In a new study, staff members of the International Monetary Fund (IMF) endorse an idea to help mitigate the impact of economic crises in developing countries: capital controls. Before the 1997 Asian economic crisis, IMF staff thought controls -- really a macroeconomic policy to smooth the amount of money coming into and leaving an economy -- should be banned. Now, and particularly since the Great Recession, the IMF has changed its tune. Capital controls are a good idea -- and now is the time for the IMF and the United States to back them.
Capital flows -- basically, investment from one country into another -- can help developing countries grow. Many developing economies lack the savings and financial institutions to help finance and kick-start business activity. Money and investment from abroad can help fill that gap.
The more capital coming in, the more the developing country benefits, one would think. But it is a bit more complicated than that. Cross-border capital flows tend to be "pro-cyclical": too much money comes in when times are good, and too much money evaporates during a downturn. In the run-up to the 2007-2008 crisis, for instance, wealthy countries poured too much money, too fast, into developing economies. This led to asset bubbles in real estate and stock prices, as well as currency appreciation. When the crisis hit, investors yanked their funds and retreated to the "safe" haven of the United States.
Capital controls help smooth the inflows and outflows of capital and protect developing economies. Most controls target highly short-term capital flows, usually conducted for speculation rather than longer-term investment. For instance, before the crisis hit, Colombia required that a certain percentage of short-term capital be parked in the central bank for a year. And last November, Brazil put a 2 percent tax on speculative inflows.
The new IMF study finds that such capital controls helped buffer against some of the worst effects of the financial crisis in some developing countries, such as Colombia, Brazil, India, Thailand, and China. It thus endorses capital controls as part of the macroeconomic policy tool kit.