CAMBRIDGE – Why does the International Monetary Fund make it so hard for people like me to love it?
The IMF has said and done all the right things since the crisis. It has acted as quickly as any international bureaucracy can to establish new lines of credit for battered emerging-market countries. It revamped its loan conditions to fit the times. Under its capable managing director, Dominique Strauss-Kahn, and distinguished chief economist, Olivier Blanchard, it has been a voice for sanity on global fiscal stimulus in the midst of much cacophony. For an institution that seemed on the verge of irrelevance not too long ago, this is quite a transformation.
But now Strauss-Kahn is throwing cold water on proposals to tax international flows of “hot money.” The occasion was Brazil’s decision to impose a 2% tax on short-term capital inflows to prevent a speculative bubble and further appreciation of its currency. When asked about the role of capital controls, Strauss-Kahn said he was not wedded to any rigid ideology on the subject. Nonetheless, according to the Financial Times which reported the IMF chief’s views, “the IMF would not recommend them as a standard prescription either – as they carried costs and were usually ineffective.” Unfortunately, this makes the new IMF sound too much like the old one.
Prudential controls on capital flows make a lot of sense. Short-term flows not only wreak havoc with domestic macroeconomic management, but they also aggravate adverse exchange-rate movements. In particular, “hot” capital inflows make it difficult for financially open economies like Brazil to maintain a competitive currency, depriving them of what is in effect the most potent form of industrial policy imaginable.
To be sure, by sending mixed signals to financial markets, the Brazilians may have botched their attempt to cool down inflows. President Luiz Inácio Lula da Silva had dismissed talk of capital controls just a few days before they were imposed. A meaningful effort to influence the currency’s level requires determination to adjust financial taxes and complementary policies until they show their effects. Timidity is counterproductive, because it backfires.
But more important was the symbolism of Brazil’s move, for it suggests that emerging markets may be getting over their doomed infatuation with foreign finance. Surely, as the economists Arvind Subramanian and John Williamson have written, emerging markets deserve the IMF’s help in designing better prudential controls over capital inflows instead of having their wrists slapped.
Strauss-Kahn’s response that taxes on capital flows are costly and ineffective is therefore unfortunate. It is also emblematic of the knee-jerk reaction that often obfuscates the pros and cons of capital controls. You can oppose capital controls because you believe financial markets are on the whole a force for good, and that any interference will therefore generate efficiency losses. Or you can oppose controls because you think that they can be easily evaded and are therefore doomed to remain ineffective. What you can’t do is oppose capital controls because they are both costly and ineffective.
Think about it. If capital controls can be easily evaded – say, by manipulating the timing of transactions or through mis-invoicing of trade flows – then there will be little effect on the actual volume of capital inflows. The controls will impose few costs on markets (though they may involve some administrative costs for the government).
If, on the other hand, market participants do bear significant costs – either because of the taxes they pay or because of the expenses they incur to evade them – the controls will be effective in restraining inflows. If you are trying to have it both ways, the chances are you have made up your mind before you have really thought hard about it.
It may seem curious that Strauss-Kahn’s instincts are so off the mark on the matter of capital controls. One might have thought that a socialist, and a French Socialist at that, would be more inclined toward finance skepticism.
But the paradox is more apparent than real. Financial markets in fact owe French Socialists a great debt. Received wisdom holds the United States Treasury and Wall Street responsible for the push to free up global finance. But far more influential may have been the change of heart that took place among French Socialists following the collapse of their experiment in Keynesian reflation in the early 1980’s. When capital flight forced François Mitterrand to abort his program in 1983, France’s Socialists performed an abrupt volte-face and embraced financial liberalization on a global scale.
According to Harvard Business School’s Rawi Abdelal, this was the key event that set in motion the developments that would ultimately enshrine freedom of capital movement as a global norm. The first stop was the European Union in the late 1980’s, where two French Socialists – Jacques Delors and Pascal Lamy (the president of the European Commission and his assistant, respectively) – led the way. Then it was the turn of the Organization of Economic Cooperation and Development (OECD). Eventually, the IMF joined the bandwagon under Michel Camdessus, another Frenchmen who had served as Governor of the Bank of France under Mitterrand.
The IMF’s reaction to Brazil’s financial taxes reflects how ingrained finance fetishism has become, and how difficult it is to reintroduce some balance in the debate on capital flows – even in the aftermath of the greatest financial crisis the world has experienced since the Great Depression. The problem is not just right-wing market fundamentalists. The failure of imagination extends across the entire political spectrum.
Referring to capital controls, John Maynard Keynes famously said: “what used to be heresy [restrictions on capital flows] is now endorsed as orthodoxy.” That was at the dawn of the Bretton Woods era in 1945. What an irony that more than 60 years later we need to undergo the same shift in mindset.