In a previous post about the efficacy of capital controls, we interpreted a passage from Reinhart & Rogoff’s epic This Time is Different by saying “there remains an awful lot we simply don’t know about the consequences of capital flows, capital controls, or, more generally, about the appropriate pace and nature of financial liberalisation in developing economies.”
Well, the crisis-expert duo is back, joined by Nicolas Magud of the IMF, with a new paper summarised at VoxEU that explains why such a prominent economic topic brings so much confusion — though their conclusions include more questions than answers about the ability of capital controls to successfully manage flows.
But first, here’s the explanation for why the evidence is so muddled:
— The lack of a unified theoretical framework (say, as in the currency crisis literature) to analyse the macroeconomic consequences of controls;
— Significant heterogeneity across countries and time in the measures implemented (even when they were in principle trying to achieve the same end);
— Multiple definitions of what constitutes a “success” (capital controls are a single policy instrument-but there are many policy objectives); and
— The empirical studies are markedly heterogeneous and are disproportionately “overweighted” by the two poster children – Chile and Malaysia.
The authors performed a meta-analysis of 37 studies, attempting to correct for the flaws above and standardising definitions of success whenever possible. Here were their main findings:
Capital controls on inflows:
— Make monetary policy more independent,
— Alter the composition of capital flows, and
— Reduce real exchange rate pressures (although the evidence on the latter is more controversial).
— Do not reduce the volume of net flows (and hence the current-account balance).
Unfortunately the summary at VoxEU isn’t very clear, so we checked the original paper for a bit more detail. To take each of the above in order, here’s what they mean.
1) Capital controls make monetary policy more independent because “the reduction in capital flows also creates a wedge in interest rates” — that is, interest rates remain higher than they would be under greater capital controls — which leaves central banks with more space to lower rates when hit with an economic downturn.
2) Capital controls have successfully lengthened the maturity of the inflows (whereby foreign investors have shifted from short- to long-term flows) in most cases, but not all.
3) Capital controls sometimes succeed in easing upward pressure on inflation.
The authors find that initial conditions under which capital controls are imposed matter. Capital controls tend to “work” at reducing total flows, for instance, when they are imposed unexpectedly.
The authors also reason that given the variability of the capital control success in prior instances, there probably certain exist country-specific conditions that would determine their effectiveness — only it’s not yet clear what those conditions actually are.
From the conclusion:
How do our results square with current policy thinking on capital controls? The consensus view, oft stated by IMF officials and policy economists, is that market-friendly capital controls on short-term capital inflows could be effective, although over time that effectiveness may be eroded as markets find more and more creative ways to avoid the controls. Even this cautious statement might exaggerate the effects of capital controls, because so much academic attention has been focused on cases where the initial conditions were favourable and because of excessive emphasis on just the Chilean and Malaysian episodes. Our results balance the discussion by broadening the set of capital controls episodes substantially, including for example less well known capital control episodes such as those in the Czech Republic, Spain, Peru, Colombia, and others.
The paper doesn’t really change our earlier thoughts on capital controls — that when done with the right motivations (to address asset bubbles, not to prop up domestic export industries) they are probably harmless, and certainly better than other kinds of protectionism — but it’s a useful addition to this ongoing discussion.