Taming Capital Account Shocks: Managing Booms and Busts

Abstract

A paradox and weakness of the triumph of the market economy in recent decades was the fact that liberalization was the strongest in the area -financewhere market imperfections are in fact the largest. Indeed, as a result of rapid and widespread liberalization of both domestic and international financial systems, as well as capital accounts, currency and financial sector crises became increasingly frequent, and developmentally as well as fiscally, costly. This has culminated in the global financial crisis, that started in 2007 in the developed countries and which was, to a large degree, also a result of extreme financial liberalization, accompanied by insufficient and inappropriate regulation. Latin America, especially in the Southern Cone, had followed this pattern of liberalization and crises since the late 1970s. Diaz Alejandro (1985) had then very perceptively synthesized this as ―Good-bye financial repression, hello financial crisis‖. Domestic financial crises interacted with the 1980s major Latin American debt crisis, to lead to a lost decade for growth and equity (see, for example, Griffith-Jones and Sunkel, 1989). In particular, the liberalization of the capital accounts of Latin American economies led to sharp surges and then reversals of capital flows, which posed both severe difficulties for macroeconomic management (Ffrench-Davis and Griffith-Jones, 2003), and led to very costly crises. As the Latin American debt crisis of the 1980s was followed by the Mexican peso crisis and the East Asian crisis, a major discussion arose internationally about the urgent need to reform the international financial architecture. Griffith-Jones and Ocampo (2003 and 2009) have long emphasized the need for strengthening counter-cyclical elements in this international architecture, to allow greater space for counter cyclical macro-economic policies at the national level. This approach has gained further relevance and support with the 2007-09 global financial crisis, and the ensuing discussion and reforms on counter-cyclical as well as comprehensive regulation and international liquidity provision. Particularly, if the attempts at international financial reform fail or are insufficient to curb excessive boom-bust patterns of capital flows, as well as their severe costs, the issue of slowing down capital account liberalization is again of great policy relevance; where this liberalization has already largely taken place like in Latin America, re-introducing capital account regulations is again becoming relevant. International capital markets have grown dramatically since the mid-1960s. Although international capital movements partly reflect expanding economies, increasing world trade and the globalization of production, they also involve purely financial factors that rose notably faster. The revolutionary innovations that have taken place in telecommunications technology, and the emergence of increasingly ―sophisticated‖ financial techniques contributed to a boom in