It was over three decades ago that the great Canadian economist Robert
Mundell first propounded his theory that, over a sustained period, a
nation cannot have exchange rate stability, monetary independence and
free capital mobility all at the same time. It can fulfill no more than
two of these three goals simultaneously. Mundell derived this insight
from the experience of his native country and was to belatedly win the
1999 Nobel Prize for his truly seminal work in monetary economics–among
other things, the common European currency owes much to him. However,
his impossible trinity remained in textbooks for long largely because
most countries retained significant controls on capital movements. The
East Asian crisis of 1997/98 brought it into the policy mainstream.
These countries had full capital mobility and were following an independent
monetary policy. But they had a pegged exchange rate that became very
vulnerable to a speculative attack even though their “fundamentals”
were strong.

A series of financial convulsions across the world in the past five
years has led a less purist view of the trilemma and a reappreciation
of the role that capital controls can play in managing it. Economists
like Jagdish Bhagwati have been arguing vociferously that financial
liberalisation is fundamentally different from and less desirable than
globalisation of trade in goods and services. Chile has had “smart”
controls specially on short-term inflows and it succeeded where Brazil
and Argentina failed. Malaysia had such curbs for a while in the aftermath
of the 1997 crisis but the evidence of their impact on its recovery
remains controversial.

In typically Indian fashion, India had managed the trilemma by trying
to have all three and has actually not made a bad job of it. Our exchange
rate regime is that of a “managed” float. However, if capital movements
are to be further liberalised and monetary sovereignty is to be preserved,
there must be even greater exchange rate flexibility. The RBI has progressively
become more autonomous of the government We maintains controls on both
inflows and outflows of capital but not in the counter-productive manner
prevalent in the pre-1991 era. But controls on capital outflows by ordinary
residents come with a cost: they eliminate a flash point that might
create a visible external crisis. In the absence of such a trigger,
the impetus for bold reforms is lost. Governments respond magnificently
to a sudden external crisis, not to slow internal strangulation. Dollar
safety allows us to live in rupee profligacy.

Taking a cue from Mundell, another noted economist Dani Rodrik of Harvard
University has recently theorised on a political version of the macroeconomic
trilemma. According to him, deep international economic integration,
a strong nation-state and mass politics cannot co-exist. A country has
to pick two out of three. The Argentinian collapse illustrates this
trilemma well. France has globalised, maintained a strong nation-state
and also retained vibrant democratic politics but in recent years even
it has been ceding greater powers to the European Union.