x Abu Dhabi, UAEThursday 27 July 2017

IMF learns to speak language of victims

IMF's new, partial embrace of capital controls comes as the financial crisis brings the perils of globalisation home to the West from the economic frontiers.

Anti-globalisation activists stage a protest outside of the annual meetings of the World Bank and International Monetary Fund in Tokyo. Yoshikazu Tsuno / AFP
Anti-globalisation activists stage a protest outside of the annual meetings of the World Bank and International Monetary Fund in Tokyo. Yoshikazu Tsuno / AFP

It's official. The IMF has put its stamp of approval on capital controls, thereby legitimising 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 globalisation 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 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 1980s, however, policymakers had become re-enamoured 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 powers over capital-account policies in 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 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 globalisation, so the solution lay not in controls on cross-border financial flows, but in domestic reforms.

Once the advanced countries became victims of financial globalisation, 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 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 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 liberalisation" 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 of global finance; 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 behaviour rather than bluntly restrict individual freedoms.

But, as the 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 behaviour is unrealistic. 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. Along the efficiency frontier of financial regulation, one needs to consider the balance 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 favour 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 regulatory integrity 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.

The assumption that all countries will converge on the ideal of free capital mobility diverts us from the hard work of formulating those rules.

Dani Rodrik, professor of international political economy at Harvard University, is the author of The Globalization Paradox: Democracy and the Future of the World Economy.

* Project Syndicate