LINDA WERTHEIMER, host:
Now, a tale of standing up to the Goliath of global finance.
For years, the International Monetary Fund has been a big advocate of free market capitalism. 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. And NPR's Tom Gjelten is here to tell us that on one big issue, at least, the IMF has actually backed down. So, Tom, a setback for free-market philosophy?
TOM GJELTEN: A partial setback, Linda. The free-market model is still mostly alive and well. But there is a story here about governments challenging an important part of the capitalist system, having to do with capital itself, the way capital moves around the world.
WERTHEIMER: By capital, I take it you mean case. You mean money.
GJELTEN: Right. In this case, capital is money. And remember, Linda, for an economy to grow, it needs workers and it needs capital: money to build factories, buy equipment, pay the workers. Put the two together, you get a boom.
The traditional view is there should be a totally free market for capitalists in this situation. Investors should be free to move their money to some country, to take advantage of an opportunity, and when they lose interest, they should be just as free to move their capital back out. The other view is that these capital flows need to be regulated by governments.
WERTHEIMER: Regulated? So that means restrictions on how capital flows around the world.
GJELTEN: Right, because as it turns out, you can actually have too much money going into a country. I talked about this with the economist John Ralston Saul, who wrote a book called "The Collapse of Globalism." He explained how this capital overflow problem gets started.
Mr. JOHN RALSTON SAUL (Economist; Author, "The Collapse of Globalism"): 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.
GJELTEN: Other investors see those guys putting a lot of money into some country. They figure it's a good bet and follow their example. Economists call this herd behavior, like when you pick a restaurant just on the basis of seeing other people eating there.
So in one year, 1996, investors sunk about $65 billion into just four countries: Thailand, Indonesia, Malaysia and South Korea - way more than those countries needed, says John Ralston Saul.
Mr. SAUL: And when you've got too much money and nothing to do with it, you start doing really foolish things. So one of the things you do is you start buying and selling companies for no particular purpose. You start saying, let's put all those companies together. And then you would say, let's take all those companies apart.
GJELTEN: The price of those companies in U.S. dollars goes up. The dollar price of just about everything in those countries goes up, because so many dollars have come in. Governments borrow even more because dollars are so cheap. Then, all of a sudden, the first little hint of trouble.
Mr. ESWAR PRASAD (Former IMF Economist): Things may not quite be the way they seem to be.
GJELTEN: Eswar Prasad is a former IMF economist, now at Cornell University. In this situation, he says herd behavior kicks in again. But this time, the herd panics.
Mr. PRASAD: So when they see a couple of investors pulling a lot of money out of their country, they wonder: Maybe there is something going on in this country that I don't understand. I better take my money out before I take big losses.
GJELTEN: This is exactly what happened in those four Asian countries: capital inflows first came to a screeching halt, then went in reverse. Economist Jagdish Bhagwati of Columbia University says that in 1997 and 1998, those four countries had a net outflow of about $20 billion.
Professor JAGDISH BHAGWATI (Economist, Columbia University): People started leaving in droves, you see, creating a massive crisis.
GJELTEN: Across East Asia, economies collapsed. The interest costs on dollar debts soared. Local stock prices plummeted. Some governments, like Malaysia, felt burned by foreign investors. They imposed limits on capital movements, both in and out, no more free flows. That set up a confrontation with the International Monetary Fund, which was still arguing there should be no controls in capital flows. Capital should move freely, according to supply and demand.
Malaysia got portrayed in Washington in IMF circles as back tracking on free market reforms. Jagdish Bhagwati says there was also IMF pressure on India, which had never allowed free capital flows.
Prof. BHAGWATI: The Indian finance minister at the time told me that he was continuously being told in the - you know, when he went to Washington, to go ahead and liberalize the capital account.
GJELTEN: In other words, lift all controls on capital inflows and outflows.
Prof. BHAGWATI: I mean he said to me, if I said no, I don't want to do it because it's risky, then I would have been considered to be not a proper reformer. So he gave the usual answer, which smart people do, which is that yes, it's a jolly good idea. We are studying it and we're looking for an appropriate time to do it. But, of course, he didn't do it.
GJELTEN: Professor Bhagwati was on India's side. In 1998, he wrote an article for the Journal of Foreign Affairs titled "The Capital Myth," disputing the notion that economic growth required uncontrolled capital movement. It was not well-received in Washington.
Prof. BHAGWATI: The IMF actually reacted violently to this and got their public relations officer to write a comment on it.
GJELTEN: The comment appeared in the following issue as a letter to the editor titled "The Capital Truth." That was 1998. Ten years pass. Another international financial crisis comes along. This time, Eastern Europe was hit the hardest. Like the Asian countries a decade earlier, East European governments had allowed foreign capital to flood their economies. As for the countries that insisted on capital controls, well, the IMF research department took a look at their experiences, and guess what? Jonathan Ostry is the deputy research director.
Mr. JONATHAN OSTRY (Deputy Research Director, IMF): What we find in our work is that countries that did have some restrictions on capital inflows tended to come into this crisis with more equity, 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.
GJELTEN: Quite a turn around. Ostry was at the IMF back in 1998, but he doesn't want to talk about that letter criticizing capital controls.
Mr. OSTRY: That episode is not at my fingertips right now, but I would just underscore again that, you know, I think our line right now is pragmatism rather than dogmatism.
GJELTEN: Pragmatism rather than dogmatism: the new IMF creed. Ostry, who laid out the IMF view in an official paper last month, says the change has been evolutionary. Maybe, says Professor Bhagwati, but given how he was once attacked for advocating capital controls, he's thrilled the IMF has finally come around.
Prof. BHAGWATI: Along the way, there were occasional indications, but never so frontally, saying, golly, Bhagwati was right. And now they have.
GJELTEN: I should make clear, Linda, Professor Bhagwati and other international economists still think the movement of capital around the world is generally good for the global economy, but conditions matter. Some countries are better prepared than others to handle an influx of foreign capital.
WERTHEIMER: So a totally free-market economy, in this case, is not such a good idea?
GJELTEN: In this case, Linda, the countries that were most diligent about following all the free-market rules actually fared worse than those countries that dared to challenge those rules.
WERTHIMER: Thanks, Tom.
GJELTEN: You're welcome, Linda.
WERTHEIMER: NPR's Tom Gjelten.
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