Quick post here to continue the theme of Christine Lagarde doing a complete makeover of the IMF. Yesterday, the Financial Times reported on an IMF staff paper that accepted capital controls as a necessary evil in specific cases, a sharp contrast to the liberalisation dogmatism that characterised IMF policy views during the 1990s. The paper does speak to the need to make controls “targeted, transparent, and generally temporary”. Nonetheless, I believe this is a significant policy shift that will have wider implications down the line.
The FT article focuses mostly on the currency wars and Brazil’s finance minister Guido Mantega’s position that the Federal Reserve’s zero rate policy and quantitative easing are creating significant problems for the Brazilian economy. In October, Mantega admitted that Brazil is now operating a dirty float in order to mitigate the impact of exchange rate volatility Mantega blames on US monetary policy. Nonetheless, that same month, Federal Reserve Chairman Ben Bernanke gave a full-throated defense of US monetary policy.
My focus goes more to Iceland because I see that as the most relevant example of where the IMF will actually start to allow capital controls. If you recall, it was extremely controversial that Iceland, having kept its own currency, decided not just to allow its biggest banks to default and go bankrupt but also to mitigate the currency implications of this policy by instituting capital controls. Last October I wrote a piece on the four biggest lessons from Iceland’s brush with national bankruptcy based on the IMF’s own assessment of the results of the IMF’s rescue plan for Iceland. The keys were to rebuild the banking sector but to make sure that bank losses were not absorbed by the state (as they were in Ireland, the US and the UK for example), to delay fiscal adjustment by backloading any austerity, and to stabilise the exchange rate.
This is not what you would have heard from the IMF during the Asian Crisis. Now, clearly these conclusions are lessons that were drawn under a program initiated under Dominique Strauss-Kahn’s leadership. But I do credit Christine Lagarde from taking these more reform-minded policy proposals forward. I increasingly see Lagarde as a change agent as evidence mounts that the IMF is turning toward more heterodox economic thinking in policy implementation.
The upshot here is that the Icelandic conclusions are the ones most likely to be used in future IMF programs, both regarding currency controls and austerity. We see that the IMF has mounted an attack on Europe’s economic policy of front-loaded austerity. And this is a direct outgrowth of the reform-mindedness of Strauss-Kahn and Lagarde. When it comes to capital controls, expect the same approach. If Greece were to exit the euro zone, it is now clear that capital controls would be an integral part of the policy response.