Cooling hot money

The IMF suggests that capital controls for policy makers (generally from emerging markets) to stem the flow of money in and out of a country.

Generally how this works is some bright spark in a bank, hedge fund or PE fund figures that there’s money to be made in Elbonia. So he dutifully piles in a bunch of someone else’s cash into the country. All the other bright sparks around him (or her) see what he (or she) is doing and after careful analysis and vigorous debate, do the exact same thing.

This is great for Elbonia because they get this sudden wave of cash pouring into their country. All sorts of economic activity is sparked and, left unattended, leads to the currency inflating, new debt and internal inflation.

Then, some other bright spark thinks Elbonia is overvalued and pulls out all of her (or his) money. All the other bright sparks around her (or him) see what she (or he) is doing and after careful analysis and vigorous debate, do the exact same thing and pull out their money.

Elbonia is then left with massive debts that they can’t pay because their currency has deflated and isn’t worth the TP it is printed on.

That’s pretty much the worst case scenario globalization-skeptics have forwarded as their critique of the IMF and its refusal to endorse capital controls.

Me, I like free movement of capital. It allows businesses in growing countries to tap global markets for capital and expertise. It helps developed and emerging markets to open up to each other and lets a seller in one find a buyer in another.

That said, it is hard to ignore the evidence that those countries with some controls have fared far better during this current economic crisis than others. I just need to look to Brazil to get much of the evidence I need.

The IMF has noticed this too and no longer condemns capital controls as the fodder of weak minds.

If capital controls help countries grow in a more sustained manner, then obviously I’m all for them (who wouldn’t be.) The problem now, however, is finding the right balance.

Globalization-skeptic Dani Rodrik offers some thoughts:

With the stigma on capital controls gone, the IMF should now get to work on developing guidelines on what kind of controls work best and under what circumstances. The IMF provides countries with technical assistance in a wide range of areas: monetary policy, bank regulation, and fiscal consolidation. It is time to add managing the capital account to this list.

This is the pendulum swinging to a more regulated economy. It may be more stable, but it is less dynamic.

The End of an Era in Finance – Project Syndicate.