The IMF's Unfinished Business

The International Monetary Fund is showing promising signs of changing with the times. In addition to recognizing that climate change poses significant risks to financial stability, it has responded to the pandemic with a major new allocation of special drawing rights (the Fund's reserve asset), while criticizing the G20's inadequate framework for dealing with debt distress. Moreover, in a recent agreement with Argentina, the Fund has largely abandoned the kind of austerity programs that have long plagued its reputation, not to mention undercutting livelihoods around the world.

The IMF will have a chance to take another major step in the right direction when it reviews its stance on capital-flow regulation later this month. The original rationale for such regulation, enshrined in the IMF's Articles of Agreement, was that cross-border capital flows could disrupt international financial markets, the stability of which was the IMF's raison d'être.

Yet, ironically, in the Fund's darker days during the 1980s and 1990s, it made bailout packages conditional on recipients deregulating financial flows; and in the late 1990s, it even tried to change the Articles of Agreement to outlaw capital-flow regulation. But the 1997-98 East Asian financial crisis, which resulted largely from capital-market deregulation, sidelined that effort. After those tumultuous years, many middle-income countries pushed back against the IMF's drive for capital-market liberalization and “self-insured” against capital-flow volatility by accumulating foreign-exchange reserves and implementing capital-account measures.

For many countries, capital flows are important for sustaining investment and growth. But some of the IMF's own research shows that international capital flows to emerging market and developing countries (EMDCs) tend to be highly unstable, surging when interest rates are low in the United States, only to undergo “sudden stops” when monetary conditions tighten. While the surges push up exchange rates and encourage EMDC companies and households to borrow excessively, the sudden stops derail growth, weaken exchange rates, and drive up debt to unsustainable levels. The resulting crises take an enormous toll on these countries' economies and citizens.

Recent advances in economic theory have proved that capital controls can make markets more efficient, not less. In 2011, Anton Korinek published an article in the IMF Economic Review showing that capital flows generate negative externalities because individual investors and borrowers are focused only on their portfolios, not on how their decisions may affect financial stability. Just as the absence of pollution controls results in excessive pollution, the absence of capital-account controls can lead to excessive capital inflows.

The following year, the IMF issued a new “institutional view” acknowledging that capital-flow deregulation is not optimal for most EMDCs, and that capital controls can indeed be effective under certain circumstances. And, to reduce the stigma, it rebranded such regulations as “capital flow management measures” (CFMs).

Yet the effects of this shift remained limited, owing to resistance from major IMF shareholders, financial lobbies, and intransigent economists inside and outside the institution, who argued for unfettered financial markets and massive bailouts when things went awry. In the end, it became IMF policy to recommend CFMs only as a last resort, after a government had exhausted all other possibilities, even though this was a decidedly ideological position with no basis in prevailing economic theory. Academic economists and the IMF's own researchers have shown that capital controls are most effective when they are deployed alongside other policies, not used in isolation.

Moreover, forthcoming research from one of us (Gallagher), Luma Ramos, and Lara Merling, suggests that the IMF's new institutional view actually had less of an impact on its behavior than proponents might have hoped – even after its new position had been tightly circumscribed. The Fund simply did not pay much more attention to capital-flow volatility in the decade after the policy was adopted; and when it issued advice on capital-account regulations, its prescriptions were inconsistent across countries.

Even in the early days of the COVID-19 crisis, when EMDCs experienced massive capital flight, which predictably depreciated exchange rates and pushed many countries into debt distress, the IMF remained reluctant to advise countries to regulate capital flows. But things began to change this past December when the IMF admitted that it should have sanctioned CFMs in its failed Argentina program, which has now been renegotiated and will take effect pending approval by the Fund's board.

Another problem, however, is that even as the IMF has slowly changed its own stance on capital controls, trade and investment treaties have further curtailed countries' ability to regulate capital flows. A recent study analyzing more than 200 trade and investment agreements finds that the majority of those between advanced economies and EMDCs not only prohibit capital controls but also allow private financial firms to challenge governments directly through dispute-settlement bodies that tend to favor the firms. Worse, treaties outlawing capital-flow regulation are fast becoming the norm, and cases against governments are on the rise.

At this month's review, the IMF's board should press for four reforms to the Fund's capital-account policy. First, the IMF must clearly advise member countries to enact permanent regulations allowing for the rapid deployment of CFMs during surges and sudden stops. Second, it must recommend that CFMs be part of a multi-pronged approach, rather than used only as a last resort. Third, the IMF should advocate reforms to trade and investment treaties to grant EMDCs more policy leeway for using CFMs. And, fourth, the IMF must set aside time to train its staff to implement these policies in a consistent and evenhanded manner.

Given the possibility that interest-rate hikes and Russia's war in Ukraine will trigger massive capital flight and a global debt crisis, it is critical that the IMF embrace capital controls and the role they can play in helping member states mitigate financial instability. The world economy may well depend on it.

Joseph E. Stiglitz, a Nobel laureate in economics and a Chazen Advisor, is University Professor at Columbia University and a member of the Independent Commission for the Reform of International Corporate Taxation. Kevin P. Gallagher is a professor and Director of the Global Development Policy Center at Boston University.

Copyright: Project Syndicate, 2022.