The Myth of Financial Protectionism: The New (and Old) Economics of Capital Controls

The provenance of this paper is a little confusing to me, but is has no bearing on the value of the paper.  The summary and link to the paper is published on the Global Development And Environment Institute At Tufts web site.

Unstable global capital flows to developing countries have been characteristic of the world economy in the wake of the global financial crisis. Such flows have triggered asset bubbles and exchange rate appreciation in a number of emerging and developing country markets, especially from 2009 until the Eurozone jitters in the fourth quarter of 2011. In response, some individual nations have deployed capital controls. Resorting to these measures has met a mixed response. On the one hand, institutions such as the International Monetary Fund have supported the use of controls in limited circumstances. On the other hand, there has been a vociferous response by leading politicians, distinguished economists, and in the blogosphere claiming that the use of capital controls amounts to financial protectionism.

This paper argues that such claims are unfounded. Specifically, the paper shows that:

  1. There is a longstanding strand of modern economic theory that dates back to Keynes and Prebisch and continues to this day that sees the use of capital controls as essential to financial stability, the ability to deploy an independent monetary policy, and to maintain exchange rate stability.
  2. The empirical record has shown that capital market liberalization was not associated with growth in developing countries.
  3. In a most recent development, economists have developed a “new welfare economics” of capital controls that sees controls as measures to correct for market failures due to imperfect information, contagion, uncertainty and beyond.

Taken as a whole, rather than the “new protectionism,” capital controls should be seen as the “new correctionism” that re-justifies a tool that has long been recognized to promote stability and growth in developing countries.

The actual paper The Myth of Financial Protectionism: The New (and Old) Economics of Capital Controls is published by Political Economy Research Institute at the University Of Massachusetts Amherst.

This paper reminds us of the sound theoretical foundation for the use of capital controls that had seemed to go out of vogue in the era of deregulation worship and over worship of supposedly free markets.  It is one thing for economic theorists to put forth theories along with their explanations as to why they ought to work.  It is quite another to measure the effects of putting these theories into practice.  When one does do the measurement, one often finds that the results are not quite what was expected due to other forces in action that the theory did not take into account.  This does not mean that the theory wasn’t consistent within its framework of explicit and implicit assumptions.  It meant that those assumptions were not representative of the economic climate at the time.  In other words, the theory could become applicable if the conditions of the economy became consistent with the assumptions.  Of course, the trick in economic forecasting is to know what are all the forces then dominating in the economy and knowing how they might change with the introduction of a new policy.

I think the lesson to be learned here, and one that I have always promoted, and thought that President Obama promoted too, is that we have to be humble in our belief about how much we can know of  all the economic forces that exist now and may exist in the future.  In the face of the uncertainty, whenever we propose policy changes or even to make no changes, we must be constantly measuring the effect of policy to detect deviations from our expectations as soon as possible.

As President Franklin D. Roosevelt did, Obama should have made clear to the public that each policy initiative was an experiment that needed to be monitored.  If it did not work as desired, it would be modified or completely abandoned as measured evidence would suggest.  President Obama used this management style during his campaign.  I fully expected that he would maintain this effective management style when he became President.

Also my pejorative remarks about deregulation worship must be taken in perspective of the lessons learned here.  When the urge to deregulate began, it probably was a reasonable tactic to adopt.  The failure is in treating deregulation as a religion.  Use it as long as it works.  Keep measuring its effects.  Stop using it when it no longer produces good results.  Oh yes, and make sure you measure the effects in all dimensions of relevance.  It may be great if the average income is going up, but not so great if some people end up starving in order to boost the average.

It pays to keep in mind the statistical quality control techniques that W. Edwards Deming so successfully taught the Japanese companies as they rose to dominance. One such technique that I learned about is the use of process monitoring charts.  There were limit lines drawn on the charts that showed how far a process could deviate and still make acceptable product.  However, there were lines drawn that were closer to the set point that showed that a process was straying out of control and action needed to be taken before unacceptable product was produced.

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