Abstract
This paper provides an introduction to the new economics of prudential capital controls in emerging economies. This literature is based on the notion that there are externalities associated with financial crises because individual market participants do not internalize their contribution to aggregate financial instability. We describe financial crises as situations in which an emerging economy loses access to international financial markets and experiences a feedback loop in which declining aggregate demand, falling exchange rates and asset prices, and deteriorating balance sheets mutually reinforce each other—a common phenomenon in recent emerging market crises. Individual market participants take aggregate prices and financial conditions as given and do not internalize their contribution to financial instability when they choose their actions. As a result they impose externalities in the form of greater financial instability on each other, and the private financing decisions of individuals are distorted toward excessive risk-taking. Prudential capital controls can induce private agents to internalize their externalities and thereby increase macroeconomic stability and enhance welfare.
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Notes
For example, from 2009 to 2011, the countries that have imposed new regulations or extended existing prudential regulations on capital inflows include Brazil, Colombia, Indonesia, Korea, Taiwan, Thailand and Peru. See Ostry and others (2011).
The literature employs several different terms for this basic mechanism, including debt deflation, Fisherian deflation, or financial accelerator.
See, for example, the description of the transfer problem in the open economy by Keynes (1929) and of debt deflation in the closed economy by Fisher (1933).
More generally, we could distinguish between the fraction κ T of tradable goods and κ N of nontradable goods that lenders can seize. As long as both are positive, our results would continue to hold.
There is an instructive analogy to asset markets: a lender who lends to an airline company that uses planes as a collateral has no intrinsic use for planes. In the event of default the lender seizes the planes and sells them to other airlines against cash.
In models of financial amplification in which the borrowing constraint depends on future prices, it is necessary to introduce investment as a link between the current period and the future. Amplification arises when borrowing constraints at time t become binding, which reduce investment at time t and lower income and prices at time t+1, which in turn reduces borrowing at time t further, and so on.
However, Kocherlakota (2000) and Cordoba and Ripoll (2004) caution that the constraint specification of Kiyotaki and Moore (1997) does not yield quantitatively large amplification effects in calibrated models.
We include yT, 1 as a separate argument to the function V(·) since it shows up not only in the budget constraint (where it is captured by the variable m) but also in the borrowing constraint.
An additional technical condition is that the preferences of all agents need to be locally nonsatiated.
There are several special circumstances, however, when equilibrium is constrained efficient even if markets are incomplete. These include economies with a single good (because there are no relative prices that could trigger pecuniary externalities) and economies with a single or representative agent (because there is no trade in such an economy). For a detailed discussion, see Arnott, Greenwald, and Stiglitz (1992).
See Hart (1975), Stiglitz (1982), Geanakoplos and Polemarchakis (1986) and Greenwald and Stiglitz (1986) for a discussion of the inefficiency of the decentralized equilibrium in economies with incomplete markets at a technical level. Arnott, Greenwald, and Stiglitz (1992) provide an excellent intuitive description.
Even if some market participants have some market power, they will not fully internalize the social costs of the pecuniary externalities that result from their actions. For example, in a duopoly, each player would find it optimal to internalize only 50 percent of the pecuniary externalities.
This formulation of a constrained planning problem, in which the planner has no other instruments than the decentralized market, is the most basic criterion for Pareto inefficiency. If we give the planner additional instruments, it is natural that she can improve the equilibrium further. See for example the section ‘Prudential Capital Controls vs. Ex-Post Intervention’ for a discussion of how a planner would use mitigating policy measures once a crisis has occurred.
However, even if prudential taxes are not employed in some time periods, the equilibrium in a multiperiod general equilibrium model will still be affected by the expectation of future intervention.
Risk-averse international investors are an important aspect of our model; otherwise domestic consumers could costlessly insure against domestic shocks.
More generally, we could assume that a fraction of the long-term debt has to be rolled over in period 1 and that this fraction enters the borrowing constraint. Our basic results would be unaffected.
However, Korinek (2010b) cautions that the opportunity cost of holding reserves in the current economic environment with low global interest rates are close to zero and fluctuate strongly with small changes in global interest rates, making the policy instrument less reliable.
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Additional information
*Anton Korinek is an assistant professor of economics at the University of Maryland. The author would like to thank Julien Bengui, Maya Eden, Martin Evans, Giovanni Favara, Rex Ghosh, Olivier Jeanne, Nicolas Magud, Ha Nguyen, Krisztina Orban, Jonathan Ostry, Roberto Piazza, Carmen Reinhart and Joseph Stiglitz as well as participants of the Inaugural Conference of the Institute for New Economic Thinking and the 2011 IEA Meetings and two anonymous referees for helpful comments and suggestions. The author would also like to acknowledge Carmen Reinhart for sharing data on the relationship between financial liberalization and instability. Work on this project was undertaken while the author was a visiting scholar at the IMF. The views expressed are those of the author and should not be attributed to the IMF. The title of this paper is inspired by the description of the emerging “new theory of prudential capital controls” by Jeanne, Subramanian, and Williamson (2012).