Capital Controls or Protectionism

Pa3752c_thumb3 Hector R. Torres in Project Syndicate:

[O]one of the main lessons of the crisis is that accumulating reserves shelters an economy from imported crises, thereby permitting governments to implement counter-cyclical policies. This is true, but, in an integrated world economy, it assumes that export-led growth is still an option.

In an environment of high liquidity, in which Latin American countries are far less successful than China in fending off capital inflows, advising them to raise real interest rates can only lure more short-term capital, compounding appreciation pressures. Nobody should be surprised to see trade tensions.

So, what should be done?

In an ideal world, liquidity creation should be regulated internationally, and the coherence of domestic exchange-rate policies ensured. But this is far from today’s real-world situation, so we need to aim for second-best solutions.

Capital controls (regulations and “prudential measures”) could help to curb appreciation pressures. Admittedly, they are not watertight and could eventually be sidestepped, but they are far better than what might follow if they prove ineffective. If capital controls do not work, governments may feel tempted to provide protection to “their” domestic industries by imposing trade restrictions.

The IMF has recently accepted that controlling capital inflows could be appropriate under certain circumstances.