Since the East Asian financial crisis of the late 1990s, a consensus among even free-market economists has been developing: financial liberalization for developing countries usually don’t make sense. The financial crisis of 2008 and the ongoing Eurozone crisis have only fortified this consensus. The mainstream economic position seems to be that, at least for developing countries with smaller markets and poorly trained regulators, restrictions on capital account transactions in liquid portfolio assets often make sense.
Even the usually reliably free-market, pro-globalization economist Jagdish Bhagwati writes in his popular book, In Defense of Globalization, that the East Asian financial crisis
…was a product of hasty and imprudent financial liberalization, almost always under foreign pressure, allowing free international flows of short-term capital without adequate attention to the potentially potent downside of such globalization. There has been no shortage of excuses and strained explanations blaming the victims… [T]he motivation underlying these specious explanations is a desire to continue to maintain ideological positions in favor of a policy of free capital flows or to escape responsibility for playing a central role in pushing for… gung-ho international financial capitalism. (199-200)
Strong words! And then there’s this from the market-liberal Economist magazine in 2008:
Dani Rodrik of Harvard University and Arvind Subramanian of the Peterson Institute, in Washington, DC, have published a timely reappraisal of financial globalisation. They conclude that it is far from obvious that developing countries benefit much from opening up to global capital… In some circumstances, capital controls may be justified if they keep the currency cheap and promote growth… Messrs Rodrik and Subramanian conclude that with the benefits of liberalised finance under the microscope in rich countries, it is time for more subtle thinking about the global picture. “Depending on context and country,” they write, “the appropriate role of policy will be as often to stem the tide of capital flows as to encourage them.”
Even I have long been persuaded by the moral hazard argument: in a world of the second-best, in which governments routinely backstop financial institutions while inadequately regulating risk, restrictions on foreign portfolio investment may make sense.
But what does the peer-reviewed literature in economics say? To my knowledge, there have been just two recent, peer-reviewed, quantitative, global, cross-national studies of the effects of capital controls on growth: Bekaert, Harvey, and Lundblad (2005) and Eichengreen, Gullapalli, and Panizza (2011).
Bekaert et al., which has been cited over 1200 times according to Google Scholar, finds that
[E]quity market liberalizations, on average, lead to a 1% increase in annual real economic growth. The effect is robust to alternative definitions of liberalization and does not reflect variation in the world business cycle. The effect also remains intact when an exogenous measure of growth opportunities is included in the regression. We find that capital account liberalization also plays a role in future economic growth, but, importantly, it does not subsume the contribution of equity market liberalizations. Other simultaneous reforms only partially account for the equity market liberalization effect. Finally, the largest growth response occurs in countries with high-quality institutions.
Eichengreen et al. contains somewhat less positive findings:
We find evidence that financial openness has positive effects on the growth of financially dependent industries, although these growth-enhancing effects evaporate during financial crises. Further analysis indicates that the positive effects of capital account liberalization are limited to countries with relatively well-developed financial systems, good accounting standards, strong creditor rights and rule of law. It suggests that countries must reach a certain threshold in terms of institutional and economic development before they can expect to benefit from capital account liberalization.
Still, neither paper finds evidence of any substantial downside risk from financial liberalization, even during crises and even when institutions are poor! One of the reasons for this may be that legislators and regulators are just as affected by irrationalities and bubble mentalities as are investors. The political market may not be more efficient than even highly impaired financial markets.
Both studies appear to be well done, and I find myself having to rethink my former position. Perhaps the economic case for financial liberalization is strong after all.