February 26, 2008
We must curb international flows of capital
By Dani Rodrik and Arvind Subramanian
First large downhill flows of capital – from rich countries to poor countries – led to the Latin American debt crisis of the early 1980s. In the 1990s similar flows begat the Asian financial crisis.
Since 2002 the flows have been uphill, from emerging markets and oil-exporting countries to the developed world, especially the US. But the outcome has not been very different. So, it does not seem to matter how capital flows. That it flows in sufficiently large quantities across borders – the celebrated phenomenon of financial globalisation – seems to spell trouble.
Causes and consequences vary, depending on which way capital flows. Developing country borrowing was associated with unsustainable fiscal policies (Latin America) and inappropriate exchange rate policies (Asia). But the financial sector was not blameless: for every overborrower there was an overlender.
The pathologies were different when the US went on a borrowing binge. Large current account surpluses and the associated savings glut in the rest of the world fed a global liquidity boom, which stoked asset prices. Even though the roots of the subprime crisis lie in domestic finance, international capital flows magnified its scale.
The remainder of this column can be read here. Debate from our panel of economists appears below.
William Easterly: To say that there are crises because of international capital flows is not very meaningful; it is like saying there are recessions because of GDP. Dani and Arvind do not adequately address two big issues on capital flows:
Posted by: William Easterly | February 26th, 2008 at 2:26 pm | Report this comment(1) what are the benefits of capital flows? Usually, a voluntary movement of capital signifies a reallocation from a low-return investment to a high-return investment. This raises the rate of return to investment overall, which is usually considered to be a good thing.
(2) To what extent are international capital flow crises the symptom or the disease? They are oftentimes the symptom, so trying to control them to treat macroeconomic imbalances is like treating fevers with ice-baths. Better to confront the underlying imbalances, as Dani and Arvind sensibly recommend in the second half of their column.
Justin Rietz (guest): “As we are unable to regulate fully the behaviour of gun owners, we have no choice but to restrict the circulation of guns more directly”
The reasoning of this argument is disconcerting. Using the same logic, “we” (which I assume to mean a government that agrees with Dani’s and Arvind’s policies), have no limit as to what we may regulate. It is not possible to fully regulate the behavior of anyone, let alone gun owners, and since most anyone is capable of committing a crime, the logic used here would allow regulation of anything that could aid in a crime. It comes down to a philosophical difference of whether or not the ends justifies the means, and while I hesitate to speak for others, I believe most of the modern, democratic world would argue that it does not.
Setting aside the moral issue, I wonder who would determine whether or not capital flows should be increased or curbed in a given country? Dani and Arvind suggest “multilaterally through the World Trade Organisation”, but the cynic in me finds this phrase to be an oxymoron. As William Easterly has often argued, markets subject to development policies and aid that work top down risk the same pitfalls as any other planned economy.
International capital flows and investment are to a certain extent self-stabilizing if allowed to work properly without interference. As more capital flows into an emerging market, the local rate of return drops, thus dissuading further investment. Of course, investors must also accurately measure risk, and they often rely upon the analysis of rating agencies endowed with significant government “approval”. Were these agencies not given such legitimacy by governments, investors would be more wary of their ratings, and hence would be more cautious about investing in emerging markets.
Justin Rietz
Posted by: Justin Rietz | February 26th, 2008 at 8:46 pm | Report this commentBA Economics, Stanford University
MBA, Haas School of Business, UC Berkeley
Emmanuel Yujuico (guest): Controlled international capital flows, a centralised apparatus for managing capital flows, and wariness about destabilising imbalances: what Professors Rodrik and Subramanian are describing is a return to an arrangement reminiscent of the Bretton Woods system. The reference to Keynes leaves in little doubt what they have in mind. While I am sympathetic to Rodrik and Subramanian’s objective—averting financial crises—I doubt whether their proposals would move us further in their desired direction. More to the point, the political hurdles which need to be cleared in moving back to a Bretton Woods-like system are formidable and are unlikely to be surmounted.
I have read the Prasad, Rajan, and Subramanian paper which indicates that there is no positive relationship between growth and reliance on foreign capital. Worse, there appears to be a negative relationship between growth and reliance on foreign capital. In light of this finding, Rodrik and Subramanian believe that restricting capital flows would be of no great loss to developing countries. Conversely, the subprime meltdown indicates to them that capital flowing uphill has not benefited those in the developed world, either. While the latter phenomenon is a comeuppance to those who theorised that developing countries sent capital to the West to take advantage of more secure financial systems—it turned out that money centre banks have not done any better investing a surfeit of capital—this alone cannot be the basis for returning to the Bretton Woods era.
I am simplifying the authors’ arguments, of course, but this appears to be their main idea: While the current subprime meltdown relates more to LDCs financing reserve centre deficits, it together with the Latin debt and Asian financial crises would have probably been avoided if a Bretton Woods-like system were still in place. If a centralised institution could discourage countries from running prolonged imbalances, all the while discouraging other capital flows financing deficits emanating from elsewhere—private and otherwise—then the occurrence of financial crises could be mitigated.
Politics being the art of the possible, let us consider their proposals. A punitive tax on gas would be a political non-starter in the United States. Politicians of both parties, after all, were tripping over themselves to offer ever more generous handouts that culminated in the $168B “economic stimulus package.” Expecting these same politicians to impose fiscal discipline which they themselves lack on voters via a gas tax is not forthcoming.
Nor is there reason to expect LDCs to cotton up to a centralised apparatus dictating that they revalue their currencies. Isn’t avoiding the IMF the point of the massive reserve accumulation that developing countries have undertaken? Hasn’t the IMF already tried beefing up its surveillance functions on currency manipulation? Without the leverage of existing loans to prod LDCs, there is little reason to believe that LDCs would voluntarily return to IMF dictates they have so determinedly sought to avoid. The Peterson Institute paper is too optimistic on the WTO taking on the role of currency undervaluation enforcer through the dispute settlement mechanism. There are very good reasons why cases of currency manipulation have no precedent for the LDC backlash would be unimaginable if such proceedings were to start. Doha deadlock would then become the least of the WTO’s problems.
The genie of freer capital flows escaped from the bottle after the collapse of the Bretton Woods system and cannot be put back. The US with its bedraggled finances is neither willing nor able to retake the mantle of financial globocop. The counterfactual that a Bretton Woods system would have deterred these crises from occurring is an interesting one, but the historical record suggests otherwise. Prior to 1973, private sources played a much lesser role in funding balance of payment shortfalls. This, however, did little to stop recurrent manias, panics, and crashes—the title of Charles Kindleberger’s well-known book which documents recurrent financial crises in a world of less free capital flows.
Ironically, political protectionism is a more likely path to reducing global imbalances.
Witness the sovereign wealth fund backlash as the EU and US vie to create voluntary codes of conduct, which in the event of LDC non-cooperation may lead to punitive measures. Biting the hand that feeds may only serve to deter capital flowing uphill and hasten the process of rebalancing as an unintended consequence.
Emmanuel Yujuico is a doctoral candidate in the Department of Political Science and International Studies at the University of Birmingham
Posted by: Emmanuel Yujuico | February 27th, 2008 at 4:59 am | Report this commentRobert Wade: I applaud the good sense of Rodrik and Subramanian’s argument. Compare it with the outrage generated in the West only 10 years ago when, in late August 1998, the Malaysian government imposed restraints on capital outflows, explicitly following China’s policy. The restraints left the ringgit convertible on the current – trade—account, as before, but no longer on the capital account. They prevented the buying of foreign exchange for speculative purposes; in other words, they were aimed at short-term flows, not at all types of capital flows. Yet while Chinese, Japanese and other Asian officials expressed support for the move, western officials and financial firms reacted as though Malaysia had dropped the atomic bomb. IMF Managing Director Michel Camdessus said that the exchange controls were “dangerous and indeed harmful”. IMF First Managing Director Stanley Fischer said that the controls were a step backwards and would bring no long-term benefit. US Treasury Secretary Robert Rubin expressed his disapproval. The US undersecretary for international trade declared that Asian nations must not follow Malaysia’s lead. Credit Lyonnais Securities (Asia) said that capital controls would turn Malaysia into “an equity black hole” for foreign investors. Indosuez W.I. Carr said the measures made “Malaysia virtually uninvestable”. (For more on the battle over capital controls at the time of the East Asian financial crisis, see Wade and Veneroso, “The gathering world slump and the battle over capital controls”, New Left Review, 231, Sep-Oct 1998.)
In the event the controls helped Malaysia recover faster than it would have – as Dani Rodrik and others have shown in careful comparisons with other crisis-affected countries. Nevertheless, former Treasury Secretary Larry Summers was still insisting, at least as late as the early 2000s, that capital controls never work, including in Malaysia. I wonder whether Larry has subsequently changed his mind?
The IMF’s Reaping the Benefits of Financial Globalization (June 2007) finds that countries with “sound” financial systems – developed countries – have not experienced increased macroeconomic volatility or crisis frequency as a result of financial globalization; but countries with less sound ones – developing countries – have. Presumably there are other potential benefits of financial opening for developing countries – like induced institutional strengthening – which should be put against costs of higher volatility, but they are difficult to capture in quantitative estimates.
One problem with the standard post-East Asian crisis advice – that countries should remove restrictions on both capital flows and on the establishment of foreign financial firms pari passu with the development of a sound regulatory framework – is that we do not have good indicators of “soundness”. What looks to be sound before a capital surge can turn out to be unsound because the surge itself undercuts the qualities that constitute soundness – for example, by generating extrapolative expectations on the part of regulators as well as financial market participants.
No one in this debate is arguing for restricting all capital flows, not even Kim Jong Il. But there is a good case for capital management instruments to be accepted as normal instruments of economic policy, to be used according to circumstances, like an umbrella. Not only for reasons of reducing volatility, but also for restraining the extent to which economic policy parameters in a national territory are set by the logic of global investment and expanding the extent to which these parameters are set through a political process involving the citizens whose lives are directly affected by them. Accepting a norm of capital management would require the US and the EU to drop their insistence on opening the capital accounts of countries at the other end of preferential trade agreements; and for the IMF not to make a presumption that all countries should make unidirectional moves towards capital account opening.
Posted by: Robert Wade | February 27th, 2008 at 10:09 am | Report this commentMartin Wolf: I have just completed a book, to be called Fixing Global Finance, which deals with many of these issues. (It is to be published by Johns Hopkins University Press in the US and Yale University Press in the UK and should appear this summer. So now you have my plug!)
I am certainly closer to the Rodrik-Subramanian position now than five years ago. But I remain of the view that free capital flows have some desirable consequences, including a degree of autonomy vis a vis the overweening or predatory state and a stimulus to institutional development.
The big question, however, is: what is to be done? I do not agree with the idea of handing over exchange-rate issues to the World Trade Organisation. That would grossly overload it, so risking its destruction. Nor do I think the IMF can do much about “global imbalances” either. But it would be desirable if the IMF staff were at least allowed to declare openly and clearly that particular countries have grossly undervalued exchange rates or that their intervention policies are indefensible. This would be the power of moral suasion.
Apart from this I have three comments.
First, this is a matter for individual countries to decide. Capital account liberalisation should neither be forced on countries nor should they be prevented by others. Outside advisers, including official advisers, should analyse the pros and cons against the particular circumstance of the country concerned and offer advice on the feasibility of the set of policies proposed.
Second, capital inflows are not a substitute for an adequate level of domestic savings. Promoting the latter is an important policy priority (though not to the excessive levels now seen in China).
Third, countries should normally discourage domestic borrowing in foreign currency, unless they adopt the foreign currency for domestic monetary use. Otherwise, countries should restrict capital inflow to direct investment, portfolio equity and domestic-currency-denominated lending. The fact that the US borrows in dollars makes the consequences of the crisis smaller and the ease of dealing with it far greater.
This last point is a central argument of my book. (Of course, I know others have made the same point, notably Morris Goldstein and Philip Turner.)
Posted by: Martin Wolf | February 27th, 2008 at 6:39 pm | Report this commentAlan Winters: Arvind and Dani appear to forget a simple rule of policy-making - to intevene as close to the identified distortion as possible. If the problem is capital flows, a commodity tax and a trade intervention (fixing exchange rates via the WTO) are very distant indeed.
I too dream of a global energy tax, but in its own right, not one that is a response to a capital flow problem and which will presumably be rolled back when capital flows return to normal. On the other hand, I have nightmares about using trade policy and our fragile trading system to address short-term macro-economic imbalances. Arvind and Dani may doubt the benefits of capital flows, but do these extend to flows of goods and services as well? Subjugating trade policies to macro objectives would certainly make trade riskier and more costly.
The virtues of free capital mobility may well have been overplayed, but, like Bill Easterly, I do not see this case made in Dani’s and Arvind’s piece. We certainly need to investiagate the counterfactual levels of income in the absence of ‘excessive’ capital flows and our ability to curtail excessive flows without killing off useful ones.
There may well be a case for managing capital flows better - including striving for a better regualtory regime. But to let uncertainty about the net benefits of capital mobility dominate environmental and trade policy seems reckless.
Posted by: L Alan Winters | February 28th, 2008 at 4:19 am | Report this comment