JOSEPH STIGLITZ: Government intervention is desirable
The global financial crisis has made capital account management more important than ever
The global financial crisis forced a rethinking of many basic precepts within conventional international policy circles: markets evidently were not on their own either efficient or stable; and self-regulation did not suffice. Of course, many of these notions were not really new: they were lessons learned in the Great Depression, and relearned in the East Asian crisis and in the many other crises that have afflicted the global economy since the beginning of the era of deregulation in the early 1980s.
For emerging markets, the instability in cross-border capital flows has been particularly troublesome. A large fraction of the crises these countries face arise as a result of volatility in international capital markets, including those brought about by the creation and breaking of credit and housing bubbles in developed countriesand not in the emerging market countries themselves. The global financial crisis, which brought such havoc on the global economy, as a result of the failure of the US to manage its financial system, is the example par excellence. Of course, some less developed countries and emerging markets will be more vulnerable than others, including those with large trade and fiscal deficits. Nevertheless, the shock to the economy can be clearly identified as originating from outside its borders.
Given this, it is reasonable that countries take actions to protect themselves, to limit their exposure to these risks. That is what capital account management is all about. It is, of course, broader than just the management of exposure to aggregate risks, and it can take many forms. It may include restrictions on derivatives, those instruments of financial mass destruction. It may include restrictions on capital inflows (as in Chile or Colombia), or, especially in times of crises, on capital outflows. It may include restrictions on foreign exchange exposure of banks.
Government interventions may entail price or quantity restrictions. While economists have long had a predilection for the former, research over the past 30 years has shown that controls may be superior to taxes in the presence of pervasive uncertainties, such as those that afflict financial markets.
The reason that government intervention is desirable is simple: there are large macroeconomic externalities associated with these capital flows. They can result in exchange rate fluctuations, imposing large costs on exporters and importers. In the extreme, they can trigger crises like the East Asian crisis, with prolonged economic and social damage. Government attempts to mitigate these fluctuations or to respond to their consequences may involve enormous costs. For instance, in the East Asia crisis, to stabilize the exchange rate, most countries raised interest rates, in some cases to astronomical levels, forcing many firms within these countries into bankruptcy. These firms bore the costs of others unbridled foreign borrowing. Additionally, many governments built up huge war chests of reserves in response to the crisis. This had a huge opportunity cost, even if it limited some risks. Most countries hold these reserves in T-bills, earning negative real interest rates, when within their countries there are innumerable investments yielding far higher real returns. Still, the price of holding reserves was worth paying, given the instability caused by unfettered global capital markets. Yet these other costs are not taken into accounteither by individuals and firms within a country, in making borrowing decisions, or foreign short-term investors, in making investment decisions.
In the crisis that began in 2007, capital account and financial market liberalization played a central role in the rapid spread of the crisis from the US around the world.
There is a cost to these capital account interventions, as there are to most regulations. But there is an even greater cost to not regulatingas the world has found out. The cumulative loss of GDP as a result of the global financial crisis, the gap between potential and actual output, and the loss of future potential output as a result of the destruction of human capital and the underinvestment in real capital, almost surely exceeds $10 trillion to say nothing of the human suffering that it has brought about. These costs dwarf, by orders of magnitude, any of the costs associated with capital account management.
All of this should be obvious. And the changed views of the IMF reflect this new understanding.
But while the global financial crisis originated from the US, the country doesnt seem to have learned the lesson. Or more accurately, the financial interests who paid so much to deregulate financial markets before the crisis want to pretend that there are no lessons to be learned. According to reliable reports, the US government is trying to restrict the use of capital account management in the so-called Trans Pacific Partnership Agreement (TPP) now being negotiated. Countries be forewarned: any slight benefits from the TPP will be dwarfed by the likely costs imposed when countries are restricted from managing their economies.
Joseph Stiglitz is University Professor at Columbia University. He received the Nobel Prize in economics in 2001.