Global Capital Rules

But we should not exaggerate the extent of the IMF’s change of heart. The Fund still regards free capital mobility as an ideal toward which all countries will eventually converge. This requires only that countries achieve the threshold conditions of adequate financial and institutional development.

The IMF treats capital controls as a last resort, to be deployed under a rather narrow set of circumstances – when other macro, financial, or prudential measures fail to stem the tide of inflows, the exchange rate is decidedly overvalued, the economy is overheating, and foreign reserves are already adequate. So, while the Fund lays out an integrated approach to capital flow liberalization, and specifies a detailed sequence of reforms, there is nothing remotely comparable on capital controls and how to render them more effective.

This reflects over-optimism on two fronts: first, about how well policy can be fine-tuned to target directly the underlying failures that make global finance unsafe; and, second, about the extent to which convergence in domestic financial regulations will attenuate the need for cross-border management 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 consequences when used accidentally or placed in the wrong hands. The IMF’s reluctant endorsement of capital controls resembles the attitude of gun-control opponents: policymakers should target the harmful behavior rather than bluntly restrict individual freedoms. As America’s gun lobby puts it, Guns don’t kill people; people kill people. The implication is that we should punish offenders rather than restrict gun circulation. Similarly, policymakers should ensure that financial-market participants fully internalize the risks that they assume, rather than tax or restrict certain types of transactions.

But, as Princeton economist Avinash Dixit likes to say, the world is always second-best at best. An approach that presumes that we can identify and directly regulate problematic behavior is unrealistic. Most societies control guns directly because we cannot monitor and discipline behavior perfectly, and the social costs of failure are high. Similarly, caution dictates direct regulation of cross-border flows. In both cases, regulating or prohibiting certain transactions is a second-best strategy in a world where the ideal may be unattainable.

The second complication is that, rather than converging, domestic models of financial regulation are multiplying, even among advanced countries with well-developed institutions. Along the efficiency frontier of financial regulation, one needs to consider the tradeoff between financial innovation and financial stability. The more of one we want, the less of the other we can have. Some countries will opt for greater stability, imposing tough capital and liquidity requirements on their banks, while others may favor greater 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 evade domestic controls and erode the integrity of regulatory standards at home. To prevent such regulatory arbitrage, domestic regulators may be forced to take measures against financial transactions originating from jurisdictions with more lax regulations.

A world in which different sovereigns regulate finance in diverse ways requires traffic rules to manage the intersection of separate national policies. The assumption that all countries will converge on the ideal of free capital mobility diverts us from the hard work of formulating those rules.

Dani Rodrik, Professor of International Political Economy at Harvard University, is the author of The Globalization Paradox: Democracy and the Future of the World Economy.

Copyright: Project Syndicate, 2012.

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