternatives. For example, Brazil's efforts to maintain both liquidity and confidence resulted in very low growth in the recent years. This happens when its economy needs approximately 5 percent growth to keep unemployment from rising22.

What could be said against multiple currencies and flexible exchange rate? At first sight, it might seem obvious that the fewer currencies there are the better. Maintaining a system of national moneys means more hassle and expense, because you have to change money and to pay the associated commissions. It also means more uncertainty, because you are never quite sure what foreign goods are going to cost or what foreign customers will be willing to pay. And as globalization proceeds - as the volume of international transactions rises, both absolutely and relative to world output - the cost of having many currencies also rises.

In favor of multiple currencies and flexible exchange rate say the following assumptions. While globalization and technological change in some ways are pushing the world toward fewer currencies, they actually reinforce the advantages of monetary pluralism. For example, right now the Irish economy is booming and the German economy's sputtering. Clearly, prices and wages in Ireland need to rise compared with those in Germany. Could one simply rely on supply and demand to do the job, producing inflation in Ireland and deflation in Germany? No. It is much easier (and this is how it works in a flexible rates system) to keep German prices stable in German currency, Irish prices stable in Irish currency, and let the exchange rate between the two currencies do the adjusting. In the same way a country whose wages and prices are too high compared with those abroad will find it much easier to make the necessary adjustment via a change in the value of its currency, than through thousands of changes in individual prices23.

But in general each option of international financial architecture is unsatisfactory in some important way. When Brazil - whose economic history is nearly as dismal as Argentina's - finally devalued in January, the predicted hyperinflation never arrived and neither did the financial meltdown. The serious lesson of the antics in Argentina is that the big issues of monetary economics - fixed vs. flexible exchange rates, whether countries should have independent currencies at all - are still wide open. It's an eternal controversy. To resolve it one has to break the vicious circle of stability, adjustment and liquidity and find new dimensions for building a financial architecture, which could provide for "perfect" stability, the one without "tradeoffs" and negative side-effects.


6.1 "Free banking" as financial architecture

Under the so-called classical gold standard, the ultimate cash, which people were entitled to, was gold. The circulating forms of money - bank notes, non-gold coins, and checkable (demand) deposits - were all supposedly payable on demand, in gold coins. At no time, however, could banks redeem all their bank notes in the gold they entitled people to. It was analogous to an airline overbooking a flight. Redemption of all checking account balances was an even more ridiculous impossibility. Now the ultimate cash (in the US) is Federal Reserve Notes. The demand-claims are Federal Reserve Notes themselves, base metal coins, and checkable (demand) deposits. Banks, as always, remain unable to cough up enough cash to cash out depositors with checkable balances. In a real systemic crisis, where increased liquidity preference means "give me folding green" instead of "sell Microsoft and send me a check" the hallowed central bank function as "lender of last resort" could easily degenerate into printing press of last resort. All the discussions about "Fed Funds" and "injecting liquidity" are describing mechanisms, which work only when you do not desperately need them.

Most central banks set monetary policy with the aim of keeping inflation low. The European Central Bank (ECB) has the statutory goal of “price stability”; the Fed also has a duty to support employment and economic growth. In most rich countries, governments now define central banks’ aims, but allow them to pursue them without political interference. Central banks’ monopoly on supplying cash and bank reserves is relatively new. In the 19th century, private banks in Britain and America issued competing currencies. With the return to a “free-banking” era the outcome might be far from stable. One of the arguments against private banks issuing their own notes and coin is that they would engage in over issue, possibly leading to hyperinflation. Proponents of laissez-faire banking like White (1984a), Selgin (1988), David Glasner (1989), and Kevin Dowd (1993) reject this by arguing that if an excess supply of banknotes existed then the amount representing excess real balances would be promptly returned to the issuer. This view is supported, in particular, by Selgin's (1988) evidence that historical unregulated banking systems were characterized by a short issue- redemption lag. Therefore, since issuing banks must stand ready to honor the claims against them, they would be clearly reluctant to engage in over issue (the principle of adverse clearing).

Another strong argument against free-banking deals with assumption that the variable exchange rate between the different notes would increase uncertainty and lead to poor co-ordination of the decentralized decisions of millions of consumers and producers. Imagine if, while a house was being built, the length of a meter kept changing, and the architect, the bricklayer and the plumber were all working to a different measure. An efficient economy needs a standard unit of account. In a free-for-all banking system, interest rates would also tend to be much more volatile24.

6.2 E-money and the „impossible trinity“:

25 There could be two ways in which electronic money could considerably increase stability of free banking. They both revolve around one of the basic features of electronic money, namely that it does not circulate. This would enable interest to be paid on electronic money. Competition would force banks to pay interest at the rate that the bank earns on its assets less some small competitively determined margin for the cost of banking services. In order to induce the public to hold more electronic money (prepaid, debit or smart card purchasing power) banks would have to offer higher interest at the margin. But they could not offer a higher rate than that which they could obtain on their assets. This condition would clearly lessen any incentive to over issue. Second, since electronic money does not generally circulate and constitutes an immediate claim on the issuing institution as soon as it is first spent, the mechanism of adverse clearing would operate even more promptly than in a system based on circulating banknotes. In Scotland in 1873 the average period of circulation of a bank note was only 10 to 11 days, a delay that is hardly long enough to encourage banks to over issue26. The delay is likely to be shorter for electronic money.

The transition to a privately operated digital cash system will require a period of brandname recognition and long-term trust. Some firms may at first have an advantage over lesser-known name brands, but that will be soon overcome if the early leaders fall victim to monetary instability. It may be that the smaller firms can devise a unit of value that will enjoy wide acceptance and stability (or appreciation).

Monetary backing is of great importance in this respect. Suggestions include equity mutual funds, commodity funds, precious metals, real estate, universal merchandise and/or services, and even other units of digital cash. Anything and everything can be monetized. This will undoubtedly develop into a main basis for competition among digital cash providers. Each one of them will likely promote its underlying currency backing as the strongest and most reliable. Unlike today's national monetary systems, the benefits of a strong currency will be immediately noticeable within a country's borders. With multiple monetary unit providers, domestic prices will adjust rapidly to reflect relative values of monetary units and the holders of stronger currencies will benefit. This is a vastly different world then we have now and consumers will analyze currencies as the investments that they really are.

We can now conclude some things about the future of the Internet-based financial system, which seems to be stable in a fundamental sense:

- Cash emulating systems can be substantially treated as demanding negligible cash balances and are equivalent to IOU systems in these respects.
- If linked into the existing financial system, digital cash issuance will be subject to self-regulation by the issuers, and to a lesser extent by monetary policy agents.
- The amount of money that is likely to flow into the system is not likely to be significant for some time to come, in comparison with the total system.

In our opinion, the publicly perceived "threat" of E-money to monetary policy is somewhat overdone. There is unfortunately no sign of a dominating demand for Internet financial intermediation and no special monetary cash demands. Also it has been assumed by many that the central banks' approach to the Internet financial system would be one of regulation and limitation. However there is nothing stopping a central bank from extending its usage of monetary policy tools to the net if there is a concern that strong monetary policy might by at risk. For example, open market operations are not likely to be a technical problem, once there exist suitable instruments to buy and sell. One may argue that who can better stabilize the credibility and value of digital cash than a central bank with a strong history of financial prudence?

Yet, even if their currencies are unlikely to be wholly replaced by digital creations, central banks cannot afford to ignore other threats posed by technology. It is, for example, making foreign-exchange transactions much cheaper. Services such as PayPal or e-gold might make it easier for residents of a country with a weak currency to shift their savings into a stronger one. The dollarization of a country might one day become a mere matter of mouse clicks. Ultimately information technology could, in theory, lead to a pure exchange economy with real-time electronic transactions. And then central bankers’ nightmares about their own obsolescence might finally come true27.


7.1 Mutual funds and E-money

The rise in share banking (of the mutual fund type) can shape the banking of the future. It possesses inherent stability in the absence of government. Much attention has been given to the dramatic growth in money market mutual fund shares. David Hale (1994) notes that in the United States, where the trend has been most in evidence, ``mutual funds are overtaking banks as the main repositories of household wealth and suppliers of capital to small and medium-sized companies.'' The U.S. mutual fund industry had an asset total figure of barely 10 percent of bank deposits in the early 1980s but by 1993 that figure had risen to 85 percent. In 1993, 28 percent of U.S. households had membership in a mutual fund, against 6 percent in 1980.

However equity-type banking was not a realistic option until recently. Now developments in information technology are making the operation of continuous marking to market of even small savings claims efficient. Consequently, a ``natural'' blockage to share banking is being increasingly diminished. This fact is supported by the greater mediation of savings into equity-type claims: for instance, as already cited, in the U.S. mutual funds are now equal to about 85 percent of U.S. bank deposits against barely 10 percent in the early 1980s.

Focusing on the option of equity mutual funds, this does not imply that a prospective digital cash provider learns to become adept at managing an entire portfolio. Mutual funds exist today and contracts can be executed with the specialist managers of those funds. Outsourcing the portfolio function takes advantage of the experts in the field today who compete already on reliability and overall performance - prime benchmarks for a private monetary unit. The issuer's skills should concentrate on distribution, monitoring geographic circulation of the unit, and managing the rate of redemption28.


What economic policy (monetary policy, fiscal policy) is the optimal? Is it the one that helps achieve stable prices, sustainable economic growth, and full employment and equilibrium of balance of payments? According to this research and various statistics29 we could state the following:

Confidence and Liquidity of single EU-11 along with Adjustment and Liquidity of EU- 11 as a whole have so far led to highest trade balance, moderate unemployment rate, slow growth and high price stability. Adjustment and Liquidity of Canada resulted in moderate trade balance, lowest unemployment rate, moderate growth and high price stability. Adjustment and Confidence of China helped it achieve high trade balance, moderate unemployment rate, highest growth and highest price stability. Argentina's Confidence and Liquidity provided for negative trade balance, highest unemployment, zero economic growth and stable prices.

Abbildung in dieser Leseprobe nicht enthalten

As one can see there is no definite winner in this game based on selected economic data. Therefore it may be necessary to employ a composite analysis of each country.

So our group decided to measure the success of different blueprints by the happiness of the countries' inhabitants. In this assessment we used the WORLD DATABASE OF HAPPINESS30 (Continuous register of scientific research on subjective appreciation of life directed by Ruut Veenhoven, Erasmus University Rotterdam). According to this research Original mean of happiness of EU-11 is 3.61, Canada - 7.88, China - 3.66 and Argentina - 4.08. In the current situation Canada seems to be the model country.

We think that this measure is at least as serious as hard facts on, i.e. inflation and unemployment, because the latter are comprised in the former. But to make the key point really serious at the end and as mentioned earlier:

Governmental regulation in any form, and that of course includes central bank activities also limits personal freedom and in consequence liberty. While global integration of financial systems on freely operating markets and on the basis of “free banking”, e-money or equivalents and discovery procedures with only guidelines set by governments, fosters individual responsibility, personal freedom and thus liberty.


1 Summers, Lawrence H., Treasury Secretary. THE RIGHT KIND OF IMF FOR A STABLE GLOBAL FINANCIAL SYSTEM". Remarks to the London School of Economics, England. 12/99.

2 Krugman, Paul. THE ETERNAL TRIANGLE. 1998

3 The Economist. TIME FOR A REDESIGN? The Survey on Global Finance. 30 January 1999.

4 Krugman, Paul. THE ETERNAL TRIANGLE. 1998

5 Ibid.

6 The Economist. TIME FOR A REDESIGN? The Survey on Global Finance. 30 January 1999.

7 Ibid.

8 15 EU members with exemption of Denmark, Great Britain, Sweden and Greece.

9 Mundell, Robert. The Stability of the International Monetary System. . January 1999.

10 Mundell, Robert A. International Economics. pp. 177-186. Macmillan. New York. 1968

11 Ibid.

12 Krugman, Paul. THE ETERNAL TRIANGLE. 1998

13 The Economist. FIX OR FLOAT? The Survey on Global Finance. 30 January 1999.

14 Shelton, Judy. Remarks at Empower America's Conference "The 50th Anniversary of Bretton Woods: Why the World Needs a New Monetary System". 8 September 1994.

15 Ibid.

16 Krugman, Paul. O Canada A neglected nation gets its Nobel Price. Slate Oct. 18, 1999

17 As Jim Frank, the chief economist of the Conference Board of Canada expressed.

18 Board of Governors of the Federal Reserve System, International Finance Discussion Papers, Number 633, February 1999, Why Has China Survived the Asian Crisis So Well? What Risks Remain?, John G. Fernald and Oliver D. Babson

19 Keynes, John Maynard. Different articles of the 1920s.

20 ARGENTINA. The Economist Survey. May 2000.

21 Don't Laugh at Me, Argentina Serious lessons from a silly crisis. By Paul Krugman

22 Ibid.

23 Friedman, Milton. Various papers.

24 The Economist. An Endangered Species. 25 September 1999


26 Selgin (1988)

27 The Economist. E-cash 2.0. 19 February 2000


29 The Economist.,


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Selected Topics of Financial Architecture
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