Friday, January 24, 2014

Exchange rate commitment always beats capital controls

The recent financial crisis has scared a lot of countries into adopting so called macro-prudential policies that introduce frictions into capital market that can be best summarized as capital controls. The idea is that you want to make sure that market participants are constrained in a way that makes them consider the consequences of their actions onto others. The IMF has encouraged a lot of countries to adopt such policies, in stark contrast to previous stances. And this is backed up by a recent literature that shows these policies are welfare-enhancing.

Gianluca Benigno, Huigang Cheng, Christopher Otrok, Alessandro Rebucci and Eric Young show this is right but suffers from the absence of other policy options. Specifically, once you add a policy to the mix that would be to stabilize the real exchange rate of the local currency in times of crisis, then macro-prudential policies are dominated. I suppose one could then even imagine better policies or policy combinations. But the point is that you need to expand the set of policy options. Why is this exchange rate commitment better? Capital controls act like Pigovian taxation that applies always and leads to a constraint-efficient outcome. A commitment to a real exchange rate applies only at particular times and leads to a conditionally-efficient outcome. That flexibility is key.

1 comment:

Anonymous said...

if international lenders take into account that taxes affect borrowers’ income available for debt repayments then exchange rate interventions are completely ineffective to manage crises and, instead, macroprudential policies are useful for correcting the externality that stems from the underestimation of the social costs of decentralized debt decisions. See