The IMF on Capital Controls: Washing Out the Shampoo Economy

December 4th, 2012 at 2:27 pm

OTE readers know I worry about the advent of the “shampoo economy:” bubble, bust, repeat.

The last few business cycles both here and in other advanced economies have been characterized by this pattern.  To be clear, economies are cyclical…that’s a given.  But nowhere is it written—well, outside of Minsky—that the cycles have to be driven by debt driven asset (or investment, as in dot.com) bubbles that are particularly damaging when they inevitably burst.  (And Minsky didn’t believe financial busts were inevitable.  He believed the bubbles naturally grew out of diminished risk adversity as the business cycle heats up, but could be adequately regulated.)

So, given these concerns, I’m always happy to see economists thinking outside the neoclassical box and thinking about ways to reduce the risk of such disruptions.  That was my response upon seeing the IMF’s adoption of this new “institutional view” on capital controls—a policy whereby countries control the inflow of foreign capital and outflow of domestic capital.

Of course, the neoclassical/American view is that it’s crass protectionism to control such flows, and in a perfect world, that’s true.  For optimal global growth, excess capital/savings should flow to its most productive use, wherever that may be.  But in the real world, you get unsustainably large inflows, leading to price and asset inflation, and sudden, deflationary outflows.

The free flow of capital across the globe can have important benefits for countries and for the global economy…

Capital flows can also pose important risks however. They are volatile and can be large relative to the size of a country’s financial markets or economy. This can lead to booms and busts in credit or asset prices, and makes countries more vulnerable to contagion from global instability.

Obviously, there’s a balancing act here and policy makers need to be mindful of the costs to internal growth of over-doing such controls.  But by introducing some reality-based nuance into the policy process of international currency flows, the Fund is giving countries the space to take a bit more control of their economic fate, and perhaps dampening the shampoo cycle as well.

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