Emerging markets have fallen victim to unstable capital flows in the wake of the financial crisis. In an attempt to mitigate the accompanying asset bubbles and exchange rate pressures that come with such volatility, a number of emerging markets resorted to capital controls. Although these actions have largely been supported by the International Monetary Fund, some policy-makers and economists have decried capital controls as protectionist measures that can cause spillovers that unduly harm other nations.
Recently-published research shows that these claims are unfounded. According to the new welfare economics of capital controls, unstable capital flows to emerging markets can be viewed as negative externalities on recipient countries. Therefore regulations on cross-border capital flows are tools to correct for market failures that can make markets work better and enhance growth, not worsen it.
This work has been developed by economists Anton Korinek, Olivier Jeanne, and others, and is summarised by Korinek in the August issue of the IMF Economic Review. According to this research, externalities are generated by capital flows because individual investors and borrowers do not know (or ignore) what the effects of their financial decisions will be on the level of financial stability in a particular nation. A better analogy than protectionism would be the case of an individual firm not incorporating its contribution to urban air pollution. Whereas in the case of pollution the polluting firm can accentuate the environmental harm done by its activity, in the case of capital flows a foreign investor might tip a nation into financial difficulties and even a financial crisis.
This is a classic market failure argument and calls for what is referred to as a Pigouvian tax (named after the 20th century Cambridge economist Arthur Pigou) that will correct for the market failure and make markets work more efficiently.
Of course, economists such as Keynes argued long ago that capital controls are important to prevent crises and to maintain an independent monetary policy that can strive for full employment and financial stability. This new work however elegantly models capital flows and capital controls in a broader contemporary economics context and thus could be seen by some to be a more rigorous justification for policy action on capital flows.
This work is not just for the blackboard. With quantitative easing, and as interest rates were lowered for expansionary purposes in the industrialised world between 2008 and 2011, capital flows returned to emerging markets at an alarming rate, where interest rates and growth were relatively higher. With eurozone jitters in the final quarter of 2011, capital flight occurred to the “safety” of the US and beyond. This has caused significant asset and exchange rate volatility that has made for an uncertain environment for policy-making and investment alike.
In response, many nations deployed capital controls to regulate the negative effects of cross-border capital volatility. Like earlier studies confirming that capital controls can change the composition of inflows, make for more independent monetary policy, and ease exchange rate tensions, new studies are emerging that show how nations such as Brazil, Taiwan, and South Korea have been at least moderately successful as well.
In addition to the cries of protectionism by Gordon Brown and others, some have also argued that controls create negative spillovers to neighbouring nations. MIT economist Kristin Forbes and colleagues examined Brazil’s numerous taxes on capital inflows from 2008 to 2011 to test whether such measures were harming Brazil’s neighbours.
On the one hand, Forbes and colleagues found that Brazil’s controls were meeting their stated objectives. However, in some attempts the authors did find that Brazil’s actions impacted other emerging market nations. Some of these spillovers were positive — some fund managers steered away from not only Brazil but from other nations that have regulated cross-border capital in the past. In other cases global investors did indeed increase their allocations to neighbouring nations.
These mixed findings miss some of the broader context, especially when seen in the light of the new welfare economics of capital controls. First, Brazil’s taxes can be seen as Pigouvian measures to correct against the negative spillovers generated from quantitative easing and the dollar/real carry trade. Second, the ‘costs’ that Forbes et al find to a small number of nations are not juxtaposed with the benefit of preventing a crisis in Brazil — one only has to look at Brazil’s 1999 crisis to see its contagious effect on the region then.
Over a dozen years ago, prominent trade theorist Jagdish Bhagwati reminded us that capital account liberalisation is not analogous to trade liberalisation and that measures to regulate capital flows are not inherently evil. The new welfare economics of capital controls further show that such measures can be seen as the new “correctionism” rather than the new protectionism — at exactly a time when nations need as many tools in their crisis preventing arsenal as possible.
This piece was originally published at the Financial Times. It is based on Gallagher’s new working paper, ‘The Myth of Financial Protectionism:The New (and old) Economics of Capital Controls’.