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Monday, June 09, 2003

Policy Ineffectivness

Jane Galt posts about capital controls. This has been a topic discussed on a couple of blogs lately, and I have a few observations.

Regarding countries that use or have used capital controls, Chile comes to mind as a prime example with its previous implicit tax on on short-term capital inflows; the new free trade agreement with the US, unfortunately, prohibits their reintoduction. China also does not have a free capital account, which is probably a good thing for the moment as their financial system is in a fragile state and could collapse due to the bad history of state-directed lending.

There is also a false dichotomy between currency controls and free capital movement. As Daniel Davies himself noted on Brad DeLong's blog, free capital movement may require sequencing--a gradual liberalisation as the policy framework improves. There are a number of recent studies that indicate that financial liberalisation has limited benefits, especially portfilio flows. The IMF is revising its policy advice after recent empirical research concluded that there are limited benefits to free capital movement, at least in the short run.

Galt's notion about the government badly controlling the money supply is odd. The reason may not be "government" but simply that monetary authoritues did not have the "technology" to properly control inflation, or had other objectives. To take the latter first, before the Friedman-Phelps expectations-augmented Phillips Curve policymakers thought they could safely tradeoff inflation for lower unemployment. This was naive, but was not, of itself, an illegitimate objective.

Paul Volcker had the good fortune to have been appointed when he was. Kyland & Prescott's paper on time inconsistency dates from 1977, two year's prior to Volcker's appointment; this is followed by Barro and Gordon's paper on Rules vs Reputation in monetary policy (1983) and Kenneth Rogoff's paper on the "conservative central banker" (1985). All of these are the foundation for the successful (so far) transition to independent central banks in many countries.

The trouble with an argument against policy is what would happen in the absence of policy, especially politically. To take two examples, while the theories are vastly different, the practical effect of both real business cycle theory and the Austrian theory of business cycles is the same--the government should not intervene in the economy to ameliorate the cycle. In a recession, this is a tough sell, especially when the public demand that something be done about the economy.