Central Banking in Latin America - Through the Lens of the Trilemma Hypothesis: A Never-Ending Rocky Journey

Topic: 
Financial Economics

The oldest central banks in Latin America are close to becoming 100 years old. Throughout, they underwent a rocky journey that entailed different and often multiple mandates in response to changes in the international economic order and domestic political developments. This note tracks the changing role of Latin American central banks through the lens of the trilemma hypothesis, which provides a suitable framework for understanding how monetary policy has been framed over time. The trilemma hypothesis contends that small open economies can only achieve simultaneously two of the following three policy goals: (i) exchange rate stability; (ii) financial integration with the rest of the world; and (iii) control of monetary policy.

As proposed by Jácome (2015), the history of Latin American central banks can be divided into three main periods: the “early years,” in which central banks endorsed the gold standard and coped with the collapse of this monetary system; the “developmental phase,” in which central banks turned into development banks under the aegis of governments; and the “golden years,” in which central banks were granted political independence in order to focus on preserving price stability. In each of these historical periods, central banks in Latin America opted for different combinations of two of the three goals envisaged in the trilemma triangle (see below).

The Early Years

The first central banks in Latin America were established in the 1920s. They included initially the Reserve Bank of Peru in 1922 and the Bank of the Republic of Colombia in 1923. Chile and Mexico established central banks in 1925, followed by Guatemala, Ecuador, and Bolivia in 1926, 1927, and 1929, respectively. Edwin Kemmerer—an American economist who became famously known as the "money doctor"—visited Latin America and influenced the creation of most of these central banks. In all of these countries, central banks were only in charge of monetary policy, whereas banking supervision was assigned to a separate agency—the so-called “Pacific” model discussed in Jácome et al. (2012).

Given that countries endorsed the gold standard, central banks committed to preserve the convertibility of their currencies at a fixed exchange rate while keeping an open capital account to allow capital flows to adjust balance of payment disequilibria. Monetary policy was, therefore, endogenous (bottom-left corner of the triangle). Central banks could only issue banknotes if they were backed with international reserves, mostly gold and foreign currency convertible into gold. This monetary system imposed an automatic adjustment mechanism for balance of payment disequilibria. When international reserves declined, money supply shrunk as central banks sold gold. Interest rates then increased restricting aggregate demand and attracting capital inflows, thereby restoring international reserves as well as money supply.

By the late 1920s, central banks started to confront the spillovers of the Great Depression. With economic activity contracting in advanced countries, their demand for commodities declined. Latin America was particularly hit as exports collapsed and the region hence fell into depression. At the same time, capital inflows reversed, as real interest rates remained elevated in the United States, fueling an increase in domestic interest rates. This automatic adjustment, however, amplified the adverse effects of the real shock. Endorsing the gold standard arrangement became an insurmountable restriction for the Latin American countries. Chile, Colombia, Ecuador, Mexico, and Peru initially suspended the convertibility of their currencies and, in 1931–32, officially exited the gold standard. Central banks preserved exchange rate stability as they introduced some capital restrictions and, as a result, they started to gain control over monetary policy (lower side of the triangle). In the years that followed, new central banks were created in El Salvador (1934) and Argentina (1935), and, later on, in Venezuela and Nicaragua.

The Developmental Phase

Latin America endorsed the Bretton Woods system established in 1945. Countries committed to maintaining a fixed—although adjustable—exchange rate regime. They also expanded the array of capital controls, which allowed central banks to enjoy a fully autonomous monetary policy (bottom-right corner of the triangle). Domestically, governments started to play a critical role in the formulation of monetary policy, shifting the focus of central bank policies toward fostering economic growth and development.

To reflect the new international monetary order and domestic economic strategies, a wave of central bank reforms took place in Latin America. Promoting economic development became the overriding policy objective of central banks. Monetary policy focused on financing agriculture, industry, and housing, as well as the government deficit, and did not aim at keeping inflation in check. Regarding the policy framework, the Bretton Woods system linked monetary imbalances with changes in international reserves, as the capital account was relatively closed.

Financing economic development proved to be inconsistent with maintaining a fixed parity. Lax monetary policies resulted in current account deficits, which drained international reserves, leading to currency crises and a rise in inflation. Behind the scenes, central banks’ balance sheets expanded rapidly, in particular in South America. For instance, in Argentina, domestic assets rose more than 200 times nominally and almost tripled in real terms between 1950 and 1970. Similarly, in Peru, domestic assets multiplied by more than 15 times and more than tripled in real terms in the same period. The main drivers of this expansion were rediscount operations to commercial banks in Argentina and credit operations to the public sector in Peru and in Argentina from the late-1950s onward (Jácome, 2015).

Following the demise of the Bretton Woods system in the early 1970s, exchange rates in several countries were adjusted more frequently in response to the growing inflation associated with the loose monetary policies in place. However, a new wave of capital inflows gave temporary relief to the region—which made room for receiving the fresh financing (right side of the triangle)—although at the cost of increasing dollarization of the economies. International liquidity had increased as the so-called “petro-dollars” were recycled to the major financial centers from the oil-exporting countries that had benefitted from the surge in world oil prices. By the early 1980s, capital inflows reversed at the time that most countries had accumulated sizable fiscal and external imbalances. Large devaluations hit the dollarized balance sheets of firms, banks, and the government, leading to devastating triple crises—currency, banking, and sovereign—that pushed inflation to the roof.

The Golden Years

Protracted macroeconomic instability took a high toll on the Latin American economies. The 1980s became the “lost decade” for the region. Thus, as economic and social costs became insurmountable, countries decided to grant central banks political independence and assigned them the task of defeating inflation. In addition, by opening the capital account and introducing exchange rate flexibility, central banks took control of monetary policy (top corner of the triangle).

Strengthening institutional underpinnings was necessary for the success of the new monetary policy. A new central bank remit was established assigning central banks a single or primary objective, namely preserving price stability—in some countries at a constitutional level. Central banks were granted political independence with the aim of untying monetary policymaking from electoral calendars as well as operational independence to allow them to increase (reduce) their short-term interest rate to tighten (loosen) monetary policy without government interference. They were also restricted and even prohibited from financing government expenditure, which was historically the chronic source of inflation. In exchange for this independence, central banks were held accountable.

By the mid-1990s, in an environment of increasing exchange rate flexibility and open capital account, monetary policy focused on price stability and inflation started to decline. Then, as inflation approached the single digits in the late 1990s and early 2000s, Brazil, Chile, Colombia, Mexico, and Peru introduced inflation targeting. The credibility of these central banks increased over time as they fulfilled their promise of keeping inflation in check.

Looking forward

Is the trilemma hypothesis still a useful analytical framework for monetary policy in the aftermath of the global financial crisis? The recent surge in the volatility of capital flows that most Latin American countries have experienced and the potential perils it poses on the stability of financial systems cast doubts on its validity. To stem the adverse effects of volatile capital flows, several Latin American countries—like other emerging economies—have recently introduced prudential measures. In this light, Rey (2013) claims that the trilemma hypothesis may have been replaced by a dilemma, as central banks can control monetary policy only if countries manage, either directly or indirectly, the capital account regardless of the exchange regime in place. Supporting this claim, however, requires conclusive empirical support. The jury is still out on this matter.


References:

Jácome, Luis I. (2015), “Central Banking in Latin America: From the Gold Standard to the Golden Years,” IMF Working Paper 15/60 (Washington: International Monetary Fund).

Erlend W. Nier, and Patrick Imam (2012), “Building Blocks for Effective Macroprudential Policies in Latin America,” IMF Working Paper 12/183 (Washington: International Monetary Fund).

Rey, Helene (2013), “Dilemma not Trilemma: The Global Financial Cycle and Monetary Policy Independence,” paper presented at “Global Dimensions of Unconventional Monetary Policy,” a symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, August. 

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