Despite new thinking in economic theory and econometrics to the contrary, United States trade and investment treaties continue to restrict the ability of nations to regulate the inflow and outflow of capital flows.
This may be changing. According to leaked text of the Trans-Pacific Partnership (TPP), a treaty among the United States and major Pacific Rim nations, negotiators are currently debating a temporary safeguard to regulate capital flows under some circumstances.
It is landmark that the United States is considering such a safeguard, as no US treaty since the 1994 North American Free Trade Agreement (NAFTA) has included one. That said, the proposed safeguards in the leaked text still remain inconsistent with new economic theory and evidence.
New Economic Thinking
A wave of new thinking has occurred in the economics profession on these questions in recent years. According to the ‘new welfare economics of capital controls,’ unstable capital flows to emerging markets can be viewed as negative externalities on recipient countries. Therefore regulations on cross-border capital flows are tools to correct for market failures that can make markets work better and enhance growth, not worsen it.
This work has been developed by economists Anton Korinek, Olivier Jeanne, and others, and is summarised by Korinek (an INET recipient) in the August 2012 issue of the IMF Economic Review. According to this research, externalities are generated by capital flows because individual investors and borrowers do not know what the effects of their financial decisions will be on the level of financial stability in a particular nation. A better analogy than protectionism would be the case of an individual firm not incorporating its contribution to urban air pollution.
Whereas in the case of pollution the polluting firm can accentuate the environmental harm done by its activity, in the case of capital flows a foreign investor might tip a nation into financial difficulties and even a financial crisis. This is a classic market failure argument and calls for what is referred to as a Pigouvian tax that will correct for the market failure and make markets work more efficiently.
Of course, economists such as Keynes argued long ago that capital controls are important to prevent crises and to maintain an independent monetary policy that can strive for full employment and financial stability. This new work however elegantly models capital flows and capital controls in a broader contemporary economics context and thus could be seen by some to be a more rigorous justification for policy action on capital flows.
There is also a new consensus in the econometrics literature that there is not a robust relationship between capital account liberalization and economic growth. In a recent study that surveys and updates the economics literature, Arvind Subramanian, Olivier Jeanne, and John Williamson conclude that “the international community should not seek to promote totally free trade in assets – even over the long run – because…free capital mobility seems to have little benefit in terms of long-run growth.”
Finally, there is also an emerging consensus that regulations on the inflows of capital can be effective, at least for short period of time. In fact, work by the IMF showed that those nations that had regulated the inflow of capital were among the least hard hit during the global financial crisis.
New Moves at the IMF
On December 3, 2012 the IMF made public an Executive-Board approved “institutional view” on capital account liberalization and the management of capital flows. In a nutshell, the IMF’s new ‘institutional view” is that nations should eventually and sequentially open their capital accounts. This is indeed in contrast with its view in the 1990s that all nations should be uniformly required to open their capital accounts regardless of the strength of a nation’s institutions.
The IMF now recognizes that capital flows also bring risk, particularly in the form of capital inflow surges and sudden stops that can cause a great deal of financial instability. Under such conditions, and under a narrow set of circumstances, according to the new ‘institutional view’ the IMF may recommend the use of capital controls to prevent or mitigate such instability in official country consultations or Article IV reports. In other words, the IMF now sanctions staff and management to recommend the use of capital controls to nations under certain circumstances. And under a very narrow set of circumstances a nation may receive recommendations to discriminate capital flows based on residency.
In a background paper for the new Institutional view the IMF said “The limited flexibility afforded by some bilateral and regional agreements in respect to liberalization obligations may create challenges for the management of capital flows. These challenges should be weighed against the agreements’ potential benefits. In particular, such agreements could be a step toward broader liberalization. However, these agreements in many cases do not provide appropriate safeguards or proper sequencing of liberalization, and could thus benefit from reform to include these protections .”
US standing alone
Despite new thinking and evidence in economics, and a new official view at the IMF, US trade and investment treaties still require that trading partners transfer funds among parties “freely and without delay.” This was a major sticking point in negotiations over a decade ago between the United States and Chile. Chile’s innovative regulations on the inflow of capital have been praised in economic circles, and Chile want to hold the option to deploy these regulations to prevent the build up of financial instability. The United States refused such requests.
Under the TPP however, the US appears to be negotiating a temporary safeguard for the regulation of capital flows. This is a welcome development but the leaked text reveals that the US approach falls short of being consistent with new economic thinking.
The proposed safeguards would grant nations the ability to regulate capital flows . The safeguard only grants nations the flexibility of regulating the outflow of capital under a serious balance of payments crisis.—and that such restrictions should not last for longer than one year. Regulating outflows may be a last resort that is necessary, but it is not the optimal way to deal with such instabilities. As the work by Korinek and others has shown, the key is to properly regulate the inflow of capital so as to prevent the instability that can lead to a balance-of-payments crisis and the need to regulate outflows.
With legal scholars and treaty experts, I have a written a broader analysis of the leaked text and capital flows which can be found here. Other core problems are that the safeguard does not give ample time for countries to regulate, and there is an exemption for equity flows that would create a loophole that could jeopardize the entire effort.
Economists have been forward on their thinking. A few years ago, more than 250 economists from around the world urged the United States to make treaties more consistent with economic thinking and IMF policy on capital flows.
The Washington Post documented how US trade policy is not dominated by economic thinking. Their investigative report was titled “Industry voices dominate the trade advisory system.” The Post found that there are 566 advisory group members that can look at U.S. trade proposals and comment on them (Congress members or their staff can not). According to the Post, though, 480 of those advisers represent industry or trade association groups—or 85 percent. Those academics, unions, and civil society members that can take part are most often relegated to small sub-committees that don’t get access to the meat of the deal.
It appears that hard politics is getting in the way of good economics.
Kevin P. Gallagher is a professor of global development policy at Boston University’s Pardee School for Global Studies, where he co-directs the Global Economic Governance Initiative. His new book is Ruling Capital: Emerging Markets and the Reregulation of Cross-Border Finance.
