EVENTS

Date:	Monday, August 11, 2003
Time:	2:00 PM -- 3:30 PM
Location:	Wohlstetter Conference Center, Twelfth Floor, AEI 1150 Seventeenth Street, N.W., Washington, D.C. 20036

August 2003
Trade Agreements and Capital Controls

On August 11, 2003, AEI held its first in a series of AEI trade policy conferences centered on trade negotiations at the upcoming World Trade Organization (WTO) ministerial meeting in Cancun, Mexico. This conference focused on a debate regarding the United States’ insistence in recent trade agreements on provisions forbidding the use of capital controls, except in emergencies. Two leading international trade economists, Under Secretary of the Treasury John Taylor and Jagdish Bhagwati of Columbia University, debated the pros and cons of including capital control requirements in trade agreements.

John Taylor
Under Secretary of the Treasury

The phrase “capital controls” conveys many connotations. The goals of the Bush administration with respect to international development are two-fold. First, we want to increase economic growth around the world--essentially raising productivity growth. The basics would include an increase in capital and technology. In both those inputs, capital must flow to where it can be most productive, and in a way capital controls are clearly the wrong thing one would do to increase such flow. This administration has taken a number of initiatives to increase the amount of capital flows, including the new program to establish a small business program in Africa. Empirical evidence also proves this to be correct. The International Monetary Fund (IMF) has performed an analysis on how much capital liberalization can raise economic growth, and those countries that liberalize their capital markets do grow more rapidly. Greater access to capital raises growth, especially since the economics are so basic.

The second goal of the administration is to improve economic stability. Of course, there have been many economic crises in recent years, and there has also been a decline in capital flows to emerging markets, which began in the late 1990s. One obvious way to tackle such problems is through prevention. Perhaps asking the IMF to look more closely at debt sustainability is one solution to such crises, but also better prudential regulation and supervision in the financial sector is another option. By investing in financial sectors, one can transfer the knowledge of better supervision and practice into the markets. Prudential regulation and practice via foreign investment and capital flows into countries has been beneficial in terms of reducing crises in countries.

Another method is to focus on the reduction of economic contagion. This administration has noted areas where opportunities existed to reduce contagion. Capital flows are important in part because it reduces the fear that countries will not impose capital controls at times of contagion. We have also limited the size of large-scale financial packages to be clear about limits to add predictability and to introduce collective action clauses in emerging market debt. All these ideas contribute to the goal of economic stability. As one can see, avoiding restrictions on capital is very much part of this strategy of increasing economic growth and improving in economic stability. While it is believed that imposing capital controls in the midst of a crisis can mitigate or perhaps even prevent them, I do not see the case.

An example is the Chilean encaje. They have had success with inflation targeting and free trade agreements. But for many years Chile has had a restriction on the flow of capital, known as the encaje. Those restrictions were meant to give more ability for monetary policy to reduce inflation. However, there is not much impact in the direction they were aiming. It certainly did not prevent crises. Impacts of the encaje raised interests costs of borrowing and limited the amount of capital flow into the country. These are the harmful affects of capital controls.

Jagdish Bhagwati
New York University

The disagreement between Under Secretary Taylor and myself comes from interpretation rather than principal. There is an important distinction to be made in this argument: free trade and capital controls are not the same thing. There is an asymmetry of information in this discussion of capital controls. We can be a bit relaxed with trade liberalization, but I do not think we can be relaxed when managing short-term capital flows. Experience shows that the Asian financial crisis did in fact devastate countries that had good fundamentals. People are at the receiving end and they see these crises happening, and, rightly or wrongly, they associate that massive exodus of short-term capital flows out of a country with fear and instability. While we may know more now about such financial crises, I am not so sure we have ruled them out enough to eliminate capital controls. Therefore I am not prepared to go so easy.

In liberalized countries like Malaysia, the choice was whether to go back to its past method of capital controls or appear resistant to liberalizing reforms and reap the criticism. Given the pressure from the IMF, Malaysia had to be careful. It did work out to some extent, only in a manner of speaking because the controls were not that strict and interest rates were already improving. In which case, Malaysia was a mixed bag and not a clear victory for either side. I do agree on many of the details of the under secretary’s argument.

The problem is quite immense in this case, and I wish I had the confidence to tell these smaller countries to push harder before they give up capital controls and move into the mode the United States is suggesting. While removing capital controls is a goal for the future, it is still a bit premature. This is where my judgment differs from Under Secretary Taylor’s. We have learned a lot, but I think we need to learn much more. There is not enough knowledge to go full steam with financial capitalism. We have to be prudent, and capital controls provide this caution.