Capital controls in the US?

In a recent Financial Times op-ed, Michael Pettis argued that the US should impose capital controls. In his view, the traditional view according to which capital inflows necessarily lower domestic interest rates and spur productive investment is based on a misunderstanding of how capital flows affect modern economies. This might have been true for rapidly growing developing economies with high investment needs and limited domestic savings, where foreign capital truly relieved a saving constraint. However, since the breakdown of the Bretton Woods system, modern financial systems can expand credit largely unconstrained. In this environment, capital inflows into advanced economies like the US, do not primarily finance new, productive investments.

In the modern context, capital inflows often lead to an increase in household or fiscal debt. Policymakers use this credit growth to sustain domestic demand and prevent recessions that would otherwise be caused by the leakage of demand abroad due to trade deficits. This is a "beggar thy neighbour" dynamic -- a term coined by Joan Robinson, and the reason she appears in the FT piece, even though she was referring to competitive depreciation and trade restrictions, not capital flows -- where trade deficits are caused by shifts in spending to foreign goods, forcing domestic businesses to reduce output. Further, this reliance on rising household or fiscal debt to absorb foreign capital inflows and the resulting trade deficits is unsustainable in the long run. It leads to rising debt levels and distorted economic structures. He concludes that restricting capital inflows would directly address the problem of aligning a country's external position with its domestic needs.

There are many problems with these views. On a theoretical level, he does suggest, as Vicky Chick in a paper that Lance Taylor liked and used in his courses, in the earlier period savings was necessary for investment. Essentially Say's Law. That is certainly not the case. Even in the 19th century, with less developed financial markets, banks had the ability to create credit, and savings (a flow) did not finance investment. Also, interest rates do not depend on the capital flows and the available funds, and are essentially an exogenous variable controlled to a great extent by the monetary authority (that was true in the past too).

More importantly, it is unclear that the external situation of the US, indebted in its own currency is unsustainable. What is the problem that this would be solving? There is no fiscal problem either, irrespective of the downgrade of US debt by Moody's recently (Standard & Poor's and Fitch had done it years ago). In fact, capital controls would affect the international role of the dollar and would be a major misstep, since it would directly affect the ability of foreigners to use dollars, and restrict its use in international financial markets. Not that this would have any chance of happening with Bessent, a Wall Street operator, as Treasury Secretary.

Private debt (not public) is considerably more dangerous than public debt, since when the government gets indebted, if it uses the money to promote growth, it directly affects its ability to pay back the debt, since its revenue is tied to the level of economic activity. That is why public debt tends to fall not by cutting spending and promoting adjustment and reducing the amount of debt, but by promoting growth and reducing the relevance of debt with respect to ability to repay. So, Pettis is not incorrect in noting that the US has depended more on private debt, which is riskier. But capital controls would do little to limit this dynamic. Policies that expand the remuneration (wages) of the people at the bottom (i.e. better income distribution) and that are more lenient with private debtors would have better results.

Regulation of financial markets too should play a role. In particular, the predatory lending practices that are still rampant in the US more than a decade and half after the 2008-9 financial crisis. But in all fairness, if there is something the US can do to grow faster and avoid financial problems, it would simply be more spending (perhaps a mix of infrastructure and social transfers) and lower interest rates. One can hope.

Capital controls and economic development

 

My talk at the Universidad Centroamericana José Simeón Cañas (UCA), El Salvador 20/10/2020. On capital controls and development and in Spanish, of course.

Raúl Prebisch as a Central Banker and Money Doctor

Here we edited with Esteban Pérez and Miguel Torres some unpublished manuscripts from Prebisch related to the Federal Reserve missions, led by Robert Triffin, to the Dominican Republic and Paraguay, in which he emphasizes the need of capital controls in peripheral countries that did NOT have the key hegemonic currency. There is also a discussion of Keynes and White's plans for Bretton Woods, which were partially published before. In Spanish. Happy New Year!

A Tale of Two Currency Crises: A Short Comment

So the Turkish foreign exchange crisis is all over the news. But the Argentine one is less conspicuous in the international media. Turkey's economy has had many similarities with Latin American economies over the years, in terms of the incomplete process of industrialization, and the types of crises associated with neoliberal reforms over the last three decades. Note, however, that the Argentine nominal depreciation has been larger than the Turkish (the same is true if you go back to the previous big crisis in both countries in the late 1990s and early 2000s, respectively) and one should expect more coverage (perhaps Erdogan has worse press than Macri, but the authoritarian credentials of the latter should not be dismissed; neither the neoliberal ones of the former, I might add).

In all fairness the NYTimes does cite Argentina (and other emerging markets; not a fan of the term, as I think I discussed before on a post about... wait for it... an external crisis in Argentina and Turkey four years ago) in the piece about it today, saying that:

"For nearly 10 years now, the flood of cash from global central banks has financed shopping malls in Istanbul, booming cities in China and 100-year bonds in Argentina. Today, many of the malls are empty, property developers in China are riddled with debt, and Argentina has just submitted to a bailout from the International Monetary Fund."

That seems to suggests that the reason for the crisis is to some extent that central banks created too much liquidity (printed too much money), allowing too much spending (perhaps by the government, wink, wink, nudge, nudge, say no more: it's a fiscal problem), and that's why we are having these problems. However, the NYTimes does get the external problem, the current account, which I always suggest is the way you should go if you are looking for fundamentals (here another discussion from 4 years ago on currency crisis, this one more theoretical). The NYTimes says:

"A country runs a current account deficit if it takes in more money — in investments and trade — from foreigners than it sends to other countries. That leaves the country at the mercy of international investors to keep it afloat financially, and those investors could find other markets more enticing — particularly when emerging markets see their currencies lose value. That is precisely what forced Argentina to go to the I.M.F., the first major emerging market to take such a step during this period of uncertainty."

However, as I noted on my earlier post on the Argentine situation, while I do think that current account positions are the relevant fundamental (the other would be international reserves) for a currency crisis (and that fiscal positions are the result not the cause of a crisis, since they are in domestic currency for the most part), it worth noting that the Turkish situation is not, at least looking at recent data, particularly bad.

Note that there is a secondary axis for the Turkish current account as a share of exports (the right hand side one), and that Turkey has a much larger deficit with respect to exports than Argentina, but not one that is deterioration drastically (these are based on IMF estimates, btw). This suggests that the current account, even though it is crucial in the long run, is probably not driving the crisis (as I noted in May, I still don't the current account is the cause of the crisis; same post as above, btw).

The fact that this is a global phenomenon (the depreciation of currencies of developing countries) suggests that the hike of the interest rate in the US plays a role. It seems also that the financial deregulation and the financial position of some developing countries explain why they are having more trouble than others (e.g. Brazil, which is in the middle of a serious economic and political crisis, but sitting on top of US$ 380 billion in reserves). I haven't found more recent data (this from the World Bank goes only to 2016), but the graph below shows the short-term debt to international reserves ratio; the reverse of the Guidotti-Greenspan rule).

Clearly the ratio has been growing in both countries (mildly in Turkey) and is higher in Argentina. Argentina has also increased its debt exposure in dollars, and somewhat incredibly the central bank has announced that it will retire debt in pesos, and will use precious reserves in dollars for that (apparently with support from the IMF). This suggests that they are clueless about the causes of the crisis. The only solution at this point is higher interest rates (and in domestic currency to reduce demand for dollars) and significant restrictions on the foreign exchange market.

The Impossible Trinity Revisited

The Economist's brief is available here (subscription required). I have discussed the limitations of the Mundell-Fleming model in some posts (here and here, for example). But I have not discussed the limits to the trilemma fully. In this paper, I argue that under certain circumstances, associated to what Ben Cohen calls the geography of money, the trilemma might not hold. The countries at the top of the pyramid with convertible currencies do not face the harsh trade offs of the countries at the base.

As I said back then:

"The United States during the current crises is an example of the reduced impact of the trinitarian trade-offs for countries with convertible currencies. In fact, even though the economy was in a deep recession by the last quarter of 2008, the dollar, which had depreciated considerably over the previous years, started to appreciate as investors increasingly fled to Treasury bonds for safety. In other words, even though rates of interest were reduced to deal with the recession and the financial crisis, and capital mobility was preserved, a certain degree of exchange rate stability was maintained."

If you're not at the top, I would recommend to give up the complete free mobility of capital, which should be no surprise.

A novel capital control proposal

New book

By Pablo Bortz (Guest blogger)*

After the breakdown of the Bretton Woods regime and the subsequent deregulation in capital flows around the globe, the movement of financial assets and liabilities has increased several times faster than trade and GDP growth. While still mainly concentrated between advanced countries, financial flows to emerging and developing economies (EDEs) have been rising at an exponential rate, particularly in the last two decades. However, public external debt (as per cent of GDP) has been on a downward trend in the 2000s (though the trend has been slightly reversed since the 2008 crisis), with a larger proportion being denominated in domestic currency, but attracting more non-resident private investors (Arslanalp and Tsuda 2014). The other big story of the last fifteen years, notwithstanding, is quite different: private external debt has been on a marked rise. As Akyüz (2014) reviews, the share of private debt denominated in a foreign currency has increased sharply, and that is not the only concerning feature observed in the data. Avdjiev et al (2014) notice the importance of private non-bank lenders in in the external financing of many emerging countries, and the role of overseas affiliates of EDEs corporations established in off-shore financial centers, rendering its recording more difficult. And though cross-border bank lending still represents the larger share of total external borrowing, there has been a fast increase in the issuance of debt securities by the private non-banking sector of EDEs and its off-shore affiliates (Butzen et al 2014), a more volatile kind of flow, together with portfolios investment.

Far too numerous crises in emerging (and some advanced) economies have been preceded by explosions in private foreign borrowing, starting from the 1970s in Latin America, and continuing during the 1990s also in Latin America and (above all) South-East Asia, as told by Palma (2001). And in the last decade we have seen the burst of the Eurozone, also triggered by sharp increases in foreign indebtedness (Storm and Naastepad 2016). Financial fragility is not the sole cause of these crises and the lasting damage they leave behind. As I mention in my recent book (Bortz 2016), private foreign borrowing turn the odds of wage bargaining against labor, lowering the wage share and putting aggregate demand in a more fragile standing. Motives for this result abound: the impact of higher indebtedness and debt servicing on firms’ balance sheet (costs that firms try to pass on consumers); the fact that mounting foreign borrowing and capital inflows are matched by financial deregulation that stimulates alternative outlays other than capacity-building investment; and because they are tied to the rise of sectors such as the FIRE sector (financial, insurance and real state) lowering aggregate productivity, among other reasons. Jayadev (2005), Stockhammer (2009) and Furceri and Loungani (2015) all find empirical support for these hypothesis.

After amending in 1997 its Articles of Agreement, requiring member countries to liberalize their capital account, the IMF has joined the large chorus of voices calling for capital controls, although in the most muted way possible (IMF 2012, p. 2). Calls for restoring capital controls rise across the economic spectrum, from authors with a more orthodox point of view such as Hélène Rey (2013) to non-mainstream economists such as Vernengo and Rochon (2000), Epstein (2005), Bibow (2011), Gallagher (2014), Grabel (2015), among many others. International institutions such as UNCTAD have been at the frontier of the debate (UNCTAD 2001, 2014), and even recent research by IMF staff has dwelled into the topic (Ostry et al 2011, Canuto and Ghosh 2013).

It is within this context that I suggest a novel proposal for consideration, the implementation of which should obviously reflect the particularities of each economy. What I propose is a refundable tax on foreign private borrowing, that discourages speculative borrowing in favor of productive investment. The basic idea is simple: companies should pay a tax when they borrow abroad, either through banks, issuing debt securities, when they borrow from their home companies or off-shore affiliates. That tax would be reimbursed if firms can prove that these credits have been used to fund productive investment.

This proposal is particularly fit to counter lending and borrowing between affiliates, a common channel to facilitate transfers of funds in times of need with disregard of the economic conditions of the country. For instance, it was one of the major channels by which affiliates in EDEs transferred large amounts of foreign currency to their home companies in developed countries during the 2008 financial crisis and the Eurozone crisis.

Implementation aspects raise a couple of questions of which I am fully aware. First, there is the need to define precisely what “productive investment” stands for: does it include software licenses and patents? Second, the State would require the administrative capabilities to verify the companies’ claims on the nature of their borrowing, while assuring that banking funds are indeed available in the domestic market (perhaps through public banks and/or development banks). However, the main intention of this proposal is to pass the burden of the proof to firms rather than the State. A further issue to be discussed concerns cross-border bank lending. The scheme should discriminate in favor of foreign lending for investment purposes, though its implementation would involved more thoughts and efforts in its design.

This proposal should not be thought of as a substitute for more specifically-FDI-oriented policies. There may well be different and valid reasons for countries to discourage FDI, and this measure does not stand in its way. It is not incompatible with other typical capital control measures such as unremunerated reserve deposits on financial investments or measures that restrict capital flights. This proposal is just one instrument, perhaps a modest one, to try to curb speculative borrowing by firms, particularly in foreign currency, an ever-increasing practice which offers negligible benefits and which adds to headwinds when foreign reserves are needed the most (Chui et al 2014).

*Pablo G. Bortz is currently Professor at the National University of San Martin. He is the author of Inequality, Growth and ‘Hot’ Money, published by Edward Elgar. With the usual caveats, the author thanks Edgardo Torija Zane for our fruitful discussions on this proposal.

References

Akyüz, Y. (2014): Internationalization of finance and changing vulnerabilities in emerging and developing economies, Discussion Paper No. 217, United Nations Conference on Trade and Development, Geneva.

Arslanalp, S. and Tsuda, T. (2014): Tracking global demand for emerging market sovereign debt, Working Paper No. 14/39, International Monetary Fund, Washington, DC.

Avdjiev, S., Chui, M. and Shin, H.S. (2014): Non-financial corporations from emerging market economies and capital flows, BIS Quarterly Review 2014, December, pp. 67–77.

Bibow, J. (2011): Permanent and selective capital account management regimes as an alternative to self-insurance strategies in emerging-market economies, Working Paper No. 683, Levy Economics Institute of Bard College, Annandale-on-Hudson.

Bortz, P. (2016): Inequality, Growth and ‘Hot’ Money, Edward Elgar, Cheltenham.

Butzen, P., Deroose, M. and Ide, S. (2014): Global imbalances and gross capital flows, National Bank of Belgium Economic Review 2014, September, pp. 41–60.

Canuto, O. and Ghosh, S. (eds) (2013): Dealing with the Challenges of Macro Financial Linkages in Emerging Markets, World Bank, Washington, DC.

Chui, M., Fender, I. and Sushko, V. (2014): Risks related to EME corporate balance sheets: the role of leverage and currency mismatch, BIS Quarterly Review 2014, September, pp. 35–47.

Epstein, G. (ed) (2005): Capital Flight and Capital Controls in Developing Countries, Edward Elgar, Cheltenham UK.

Furcer, D. and Loungani, P. (2015): Capital account liberalization and inequality, Working Paper No. 15/243, International Monetary Fund, Washington, DC.

Gallagher, K. (2014): Ruling Capital: Emerging Markets and the Re- regulation of Cross-Border Finance, Cornell University Press, Ithaca, NY.

Grabel, I. (2015): The rebranding of capital controls in an era of productive incoherence, Review of International Political Economy, Vol. 22 (1), pp. 7-43.

International Monetary Fund (2012): The liberalization and management of capital flows: an institutional view, International Monetary Fund, Washington, DC.

Jayadev, A. (2005): Financial liberalization and its distributional conse- quences: an empirical exploration, Ph.D. dissertation, University of Massachusetts Amherst.

Ostry, J.D., Ghosh, A.R., Habermeier, K., Laeven, L., Chamon, M., Qureshi, M.S. and Kokenine, A. (2011): Managing capital flows: what tools to use?, Staff Discussion Note No. 11/06, International Monetary Fund, Washington, DC.

Palma, J.G. (2001): Three-and-a-half cycles of ‘mania, panic, and (asymmetric) crash’: East Asia and Latin America compared, in H.J. Chang, J.G. Palma and D.G. Whittaker (eds): Financial Liberalization and the Asian Crisis, Palgrave, Basingstoke.

Rey, H. (2013): Dilemma not trilemma: the global financial cycle and monetary policy independence, Proceedings of the Economic Symposium of the Federal Reserve Bank of Kansas City, Jackson Hole, WY.

Stockhammer, E. (2009): Determinants of functional income distribution in OECD countries, IMK Studies No. 05/2009, Hans Böckler Stiftung, Düsseldorf.

Storm, S.T.H. and Naastepad, C.W.M. (2016): Myths, mix-ups and mishandlings: understanding the Eurozone crisis, International Journal of Political Economy, Vol. 45 (1), pp. 46-71.

UNCTAD (2001): Trade and Development Report, UNCTAD, Geneva.

UNCTAD (2014): Trade and Development Report, UNCTAD, Geneva.

Vernengo, M. and Rochon, L.P. (2000): Exchange rate regimes and capital controls, Challenge, Vol 43 (6), pp. 76-92.

Ilene Grabel on capital controls

New paper on the resurgence of capital controls. From the Abstract:

The startling resuscitation of capital controls during the global crisis has substantially widened policy space in the global north and south. The paper highlights five factors that contribute to the evolving rebranding of capital controls. These include: (1) the rise of increasingly autonomous developing states, largely as a consequence of their successful response to the Asian crisis; (2) the increasing confidence and assertiveness of their policymakers in part as a consequence of their relative success in responding to the global crisis at a time when many advanced economies have and still are stumbling; (3) a pragmatic adjustment by the IMF to an altered global economy in which the geography of its influence has been severely restricted; (4) the intensification of the need for capital controls during the crisis not just by countries facing fragility or implosion, but also by those that fared “too well”; and (5) the evolution in the ideas of academic economists and IMF staff. The paper explores tensions around the rebranding of capital controls. These are exemplified by efforts to develop a hierarchy in which controls on inflows that are a last resort and are targeted, temporary, and non-discriminatory are more acceptable than those that are blunt, enduring, discriminatory, and that target outflows. In addition, tensions have increasingly focused on whether controls should be used by capital-source rather than just capital-recipient countries.

Read full paper here.

Financialization and the Resource Curse in Brazil

"Financialization and the Resource Curse: The Challenge of Exchange Rate Management in Brazil"

By Kevin P. Gallagher and Daniela Magalhães Prates

Indeed, Brazil has been blessed and cursed with high commodity prices (from 2003 to mid-2008 and 2009-2011) and low interest rates in the core economies after the 2008 global financial crisis. Such an environment, coupled with the high domestic policy rate and the sophistication of the Brazilian financial system, has made Brazil a much sought after destination for carry trade operations through short-term financial flows that are largely transmitted through the foreign exchange derivatives market. Speculative operations into this market have accentuated the upward pressure on the exchange rate, which has come with higher commodities prices, leading to what we refer to here as a financialization of the resource curse (pp. 2).

Read rest here.

Chang & Grabel on The End of The Neoliberal Approach To Development

The following is an extract from Ha-Joon Chang and Ilene Grabel's new book Reclaiming Development: An Alternative Economic Policy Manual :

We should take note of what we see as the beginning of the end of the neoliberal approach to development. The process of discrediting that development model begins in the aftermath of the east Asian financial crisis of 1997–98. At the time there appeared to be nothing new in the nature of the east Asian crisis or in the crisis response. But, in fact, the east Asian crisis marked the gradual beginning of the end of the neoliberal consensus in the development community. The severe constraints on policy space that followed the east Asian crisis created momentum behind a new vision – that developing countries had to put in place new strategies and institutions to prevent a repeat of the events of the late 1990s. Policymakers in a number of Asian countries and in other successful developing countries sought to insulate themselves from the hardships and humiliations suffered by east Asian policymakers at the hands of the IMF. Indeed, as a consequence of the crisis, the IMF suffered a loss of purpose, standing and relevance. In the early 2000s, demand for the institution's resources was at a historic low. In 2005, just six countries had standby arrangements with the fund, the lowest number since 1975. From 2003 to 2007, the fund's loan portfolio shrank dramatically: from $105bn (£63bn) to less than $10bn. The fund's loan portfolio contracted even further after the loans associated with the east Asian crisis were repaid, as those countries that could afford to do so deliberately turned away from the institution. This trend radically curtailed the geography of the IMF's influence. In this context, the IMF began to soften its traditional opposition to policies that regulate the international movement of capital (ie policies called "capital controls"). At the same time, the World Bank also began to show signs of grudging change in its traditional opposition to industrial policy.

Read the rest here.

Note: Chang & Grabel's book has an introduction written by Robert Hunter Wade. Although I could not transcribe parts of his intro into this post, let it be known that much of Wade's position with respect to the topic at hand is illustrated here.

Kevin Gallagher on capital controls in developing countries

From the letters section in the Financial Times.

For the piece Kevin is responding to go here (subscription required)

G-24 Policy Brief: Capital Flow Management and the Trans-Pacific Partnership Agreement

A recent Global Economic Governance Initiative (GEGI) G-24 policy brief by Kevin P. Gallagher, Anna Maria Viterbo, and Sarah Anderson asses the degree to which the final draft of Obama's TPP (Trans-Pacific Partnership) deal must include significant safeguards to prevent and mitigate financial crises. The authors provide an alternative legal language that could be incorporated in future trade deals such that nations have the space and flexibility requisite to ensure financial stability. In my view, however, it is perhaps highly unlikely that the power brokers of TPP would even consider or critically reflect on the far-reaching proposals. From the Intro:

The Trans Pacific Partnership (TPP) being negotiated by 12 governments represents an important opportunity for a fresh approach to the treatment of capital flow management measures in trade agreements. Most regional and bilateral free trade agreements (FTAs) and bilateral investment treaties (BITs) enacted in the past two decades have encouraged capital account liberalization based on the view that this policy choice would facilitate more efficient international allocation of resources and spur foreign investment and growth in developing countries. In recent years, however, there has been a major re-thinking on the issue of capital account liberalization. In December 2012, the International Monetary Fund (IMF) issued a new “institutional view” that endorses the regulation of cross-border finance in some circumstances. The IMF also pointed out that many trade and investment treaties do not provide the appropriate level of policy space to regulate cross-border finance when needed. While the IMF’s new position was the outcome of many years of analysis, it was no doubt influenced by the 2008 financial crisis and the fact that a number of governments have used various forms of capital flow management measures (CFMs) in recent years to address financial volatility. The Trans-Pacific Partnership, as the first major trade negotiations since the 2008 crisis, presents an important arena to ensure coherence between current thinking on CFMs, including the IMF’s “new view," and trade and investment agreements.

Read rest here.

Yves Smith and Dean Baker on the Trans-Pacific Partnership Agreement

The Trans-Pacific Partnership Agreement (TPP) is a somewhat secretive Free Trade Agreement that the US and several Asian and Latin American countries are negotiating. In the short part below Yves Smith (from Naked Capitalism) talks about the restrictions on financial regulations and capital controls that the agreement would impose.

Watch the whole interview conducted by Bill Moyers here. A similar take by Kevin Gallagher here.

Gallagher on Why Trade Deals Must Allow for Regulating Finance

From the Global Economic Governance Initiative (GEGI).

APEC leaders gather in Bali this week to discuss the Trans-Pacific Partnership (TPP) agreement, among other topics. In this opinion article that will appear this week in the Bangkok Post, Jakarta Post, China Daily and other Asian papers via the Globalist, GEGI's Gallagher urges reform of the TPP. Based on new GEGI research with Chilean and Malaysian economists, Gallagher argues that the TPP should have safeguards that allow nations to regulate cross-border finance to prevent and regulate financial crises.

Read the whole thing here.

IMF's New View on Capital Controls

By Kevin P. Gallagher and Jose Antonio Ocampo

"Weeks before the spring meetings of the International Monetary Fund (IMF) in Washington next month, GDAE Senior Researcher Kevin P. Gallagher and Colombia University economist Jose Antonio Ocampo offer a critical analysis of the IMF's new view on capital account liberalization and the management of capital flows. The article, “The IMF’s New View on Capital Controls,” appears in India's Economic and Political Weekly (see here).

In the 1970s the International Monetary Fund became an advocate of capital account liberalization, and in 1997 it tried to change its Articles of Agreement to include capital account convertibility among its mandates. In contrast, the IMF embraced in December 2012 a new "institutional view" on this issue. While it remains wedded to eventual financial liberalization, it now acknowledges that free movement of capital rests on a weak intellectual foundation. Gallagher and Ocampo claim that this is a step in the right direction, but that the new institutional view still suffers from a number of shortcomings that will need to be addressed in national capitals and in other international fora.

Although a significant step forward, the new institutional view is still out of step with country experience and economic thinking in many respects. In particular, it continues to insist on eventual capital market liberalization despite the lack of evidence supporting it, is too narrow concerning the sanctioned use of capital account regulations on inflows and outflows, and does not deal with the implications for multilateral aspects of regulating cross-border finance."

What is new about the IMF's views on capital controls?

I wanted to write about this topic for a while, but didn't have enough time. The IMF has adopted a new institutional view on capital controls, which will inform their policy advice and surveillance of member countries, which they suggest reflects "a very broad consensus" [I'm always a little bit wary of broad consensuses]. Note that the Fund is still in favor of capital account liberalization, as noted in the second key feature of their institutional view, which says that "capital flow liberalization is generally more beneficial and less risky if countries have reached certain levels or 'thresholds' of financial and institutional development."

The question is how to get beyond the threshold, but there is no doubt that liberalization should be ultimately pursued, at least to some degree. They do add a cautionary note that full liberalization might be an impossible goal for many countries. In their words: "countries with extensive and long-standing measures to limit capital flows are likely to benefit from further liberalization in an orderly manner. There is, however, no presumption that full liberalization is an appropriate goal for all countries at all times."

The new institutional view is based on the notion that capital flows will continue to move away from the center, and that developing countries will be faced with a persistent pressure for the appreciation of their currencies. Blanchard says in his post that "looking at the relevant set of investors suggests higher flows to emerging markets are here to stay." He also suggests that the biggest threat from those inflows, the so-called Dutch Disease that New Developmentalist authors like Bresser-Pereira (here, for example) have emphasized, is not that dangerous and the empirical evidence about it is not well established [by the way, I tend to agree with Blanchard on this one, and believe that fears of a Dutch Disease are exaggerated].

My concerns with the new institutional view are twofold. On the one hand, I would rather not accept a general rule in which the IMF has a say on when and why a member country should use capital controls. Right now countries have a right to do it. So this new institutional view actually reduces policy space for developing countries. Note that the IMF, in spite of all the talk about the new macroeconomics is enforcing austerity in the European periphery. So the orderly manner that would lead to benefits from capital account liberalization are basically fiscal asuterity and inflation targets (slightly higher, 4% and not 2%).

Second, the view of the relevance of capital controls is limited to its effects on exchange rates, its volatility, the risk of appreciation, and last the possibilities of depreciations with disruptive outflows (or sudden stops). I tend to see capital controls as an essential tool not just for exchange rate management, but also for industrial policy, since the availability of dollars is often essential for determining which sectors can be promoted by allowing imports of essential goods (e.g. capital and intermediary goods), and which ones would be forced to rely on domestic substitutes. Import substitution and alternative development policies, of course, remain an anathema at the IMF.

Further, exchange rates are connected and do affect income distribution. It is far from clear that the only thing a country wants to do is avoid 'excessive' appreciation and loss of external competitiveness. Higher wages, associated with appreciated exchange rates, might be relevant for demand expansion too. At any rate, the point is that a great deal of discretionary power by domestic authorities should be the norm when it comes to capital controls. The less power the IMF has in this respect, the better.

Capital controls and exchange rates

This was the topic of the RBI/ADB conference in Mumbai. No particular surprises. The consensus is that capital controls affect the composition of flows, but not their volume, and even the IMF, represented by Jonathan Ostry, suggested that capital controls should be part of the tool kit used by central banks. Also, some skepticism on the efficiency of short term (or episodical controls, such as the ones used by Brazil) was raised. Of course there are still differences on what circumstances capital controls are actually necessary.

Most of the discussion was related to the use of capital controls to reduce the risk of appreciation, since in the last decade developing countries have had to deal with inflows and a depreciating dollar. Note, however, that capital controls were not thought when originally defended by Keynes and White at Bretton Woods to be necessary for reducing appreciating tendencies, but to limit capital flight (and avoid and external crisis) and provide monetary autonomy (Impossible Trinity or Trilemma).

Further, in historical perspective, exchange controls (capital controls on quantities not prices) have been used as an instrument for industrial policy, to determine that the use of dollars is prioritized for capital equipment imports particularly in the periphery. In that sense their use is in fact an essential an permanent tool in the developing economy set of instruments, and that's why signing FTAs or BITs that reduce the ability to deploy capital controls is dangerous.

PS: On the long standing issues related to capital controls and exchange rate regimes see this paper.

Graph of the Day: Frequency of Banking Crises

The graph below, from Alan Taylor's recent paper shows the frequency of banking crises around the world.

As you can see in between the Great Depression in the 1930s and the 1980s, with the beggining of financial deregulation there are NO banking crisis. As Taylor (p. 2) notes: "none [banking crises] at all occurred from World War 2 until the 1970s."That's how effective the regulation of the 1930s and the capital controls of the Bretton Woods era were.

PS: Any similarity with the graph on income inequality, that decreases after the Great Depression and grows after Reagan too, is NOT a coincidence.

The IMF and stylized fiction

The IMF has posted their Top 20 list of most popular entries since the launch of the blog. At #3 they have the Ten Commandments of Fiscal Adjustement in Advanced Economies, which is from 2010, but still worth reading, since their views have hardly changed. I am not going to go through the whole list, even though it does merit careful analysis. I want just to point out a few problems with three of the commandments (do they really need the religious analogy?). This 10 Commandments are based on the IMF's views on the stylized facts of fiscal consolidations.

Note that the IMF wants a reduction in debt-to-GDP ratios in the long run (commandment #3), even if nobody knows exactly what is the difference of having a 40% ratio, which they recommend for 'emerging markets' (meaning developing economies), or a 250%, as the UK had during the Napoleonic Wars (here). My first concern is with the idea that consolidation (by which they mean austerity) should be done by cutting spending and not increasing taxes (#4), because this is more conducive to growth.

This is a proposition they repeat in their last Fiscal Monitor (2012: p. 35), where we are told that:

"a number of earlier studies have shown that expenditure-based fiscal consolidations have a more favorable effect on output than revenue-based consolidations, in spite of the standard multiplier analysis … Chapter 3 of the October 2010 World Economic Outlook reaches the same conclusion (IMF, 2010b) and notes that this result is partly because, on average, central banks lower interest rates more in the case of expenditure-based consolidations (perhaps because they regard them as more long-lasting)."

Note, however, that the reason for the superior performance for cutting spending instead of raising taxes (on the rich one would hope) is that the Central Bank does not hike rates in the former case, since it is part of a conservative plan to reduce the size of government (note that the IMF asks for consolidations to be fair, #6, but then wants to cuts social spending, #5). Worse the notion is also based on the idea that lower (higher) spending brings down (up) the rate of interest and leads to crowding in (out) of private investment. The problem is that the evidence for a positive (negative) effect of fiscal deficits (surplus), or public spending increase (reduction), on interest rates, is that it is almost non-existent (see UNCTAD, 2011, chapter 3 for a review).

The other point is related to the last commandment (#10), which says that you should coordinate your macroeconomic policies with other countries. I'm not even going to deal with the problems of coordination. My problem is that the arguments tend to be based on the Mundell-Fleming (MF) model (the ISLMBP with perfect capital mobility), which suggests that fiscal policy is less efficient in a small open economy. In this case, fiscal policy raises the rate of interest, with capital mobility, pressures for inflows lead to an appreciation of the currency, and lower trade surpluses. Instead of crowding out, meaning lower investment, one gets lower output from the external accounts. That's why they say in their last Fiscal Monitor that "in line with the theory, fiscal multipliers tend to be smaller in more open economies" (2012, p. 33).

Again this depends on a weak empirical relation. In the United States seldom is the case that expansionary fiscal policy causes higher rates of interest. In fact, the policy of the strong dollar, with the impact on manufacturing output and exports, has often been detached from fiscal expansionism or higher rates of interest (e.g. the Clinton years in which a strong dollar went hand in hand with fiscal consolidation and monetary easing to feed the dot-com bubble).

Finally, note that even small open economies in several periods were able to have very effective fiscal policies, because in spite of relatively flexible exchange rates, they used capital controls to avoid the effects of volatile capital flows on their external accounts. In this sense, the world of relatively regulated capital flows, rather than of fixed exchange rates (even if sometimes the two are confounded as a result of the Bretton Woods arrangement), seems to be more conducive to effective fiscal policy. So the lesson should not be that small open economies cannot do effective fiscal policy, but that capital controls (which they are not quite okay with contrary to what you might have heard, but I leave for another post) are necessary.

PS: For a more consistent theoretical critique of the MF model see Serrano and Summa (2012).

Kevin Gallagher on capital controls

Another interesting talk at the Central Bank of Argentina, this one by Kevin Gallagher from the University of Boston based to a great extent on his recent work with José Antonio Ocampo and Stephany Griffith-Jones on the regulation of capital flows (see here).

He has three main points to make. First, there is increasing and overwhelming evidence that there is no connection between capital account liberalization and economic growth. He cited the recent work by Arvind Subramanian, Olivier Jeanne and John Williamson (the latter of Washington Consensus fame) at the Peterson Institute, called "Who Needs to Open the Capital Account?," who argue (2012, p. 5) that "the international community should not seek to promote totally free trade in assets -- even over the long run-- because ... free capital mobility seems to have little benefit in terms of long run growth."

Second, it seems that the International Monetary Fund (IMF) has come to partially recognize the appropriateness of capital account regulations and has gone so far as to recommend (and officially endorse) a set of guidelines regarding the appropriate use of Capital Account Regulations (CARs), the new term for capital controls within the IMF. He warned, correctly I think, that changes within the IMF can be seen as a reform that tries to restrict the use of capital account regulations to emergencies, and situations approved by the IMF within article 4 consultations, when article 6 guarantees that countries can use them freely.

Finally, and more importantly, Kevin warned that Bilateral Investment Treaties (BITs) and Free Trade Agreements (FTAs) have regularly included very restrictive language on capital account regulations, and have a tendency to restrict the policy space in developing countries, exactly when a consensus that this restrictions do not provide any benefit in terms of growth.

Is China really opening the capital account?

Martin Wolf tells us in a recent column that China is opening up its capital account, according to a report from the People’s Bank of China, and that it is taking a gradual approach. Reform will be in three steps:

"The first, to occur over the next three years, would clear the path for more Chinese investment abroad as ‘the shrinkage of western banks and companies has vacated space for Chinese investments’ and so presented a ‘strategic opportunity’. The second phase, in between three and five years, would accelerate foreign lending of the renminbi. In the longer term, over five to 10 years, foreigners could invest in Chinese stocks, bonds and property. Free convertibility of the renminbi would be the ‘last step’, to be taken at an unspecified time."

Wait what? What this says is that they are going to lend more in yuan, given the retreat of American and European banks, and will eventually allow some amount of foreign ownership of assets denominated in yuan. This, by the way, is just trying to expand the international role of the yuan, something aptly called the yuan diplomacy by Kevin Gallagher, who notes that already: "China became the largest source of finance for Latin American governments."

Yet, only the last step, the one to be taken at an unspecified time, would constitute opening the capital account. So basically they announced that they want to increase the international use of the yuan, getting more developing countries to borrow in their currency, while maintaining a strict control of the supply of their currency. In fact, The Economist tells us that Sheng Songcheng, head of the central bank’s research department and the lead author of the study cited by Wolf said that: "If you wait for the exchange rate and interest rates to be fully liberalized ...  you may wait forever." I guess then never is when the capital account will be fully open. That's slow enough, and is a capital account liberalization I would recommend too.