The Capital Truth: What Works for Commodities Should Work for Cash

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Jagdish Bhagwati insists that trade in dollars is fundamentally different from trade in widgets or any other commodity -- so different, in fact, that governments should restrict the global flow of capital even while they vigorously promote free trade in goods and services ("The Capital Myth," May/June 1998). However, Bhagwati's argument for controls on the free flow of currency for buying and selling assets is unconvincing. First, he fails to acknowledge that the case for the free movement of dollars mirrors that for free trade in widgets (and that the same logic applies to both). Take California and Texas, states that enjoy both free trade and free capital flow. Residents of both states benefit from the fact that neither state must make all the goods it needs for its own use. Instead, the more efficient state produces widgets for both, resulting in a cheaper widget. The effect on capital is similar; Californians looking for investments are not limited to their own savings but can draw on Texan money. Free capital movement offers borrowers in both states a deeper reserve of savings and gives investors more investment opportunities. Stopping this flow of money would make no more sense than would halting the movement of goods and services.

At the international level, a similar argument applies, although influenced by changing exchange rates and differences in legal systems. Conceptually, therefore, those who argue for free trade internationally should also advocate the free flow of capital across national borders. If savers and investors in Los Angeles and Dallas benefit from access to each others' resources, why should similar benefits not be available to their counterparts in Sao Paulo, Beijing, or Canberra?

Bhagwati also ignores one of the most profound economic developments of the last quarter-century: the expansion of international capital flows and the resultant benefits to the world economy. It is true that further liberalization of financial markets will only succeed if preceded by a strong institutional framework. But it is also true that policymakers around the globe have already endorsed the free movement of both domestic and international capital in their policies.

Bhagwati assumes that countries seek the unregulated and instantaneous flow of capital. In fact, policymakers have long recognized the need for safeguards, which are as essential for capital as they are for trade. Capital must be liberalized in a prudent manner, supported by supervisory regulations that strengthen the financial system. Given the great benefits offered by freer international capital markets, however, the best response to volatile conditions is surely to strengthen those markets' foundations (through improved accounting and disclosure rules, for example), not close them down -- especially since there is little evidence that the alternative, stopping the flow of capital, works well or for long.

CONSENSUS, NOT CONSPIRACY

The suggestion that the push toward free capital reveals a Wall Street-Treasury Department conspiracy overlooks two things: first, that the rapid growth of capital flow has involved countries beyond the United States and its G-7 partners, and second, that advances in technology, rather than economic or political intrigue, have led this expansion.

A glance at the IMF's history attests to its ability to manage the transition to open markets. For example, securing acceptance of the IMF charter's Article VIII, which creates an open system for current payments (that ensures, among other things, that exporters get paid for the goods and services they send abroad) took years to accomplish. Western Europe came on board only in 1958, and today, 37 of the IMF's 182 members have yet to ratify. The IMF has encouraged incremental moves, not instant change. It has helped strengthen developing economies through structural reforms, rather than forcing them to swallow Article VIII obligations prematurely.

Were the IMF now directed to promote free capital markets, we should expect a similar process of gradual adaptation. The international community and the IMF recognize that without both sound macroeconomic policies -- which many of the Asian crisis countries had -- and strong, transparent, and properly supervised banks -- which most of them lacked -- opening up capital flows is dangerous and inadvisable.

The opening-up must occur in proper sequence; this is the moral of the Asian story. Some Asian states chose, mistakenly, to stress short-term borrowing by domestic banks over longer-term foreign investment. The sequence of these measures, not liberalization itself, compounded the suffering when the crisis erupted and confidence vanished.

Building national institutions strong enough to cope with the volatility of capital flows will take time, which is precisely why the effort should start sooner rather than later. And because it will be difficult, the effort must be backed by international bodies, including the IMF.

Shailendra J. Anjaria is Director of the External Relations Department of the International Monetary Fund.