Before the financial crisis spread from the US housing market to the world, the idea that countries should restrict the flow of money into and out of their economies was considered heresy at the International Monetary Fund.
The consensus was that countries were encouraged to set liberal rules so investors could buy and sell assets as freely as possible — and any restrictions or ‘capital controls’were considered a hindrance to development and better economic performance.
But in one of the starker examples of how the US-born crisis has reshaped economic thinking, the IMF on last Monday said it now regards capital controls as an important policy tool that can help nations shield themselves from potential problems. Such limits — whether taxes to slow money coming into a country or rules to prevent it from rushing out too fast — should be imposed carefully, the IMF said, and not be used to avoid confronting other problems in a country’s economy.
Yet, after watching nations devastated as US-originated investments proved toxic to banks around the world, the IMF now argues that “there is no presumption that full [capital account] liberalisation is an appropriate goal for all countries at all times.”
“In certain circumstances,” it concluded, capital controls “can be useful for supporting... and safeguarding financial system stability.”
Unlike many papers produced by the IMF research staff, the report on capital controls was approved by the IMF board and characterised as the agency’s ‘institutional view.’
The paper marks a victory of sorts for developing nations such as Brazil and China over an orthodoxy whose chief advocate has been the United States, a nation whose markets are among the most open in the world to foreign investments, and whose companies and entrepreneurs are among the largest and most active in other nations. Developing countries have long defended their right to maintain capital controls as a way to protect themselves from the rapid movements of money that can cause inflation as it moves in, and unemployment or recession on the way out.
The change also shows how fully economic policy is being rethought in the wake of a crisis that forced central bankers, finance ministers and regulators around the world to take a host of unprecedented steps — from government interventions in heavy industry and banks to rounds of ‘quantitative easing,’ and a painful restructuring of the euro zone.
Prior to the crisis, mainstream thinking held that financial markets in particular could virtually regulate themselves, as investors vetted deals and each other in a way that would let the best strategies win out, and produce both economic stability and growth.
“The official position was basically that… it is more efficient, if it turns out to be a bubble, to clean up afterwards,” said William R. Cline, a senior fellow at the Peterson Institute of International Economics. “The crisis cast serious doubt on that approach.”
In the aftermath, governments and agencies such as the IMF are still trying to craft alternate approaches that, for example, restrict the size of financial institutions so that none are considered ‘too big to fail,’ or spread the cost of major bank failures across several nations.
In Switzerland last week, a committee of the Bank for International Settlements, an organisation of the world’s major central banks, released guidelines for regulators who want to curb rapid growth in order to minimise the risk of a subsequent crash. The committee, chaired by Federal Reserve Bank of New York Chairman William C. Dudley, acknowledged that such efforts might exact a price if officials use tighter bank or other regulations to slow an otherwise safe economic expansion.
But the committee said it regarded financial crises of the sort just experienced as ‘generally more costly’ than an imposed economic slowdown.
The IMF’s paper on capital controls is part of the larger debate about how to allow markets to operate and money to move freely around the world while also guarding against the most harmful excesses.
Countries in Latin America and Asia, for example, were hit hard in the 1990s and early 2000s after foreign investors lost confidence and began pulling out, weakening local banks and markets. More recently, the expansion of the global money supply, driven by the US Federal Reserve, has led some officials in developing countries to complain about the impact as money rushes into the local economy, driving up asset prices and exchange rates.
In its paper, the IMF maintained its general recommendation that countries gradually open their capital account — particularly those, like China, that are large, rich and sophisticated enough to weather any problems.
But the IMF also said that in a volatile world, “when a country faces an inflow surge or an outflow crisis,” it ‘may be appropriate’ for a government to put controls on the monetary spigot.