Capital account convertibility and capital controls in emerging market countries.

On November 6, 1998, a group of leading researchers and practitioners in international finance gathered in Cambridge to discuss capital controls in emerging markets. The backdrop to the meeting, chaired by NBER President Martin Feldstein, is of course the international financial crisis that has spread from Asia to Russia and continues to threaten Latin America. The conference considered the role that controls might play in managing the crisis, and in preventing similar disruptions in the future. The format was a series of short presentations by researchers who have written extensively on the topic,(1) interspersed with a free ranging and lively discussion with a number of invited participants.(2)

Do controls on capital outflows have a role to play in the management of the kind of financial crises that followed Mexico's devaluation in 1994 or Thailand's devaluation less than three years later? The discussion on this question revolved around Paul Krugman's organizing device of the "eternal triangle" (which he also referred to as the "irreconcilable trilogy"). The idea of the triangle is that there are three desirable capacities: the capacity to use stabilization instruments; the capacity to defend the exchange rate; and the capacity to have free capital movement. The dilemma is that only two of the three are achievable. If you demand free capital movement and a defense of the currency, then stabilization must be sacrificed. If you demand free capital movement and freedom in the use of monetary and fiscal policy to attempt stabilization, then you will not be able to defend the exchange rate. Since both macroeconomic policy austerity and a collapsing exchange rate are likely to lead to deep recessions, capital controls - however undesirable in themselves - may be the only way out.

The Krugman depiction of the policy constraints did not go unchallenged. One challenge that was raised in various ways by numerous participants was to the Krugman presentation of the nature of the crisis as one involving self-fulfilling expectations (or multiple equilibria) as distinct from flawed fundamentals. The strongest challenge to the multiple equilibria view came in Michael Dooley's presentation. Dooley questioned the claim that the fickleness of financial markets is the source of the problem, rather than "governments' participation in financial markets." This participation comes in the form of implicit government guarantees, which lead money borrowed abroad to be misused, say by hiding the proceeds...