Kevin Gallagher
In 1942, when working to establish the International Monetary Fund, John Maynard Keynes said the "control of capital movements, both inward and outward, should be a permanent feature of the post-war system."
In his new book Capital Ideas: The IMF and the Rise of Financial Liberalization, Jeffrey Chwieroth argues that despite the fact that the economics profession largely maintained their support of Keynes's position, by the late 1990s the IMF motioned to change its articles of agreement in order to outlaw capital controls across the world.
The about-face in IMF thinking, according to Chwieroth, was due to a change of position among IMF staff. In yet another about-face, the IMF staff just released a position paper where they retract their rejection of Keynes ideas. Now it's time to practise what they preach.
The movement to outlaw capital controls lost steam given that premature capital account liberalisation in part caused the Asian Crisis of 1997-8 and that nations such as Malaysia used capital controls to avoid the worst of that crisis. Behind the scenes however, the IMF still advised nations to liberalise their capital accounts and steer clear of capital controls.
Indeed as recently as November 2009, in response to Brazil's announcement of a temporary tax on inflows of speculative capital, IMF head Dominique Strauss-Kahn said "the problem is that most of the time it does not work".
All that changed on Friday 19 February when Strauss-Kahn's own economists published a staff position note empirically showing that capital controls not only work but "were associated with avoiding some of the worst growth outcomes" of the current economic crisis. The paper concludes that the "use of capital controls - in addition to both prudential and macroeconomic policy - is justified as part of the policy toolkit."
The new IMF report singles out measures such as taxes on short-term debt (like Brazil's) or requirements whereby inflows of short-term debt need to be accompanied by a deposit to be placed in the central bank for a certain period of time (as practised by nations such as Chile, Colombia, and Thailand). The goal of these measures - which are often turned on when capital flows start to overheat and turned off when things cool - is to prevent massive inflows of hot money that can appreciate the exchange rate and threaten the macroeconomic stability of a nation.
The IMF's findings couldn't come at a better time. The carry trade is again bringing speculative capital to developing countries that could disrupt their recovery from the crisis. To make the proper deployment of capital controls effective however, at least three obstacles need to be overcome.
First, speculative capital can still wreak havoc because hot money blazes by countries that successfully deploy controls to nations that don't. Second, after a while investors creatively evade capital controls through derivatives and other instruments. Third, US trade and investment agreements make capital controls illegal.
Former IMF economist Arvind Subramanian proposes a solution to the first two problems. First, full-fledged co-ordinated capital controls among all emerging market economies. To solve the problem of capital control evasion, he says, the IMF should aid nations in regulating capital controls and see to it that controls are not evaded.
The third problem may be the biggest obstacle. If a nation has a trade agreement with the US, capital controls are illegal. Chile is renown for its measures to stem inflows but the Bush-era US-Chile Free Trade Agreement the US effectively forces Chile to literally pay the consequences (pdf) if Chile tries to use capital controls again.
The pending US-Colombia Free Trade Agreement, also negotiated under Bush, outlaws that country's use of controls on capital inflows. Democrats - who were against the Bush administration's rejection of capital controls in trade agreements - have pledged a new model for trade policy. US trade representative Ron Kirk is said to be unveiling the new model US trade agreement on Wednesday.
It's time to practise what economists have preached at least since Keynes: capital controls should be part of the toolkit. Developing economies should contemplate co-ordinated capital controls and the IMF lend its expertise to ensure such controls are not evaded. On Wednesday, Kirk should heed the new findings of the IMF and the positions of his own party by enabling nations to deploy capital controls to prevent and mitigate financial crises under US trade agreements. In Keynes's words: "It would not be foolish to contemplate the possibility of a far greater progress still."
