Capital controls as a policy solution back in vogue

The Washington consensus espoused by the US and IMF focused on free trade and open capital markets as the keys to a successful global economy. There was no doubt about what countries should do. The use of capital controls to limited short-term movements was viewed as a step backwards. This doe snot mean that some countries did not use capital controls effectively, but the overall objective was for countries to reach a better financial state and that included markets free of capital controls.

The IMF staff position note Capital Inflows: the Role of Controls SPN 10/04 now takes a difference view that capital controls are justified as part of a policy toolkit. The objective of controlling exchange rates and eliminating savings imbalances may dominate the role of open financial markets.

The premise for the work is that countries that have capital controls were less susceptible to changes in GDP than those that had open capital markets. It may seem obvious that if you limit flows there will be less reaction. The point is that the limited flows would have reduced overall growth before the crisis. (Of course, there is the point that governments should try and minimize crises, then capital controls would not be necessary.)

We have learned that an economy can become fragile when there is a poor mix of external liabilities. The authors also argue that external liabilities get longer when there are capital controls. Again, this should be expected. If you cannot take your money out in the short-run, you will not lend in the short-run. Similarly, if there is a lower stock of debt, less leverage, there will be less of an impact of any GDP shock.

The normal adjustment in an open market would be to allow the exchange rate to appreciate when capital flows start to become excessive. This may lead to overshooting which is viewed as potentially being worse than the choice of capital controls. It is hard to believe that a good policy would be to control capital because a rabid herd of speculators cannot be controlled.

The authors clearly state that capital controls should only be used in special situation bu this part of the paper will probably be missed. The authors admit that the jury is still out whether capital controls have worked in practice. Their view is that capitla controls may be choice no different than exchange rate appreciation or reserve accumultion.

The impact of change in IMF policy is far-reaching. Not in the short-run, but longer-term, capital controls will place more frictions or sand in the engine of commerce which will reduce global financial diversification. A short-term fix as an alternative to solving deeper problems like credible monetary policy seems short-sighted. Delinking capital flows as a global solution for a lack of policy coordination will not be an effective solution to any imbalance problems.