From the impossible monetary trinity towards economic depression *

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Zb. rad. Ekon. fak. Rij vol. 29 sv Preliminary communication UDC /.77: From the impossible monetary trinity towards economic depression * Stjepan Zdunić 1 Abstract
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Zb. rad. Ekon. fak. Rij vol. 29 sv Preliminary communication UDC /.77: From the impossible monetary trinity towards economic depression * Stjepan Zdunić 1 Abstract The aim of the paper is to determine the interdependency of both balance of payments and fiscal deficit in the context of liberalized systems of capital flows with mainly stabile and appreciated exchange rate and their impact on the dynamics of growth of transition economies of Central and Eastern Europe with special retrospect to Croatia. In the research we used a classical econometric model for aggregated series of data of a group of transition countries, and individually for Croatia and Poland. We determine a significant regression interconnection between fiscal and balance of payments deficits for the group of transition countries, and individually for Croatia, with the exception of Poland and Eurozone. Furthermore, we explore the interdependency of these deficits with the growth rate of gross domestic product of analysed CEE countries and Croatia, where we obtain only partially significant regression results. The final conclusion of the analysis is the existence of significant inverse relationship of balance of payments and fiscal deficits of aggregates of transition economies and Croatia. Growth rates of gross domestic product loosely depend on the balance of payments deficit of groups of transition countries, which cannot be concluded for Croatia. In the case of relationship between the growth rate of gross domestic product with current budget deficits of the analyzed group of transition countries we do not obtain satisfactory significance. From the entire analysis we can conclude that the policy of reducing the balance of payments deficit with the secondary goal of reduction of budget deficit and a decrease in foreign debt, in present condition, has a pro-recessionary effect for the majority of transition countries. Key words: twin deficit, monetary trinity, econometric model, fixed exchange rate, currency clause, liberalized financial market, depression JEL classification: E52, F31, F32, H62 * Received: ; accepted: Scientific advisor (ret), Stjepana Ljubića Vojvode 12, Zagreb, Croatia. Scientific affiliation: economic and development policy, monetary policy, international economic relations. Phone: 396 Zb. rad. Ekon. fak. Rij vol. 29 sv Introduction Coming from the theoretical Mundell-Fleming model which links growth rate of gross domestic product (GDP) with the regime of exchange rate and the degree of capital flows liberalisation, in our conditions it is necessary to specifically examine the issue of limitations of monetary and fiscal policy as instruments of antirecessionary policy in conditions of fixed exchange rate. This is due to the fact that we have exogenously given both the exchange rate and current budget deficit, which we illustrate by a theoretical model in picture 1. That model logically depicts basic properties of present Croatian fiscal and monetary policy that operate in such given constraints that reduce their efficiency. The limitation of efficiency comes from the Maastricht criteria, liberalized capital account and monetary sovereignty of the country. We can term this phenomenon as the impossible monetary trinity. In such conditions the Croatian development strategy suffers too large constraints in order to successfully overcome long-term recession which transited into the state of depression of the Croatian economy in whole, for the long-term. In regards to that, starting hypothesis of the research is, first, fixed exchange rate regime and liberalized system of capital flows conditions non-sovereign monetary system which prevents an active anti-recessionary and development policy of the country; second, regression relationship between current account deficit of balance of payments with growth rate of GDP, on the other hand, has to show previous character and (im)possibility of monetary and fiscal policy in overcoming depression and attaining dynamic growth of transition economies of Eastern Europe and Croatia. Therefore, in the next part of the study we cover the following areas: (2) According to the Mundell-Fleming model, in present conditions, fiscal policy in stimulating growth is limited by the Maastricht criteria, (3) Monetary triangle and twin deficit, (4) Empirical and analytical test of thesis of monetary trinity and twin deficit of CEE countries with Turkey, including Croatia as well, (5) Is it possible to overcome the depression in current model of economic system of EURO zone and IMF?, (6) Concluding discussion on the results of the research, (7) Concluding remarks. 2. According to the Mundell-Fleming model, in present conditions, fiscal policy in stimulating growth is limited by the Maastricht criteria This chapter provides a theoretical basis (Gartner, 2006) and is the starting point of our analysis, which assumes sufficient knowledge of real economic processes in the Croatian economy, particularly in regard to monetary and fiscal system and policy. Therefore, we do not bore the text with empirical data. In the next chapter, on the contrary, we empirically test the basic theoretical settings presented here, mainly by Zb. rad. Ekon. fak. Rij vol. 29 sv using the appropriate chart of empirical data, then a regression analysis, for Croatia and the wider group of countries in transition. Picture 1: Conditions of the increase of gross domestic product Source: According to Gartner, 2006 The model thus highlights the increase in GDP, influenced by the growth of government spending in conditions of a fixed exchange rate, FE, and liberalized capital flows and interest rates. The theoretical implications of the fixed exchange rate and liberal capital flows, and built-in constraints, as derived from the analysis given in Picture 1, can be summarised as follows: The increase in government expenditure shifts the IS curve to the right. This increases the GDP, which entails an increase in demand for money, which then increases the interest rate, i. The consequence is the further increase of attractiveness of government bonds and strengthening of foreign capital inflows, which again increases the demand for domestic currency. Since the central bank is obligated to meet the demand for domestic currency, which is required for the purchase of an increased supply of foreign currency, the LM curve also shifts to the right. At this point GDP 0 raises to GDP 1, but interest rates return to the equilibrium interest rate i 0 as well. In this process the initial equilibrium point A transits to the final new equilibrium point B. However, in the circumstances of given fixed exchange rate regime and ratio of budget deficit in GDP, as well as in terms of the Maastricht criteria, the process falls into a sort of budget and fixed-exchange rate limitation, or trap. Theoretically speaking, this refers to the Croatian case. Therefore, we cannot fully unwind circular flow as described above, so that completion of this course is 398 Zb. rad. Ekon. fak. Rij vol. 29 sv an increase in GDP from GDP 0 to GDP 1. Due to given constraints, the new equilibrium is established between points A and B, i.e. the capacity to increase government spending can not be fully exploited to increase GDP growth in a state of recession! Fixed exchange rate and the forwardly given too narrow (or zero!) budget deficit in relation to GDP limits the effect of depicted circular flow in terms of GDP growth. With underdeveloped institutional mechanisms in monetary and fiscal system to overcome these limitations, such process produces long-term recession, what is being observed nowadays in Croatia. 3. Monetary trinity and twin deficit In this chapter, based on the previous analysis of the Mundell-Fleming model, we will first explain the schematic version of the monetary trinity where the sole objective of monetary policy is stable and fixed nominal exchange rate with fully liberalized capital movements. Such an objective of monetary policy and the regime of balance of payments capital account entails non-sovereign monetary system, which can not support national development goals such as full utilization of the economic potential and the country s workforce. The degree of openness of foreign trade and capital flows in practical policy is quite different. We simplify, for analytical reasons, that these systems in our circumstances can be categorized as liberalized. Further on this basis we establish the existence of an inverse correlation of balance of payments current account deficit and current deficit of the general budget, or so called twin deficits (twin deficit, Eng.), i.e. when one increases the latter decreases (Zdunić, 2009:231). In other words, there should be a significant regression correlation, i.e. satisfactory significance of dependent variables with a negative coefficient for the explanatory variable. In doing so, the dependent variable is the state budget deficit, GVNDEF, expressed as a percentage of gross domestic product, GDP, and the explanatory variable is the current account deficit of balance of payments, CAD, expressed by a percentage of GDP. In specific models with these variables we add a label which denotes the country or countries to which the variables are related. All these issues are synthesised in Scheme 1. Zb. rad. Ekon. fak. Rij vol. 29 sv Scheme 1: Monetary trinity in conditions of fixed exchange rate and open capital markets non-sovereign monetary system A. Fixed exchange rate C. Non-sovereign monetary system B. Open capital market The Mundell-Fleming model shows that due to the fixed exchange rate there is impossibility of monetary expansion with the goal of increase of the GDP growth rate and that capital market balances the national interest rate with the global interest rate; Since the ultimate goal of monetary policy is fixed exchange rate, in Croatian circumstances, and by the request set by the Maastricht criteria, the budget deficit is limited with the secondary goal of keeping interest rates at a given level. When it comes to the EMU countries, monetary expansion and, in such manner, limited fiscal expansion do not allow the so-called quantitative easing policy aimed at encouraging the growth rate of GDP; The foreign exchange clauses, in Croatian situation, increase the limiting role of fixed exchange rates, by making monetary expansion impossible. Contradictory, in the same time they increase the risk of the rise of interest rates on national credit and financial markets on the basis of the interest rate parity, and based on the exchange rate differences and risk premiums; then, exchange rate clauses bring more monetary systems in a single monetary area, breaking it, i.e. parcel monetary system of Kuna by other currencies like the euro, Swiss franc, U.S. dollar and the like, and it makes it chaotic; However, fixed stable and appreciated exchange rate in a liberalized foreign trade and the balance of payments system produces the persistent current account deficits of balance of payments, by substituting domestic supply with imports which results in growth of gross external debt, mainly generated by the private sector; Given that by the logic of the triangular proposition, or impossible trinity theorem, we have nonsovereign monetary system in Croatia, we can pose a question on the kind of mutual dependence of the balance of payments deficits and fiscal deficits. For this purpose, we examine the characteristics of the so-called dual deficit (twin deficits), which created the illusion of tolerable budget deficit. This tolerance is determined by the autonomous movement of the balance of payment deficit in relation to the budget deficit, which is predominantly associated with stable fixed rates, which due to increased free and competitive imports lowers the budget deficit, i.e. increases the budget revenues. Thus, the fixed exchange rate and tolerable budget deficit, based on the free import of goods, to which domestic production could not compete, is the fundamental and long-term causal factor in depression of Croatia and other countries as well. Source: Author 400 Zb. rad. Ekon. fak. Rij vol. 29 sv Further specificities of the exchange rate regimes in relation to the policy of increasing rates of GDP growth can be summarized as follows: 1) The low of the monetary triangle connects the points A, B and C in the previous Scheme 1 into a single geometric figure, i.e., a triangle, which shows that in the same direction there can lie only two vertices of the triangle. Stated by economic terms, this means that only two of the three monetary objectives can be mutually consistently achievable. Economic policy must, therefore, decide which one will be rejected. If monetary policy desires to achieve the goal of C, according to our scheme that is monetary sovereignty, which is used to achieve higher growth rates, then the domestic interest rate should be lower than the rate in the world market. This can be achieved if we restrict the outflow of the domestic and already existing foreign capital and increase the domestic monetary expansion. However, in policy of capital market liberalization domestic interest rates may be higher than the world ones at the beginning, which encourages the inflow of foreign capital. In that case it is possible to have higher market interest rates, which stemmed from open capital markets and fixed exchange rate, in conflict with the aim of reducing interest rates to stimulate the growth rate of GDP. In order to maintain the capital in these conditions the restrictions on its outflow have to be imposed. The points A and B have the same direction, i.e., fixed exchange rate and the free inflow of capital, and point C is outside, and thus, the goal of C, i.e. monetary sovereignty to promote growth can not be achieved in this combination. All three goals cannot be accomplished at the same time. If we want to stimulate growth we should regulate capital inflows and outflows and introduce the flexible exchange rate regime, in order to boost exports and investment and limit the substitution of domestic supply with imports. It is therefore necessary to have a monetary sovereignty, which allows an active exchange rate and interest rate policy by using appropriate monetary and fiscal instruments. 2) Furthermore, the theoretical solution to increase of GDP growth rate in terms of fixed exchange rate is fiscal expansion, as shown in Figure 1. However, our fiscal authority must pursue the policy of zero or limited total budgetary deficit, which aims to achieve a primary surplus in the amount of interests on total external debt, and possibly for part of the private sector debt, coupled with the arrangements of the Croatian Bank for Reconstruction and Development. With the Maastricht criteria, in manner that they are understood and tried to accomplish in Croatia, an instrument of fiscal expansion can not be satisfactorily used to stimulate the growth of GDP. Eventually, the use of budgetary funds for investment can be on the account of reduction of current expenditures on social services, pensions and salaries in the public sector and on the charge of increasing tax revenues. This in turn means that the fiscal expansion as a tool to stimulate growth rates, as is shown in the next part of the paper, is very limited in our conditions. To summarize, this means that together with limited monetary we suffer limited fiscal sovereignty as well. Zb. rad. Ekon. fak. Rij vol. 29 sv Specifically, in terms of flexible exchange rate a theoretical solution to increase the growth rate of GDP is the monetary expansion, which is achieved by the interest rate which is set lower than the rates on the global financial markets, but also by currency depreciation, which should induce the growth rate of GDP, i.e. exports and restrict imports. Our monetary authority, however, manipulates by expansion and contraction in order to maintain a fixed exchange rate, and thus inflation at a given level and its focus cannot be the rate of growth of GDP, i.e. exports and restriction of imports. The monetary authority has to sterilize or relax mandatory reserves in order to maintain the exchange rate at a certain level, and interest rate is by-product of this process. Thus, open market operations in a liquidity policy of the CNB as the target variable have only stable and tentatively stated fixed exchange rate. This eliminates the growth of GDP as a target variable, on the basis of eventual depreciation, and on the basis of lower interest rates on the domestic market for domestic capital. 3) Therefore, from the law of monetary triangle it follows: Fiscal and monetary autonomy depends on the country s exchange rate regime: a fixed exchange rate causes a low monetary sovereignty, and a free capital market undermines a fixed exchange rate regime with a tendency towards appreciation. As the present wider world experience shows, this is the phase process, which often leads to a prolonged recessionary crisis. The Maastricht criteria, in turn, undermine fiscal sovereignty in the function of substitution of impaired monetary sovereignty, and this comes in the form of restrictions on budget deficits. The aim of budget deficit limitations in the euro zone is to restrict the growth of interest rates in order to reduce competition in attracting capital among EMU countries. In fact, in order to avoid the administrative control of capital movements, in fixed exchange rate regime, i.e. in conditions of a common currency, EMU, the restrictions on the current budget deficit are introduced, to prevent its impact on the rise of interest rates in some of the member states and which would excessively attract foreign capital. This limits fiscal sovereignty in the EMU countries with the primary aim that the movement of capital among the EMU countries is mostly determined by microeconomic criteria. The present crisis in the euro zone precisely confirms this hypothesis. The principles of the movement of capital associated with stable exchange rates and the policy of budget deficits, but loose restrictions on the balance of payments deficit, results in contradictory effects in CEE countries, especially in Croatia. Setup of different combinations of these constraints determine the varying degrees of denial of the economic sovereignty of the country: sturdy and low current budget deficit, combined with fixed exchange rates and liberal system of international capital movements result in a high degree of non-sovereignty of the economic system of a country and limit the policy of maximizing the growth rate of GDP and employment, i.e. policy of economic recovery from a state of recession. 402 Zb. rad. Ekon. fak. Rij vol. 29 sv Empirical and analytical test of thesis of monetary triangle and twin deficit of CEE countries and Turkey Statistically speaking, the lower regression correlation of the current budget deficit and balance of payments deficit, the higher a degree in which economic policy of the country follows their own goals: intentional, accidental or coerced, particularly in terms of maximizing the growth rate of GDP and employment. Then, it means that it can enjoy greater monetary and fiscal autonomy, which can be practiced in policy of development. Otherwise, the goal of integration into the global economic system dominates, which is reflected in the regression relationship between two deficits with respect to the coefficient of the independent variable, CAD, which can have a positive or a negative sign. Our analysis shows that a lower budget deficit, stable and appreciating exchange rate and liberalized capital and commodities market implies a larger balance of payment deficit, as a result of lower level of monetary and fiscal autonomy. This case is present in Croatia, but also increasingly in other countries with fixed and appreciating exchange rates. Thus, further in text, we explore the relat
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