Impossible Trinity Taking the Market Lower

Despite claims to the contrary, economists have envied physicists for decades.

Physics envy is based on the desire for economic theories to replicate the beauty and symmetry of the mathematical formulae of physicists.

And a big part of this phenomena is the emphasis of finding equilibria.

You see, the concept of equilibrium in economics was imported from the field of physics, even though it isn’t a proper fit. Because economics is essentially a science of human action, the empirical data necessary to mimic the mathematical equations of physicists will forever remain out of reach.

It’s also the reason that former Federal Reserve Chairman, Ben Bernanke, recently told an audience in Korea that his policies were ‘economic experiments,’ and that the costs and benefits of his policies wouldn’t be understood for decades. Not exactly a resounding endorsement of activist monetary policy!

But make no mistake. Economists are able to formulate certain economic rules that, if violated, will cause economic harm to various participants.

One such rule is the Impossible Trinity.

The Impossible Trinity is a rule developed by Nobel Prize winning economist Robert Mundell in the early 1960s.

The premise of the rule is that no country can have an independent monetary policy, an open capital account, and a fixed exchange rate at the same time. Any attempts to do so will be met with the loss of monetary sovereignty when currency arbitrageurs use the resulting carry trade to their advantage.

China is the latest country to make a futile attempt to circumvent the rule. Of course, they have failed miserably. But their failure will not be confined to themselves. The country risks precipitating a massive global currency crisis.

China started the current crisis in early December by switching from a dollar currency peg to a trade-weighted exchange basket. The inability of the People’s Bank of China to properly make the switch inadvertently set off capital outflows from China. Now, the PBOC is struggling to pick up the pieces.

In the meantime, the PBOC is perilously close to a devaluation crisis as the yuan threatens to break through the floor of its currency basket. This is occurring despite a massive intervention by the central bank to defend their exchange rate.

The chart below illustrates China’s inability to support its currency.

Yuan

Now, in December, China burned through more than $120 billion of foreign reserves, and it’s a clear signal that capital outflows have reached systemic proportions.

But the PBOC doesn’t fully appreciate their problem. Not by a long shot.

In the near future, China will be forced to devalue its currency further, and possibly close or modify its capital account to some extent in order to preserve its remaining reserves.

This is a dangerous condition…

By devaluing its currency further, a strong deflationary signal will be received by a global economy already on the cusp of recession.  Even more worrisome, further devaluing by the PBOC risks setting off a chain-reaction much larger and more dangerous than the Asian crisis of 1998.

For now, any further currency devaluations will roil U.S. markets. It’s time to consider taking profits as a precautionary step to Chinese induced volatility.

The stock market will be unable to rise to its previous highs in light of the surge in volatility. Worse, the risk of a serious global recession becomes a greater possibility.

Economists don’t have the beautiful math formulae of physicists, but we do have rules by which an economy functions.   China has violated the rules, and without swift action to remedy the errors, a financial bloodbath is a distinct possibility.

 

 

 

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