A New 'Impossible Trilemma'?

By Niall O’Sullivan

Can we lower government debt, sustain positive real rates and finance the transition to a low-carbon economy?

It’s been 60 years since John Fleming and Robert Mundell described the “impossible trilemma” of international economics.

It’s not possible to have (1) fixed foreign exchange rates, (2) free movement of capital and (3) an independent monetary policy at the same time: Try to set your policy rate at 3% when the global rate is 5%, and freely mobile capital will flee your assets and put downward pressure on your currency. You can sell foreign currency reserves to maintain your fixed exchange rate, but only until those reserves run dry. So, take your pick.

Joe Amato wrote about the central banking trilemma last week. We think a similar trilemma could start to assert itself in capital markets over the coming years.

Is it possible to have all three of (1) lower government debt ratios and costs, (2) positive, “old normal” real rates under free movement of capital and (3) the infrastructure spending required to adapt the world to the effects of climate change and achieve the transition to a low-carbon economy?

A lot of commentary makes hard-and-fast prognostication about one or two of these without accounting for the constraints of the third.

For example, how will we finance the low-carbon transition if debt levels “must” come down while debt costs “must” go up?

As a society, we’ll need to take our pick. Different countries may make different choices, but those choices will be of huge importance to long-term investors. If history is a guide, these choices may lead to a level of state involvement in economic affairs that is perhaps more familiar in emerging economies and greater than many in the West are used to.

Government Intervention

Let’s start with the assumption that the spending required to achieve the low-carbon transition and adapt to the impact of climate change will occur. This is a huge task requiring tens of trillions of dollars’ investment.

We believe the scale of the task requires government intervention, and the history of similarly massive projects, such as fighting wars and rebuilding after them, strongly suggests that government debt ratios will rise.

In such an event, which of the other two legs of our trilemma “have to give”?

In some countries, covetous eyes will be drawn to pots of domestic savings or capital, to replace that which is more able to seek lower risk or higher compensation elsewhere. In Europe, for example, both the European Union and the post-Brexit U.K. are revising the Solvency II rules that govern their insurance sectors, with both aiming to encourage insurers to make more long-term investments in domestic real assets.

In his Autumn Statement last year, U.K. Chancellor Jeremy Hunt was explicit that the rules were being rewritten to release “tens of billions of pounds” for infrastructure investment.

Others will think about mobilizing the printing press and try, to some extent, to meet the need from money creation and tailored banking.

The recent banking crisis could mean that the quid of wider deposit insurance is followed by the quo of greater regulatory oversight—and direction—of where banks lend and how they invest their assets, for example. In addition, among the proposals to aid the pursuit of a just transition coming out of last year’s COP27 meetings were an expansion of the lending capacity of the World Bank and other development banks, without requiring more equity capital from their state or private shareholders; and the issuance of hundreds of billions of dollars of Special Drawing Rights (SDRs) to fund a Global Climate Mitigation Trust at the International Monetary Fund (IMF).

Finally, while keeping inflation under control will probably dominate in the short to medium term, some may desire to inflate away a portion of the debt and manage real interest rates. The example of recent declines in debt-to-GDP ratios driven by inflation, but also the period from 1945 to 1980 when real interest rates in advanced economies were negative for half the time, gives an idea of historical playbooks to favor debtors over creditors.

The blurring divide between governments, central banks and the markets during and after the Global Financial Crisis (GFC) and COVID-19 pandemic arguably paves the way for these trade-offs.

Recognize the Trilemma

This is going to be a key debate for our age—but it’s a debate that has been put off while inflation has been at close to double digits. Real interest rates had to rise in that environment, but there may be limits that constrain them from reverting all the way back to historical levels.

Societies and governments may need to get used to operating at higher debt-to-GDP levels. This will make systems more vulnerable and exposed to “bond vigilantes,” as the U.K. learned last year. It will also add to the tightrope that central banks are already trying to walk between growth, inflation and financial stability.

There are, of course, other ways to resolve the trilemma. Spending could be diverted from other projects to finance the transition, or taxes (including carbon taxes and border charges) could be raised to cover the costs. But these are both harder political decisions, and the siren song of money printing and financial repression will prove hard to resist.

What might this mean for investors?

There are both threats and opportunities. Fundamentally, the transition will be “capital- and labor-heavy.” It should support broader economic growth and also create opportunities in infrastructure investment and other areas. It will be supportive of many sectors of the economy, but perhaps reward different parts of the stock market than the recent leaders. The transition and adaption themselves will require commodities.

Many of these opportunities will present themselves to institutional investors via the kind of “financial encouragement” we saw in the aftermath of the GFC, and which we may be seeing again in things such as the rewrite of Solvency II, but the flipside of that may be the threat of “financial repression,” particularly of very long-dated, fixed-rate assets.

But the first thing we all need to do is recognize the trilemma and then join the debate. It’s all too easy to celebrate the return of positive risk-free real yields and bond market discipline one day, and rub our hands at the prospect of green transition-financed returns the next. It may not be possible to sustain all three—and if they are not risk-aware, the choice is likely to be picked for investors, not by them.

In Case You Missed It

• ISM Manufacturing Index: -1.4 to 46.3 in March
• Eurozone Producer Price Index: +13.2% year-over-year in February
• JOLTS Job Openings: -632k to 9,931k in February
• ISM Services Index: -3.9 to 51.2 in March

What to Watch For

• • Monday, April 10:
    • China Consumer Price Index
    • China Producer Price Index
  • Wednesday, April 12:
    • U.S. Consumer Price Index
  • Thursday, April 13:
    • U.S. Producer Price Index
  • Friday, April 14:
    • U.S. Retail Sales
    • University of Michigan Consumer Sentiment

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