The economic orthodoxy that swept the world in the 1990s and 2000s attests to the terrifying power of ideas. Economists built “general equilibrium” models that, underneath all the fancy math, just assumed markets are stable and optimal. The models concluded — in a sort of “divine coincidence,” as the MIT economist Olivier Blanchard and a colleague quipped — that if central banks merely maintained steady, low inflation, they would achieve economic stability and the best growth possible. Washington and London espoused this orthodoxy. The Treaty on European Union practically inscribed it in law.
In the Wake of the Crisis: Leading Economists Reassess Economic Policy collects essays by economists who are, indeed, leading — and are reassessing that orthodoxy. Never quite a true believer in it, Blanchard, now chief economist of the International Monetary Fund (IMF), acknowledges the terrible damage it caused. The macroeconomist David Romer concedes that the performance of pre-crisis state-of-the art models — some of which he developed — was “dismal.” The editors frankly admit they have no clear idea how to replace them.
However, major Asian and Latin American nations offer pragmatic financial and economic guidance. Policymakers there deferred to orthodoxy in their words but not in their deeds — and avoided crisis. None of those nations’ principal banks got in trouble, and growth there suffered far less than in the advanced nations. In fact, it wasn’t a global financial crisis; it was a North Atlantic financial crisis.
Global financial flows had for several decades helped drive cycles of boom and bust in the developing world. Whenever central banks lowered interest rates in advanced nations, capital ran to higher returns in emerging economies, Rakesh Mohan, former deputy governor of the Reserve Bank of India, writes in the book. Borrowing in those nations surged, economies boomed, government coffers swelled. Until the crash and the flight of money. Local politicians were not quite innocent, either. The same ones who lambasted finance as it headed for the borders during crises had often hailed plata dulce, “sweet silver” as the Argentines call it, when it had poured in fueling the good times.
This picture looks remarkably like the 2000s in the advanced nations, as torrents of money from China and elsewhere inflated the U.S. housing bubble, and torrents of money from core Europe inflated housing bubbles and wasteful public spending in peripheral Europe. We too loved plata dulce, until we hated it.
If footloose finance is the problem, Mohan and several other authors recommend using “capital controls,” albeit cautiously, to limit its flows. The 1944 Bretton Woods treaty establishing the IMF gave nations the right to use such controls — and still does. The House of Lords would have killed the treaty had John Maynard Keynes not promised that Britain could manage its own economy “without interference from the ebb and flow of international capital movement or flights of hot money.”
As market orthodoxy began gaining credence in the 1980s, “capital controls” became a dirty phrase in the IMF lexicon. Policymakers were supposed to control inflation and let capital markets work their magic. A move in the 1990s to ban capital controls failed when the conflagration of the Asia Crisis cast a lurid glow on it. Last November, the IMF officially retreated from blanket condemnation of capital controls.
The orthodox view was that free capital flows allowed a more efficient allocation of resources, as finance flowed into investment-starved developing nations to pay for plant and equipment. In fact, finance generally did just the opposite in the 1990s and 2000s, flowing from those nations to credit-hungry U.S. consumers. Mohan reports that fewer than a quarter of all studies on opening financial flows find that it raises growth, and those few find small benefits.
Another argument against capital controls is that they’re evaded — a little like arguing that shoplifting should be legalized because people shoplift. But José Antonio Ocampo, former finance minister of Colombia, writes that the major studies, notably a 2000 IMF study, find that capital controls can limit short-term flows and help manage interest rates, as Keynes promised. (Nobody wants to limit long-term investment in plant and equipment.) Ocampo concedes that controls are “speed bumps rather than permanent restrictions because market agents learn how to avoid them.” His conclusion is not to drop them but to dynamically close loopholes to keep them effective — just as with any other financial regulation.
A final argument against capital controls is that if only the financial sector were more developed, they would be unnecessary. The United States provides the obvious rebuttal: finance pouring into the most financially sophisticated economy in the world helped inflate the housing bubble. Y. V. Reddy, former governor of the Reserve Bank of India, argues that a moderate level of financial development enables “growth with stability,” but an oversophisticated sector just inflates consumption.
Alongside exercising some management over financial flows, developing-nation policymakers also instituted “prudential” financial regulations that had become unpopular in advanced nations, such as prohibiting excessive bank leverage. The Reserve Bank of India even adapted standard drug-regulation procedures to the financial sector: “If the [financial] innovation’s benefits do not convince the regulator of its safety, then it will not be permitted or permitted only with conditions,” writes Reddy.
Likewise, contrary to the orthodox injunction to just focus on inflation and let financial markets be, and contrary to what Mexico was often said to be doing, former Mexican Finance Minister Guillermo Ortiz notes that developing nations piled up foreign reserves to help cushion capital flows. He says they intervened to avert violent swings in the value of their currencies “before, during, and after the crisis.” And their reserves did help cushion capital flight after Lehman Brothers’ collapse, adds Mohan.
Because of free capital flows in the Eurozone, when Spain boosted government spending in 2009 to counter recession, it just racked up debt. But with ability to moderate capital flows, Indonesian Finance Minister Sri Mulyani Indrawati says fiscal expansion (a policy supported by Romer) was “critical” in helping soften the crisis. Indonesia’s 2009 budget even allowed spending increases if the crisis deteriorated unexpectedly.
These suggestions are just that. Regulators must recognize their limitations. The state of the art offers no guarantees. Alas, advanced nations may not have learned their lesson. Mohan quotes an appalling piece of hubris from the usually more sensible Fed Chairman Ben Bernanke. Admitting that financial flows can cause “devastating results.” he still urges not limiting them: “The ultimate objective should be to be able to manage even very large flows of domestic and international capital.”
Please, Professor Bernanke, don’t try that idea in practice. Make it a research project on your return to Princeton.
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