After six decades of zealously promoting free market economic policies, the International Monetary Fund has traded its dogmatism for pragmatism.
For years, governments that dared to challenge the IMF model found themselves out of favor in Washington and other Western capitals.
But the financial crisis that swept the planet in 2008 prompted a new debate over free market policies and IMF ideology.
Now, in a notable turnaround, the IMF has acknowledged that in some instances, developing countries might benefit from controlling how much foreign capital enters their economies — and how it's used.
The issue goes to the heart of the capitalist system. Free market advocates have long insisted that capital should be allowed to move around the world unimpeded by government regulation, responding to the same supply and demand forces that drive global trade in manufactured goods.
Investors who see opportunities in the labor-rich but capital-poor countries of the developing world, free marketeers argue, should be free to move into those economies whenever they sense a profit to be made — and free to withdraw their money as soon as they lose interest.
They say it's a sure way to economic growth.
That proposition is now being questioned, however, by the very IMF economists who once championed it. Turns out there is such a thing as too much capital flowing into an economy.
Challenge To Orthodoxy
The new IMF view is summarized in an official paper published last month, "Capital Inflows: The Role of Controls." After examining the experience of governments that have regulated capital flows, the IMF authors concluded that such policies helped reduce "financial fragility."
Specifically, the IMF now acknowledges that some countries are better prepared than others to handle an influx of foreign capital. Nations with no reason to fear overvaluing their currencies should probably refrain from capital inflow controls, the IMF says.
On the other hand, countries worried about inflation or exchange rates should consider controls, the IMF says. It also advises countries to assess the type of capital coming into their countries, differentiating between risky short-term foreign currency debt and foreign direct investment, which is relatively safer.
Behind the new position is a remarkable story of how critics of gung-ho global capitalism finally succeeded in challenging IMF orthodoxy, in part because the financial crisis of 2008 prompted reconsideration of conventional economic theories.
Roots In The Asian Financial Crisis
The story begins with the financial tremors that swept through East Asian economies in 1997 and 1998. In previous years, foreign capital was flooding Asian financial markets. Investors sensed that the emerging economies of the region were ripe for takeoff, rich in labor and natural resources, and only needed an infusion of capital to jump-start growth.
Lacking the information they often have about incipient industries, however, investors acted impulsively.
The problem starts "when a couple of guys in New York or London, who have far more capital than they know what to do with, simply dump it into a country," economics essayist John Ralston Saul explains.
Other investors then take a cue and mindlessly follow their example — "herd behavior" in action.
As a result, foreign investors in 1996 poured about $65 billion into just four Asian countries: Thailand, Indonesia, Malaysia and South Korea. It was far more than those countries needed, and the result was disastrous.
"When you've got too much money and nothing to do with it, you start doing really foolish things," says Saul, author of The Collapse of Globalism.
That includes buying and selling local companies for no particular purpose, Saul says. "You start saying, 'Let's put all those companies together.' And then you say, 'Let's take all those companies apart.' "
Such frenzied investment and speculation drive the local stock prices of those companies, in U.S. dollar terms, sky high. The dollar price of almost all local goods and services rises steeply, because so many dollars have flooded the local currency markets.
Businessmen, homeowners and governments are tempted to borrow even more dollars, because they are cheap. The local currency is soon overvalued; signs of trouble appear.
The Panic Begins
Herd behavior kicks in again. But this time, the herd panics.
When investors see other investors pulling large amounts of money out of a particular country, they begin to wonder if there are underlying factors or other issues that they don't understand, says Eswar Prasad, a former IMF economist now teaching at Cornell University. That uncertainty — and the potential for huge losses — leads them to pull out their money.
This is exactly what happened in Thailand, Indonesia, Malaysia and South Korea. Capital inflows first came to a screeching halt, then went in reverse.
Jagdish Bhagwati, an economist at Columbia University, recalls that investors began leaving those markets "in droves, creating a massive crisis." Those four East Asian countries, according to Bhagwati, experienced a net capital outflow of about $20 billion in 1997 and 1998.
Across the region, economies collapsed. The interest costs on dollar debts soared. Local stock prices plummeted.
Some governments, notably Malaysia, felt burned by foreign investors. The Malaysian government soon imposed limits on capital movements, both in and out.
The Malaysian action set up a confrontation with the IMF, which at the time vigorously opposed all controls on capital flows. The IMF said Malaysia was backtracking on free market reforms.
In Defense Of Controls
Governments that had not yet permitted open capital flows, such as India, remained under IMF pressure to do so, Bhagwati notes.
India dragged its feet on the issue of liberalizing its capital account; in the end, it never did.
That's a position Bhagwati supported. In an essay titled "The Capital Myth: The Difference Between Trade in Widgets and Dollars" that appeared in Foreign Affairs in 1998, he disputed the notion that free movements of capital were analogous to free trade in manufactured goods and should therefore be unrestricted.
The IMF was quick to respond. The following issue of the magazine included a letter to the editor from the IMF head of external relations, Shailendra Anjaria. The IMF rejoinder was titled "The Capital Truth: What Works for Commodities Should Work for Cash."
"Those who argue for free trade internationally should also advocate the free flow of capital across national borders," Anjaria wrote.
That was in 1998.
Ten years later, another international financial crisis came along. This time, it hit Eastern Europe the hardest. Like the East Asian governments in the 1990s, Eastern European governments such as Poland and Romania had been allowing foreign capital to flood their economies, in line with IMF preferences. Once again, economies experienced credit crises, and debt-servicing costs went through the roof.
But this time, the IMF research department took heed. After a thorough comparative analysis of economic developments in countries with and without capital controls, IMF economists came to a provocative conclusion.
Jonathan Ostry, the IMF's deputy research director, says the group's research found that "countries that did have some restrictions on capital inflows tended to come into this crisis with more equity [and] less debt. And this served them well in terms of having less of a credit boom, less of a run-up in asset prices in the good times, and therefore less of a bust in the bad times."
The conclusion was a complete turnaround from the previous IMF position. Ostry was working in the IMF research department at the time the letter was published, but deflected a question about it, noting instead that the IMF line now is "pragmatism, rather than dogmatism."
As the principal author of the new IMF paper, Ostry disputes any notion of a dramatic U-turn in policy, saying the change was "evolutionary."
Bhagwati, the target of the 1998 rejoinder in Foreign Affairs, doesn't dispute that the change in IMF thinking unfolded gradually. For his part, he believes the movement of capital around the world, in general, is healthy and boosts the global economy.
But he is thrilled the IMF has finally acknowledged publicly that his previous views were valid.
"Along the way, there were occasional indications [that the IMF had changed positions]," Bhagwati says, "but never so frontally saying, 'Golly, Bhagwati was right,' and now they have."