IMF changing its mantra?

Control capital, not inflation

15 April 2010

After four decades of promoting policies of targeting very low inflation rates and unfettered capital flows, the global financial crisis has prompted new debate over IMF ideology.

A February IMF staff position note Rethinking macroeconomic policy, lead-authored by IMF chief economist Olivier Blanchard, admits that “the behaviour of inflation is much more complex than is assumed in our simple models.” Days later, another staff position note stated that “capital controls are a legitimate part of the toolkit to manage capital inflows in certain circumstances.”

These admissions are a significant reversal of the Fund’s historic approach to macroeconomic policy. In the late 1990s rich countries pushed for an amendment to the IMF articles of agreement to explicitly promote unrestricted capital flows (see Update 46, 9). As recently as last November, IMF managing director Dominique Strauss-Kahn criticised Brazil’s efforts to regulate capital inflows, stating that he would not recommend such controls “as a standard prescription” (see Update 68). However the financial crisis, which hit developed and developing countries alike, has demanded a rethink of traditional IMF economics.

Moving targets for central banks

IMF’s chief economist Oliver Blanchard questioned the focus of modern macroeconomic policy on keeping inflation very low, suggesting that central banks in advanced economies should aim at an inflation rate of 4 per cent, rather than the conventional goal of 2 per cent. A higher inflation rate would enable interest rates to be higher, giving more room to cut interest rates in order to boost the economy in a recession.

Additionally, Blanchard recognises the role of fiscal policy in stimulating the economy: “Had governments had more room to cut interest rates and to adopt a more expansionary fiscal stance, they would have been better able to fight the crisis,” Blanchard said.

Contrary to traditional IMF thinking, which promotes inflation targeting as the sole objective of central banks, the study argues that “central banks in small open economies should openly recognise that exchange rate stability is part of their objective function.”

Acknowledging that low interest rates may have contributed to the financial crisis by leading “to excessive leverage or excessive risk taking,” Blanchard notes the importance of central banks ensuring financial stability and looking at asset prices and credit aggregates. The paper argues that inflated house prices and excessive consumption may be more damaging than core inflation, which was stable in the build up to the financial crisis. The note suggests, however, that increased regulation would be preferable to central banks using interest rate policy to deal with asset price bubbles. It recommends that “If leverage appears excessive, regulatory capital ratios can be increased; if liquidity appears too low, regulatory liquidity ratios can be introduced and, if needed, increased; to dampen housing prices, loan-to-value ratios can be decreased; to limit stock price increases, margin requirements can be increased.”

The report sparked fierce criticism from rich country central bankers. The head of the European Central Bank, Jean-Claude Trichet, said: “Pandora’s box must remain shut. The weakening of our price stability objective is out of the question.” Even US Federal Reserve Chairman Ben Bernanke remarked, although more mildly, that it may be difficult to keep 4 per cent inflation from rising further. However at a February conference held by the Reserve Bank of India (RBI), the Bank’s governor, Dr. Subbarao, suggested that in order to regain credibility in the aftermath of the financial crisis, central banks will have to take on the responsibility of ensuring financial stability and consider looking at asset prices in a world where developing countries often have to face the consequences of global imbalances to which they did not contribute.

Chinese economist Andong Zhu of Tsinghua University says that while “the IMF is moving in the right direction with its shift in attitude towards inflation targeting, it should have gone further. Maybe we should replace inflation-targeting with employment targeting, or at least combine them.” He adds that “in the past three decades, the Chinese government didn’t adopt inflation targeting policies from the IMF, and I am really proud of it.”

Capital controls finally accepted

The new IMF view on controlling international capital flows is summarised in the staff paper Capital inflows: the role of controls. After examining the experience of governments that have regulated capital flows, the IMF noted “that the use of capital controls was associated with avoiding some of the worst growth outcomes associated with financial fragility.”

Specifically the authors find that GDP fell less sharply during the financial crisis in countries that already had such policies in place. The report cites Brazil’s taxes on speculative inflows, and policies pursued by Chile, Colombia and Thailand which require inflows of short-term capital to be accompanied by a deposit with the central bank.

The study accepts the view, long held by NGOs and academic critics, that “large capital inflows may lead to excessive foreign borrowing and foreign currency exposure, possibly fuelling domestic credit booms (especially foreign-exchange denominated lending) and asset bubbles (with significant adverse effects in the case of a sudden reversal) (see Update 67, 66). Can such concerns justify the imposition of controls on capital inflows – not only from the individual country’s perspective, but also taking account of multilateral considerations? The answer is yes – under certain circumstances.”

The note however, cautions against “excessive” use of controls and argues that the capital controls should be “temporary”, warning that their “widespread” use may have “distortionary” effects and that, in the longer term, the controls would “lose their effectiveness”.

Additionally, the paper has little to say on what an effective system of controls on capital inflows would look like, nor does it offer any advice on how countries may design them. Harvard professor, Dani Rodrik states in his recent article that “with the stigma on capital controls gone, the IMF should now get to work on developing guidelines on what kind of controls work best and under what circumstances.”

Kavaljit Singh from the Indian NGO Public Interest Research Group says that “the renewed interest in capital controls by the IMF is a positive development.” However he warns that “any wisdom, which perceives capital controls as a temporary, short-term, isolationist and quick-fix solution to deal with volatile capital flows is unlikely to succeed. Rather capital controls should be seen as one of the policy instruments in the hands of governments to pursue independent economic policy making, growth and financial stability.”

Whether the ideas presented in these staff notes become part of IMF official policy, will depend on whether the board decides to endorse them. The issue of capital controls will be discussed in the context of the IMF mandate review, promising a controversial board discussion (see Update 70).To date, the board does not have plans to review the issue of inflation targeting.