Wednesday, April 14, 2010

IMF backpedals its endorsement of capital controls

Maladjusted's readers may know that after being snubbed by developing countries because of its horrible policy advise, the IMF had a midlife crisis and was forced to do a little soul searching. But right when it was on the brink of utter irrelevance, the global financial crisis hit and the ailing institution was given a new lease on life. In the process, headed by french "socialist" DSK, the IMF began reevaluating many of its long held dogmas.

Most recently, the IMF came out in favor of using short-term controls on capital inflows. This was considered a BIG FUCKING DEAL, and rightly so, but the details of how this would translate into actual policy were anything but clear. So now it shouldn't exactly come as a surprise that the IMF seems to be softening it's support for capital controls--that is, taxes and restrictions on moving capital across national borders.

A little background might be in order.

Throughout the '80s and '90s, the IMF encouraged developing countries to liberalize their financial markets and to do it fast. Free market types basically believed that doing this would promote the efficiency of financial markets, channeling funds to where they were needed most and thus leading to better economic growth.

Well, at the beginning of the '90s many developing countries began to liberalize and, due to a combination factors, were faced with massive inflows of foreign capital. To simplify, the US Fed had pushed interest rates down to help the US recover from a recession, prompting investors to look elsewhere for places with higher rates. At the time, Latin America was just such a place. Moreover, apart from having high interest rates, most countries in the region had spent the last decade--the lost one--pursuing neoliberal reforms that investors perceived favorably.

In any case, countries that had been cutoff from international capital markets for years suddenly experienced a huge surge of foreign capital inflows. The problem, however, was that when it comes to capital flows you really can have too much of a good thing. It quickly became apparent that these large flows of foreign capital carried significant risks and posed a challenge to macroeconomic management.

One side effect of capital inflows is that it puts pressure on your currency to appreciate and for many of these countries, which were pursuing an export-led development strategy, this was a big problem.

Many of these countries were also concerned with a loss of monetary policy independence, meaning that the abundance of foreign money was pushing interest rates down despite the wishes of central banks to keep them high in order to fight inflation.

Policy makers were also concerned that these large inflows could make countries more vulnerable to financial crises. In particular, Latin American banks took advantage of all this cheap foreign money and borrowed excessively short-term and in foreign currencies, which put them at risk if the inflows were to stop and the currency to collapse.

The point of this story is that one country in particular managed to juggle all these problems quite well and it did so using capital controls. This country also happens to be the free market darling Chile (Colombia and Brazil have used similar controls with varying degrees of success).

Another famous success story comes from Southeast Asia during the Asian financial crisis. Facing massive capital flight, Malaysia broke with the IMF and imposed temporary controls on capital outflows to prevent it's economy from collapsing. Its economy proceeded to recover rapidly.

Whatever. So now, in spite of mounting evidence and it's own endorsement, the IMF is warning that capital controls could cause significant distortions:
"Since the use of capital controls is advisable only to deal with temporary inflows, in particular those generated by external factors, they can be useful even if their effectiveness diminishes over time... However, the decision to implement capital controls should consider their distortionary effects not just on the individual country, but also on the global economy in the event their use were to become widespread."
To be fair, there's nothing wrong with this statement. Controls on capital inflows shouldn't be used as an excuse to avoid pursuing meaningful macroeconomic adjustments and if controls become widespread they might slow global recovery (a rather large claim backed by little evidence). But it's clear that there are actors within the IMF trying to prevent capital controls from becoming standard policy. So before we rush to the conclusion that the IMF is seriously reconsidering it's long-held policy stances, we should wait to see how it's endorsement of capital controls translates into actual policy.

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