The International Monetary Fund has rethought its doctrine on capital controls. The IMF, which previously favored unfettered flows of money across borders, now accepts that controls are sometimes necessary.
This is a real improvement, yet it’s incomplete because it lacks a mechanism for supervision and enforcement. The fund can’t rectify that omission by itself. Member governments can and should.
The previous orthodoxy said that restricting international flows of capital is almost always wrong: The benefits of liberalized capital markets exceed the costs. Even before the global recession that started in 2008, successive financial crises had challenged this idea. Surging capital flows are capable of destabilizing and even overwhelming the financial systems of developing countries.
The new thinking is that capital controls are sometimes the lesser evil. In adopting this as its new official position, the IMF has tried to spell out the conditions under which resorting to controls makes sense. The aim is to give members consistent advice.
There’s still a presumption in favor of open capital markets -- and rightly so -- yet on a milder scale. When other policies are available to restore financial stability, the IMF says, they will usually be preferable. But sometimes capital controls are the only effective response.
One way to curb a destabilizing inflow of capital, for example, would be to cut interest rates. Suppose, though, that an economy is overheating: Lower interest rates would make that problem worse. Instead, the government could let the exchange rate appreciate -- unless its currency was already overvalued. The combination of accelerating inflation and an overvalued currency narrows the options for dealing with a dangerous inflow. Under those conditions capital controls might make sense.
The IMF’s new position continues to stress the drawbacks of capital controls and the need to use them reluctantly. “Only rarely,” it says, would capital controls “be the sole warranted policy response to an inflow surge.” In addition, the fund says, the effectiveness of controls tends to erode over time, so they should usually be seen as a temporary expedient. Nonetheless, they are the best choice sometimes.
This qualified approval is the right basic approach. Trouble is, capital-flow restrictions can also be abused, including when they are designed to maintain a deliberately undervalued exchange rate for purposes of export promotion.
The IMF can advise against such policies, and it has surveillance powers that let it examine the harm that un-neighborly capital controls can inflict on trade partners. Still, governments are mostly under no obligation to do as it recommends.
The fund’s governing document generally precludes it from making the removal of capital controls a condition for access to its resources. As we’ve previously argued, stronger rules to prevent abuse need to go hand-in-hand with the view that capital controls can sometimes be the right policy.
For this, the global trade rules enforced by the World Trade Organization are the right model. Both the form of capital controls and the rationale for resorting to them should be regulated. For the sake of efficiency, controls should be price-based rather than quantity-based, similar to a rule of thumb in trade policy: Tariffs that slightly raise the price of each imported item are preferable to quotas that limit the overall volume of that item.
A moderate tax on capital flowing into a country, subject to a cap, would cause less collateral damage than a restriction on the quantity of money coming across the border.
Governments imposing controls, moreover, should have to show an oversight body (possibly the WTO) that their intent is to prevent financial instability rather than to seek advantage by creating or perpetuating a currency misalignment.
Armed with its improved doctrine, the IMF could do for capital controls what the WTO does for trade barriers. The global capital markets would run more smoothly. For that to happen, governments must give the IMF the power.
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