It’s official. The InternationalMonetary Fund has put its stamp of approval on capital controls, therebylegitimizing the use of taxes and other restrictions on cross-border financialflows.
Not long ago, the IMF pushed hard for countries – rich orpoor – to open up to foreign finance. Now it has acknowledged the reality thatfinancial globalization can be disruptive – inducing financial crises andeconomically adverse currency movements.
So here we are with yet another twistin the never-ending saga of our love/haterelationship with capital controls.
Under the classical Gold Standard that prevailed until1914, free capital mobility had been sacrosanct.But the turbulence of the interwar period convinced many – most famously JohnMaynard Keynes – that an open capital account is incompatible withmacroeconomic stability.  The new consensus was reflected in the BrettonWoods agreement of 1944, which enshrined capitalcontrols in the IMF’s Articles of Agreement. As Keynes said at the time, “whatused to be heresy is now endorsed as orthodoxy.”
By the late 1980’s, however, policymakers had become re-enamored with capital mobility. The European Unionmade capital controls illegal in 1992, and the Organization for EconomicCooperation and Development enforced free finance on its new members, paving the way for financial crises in Mexico andSouth Korea in 1994 and 1997, respectively. The IMF adopted the agendawholeheartedly, and its leadership sought (unsuccessfully) to amend theArticles of Agreement to give the Fund formal powers over capital-accountpolicies in its 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 Westerneconomists argued that governments in Mexico, South Korea, Brazil, Turkey, andelsewhere had not adopted the policies – prudentialregulations, fiscal restraint, and monetary controls – needed to take advantageof capital flows and prevent crises. The problem was with domestic policies,not with financial globalization, so the solution laynot in controls on cross-border financial flows, but in domesticreforms.
Once the advanced countries became victims of financialglobalization, in 2008, it became harder to sustain this line of argument. Itbecame clearer that the problem lay with instabilityin the global financial system itself – the boutsof euphoria and bubbles, followed by the suddenstops and sharp reversals that are endemic tounsupervised and unregulated financial markets. The IMF’s recognition that itis appropriate for countries to try to insulate themselves from these patternsis therefore welcome – and comes none too soon.
But we should not exaggerate the extent of the IMF’s changeof heart. The Fund still regards free capital mobility as an ideal toward whichall countries will eventually converge. Thisrequires only that countries achieve the threshold conditions of adequate“financial and institutional development.”
The IMF treats capital controls as a last resort, to bedeployed under a rather narrow set of circumstances – when other macro, financial,or prudential measures fail to stem the tide of inflows, the exchange rate isdecidedly overvalued, the economy is overheating, and foreign reserves arealready adequate. So, while the Fund lays out an“integrated approach to capital flow liberalization,” and specifies a detailedsequence of reforms, there is nothing remotelycomparable on capital controls and how to render them more effective.
This reflects over-optimism on two fronts: first, about howwell policy can be fine-tuned to target directly the underlying failures thatmake global finance unsafe; and, second, about the extent to which convergencein domestic financial regulations will attenuate the need for cross-bordermanagement 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 consequenceswhen used accidentally or placed in the wrong hands. The IMF’s reluctantendorsement of capital controls resembles the attitude of gun-controlopponents: policymakers should target the harmful behavior rather than bluntlyrestrict individual freedoms. As America’s gun lobby puts it, “Guns don’t killpeople; people kill people.” The implication is that we should punish offendersrather than restrict gun circulation. Similarly, policymakers should ensurethat financial-market participants fully internalize the risks that theyassume, rather than tax or restrict certain types of transactions.
But, as Princeton economist Avinash Dixit likes to say, theworld is always second-best at best.  An approach that presumes that wecan identify and directly regulate problematic behavior is unrealistic. Mostsocieties control guns directly because we cannot monitor and disciplinebehavior perfectly, and the social costs of failure are high. Similarly,caution dictates direct regulation of cross-border flows. In both cases, regulatingor prohibiting certain transactions is a second-best strategy in a world wherethe ideal may be unattainable.
The second complication is that, rather than converging,domestic models of financial regulation are multiplying, even among advancedcountries with well-developed institutions. Along the efficiency frontier offinancial regulation, one needs to consider the tradeoff between financialinnovation and financial stability. The more of one we want, the less of theother we can have. Some countries will opt for greater stability, imposingtough capital and liquidity requirements on their banks, while others may favorgreater 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 evadedomestic controls and erode the integrity of regulatory standards at home. Toprevent such regulatory arbitrage, domesticregulators may be forced to take measures against financial transactionsoriginating from jurisdictions with more laxregulations.
A world in which different sovereigns regulate finance indiverse ways requires traffic rules to manage the intersectionof separate national policies. The assumptionthat all countries will converge on the ideal offree capital mobility diverts us from the hard work of formulating those rules.