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Journal of International Economics 90 (2013) 232–235 Contents lists available at ScienceDirect Journal of International Economics j o u r n a l h o m e p a g e : w w w. e l s ev i e r. c o m / l o c a t e / j i e Book reviews Olivier Jeanne, Arvind Subramanian, John Williamson, Who Needs to Open the Capital Account?, Peterson Institute for International Economics, 2012 The empirical relevance of theories of international risk sharing is an issue of long-standing interest in international finance. While international trade in financial assets brings many potential welfare gains, it also entails significant risks. As part of the larger debate about financial globalization, the extent to which policy-makers should allow foreign capital to flow into their economies remains a controversial issue. Following the advice of academics, many emerging market policy makers opened up their capital markets to foreign capital in the late 1980s and early 1990s. In the aftermath of a spate of financial crises in the late 1990s however, a heated debate over capital account liberalization has consumed the profession. Opponents of capital account openness maintain that hot money flows of international capital flee emerging economies at the first sign of trouble and the financial crises that ensue impose massive costs on these economies. Further, opponents cite evidence from a series of studies suggesting that the role of capital account openness for financing growth is ambiguous at best. This swing in the academic pendulum has not been lost on developing country policy makers who have increasingly taken to imposing a variety of capital controls to curb foreign capital inflows, effectively reversing the process of capital market openings that began in the 1980s. A new monograph by Olivier Jeanne, Arvind Subramanian and John Williamson, Who Needs to Open the Capital Account?, revisits the issue of capital market integration and draws attention to the wide diversity of capital account policies around the world ranging from some countries adopting complete openness, to others with market-based prudential controls (notably Brazil) to others with tight restrictions on their capital accounts (such as China). The authors set out to uncover the lessons and implications of global financial crises for capital account policies in developing and emerging countries. They argue that unlike free trade in goods that took place under the aegis of international rules and multi-lateral institutions such as the WTO, free trade in financial assets did not happen by design but rather under a vague promise of an economic growth dividend and primarily because under the world order of global finance, “advanced country club” status required that free capital mobility be embraced and because capital controls were seen as vestiges of economic backwardness. The introduction reviews the evidence regarding capital flow volatility in both developed and emerging countries during the global financial crisis and discusses the resurgence of capital controls with a focus on the recent Brazilian foray into taxing capital inflows. The authors then present the case for prudential capital controls which provides a discussion about the distinction between prudential controls designed to mitigate the volatility of foreign capital inflows and protectionist controls aimed at maintaining persistent currency undervaluation. The evidence about the impact of capital account liberalization on economic growth using a “meta regression” approach is presented where the authors argue that the diversity of capital account policies is consistent with a lack of conclusive evidence about the benefits of free capital mobility on economic growth. Following this the evidence disaggregated by the type of capital flow (portfolio equity, debt, FDI and bank flows) is reviewed. While the authors maintain that their focus on capital controls is technical rather than ideological and circumstance dependent, they also argue that there is no rationale to promote totally free trade in financial assets. The book concludes by proposing an international code of good practices that embodies capital account policy norms including desirable capital controls. The authors highlight a need for an international consensus about a framework of rules that legitimizes the use of appropriate capital controls (“good controls”) and discourages harmful ones (“bad controls”). According to the authors, the basic difference between good and bad controls is that the former correct distortions that occur under free markets while the latter create distortions. In particular, they favor transparent, price-based prudential measures, such as a counter-cyclical tax on capital inflows to curb boom–bust cycles in asset prices generated by these flows. The authors argue that controls like the Chinese case, have negative global spillover effects such as repressing domestic demand combined with reserve accumulation to maintain capital account surpluses are inappropriate and harmful as they are protectionist and not prudential in nature. It is important to note that the economic rationale for capital account liberalization draws upon the notion of allocative efficiency or the neoclassical view that capital account openness allows financial resources to flow from capital-abundant countries, where expected returns are low, to capital-scarce countries, where expected returns are high. The flow of resources into capital-scarce countries in turn is expected to reduce the cost of capital, increase investment, and raise output in the recipient countries (Fischer, 1998, 2003; Henry, 2007; Obstfeld, 1998; Rogoff, 1999; Summers, 2000). Jeanne, Subramanian and Williamson (2012) are skeptical of the case for free capital mobility that relies on allocative efficiency and instead maintain that the push to liberalize capital accounts over the last few decades was driven by a “foreign finance fetish.” Consistent with arguments in Bhagwati (1998), Edison et al. (2004), Eichengreen (2001), Kose et al. (2009), Rodrik (1998), and Stiglitz (1999, 2000, 2002), the authors consider the evidence regarding the benefits of capital account openness for investment and economic growth unconvincing and the costs in the form of recurring financial crises in emerging markets immediately obvious. To make their case the authors adopt a “meta-regression” approach that involves running more than 2300 regressions using six de jure and de facto measures of financial liberalization, three different ways of specifying financial liberalization (as an initial level, a change and an average), twelve disaggregated measures of financial liberalization, various time horizons, time-series and panel approaches, threshold effects and conditioning variables. Unfortunately the analysis suffers from the critique leveled by Henry (2007) against the wide body of literature that seeks to examine the impact of capital account openness on real variables such as investment and growth—namely, most of these papers tell us nothing about the empirical validity of the theory they set out to test. Book reviews The neoclassical model provides no theoretical basis for conducting cross-sectional tests of a permanent relationship between capital account openness on growth and therefore does not suggest the causal link needed to justify cross-sectional regressions (Henry, 2007). In contrast, papers in the policy-experiment genre that take the predictions of neoclassical theory seriously find that in the immediate aftermath of capital account liberalization, the cost of capital falls, investment rises as does economic growth and the effects are economically meaningful and statistically significant. However, while the impact on the standard of living or per capita incomes is permanent, the growth impact is temporary and lasts only during the transition between the autarkic and liberalized steady states. Theory suggests that one tests for either a permanent level effect on per capita incomes or a temporary growth effect. Therefore it is not surprising that analyses that test for a permanent growth impact of capital account openness do not find statistical significance—the neoclassical model provides no theoretical rationale to expect such a relationship. Therefore the justification for running over 2300 regressions with noisy data and an analysis that is untethered from the theory the authors set out to test is not clear. The exercise creates a false sense of precision and fails to provide a compelling analytical approach. As an example, the IMF's AREAER measure which the authors use as one of the main capital account openness measures provides no information on the specific aspect of the capital account the country liberalized and neither can any index that is based on such data. Therefore, it is unclear how to map that variation in such an index to a wellarticulated model for the purpose of empirical estimation (Henry, 2007). For instance, neoclassical theory predicts that liberalizing capital inflows will lead to effects on the cost of capital, investment and growth. Without knowing the distinction between capital inflows and outflows from the AREAER measure, it is unclear how one would use this measure to use the theory to guide empirical analysis. Using data and measures that do not correspond or at best loosely correspond to what theory predicts is far from convincing. In advancing the theoretical rationale for prudential capital controls the authors focus on boom–bust cycles in capital inflows to identify and prescribe policies to mitigate externalities generated by an amplified build-up in external debt during capital-inflow booms which in turn lead to costly deleveraging if there is a sudden stop in these flows. The case for counter-cyclical prudential controls is the same as for the macro-prudential regulation of the financial sector. Its objective is to design measures that make agents internalize their contributions to systemic risk to curb the destabilizing impact of capital inflow booms and busts. It must be noted that the models used by the authors to develop the case for prudential controls all rely on external debt to generate excessive leverage build-ups during capital inflow booms. There is a general consensus that the distinction between debt and equity is an extremely important one when discussing the benefits of capital account openness. Since debt does not embody the risk-sharing aspects of international equity flows, excessive reliance on external debt (especially foreign-currency denominated bank loans that generate currency mismatches on balance sheets) can cause financial distress as we have seen in many an emerging-market crisis. It is also important to observe that in contrast to the sharp reversal in debt flows during recent emerging-market crises, net portfolio equity inflows remained more stable. Given that the type of capital inflow that appears to generate the greatest systemic vulnerability is an excessive reliance on short-term external debt, it is not clear why the authors favor a counter-cyclical tax that ought to be applied to all capital inflows, albeit of varying magnitude depending on the inflow type. It is also not obvious why domestic macro-prudential regulations that directly address a build-up of excessive leverage in the financial system would not suffice. The authors' suggestion that a diversification across wide range of policy 233 instruments (domestic macro-prudential regulations and capital controls) would serve to enhance the effectiveness and compliance of regulatory measures is not particularly convincing especially when we consider the empirical evidence regarding the impact of capital controls on real variables. Using data that differentiates between capital controls on different categories of assets, Klein (2012) finds that with a few exceptions, there is little evidence of the efficacy of capital controls on the growth of financial variables, the real exchange rate, or GDP growth casting doubts about assumptions behind recent calls for a greater use of episodic controls on capital inflows. Combined with the evidence on the adverse real effects of restrictions on capital inflows such as on financing constraints faced by firms (see for example, Forbes, 2007) it is not clear that capital controls should be a “regular instrument of economic policy” as the authors suggest. On balance, it is not obvious that the way forward is towards a more dirigiste international regime where government-designed controls act as sands in the wheels of international finance. The book is targeted to an international policy audience. While the evidence presented may give the impression of rigor, it does not survive closer examination. Readers in policy circles may be advised that the arguments favoring capital controls advanced by the authors have not yet been established in theory or in fact. References Bhagwati, J., 1998. The capital myth: the difference between trade in widgets and dollars. Foreign Affairs 77, 7–12. Edison, H.J., Klein, M.W., Ricci, L.A., Sløk, T., 2004. Capital account liberalization and economic performance: survey and synthesis. IMF Staff Papers 51, 220–256. Eichengreen, B., 2001. Capital account liberalization: what do cross-country studies tell us? World Bank Economic Review 15, 341–365. Fischer, S., 1998. Capital account liberalization and the role of the IMF. Should the IMF pursue capital-account convertibility. Essays in International Finance, no. 207. Princeton: International Finance Section, Department of Economics, Princeton University, pp. 1–10. Fischer, S., 2003. Globalization and its challenges. American Economic Review 93, 1–30. Forbes, K.J., 2007. The microeconomic evidence on capital controls: no free lunch. In: Edwards, S. (Ed.), Capital Controls and Capital Flows in Emerging Economies: Policies, Practices, and Consequences. University of Chicago Press, Chicago and London, pp. 171–202. Henry, P.B., 2007. Capital account liberalization: theory, evidence, and speculations. Journal of Economic Literature 45, 887–935. Klein, M., 2012. Capital controls: gates versus walls. NBER Working Paper 18526, Cambridge, MA. Kose, M.A., Prasad, E.S., Rogoff, K.S., Wei, S.-J., 2009. Financial globalization: a reappraisal. IMF Staff Papers 56, 8–62. Obstfeld, M., 1998. The global capital market: benefactor or menace? Journal of Economic Perspectives 12, 9–30. Rodrik, D., 1998. Who needs capital-account convertibility? Should the IMF Pursue Capital-Account Convertibility. Essays in International Finance, no. 207. International Finance Section, Department of Economics, Princeton University, Princeton, pp. 55–65. Rogoff, K.S., 1999. International institutions for reducing global financial instability. Journal of Economic Perspectives 13, 21–42. Stiglitz, J.E., 1999. Reforming the global economic architecture: lessons from the recent crises. Journal of Finance 54, 1508–1521. Stiglitz, J.E., 2000. Capital market liberalization, economic growth, and instability. World Development 28, 1075–1086. Stiglitz, J.E., 2002. Globalization and its Discontents. Norton, New York and London. Summers, L.H., 2000. International financial crises: causes, prevention, and cures. American Economic Review 90, 1–16. Anusha Chari CB #3305 Department of Economics, University of North Carolina at Chapel Hill, Chapel Hill, NC 27599, United States Tel.: +1 919 966 5346; fax: +1 919 966 4986. E-mail address: [email protected]. http://dx.doi.org/10.1016/j.jinteco.2013.01.002