Opinion

End of an era for global finance

(China Daily)
Updated: 2010-03-13 09:40

In the world of economics and finance, revolutions occur rarely and are often detected only in hindsight. But what happened on Feb 19 can safely be called the end of an era in global finance.

On that day, the International Monetary Fund (IMF) published a policy note that reversed its long-held position on capital controls. Taxes and other restrictions on capital inflows, the IMF's economists wrote, can be helpful, and they constitute a "legitimate part" of policymakers' toolkit.

Rediscovering the common sense that had strangely eluded the fund for two decades, the report noted that "logic suggests that appropriately designed controls on capital inflows could usefully complement" other policies. The IMF's policy note makes clear that controls on cross-border financial flows can be not only desirable, but also effective. This is important, because the traditional argument of last resort against capital controls has been that they could not be made to stick. Financial markets would always outsmart the policymakers.

Even if true, evading the controls requires incurring additional costs to move funds in and out of a country - which is precisely what the controls aim to achieve. Otherwise, why would investors and speculators cry bloody murder whenever capital controls are mentioned as a possibility? If they really couldn't care less, then they shouldn't care at all.

One justification for capital controls is to prevent inflows of hot money from boosting the value of the home currency excessively, thereby undermining competitiveness. Another is to reduce vulnerability to sudden changes in financial-market sentiment, which can wreak havoc with domestic growth and employment. To its credit, the IMF not only acknowledges this, but it also provides evidence that developing countries with capital controls were hit less badly by the fallout from the subprime mortgage meltdown.

The IMF's change of heart is important, but it needs to be followed by further action.

We currently don't know much about designing capital-control regimes. The taboo that has attached to capital controls has discouraged practical, policy-oriented work that would help governments to manage capital flows directly.

There is some empirical research on the consequences of capital controls in countries such as Chile, Colombia, and Malaysia, but very little systematic research on the appropriate menu of options. The IMF can help to fill the gap.

Dani Rodrik is a professor of political economy at Harvard University's John F. Kennedy School of Government.