US 10-Year Yield Hits 5%: The Impossible Trinity Explained | Anand Talks | Sashwat Srinivasan

0:00 Hey guys, welcome back to Anan talks. Good morning. And I wanted to talk about two major topics today. One is more of a conceptual topic about macroeconomics. Another topic is about the current happenings in the global macroeconomy. So as for the global macroeconomic topic, we have Treasury yields on the 10-year Treasury. Well, it touched 5% as of the time of recording this video. And it's it's something that I I'm sure that the Treasury Secretary Scott Bessent is not very happy about. So this happening is basically a sign from bond traders that look we believe that yields are supposed to be going up. So this is a reflection of the macroeconomic situation of the US because in the US you've been seeing persistent inflation and then there's also a reflection not just of the US inflation rate but also a reflection of the fact that the fiscal expenditure of the US government is something that people are worried about. We've discussed this at large on this channel in the past few videos. Please feel free to go visit them for an explainer on why there is an interest rate pressure in the US. But this is nothing that we didn't expect. We talked about it on this channel and it's something that is going to continue to exist. This upward interest rate pressure unless something dramatically changes. Suppose the US suddenly announces that it's going to reduce its spending over the next few quarters or suddenly that the US decides to wake up and end the Middle Eastern crisis that is also raging on because that is placing an upward pressure currently on oil prices and if energy prices are up then most of your other goods are also going to be expensive for the time for the foreseeable future. So given these factors, the yield rise in bonds is not very surprising to me. Also came to be is that I think I believe the Treasury Secretary Scott Besson fell short on some of his promised interventions. We have to wait and watch because some people are saying that the Treasury Secretary might have intervened already because the bond yield fell back down from 5% shortly after but then it also recovered. So, whoever intervened, I'm not saying that it's the Treasury Secretary, but whoever intervened in the bond market, it it seems to be that that was shortlived as of the time of recording this video. We will have to wait and watch for updates and as and when we see updates, I'm happy to come here and discuss it with you guys.

2:36 So, keep that in your purview. Suppose you are interested in investing abroad because if interest rates are going to climb, we will possibly be seeing nice discounts on some of the stocks in our watch list in the US. So that's going to be a very interesting time for us as investors. Second topic that I wanted to discuss today and I believe this is of more importance than the first topic. But the reason why I wanted to cover this topic today is because of the current affairs that's going on in the US. So the topic is none other than the economic concept of the impossible trinity or the Mandel Fleming trilmma however you want to call it. So it's basically a triangle.

3:18 Envision a triangle. And the trilmma basically says that you can only have two things on that triangle. You can only have one side of the triangle. You cannot have all three things on the triangle. Now if you look at the image on screen, there are three dots. One aspect of this triangle is free capital flow. So free capital flow is important because it lets you be capital efficient when your economy is is doing well and even when your economy is doing poorly it still lets your citizens be capital efficient if they need to move capital out of your country. So capital efficiency is something that comes with free capital flow. And theoretically speaking, having free capital flow basically means that when there are opportunities within your country, it allows for foreign capital to come chasing it. And when there are better opportunities abroad, capital that is stored up in your country can be invested elsewhere for a higher return than what it might achieve back home. So all in all, we see that free capital flow is generally supposed to be a desirable thing. if we do not have other consequences that come with free capital flow. Of course, there are many ideas as to why free capital flow might not be ideal. But by and large, if you believe in the efficient market hypothesis, having free capital flow is a good thing for an economy. Second aspect of the trilmma is independent monetary policy or basically monetary policy autonomy. What this means is that the entire world usually tends to set different interest rates, right? You you have monetary policy that is determined by the Federal Reserve, by the European Central Bank, by a Chinese central bank and you have different every country has its own central bank setting its monetary policy. But one thing you'll notice is that a lot of these policies, a lot of these central banks move in tandem. Of course, some of this is coincidence, but a lot of it comes down to their economies being linked.

5:15 Suppose the US economy doesn't do well. It is also likely that the Japanese economy is not going to do so well or the European economy not going it's not going to be doing so well because when you have large economies that are interlin, you'll end up seeing that the central bank has to act in tandem. So if the US economy is not doing so well, the f Federal Reserve will decide to cut its interest rates. And we saw this happening during covid when economic malaise was affecting most of the world.

5:43 So most of the world central banks decided to cut interest rates. So all of this depends on the economic state of each country. But there is a situation that we need to think about. One situation is suppose it's well and good if if the same economic situation is is prevalent across all countries. However, suppose your own country that is suppose India, India has a different economic state. Suppose that the US is doing very economically poorly for some reason. But India is doing well. Our inflation rate is up, our growth is up.

6:17 Now the question to the RBI is are you going to decide to cut rates or not? And that depends because your economy is already doing well. If you and the RBI is going to say well why why should I cut interest rates? Because there is another aspect to this. If the RBI doesn't cut interest rates and the rest of the world is cutting interest rates, what will end up happening is your currency will appreciate. If your currency appreciates, that means that your imports are cheaper. Your exports are more expensive. So your economic activity will naturally dwindle over a period of time because you're not export you're not going to be as export competitive as suppose your competitor.

6:58 Suppose China is is going in tandem in lock step with the rest of the economies. They might end up cutting their cutting their interest rate thereby preventing a major appreciation of their current currency. So China is going to end up exporting more. So this is this is basically an idea that comes from the capital flow being open. So when you have open capital flow if your interest rate differential exists then capital will go to chase the higher interest rate economy that is assets that are denominated in higher interest rates in the different in in a different economy. So this is the basic idea of interest rate differentials. Now that being said it is very important in my opinion and a lot of economists opinions to have independent monetary policy.

7:46 This is usually seen as a non-negotiable because you want to be able to set your own monetary policy according to what your economic state is. If you are in a recession, you cannot simply avoid cutting interest rates because your currency is going to depreciate. That is what you might end up getting forced into if you're not willing to sacrifice the other two. One being free capital flow and the third thing which I'm going to come to now being the fixed exchange rate or stable exchange rate. So this is the third aspect of the Mandel Fleming trilmma or the impossible trinity. The fixed exchange rate is the third aspect.

8:24 You cannot have a stable or fixed exchange rate along with free capital flow along with independent monetary policy. You have to make a compromise somewhere. And as we talked about in the independent monetary policy segment, you basically have a situation where if you decide to have independent monetary policy, that might create an interest rate differential. If there is an interest rate differential cap one capital flow if it's free then your currency is going to either depreciate or appreciate. So to prevent that you could freeze. So suppose you're a central banker. Let's imagine that you are the man who is managing or woman who is managing the economy for your country. Then you get a few options. One suppose that there is an interest rate differential that is now coming up.

9:09 You're not willing to sacrifice independent monetary policy. Usually no country is decid is willing to sacrifice independent monetary policy. So you are not viewing that as an option. So suppose then you are facing either a currency depreciation or an appreciation due to that interest rate differential. Then you have two choices. One you say to hell with it let the currency do what it need wants to do. But there's a problem with that. People might start complaining. There might be political issues. you you'll have the government coming knocking at your door saying that how are you letting our currency depreciate that's not going to let me win the next election. That is one aspect. Of course, that is not a real that's not a real reason as to why you need to actually prevent a currency depreciation. Usually, the politics of it is is is not very important and it it actually should not be considered at all if you're if you're actually managing the managing the currency. So that is that is supposed to be a non-issue but in in the real world it tends to become an issue because you can see all the hoo-ha that is the that is you know kicked up when your currency depreciates. The truth of it is like what manuhan Singh said in his speech that most Indians view a depreciating currency as a matter of pride and a matter of national embarrassment. But what it actually signifies is an opportunity to export. Of course, in the short run, you will end up having issues relating to import bills. Your import costs are going to rise because of petrol imports will end up taking a larger portion of of your money in order to be able to finance it. Of course, there are aspects relating to higher import costs when your currency depreciates. By and large, a depreciating currency is not necessarily a bad thing for the economy. If your exports become more competitive, that will only end up working in your favor because that will put more money into your pocket. Okay, we've talked about that. Now, you have you have a couple of options. So, if you do let the currency depreciate or appreciate whichever direction, you will end up having repercussions with regards to inflation/dlation and export import. So, either you will export less or you might import more.

11:20 Whatever the situation is, you will end up having some sort of change happening in that regard. Okay, suppose you don't want that to happen. Suppose we fix the exchange rate. Okay, if you want to fix the exchange rate, then you have to look at the other end of the triangle. You need to look at capital and capital flow. So, you cannot have free capital flow. It's as simple as that. If you have free capital flow, capital will flow and your exchange rate is going to go for a toss. This is exactly what's happening arguably with India. So we are trying to work on the capital flow aspect of things and we're trying to maintain an independent monetary policy and our currency is free falling because why you you just heard from me that the interest rate in the US is rising and we are our economy is not sturdy enough for us for us to be able to match that interest rate hike compared to the US.

12:11 So we are facing a depreciation in our currency and we are not able to work on the independent monetary policy arm. We're not able to work on the fixed exchange rate arm. So we're trying to work on capital flows. But something that you'll have to keep in mind is that in a modern economy controlling capital is not a very viable thing. So de facto generally unless you are something like a an authoritarian or a totalitarian government like China it's going to be very difficult for you to control the capital arm of things because even in China we're seeing people circumvent the capital controls in order to park money abroad. So in a country like India you're going to have far more opportunities for people to park money abroad in ways that the Indian government is not going to be able to stop them though they're trying very hard to bring in capital controls.

13:01 They've brought multiple taxes, multiple tariffs. I don't think I need to explain it to our viewers because any of you who have expat friends or you yourselves are expats are familiar with the struggles and many challenges that comes with earning in a foreign currency or wanting to park your money in foreign currency. So if capital flow cannot be controlled then finally your choice comes down to struggling with your exchange rate. That is all that that it is. Finally at the end of the day the US the US generally maintains an independent monetary policy. They maintain relatively yeah usually yeah free capital flow. We can say that the US maintains free capital flow and the one thing that they let freely float is their currency. The US does not care about what happens to their currency.

13:46 Generally speaking they are happy to either let it free fall or appreciate or whatever the necessity of the hour is. They let they're happy to let it happen within bounds. So there's something that I that I failed to give you a picture of when you were when you were making the decision for the economy in the in the scenario that I was giving it to you. You could also do something where you have a mixed policy. You need not be on one end of the spectrum. You can be somewhere in the middle. There's a gradation. You can have some capital control, some free floating, but then you can also have some independent monetary policy. So it's not a black and white situation. From time to time you can change your position on this trillemma. so you can go anywhere across the triangle and you can decide to go half and half and try to balance everything together and that is the mark of a good economist who is able to sort of try and figure out where in each situation you need to be on the triangle. Suppose your country is going to have a huge export bill. Then maybe during that period it's not a very very wise decision to let your currency completely freef fall. You might want to manage the the depreciation of your currency. In which case you might have to introduce some capital control in order to be able to let the gradual fall of the rupee happen. We've seen this happen in the past. So it depends. All of this depends on where in the triangle that you need to be. But one thing is for certain in the long run, you cannot have more than two things on that triangle at any given moment. That is simply just how the logic of this triangle works out. And we've seen it happen time and time again with the Mexican peso. We've seen it happen with the Indian rupee. We've seen it happen with the British pound and the We we are seeing it happen currently with China's yuan. We're seeing it happen with the Japanese yen. all across the world, every single country you look at, if you bring in the talk of exchange rates, monetary policy and you bring in capital flow, you will have to end up adhering to this triangle. I have not seen an example thus far of a country achieving all three things sustainably.

15:56 So that being said, the segment has run on along a little longer than I expected, but I hope you enjoyed the segment and a lot of you wonder how we at this channel view macroeconomic situations. We usually use this lens and then there's another thing called the Triffin dilemma. I'd be happy to take that up in a in a future segment. It's a very interesting one and I think it is a great lens to view the current macroeconomic situation through. With that being said, I thank you for your support. I hope that you will share it with your friends and family members who are not familiar with this channel who might be watching our other channels. Please do share it with them and let them know that we are making videos here. And also please like, share, subscribe, hit the bell icon and do leave comments about what you want to see on this channel and maybe topics, historical topics, economic topics, whatever it be, please do leave comments. I'm happy to take up those topics in future videos. That being said, thank you very much for watching Anon Talks.