Friday, March 14, 2008

Case for capital controls

It is widely acknowledged that while greedy borrowers and lenders, coupled with lax regulation and poor credit assessments, contributed to the global financial market crisis today, massive international capital flows magnified the extent of the crisis.

Dani Rodrik and Arvind Subramanian argues that financial innovation will always remain one step ahead of prudential regulation, and hence calls for controls on international capital flows as the only solution to reducing financial market volatility. They write, "If the risk-taking behaviour of financial intermediaries cannot be regulated perfectly, we need to find ways of reducing the volume of transactions. Otherwise we commit the same fallacy as gun control opponents who argue that “guns do not kill people, people do”. As we are unable to regulate fully the behaviour of gun owners, we have no choice but to restrict the circulation of guns more directly." Similarly, as we are not able to account for all future financial innovations in our regualtory architecture, we are left with no option but to regulate capital controls.

They argue in favor of keeping finance "primarily national". The authors call for reducing the large current account surpluses of the oil exportrers and the East Asian economies through a two pronged approach - some form of a petrol tax in the oil importing nations to reduce their oil demand, and some appreciation of East Asian currencies.

This call for capital controls generated a wave of strong reactions, which Prof Rodrik counters here in his blog. He writes that any government regulation is vulnerable to capture by vested interests and corruption, which is strengthens the case for "better designed regulation" and not for dispensing with regulation altogether.

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