Thursday, July 31, 2014
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Global Capital Rules

CAMBRIDGE – It’s official. The International Monetary Fund has put its stamp of approval on capital controls, thereby legitimizing the use of taxes and other restrictions on cross-border financial flows.

Not long ago, the IMF pushed hard for countries – rich or poor – to open up to foreign finance. Now it has acknowledged the reality that financial globalization can be disruptive – inducing financial crises and economically adverse currency movements.

So here we are with yet another twist in the never-ending saga of our love/hate relationship with capital controls.

Under the classical Gold Standard that prevailed until 1914, free capital mobility had been sacrosanct. But the turbulence of the interwar period convinced many – most famously John Maynard Keynes – that an open capital account is incompatible with macroeconomic stability.  The new consensus was reflected in the Bretton Woods agreement of 1944, which enshrined capital controls in the IMF’s Articles of Agreement. As Keynes said at the time, “what used to be heresy is now endorsed as orthodoxy.”

By the late 1980’s, however, policymakers had become re-enamored with capital mobility. The European Union made capital controls illegal in 1992, and the Organization for Economic Cooperation and Development enforced free finance on its new members, paving the way for financial crises in Mexico and South Korea in 1994 and 1997, respectively. The IMF adopted the agenda wholeheartedly, and its leadership sought (unsuccessfully) to amend the Articles of Agreement to give the Fund formal powers over capital-account policies in its member states.

As long as it was developing countries that were whipsawed by global finance, it was fashionable to blame the victim. The IMF and Western economists argued that governments in Mexico, South Korea, Brazil, Turkey, and elsewhere had not adopted the policies – prudential regulations, fiscal restraint, and monetary controls – needed to take advantage of capital flows and prevent crises. The problem was with domestic policies, not with financial globalization, so the solution lay not in controls on cross-border financial flows, but in domestic reforms.

Once the advanced countries became victims of financial globalization, in 2008, it became harder to sustain this line of argument. It became clearer that the problem lay with instability in the global financial system itself – the bouts of euphoria and bubbles, followed by the sudden stops and sharp reversals that are endemic to unsupervised and unregulated financial markets. The IMF’s recognition that it is appropriate for countries to try to insulate themselves from these patterns is therefore welcome – and comes none too soon.

But we should not exaggerate the extent of the IMF’s change of heart. The Fund still regards free capital mobility as an ideal toward which all countries will eventually converge. This requires only that countries achieve the threshold conditions of adequate “financial and institutional development.”

The IMF treats capital controls as a last resort, to be deployed under a rather narrow set of circumstances – when other macro, financial, or prudential measures fail to stem the tide of inflows, the exchange rate is decidedly overvalued, the economy is overheating, and foreign reserves are already adequate. So, while the Fund lays out an “integrated approach to capital flow liberalization,” and specifies a detailed sequence of reforms, there is nothing remotely comparable on capital controls and how to render them more effective.

This reflects over-optimism on two fronts: first, about how well policy can be fine-tuned to target directly the underlying failures that make global finance unsafe; and, second, about the extent to which convergence in domestic financial regulations will attenuate the need for cross-border management of flows.

The first point can be best seen using an analogy with gun controls. Guns, like capital flows, have their legitimate uses, but they can also produce catastrophic consequences when used accidentally or placed in the wrong hands. The IMF’s reluctant endorsement of capital controls resembles the attitude of gun-control opponents: policymakers should target the harmful behavior rather than bluntly restrict individual freedoms. As America’s gun lobby puts it, “Guns don’t kill people; people kill people.” The implication is that we should punish offenders rather than restrict gun circulation. Similarly, policymakers should ensure that financial-market participants fully internalize the risks that they assume, rather than tax or restrict certain types of transactions.

But, as Princeton economist Avinash Dixit likes to say, the world is always second-best at best.  An approach that presumes that we can identify and directly regulate problematic behavior is unrealistic. Most societies control guns directly because we cannot monitor and discipline behavior perfectly, and the social costs of failure are high. Similarly, caution dictates direct regulation of cross-border flows. In both cases, regulating or prohibiting certain transactions is a second-best strategy in a world where the ideal may be unattainable.

The second complication is that, rather than converging, domestic models of financial regulation are multiplying, even among advanced countries with well-developed institutions. Along the efficiency frontier of financial regulation, one needs to consider the tradeoff between financial innovation and financial stability. The more of one we want, the less of the other we can have. Some countries will opt for greater stability, imposing tough capital and liquidity requirements on their banks, while others may favor greater innovation and adopt a lighter regulatory touch.

Free capital mobility poses a severe difficulty here. Borrowers and lenders can resort to cross-border financial flows to evade domestic controls and erode the integrity of regulatory standards at home. To prevent such regulatory arbitrage, domestic regulators may be forced to take measures against financial transactions originating from jurisdictions with more lax regulations.

A world in which different sovereigns regulate finance in diverse ways requires traffic rules to manage the intersection of separate national policies. The assumption that all countries will converge on the ideal of free capital mobility diverts us from the hard work of formulating those rules.

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  1. CommentedProcyon Mukherjee

    In the seminal book, ‘This time is different’, Roggoff and Reinhart have coalesced the reasons that attract capital flows to move towards an investment destination; it is not capital to labor ratios, not even high marginal product of capital. But the authors were not very explicit about cross border flows.

    For cross border capital flows, the reasons are embedded in a rather circular logic that surplus finds a temporary haven to temper the effects of surplus; given such a narrow reason, it is in the speculative judgment of principals and agents that cross border flows have exploited, rather than facilitated the development of investment destinations. When the quantum of surplus is rising together with the volatility of the surplus, it is very right to temper such flows with a transparent mechanism that allows the would-be victims to be aware, at least, of the possible risks.

    Procyon Mukherjee

  2. CommentedJonathan Lam

    Gamesmith94134: Argentina’s debt conundrum
    Inasmuch the lock law and the pari passu (“equal footing”) clause included in the bonds, I see technical default and sovereignty debt default are inevitable; since there is no firewall in safeguard the financial architecture and sovereignty when there is a credit-debtor conflict. Even though Argentina or BNY Mellon repeals in the Supreme Court, there would be ruling granted differently in regard of the holdout of the “vulture Funds”, or guilty on the technical transfer default; but the situation would be the same as the ECB to accommodate the PIIGS under the auspice of the Euros and each sovereignty could have lost its right to trade under the free trade agreement or simply dollars. Therefore, US Supreme court is not the proper resolution to the international financial architecture, and it is not.
    Based on the precedent cases of international creditor-debtor conflict, it is due to have a crucial change in the change of attitude of the Central Bank system and the firewall that sovereignties can contain. Apparently, those debtor nations are entrapped in the dominant currency and system they relied on; like always, some may expected the new debts added on to the old ones till it is unsustainable or the next card unfolded. At present, I do not see the system itself can change its outcome, like pari passu, in the near future till there is a real architectural development in the international financial system.
    Basically, we do have existing infrastructures to support the international central bank that consisted of World Bank that can be authorized to intervene as the Central Bank of the world, IMF to facilitate the inflows and outflows of “vulture funds” for sovereignty that allows, and WTO can supervise and control the sum of transactions that are utilized in trade or monopoly. Perhaps, I would recommend the “one percent” to the transfer that would service the contingency fund to the needed, and provide the cushioning to local economy when it is overheated or stagnated. In addition, I think sovereignty debts must be treated separately with the commercial since the administration of the sovereignty debt must be guaranteed by the zone with its tribunals of sovereignties; so, monetarists may not abuse its currencies to loot or invade others and assistance of other nations with its surpluses would not evaporated under the condition of the underdeveloped
    In order to having a common architecture financial system established, it may rely on the treaty agreement and control and rulings of the United Nations Security Council in mediating the disputes. It is a long ride, but unlimited litigations are more unbearable if one is contentious to abuse.
    May the Buddha bless you?

  3. CommentedVenu Madhav

    Dear Dr. Rodrik, I like the fact that IMF has preferred a more active approach now, and yes I subscribe to your opinion on "the bouts of euphoria and bubbles, followed by the sudden stops and sharp reversals that are endemic to unsupervised and unregulated financial markets".

    Being from a non-Economics background I do feel Cross border financial flows are welcome as long as there are two objectives that get addressed and not one, which is the country that gets the investment gets a time period to safe-lock the investment and show results within say 3 years else it will be a gradual phase-out within next 6-8 quarters, and of course the second objective is to get the minimum assured returns for the investors so there is capping on the downside so any phase-out is based on tangible milestones, else it will be a revolving door or like a stay-at-night hotel service. Something that I assume of course the investors are rational in their decision making and are not getting carried away a by herd mentality!

  4. CommentedHelmut Reisen

    As a former OECD economist who has argued early on ( for the need of inflow controls, I should like to rectify a slight error that Dani keeps repeating. He overemphasizes the role of the OECD.
    As for Mexico, I was a member of the team to prepare the country´s accession to the OECD and had opportunity to discuss the matter of financial opening cum hard peso peg to the dollar at length with Guillermo Ortiz. He agreed with the points I made but was very clear that Carlos Salinas, the President, and Pedro Aspe could not be convinced on the logic of either flexible FX rates or selective encaje-type controls.
    As for Korea, a country that asked the OECD that I advise them in their talks on how to deal with the OECD Codes on Liberalisation, they finally entered the OECD to escape the much harder bilateral pressure - notably by the US treasury - to open up. They finally understood that the OECD is about soft, not hard, law that is difficult to enforce. As an OECD member, they happily continued with a semi-closed capital account for quite a while.

  5. CommentedFaruk Timuroglu

    The true sovereigns of the world are the advanced countries. They regulate finance in most convenient way to their interest and oblige the rest to follow.