Economic theories are often accused of being shrouded in unrealistic assumptions and convoluted math, seldom grounded in reality. Witnessing a set of real-world events that aptly illustrate an important economic theorem is a rare occurrence indeed. The recent market turmoil in China provides precisely this opportunity.

We will not diagnose the root causes of China’s economic woes or claim knowledge of some cure-all to its present troubles – there are already far too many economists, politicians, and academics on that bandwagon. Rather, let us focus on a principle of international economics known as the Monetary Policy Trilemma, also referred to as the Impossible Trinity, Unholy Trinity, and probably a dozen other catchy names. The theory states that, although the following three policy objectives are all desirable, only two are achievable at any one time:

Photo: Wikicommons.

1. Stable currency (e.g. via a fixed foreign exchange rate)

2. Freedom of capital flows

3. Ability to pursue independent monetary policy (i.e. set interest rates)

In other words, you cannot have your cake and eat it, too.

There is no agreement as to which two constitute the optimal combination, because each country faces a unique set of policy goals and constraints. The vast majority of “Western” developed economies have opted for #2 and #3, allowing their currencies to fluctuate freely. Hong Kong is a rather special case of #1 and #2. Our currency is pegged to the U.S. Dollar and the Hong Kong Monetary Authority thus follows the U.S. Federal Reserve closely in its interest rate policy. The stability of the Hong Kong Dollar is sometimes lauded as one of the pillars of the territory’s strong economic development over the years, but having to “copy” American monetary policy has also led to a decade of artificially cheap borrowing, which has fueled our astronomical property prices.

Photo: Wikicommons.

China is an example of the third possible combination, #1 and #3. It is the natural policy choice for an authoritarian regime – by definition, a control freak. It controls the exchange rate, exercises its own domestic monetary policy, and imposes tight controls on money entering and leaving the country. Like the Communist Party’s fear of free elections, Big Brother leaves nothing to chance or the whims of global markets.

China’s macroeconomic problems began to manifest earlier this year, with a slowdown in economic activity and a stock market rally that was losing steam if not bursting outright. A cooling down of the economy was probably unavoidable regardless of which two policy options China adopted; years of feverish growth spurred in no small part by monetary imbalances, inefficient lending, and overinvestment had to end. Had China swapped policy #1 for #2, however (thereby fully opening its capital markets to the world), the stock bubble may have been mitigated. Of Chinese stocks, foreign investors and media had been screaming “irrational exuberance” for many months, pointing to absurd company valuations and a complete misalignment with the state of the Chinese economy.

Photo: Wikicommons.

If foreign investors could have participated in the Chinese market, perhaps their profit-taking could have stemmed the runaway rally somewhat. At the same time, freedom of capital flows means that domestic Chinese investors could have shifted some of their assets overseas, in search of alternative investments and diversification. In this way, dampened local demand could also have curtailed the stock bubble and subsequent fall. For many years, Chinese residents, disenchanted with lackluster stock market performance, had nowhere else to park their newfound savings except real estate. Unaffordable Chinese home prices, therefore, can also be attributed in some part to lack of capital mobility in and out of the mainland.

China’s Premier Li Keqiang. Photo: Reuters/Jason Lee.

At this point, the game has become largely political and Chinese policymakers have little choice but to stay the course. Whatever little legitimacy the Party has hinges on its ability to keep the economic engine oiled and to avoid further slowdown. Speaking at the World Economic Forum in Dalian on Thursday, Li Keqiang told world business leaders that China still had ample tools in its war chest to keep the Chinese economy afloat. The CCP is powerful, with all its Great Firewalls and aircraft carriers, but it cannot defy the Impossible Trinity.