Capital Spillovers: Towards a New Regime

A look at the externalities from capital controls and potential effects on international finance


The focus of this post is going to be on the arguments in a recent NBER working paper on how capital controls in one country should be evaluated on an international level.

An interesting development in the analysis of capital markets in the past few years has been a changing paradigm on the use of capital controls as macroprudential policy. Through empirical analysis, we've found various channels through which capital controls function. As per the working paper:

Some economists and policymakers have recently become more supportive of controls on capital inflows, particularly if they are aimed at limiting the appreciation of overvalued currencies and reducing financial fragilities resulting from large and volatile capital flows. This support has been bolstered by theoretical work showing that taxes on capital inflows can improve a country’s welfare by reducing negative feedback effects due to capital flow volatility (Korinek, 2010 and Jeanne and Korinek, 2010) or by adjusting the terms-of-trade to shift consumption across periods (Costinot, Lorenzoni, and Werning, 2011). This theoretical work has been supported by empirical work showing that even if capital controls cannot significantly affect the total volume of capital inflows, they can improve the country’s liability structure and increase its resilience to crises (i.e., Ostry et al., 2010).1

Yet the analysis hasn't really focused on external effects of capital controls of country on others. This is an important field of study because, as the study of customs unions or financial contagion has taught us, the effect of controls or restrictions change significantly in a second-best world populated by other states with their own policy regimes. Thus, any possible externalities from one country's capital controls are extremely important in the formulation of policy.

The paper looks at 'moderate, market-based controls on capital inflows in a country which previously had a relatively open capital account." In effect, it shies away from large scale capital controlled regimes like China.  Also, these types of capital controls are unlike the command-and-control regulations that China uses in stopping capital mobility. Instead of a quota, the controls analyzed in the paper make capital harder to move on a per-unit basis. While Chinese capital controls can be represented by a levee, the capital controls analyzed in the paper are the equivalent of making the hill a bit steeper or moving to higher ground. For more rigorous empirical analysis, the paper looks at Brazilian markets, as they are relatively deep and have been subject to multiple changes in capital restrictions over the years. The authors use the Emerging Portfolio Fund Research (EPFR) to analyze changes in mutual and bond funds.  In addition, they interview investors from a variety of backgrounds to learn about how market practitioners respond to capital controls.

An interesting nugget from the empirical analysis is that a large part of the impact from Brazilian capital controls arises from the expectation about future policy. Capital controls in Brazil lower investment in Brazil, but also in other countries that have a higher risk of implementing more capital controls. The specific wording from the paper:

Given these significant portfolio effects of capital controls on investor allocations to Brazil, it is not surprising that there are externalities on portfolio allocations to other countries as well. Confirming comments in some of the investor interviews, we find that these spillovers are heterogeneous and depend on country characteristics and the fund manager’s strategy. When Brazil increases its capital controls, investors increase their portfolio allocations to other countries that are closely linked to growth in China (through commodity or regional exports). There is also mixed evidence that investors may increase their portfolio allocations to other countries in Latin America. At the same time, increased capital controls in Brazil cause investors to reduce their portfolio allocations to countries that are perceived to have a higher risk of following Brazil’s example and implementing new controls (including countries that are traditionally open but recently imposed new controls as well as countries that traditionally have extensive restrictions on capital mobility). These results confirm that much of the effect of controls is from signalling, i.e. changes in investor expectations about government policy, even for countries that are not concurrently adjusting their capital controls (6). 

This shift in expectations then has implications for whether capital controls can be targeted. If controls cause markets to judge an entire government as heterodox, then capital flows as a would reduce all forms of foreign investment. Additionally, Brazilian capital controls may change global expectations about policy for capital controls.  This may change the allocation of funds at a global level as well.


The shift towards Chinese investments in the face of Brazilian capital requirements is quite interesting. This suggests that there's something offered by investments related to China that similar to that of Brazilian investments. This relationship is probably built on the BRICs of emerging markets, but these similar flows weren't recorded as going into Russia or India. Brazil is also unique in its central placement in South America, which is probably the reason Brazilian capital controls pushed a substantial portion of the new flows into other Latin American countries. Although their development has not kept pace with Brazil, they are likely exposed to similar risks with respect to commodity price shocks on the global marketplace. As a result, an investor might decide to shift away from Brazil, which has capital controls, to another Latin American country which would offer a similar type of investment, but with a higher yield due to lower capital controls. The authors use these spillover effects of capital controls to justify more international coordination:

If capital controls shift vulnerabilities from one country to another, this “bubble thy neighbour effect” should be incorporated in any reassessment of the desirability of capital controls. Moreover, if several countries simultaneously adopted controls as part of a standard “policy toolkit”, or if a single large country adopted more stringent controls than Brazil’s small tax analyzed in this paper, the externalities could be substantial. This does not necessarily mean that capital controls will reduce global welfare and should always be avoided. Instead, these results support a role for international coordination or oversight of the use of capital controls to avoid a “bubble thy neighbor” effect which could lead to retaliation across countries and reduce global welfare (6).

The argument about "retaliation across countries" exposes an important weakness of capital controls. If capital controls function primarily by pushing hot money flows onto other countries, a global regime of capital controls is likely to have the same effect that capital controls have on a country-by-country basis. In effect, the fallacy of composition strikes again, as if every country imposed capital controls, capital controls would no longer address vulnerabilities in finance. Rather, they would just lower the global return on capital.


Section 2 of the paper moved on to investor surveys of attitudes towards capital controls. They reveal a wide diversity of views on capital flows.  While some investors were neutral (“cost of doing business”), quite a few of them interpreted capital controls as signalling something more fundamental about the country (“anti-investor bias of the country,”  “an increase in policy uncertainty in the future,” “a government that does not know what to do,” or a “lack of stability in economic policy”) that constituted "a draconian policy".  Other investors had positive views, as "controls showed the country was addressing potential vulnerabilities due to a rapid expansion of credit related to capital inflows".  If capital flows substantively affect future expectations of capital stability, these yield expectations should be integrated into the design of policy.  Yields could be used as a tool to look at market expectations of the future path of policy.

Capital controls also have heterogenous effects on different investors.  Equity investors face higher levels of volatility, so taxes on the order of a few percentage points of return were not very worrisome. On the other hand, for those who were dealing with fixed income assets or had absolute thresholds to reach, the tax on incoming capital had a major effect.

The surveys also reveal that capital controls, as currently implemented, affect the economy with long and variable lags.  This would take place in spite of advanced knowledge of when the controls would be implemented.  There were four key reasons for this:

1. Expectation lag - even though capital controls changed the expectations of future policy, any given change could only be part of a "broad assessment" of investments in a country.  As a result, one capital control would not immediately affect a change in investment strategy.
2. Institutional lag - in many institutions, fund allocations depend upon decisions of large committees that go through a "lengthy process of meetings, documentation and approvals" (10).  As a result of the internal transaction costs of making the decision, capital controls don't have immediate effects.
3. Coordination lag - the effect of capital controls extends beyond one firm.  Rather, investors require information about the actions of other agents to make a decision; they can't ex-ante coordinate to figure out how much each firm will invest.  As a result, responses to capital controls take time.

All of this shows that investors respond in very different ways to capital controls; the image of a representative investor investing symmetrically with the market is an illusion.  Policy then needs to be designed carefully to take into account these different types of investments.

Overall, this paper has notable implications for a global shift away from financial fragility through capital controls. The signalling argument means there's room for rule based policy when it comes to macroprudential regulation.  To clarify what the government wants to do with capital flows, they can create a "macroprudential regime" to try and anchor investor expectations, thereby creating an environment more conducive to growth. 

Also, the international spillovers of capital flows make the dynamics of adjustment to an international landscape dotted with capital controls unpredictable. As more and more large economies move towards capital controls, two scenarios could evolve. One is that the states without capital controls would be seen as freer to capital flows. This would create strong incentives for the remaining states to implement controls so as to prevent the new flows of hot money from coming into their polities. Even without international coordination, there would be a snowballing effect towards a new regime on capital controls. On the other hand, if the expectations channel was strong enough, the remaining states could go without controls as investors already expect them to be willing to take measures to moderate capital flows. In effect, the actions of the first movers would immunize the rest. Under this scenario, the first movers would be providing a public good with their decision to move first. As a result, there would be an inefficient level of capital controls. I'm not sure which one is more correct, but either way they make the study of international finance very exciting as development marches forward.

The Difficulties of Dodd Frank

Financial regulation is such a pain...

There's been some recent news on how slowly Dodd Frank is being put together.  From the Financial Times, we see that most of the rules have missed their deadlines by a long-shot.  the original Polk report also notes that:

Of the 398 total rulemaking requirements, 108 (27.1%) have been met with finalized rules and rules have been proposed that would meet 146 (36.7%) more. Rules have not yet been proposed to meet 144 (36.2%) rulemaking requirements.

This certainly isn't good news for the face of financial regulation.  In the face of so much opacity, it's not too hard to imagine that finance will become even more difficult.  Even though the Volcker Rule is short and cute, it's most certainly not simple.  There are attempts to gain exemptions for investments such as venture capital, and it even may be a violation of NAFTA trade rules.  If all these crucial issues hang in the balance, this may worsen uncertainty and information uncertainties within financial markets.  And given that information asymmetries are the source of many of the frictions within financial markets, the uncertainty from this piece of regulation will probably have a short-term destabilizing effect on markets.

The way that the law creates short term opacity seems to create a Second Best argument against the policies advocated by Taleb that, in theory, would help reduce market fragility.  While financial markets in a whole would benefit from Volcker Rules that separate proprietary trading from commercial banking, the way that the rule is implemented may cause it to worsen problems.  The law also poses an interesting conundrum for those who advocate rules based on heuristics, because how do you design them to be specific enough to be appropriate for the market, yet also broad enough to capture all the possible destabilizing issues?  Moreover, the possibility of policy error in the writing of the laws is huge.  What if one of the exceptions is the exception that creates a new financial product that causes the next crisis?  The fundamental issue is that we would never know until we become the turkey and suffer through the next unpredictable crisis.

Then where do we go from here?  Although financial regulation may have slipped from public awareness, it's more important than ever to ensure that our financial system is diverse and robust (maybe even antifragile?) to shocks.  Regulation must also focus on the payoffs and maybe assets of the banks, which are observable, rather than the banks' methodologies or trading strategies.  A rather elegant way to do it would be to impose a Pigouvian tax on financial monoculture, for which firms that tend to follow the market are penalized vis a vis firms that can consistently go opposite the market.  While there may be measurement issues that prevent that policy from being a full-fledged way to stop all crises, this kind of thinking about the payoff will be increasingly important when information and probabilities become more opaque.

Escaping from the Golden Fetters

An intermediate to currency disunion

The prospects for the Eurozone look bleak.  CDS spreads are going up, large countries have downgraded debt, politics is turning against fiscal consolidation, and the central bank still feels trying to save the Euro would jeopardize (what's left of) its credibility.  This has led to widespread pessimism about the long-run sustainability of the Euro, including from my fellow soon-to-be-undergraduate blogger Evan.  But, we must remember that "The long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is past the ocean is flat again."  Our goal for the endgame of the European economy is irrelevant if sovereign debt crises interrupt our theorizing.  Especially given the precipitous state of several other key economic powerhouses, such as India and China, adding a large scale currency adjustment hardly seems like a credible option.  The sheer physical demands of such a transition would make it nigh impossible to create an orderly transition.

Thus, even if all the nations are bound by the "golden fetters" of the Euro, simply abandoning the fetters is not a sufficient answer.To begin this walk away from the abyss, there needs to be more room for national policy in a continent that is otherwise deeply integrated.  The apparent struggles of the Eurozone are a particularly interesting case of what Dani Rodrik calls for in a path to a saner globalization.  We cannot let the perfect become the enemy of the good, and therefore let a potentially destabilizing deep integration get int the way of the many beneficial forms of shallower integration. Nations are different; why shouldn't their laws be the same?  In the words of Rodrik:

We have to think of these differences not as aberrations from the norm of international harmonization, but as the natural consequences of varying national circumstances.  In a world where national interests, perceived or real, differ, the desire to coordinate regulations can do more harm than good.  Even when successful, it produces either weak agreements based on the lowest common denominator or tougher standards that may not be appropriate to all.  It is far better to recognize these differences than to presume that they can be papered over given sufficient time, negotiation, and political pressure (The Globalization Paradox, 262).

Too often, attempts at harmonization result in policies that are "one size fits none."  Interest rates or macroprudential requirements may be too high in one polity, too lower in another, thereby aggravating the procyclical tendencies for both.  Stricter fiscal pacts and banking unification won't help; if anything, they would likely worsen the situation.

So if the Euro isn't going away in the short run, then there needs to be a way to introduce frictions to give national governments "policy space" to adjust.  This is where national macroprudential policies and potentially capital controls come into play.  Even if Eurobonds and enhanced lender of last resort capabilities are necessary, they need to be paired with policies that can ensure that the question of liquidity does not evolve into a question of later solvency.  Without national policy space, differing unit costs of capital and labor can evolve into serious financial issues, replicating the current European debt crisis.

This kind of financial segmentation would be even more appropriate given the dangerous roles of private capital flows in promoting the current crisis.  Private capital, freed from exchange rate risk and in search for higher yields, would flow from core banks to the periphery.  However, due to the poor institutional underpinnings of the periphery, there was no proper way to organize that capital (interfluidity).  In the time of adjustment, the common currency then prevents any kind of external devaluation that otherwise might have blunted the highly procyclical capital flows.  Since the currency cannot self adjust the capital flows, the governments may have to take a stronger role in ensuring that destructive capital flows don't distort national economies.

Eventually, when things have stabilized, the Euro can be steadily phased out  But with the current uncertainty and chaos, that option hardly seems viable.

Update 4/29/12:


New article from the economist that discusses the prospects for financial integration:

Breaking that interrelationship requires a number of things, Lord Turner argues. He would like to see Eurobonds that can, among other things, act as a risk-free asset that liberates banks from the “wrong-way risk” of holding their own sovereign’s debt; and he argues, too, for a pan-euro-zone approach to bank resolution, deposit insurance and supervision. National authorities should, he thinks, have responsibility for pulling “macroprudential” levers designed to prick booms before they get out of hand.

A much more integrated euro-zone banking system is a logical response to the euro crisis, but boy will it be difficult. Just imagine the implications. A big European supervisory authority that excludes Britain, the continent’s biggest financial centre; a system that would see taxpayers in creditor countries backing the banks of debtor countries; a process that could end up with supervisors in Frankfurt telling the Spanish, say, they cannot have more credit. Thorny stuff, but still better than the direction in which the euro zone is now travelling.

 But why are we trying for force all European countries into the same financial straitjacket if they're, quite obviously, Not The Same?

99 Reasons to Fail: Financial Monoculture

Is size necessarily fragile?  Another look at Too Big to Fail

The scale of finance has drawn heightened scrutiny in the years after the financial crisis.  Yet in spite of this concern, the size of banks has only grown.  There's fear that the government may have to intervene again if another financial crisis comes along, and Fisher, the Dallas Fed president, has blasted this trend.

It is imperative that we end TBTF. In my view, downsizing the behemoths over time into institutions that can be prudently managed and regulated across borders is the appropriate policy response. Only then can the process of “creative destruction”— which America has perfected and practiced with such effectiveness that it led our country to unprecedented economic achievement— work its wonders in the financial sector, just as it does elsewhere in our economy. Only then will we have a financial system fit and proper for serving as the lubricant for an economy as dynamic as that of the United States.

Of course, the regulatory confusion that would arise from breaking up the banks would have massive effects, but are there also other theoretical reasons to be suspicious of "just" breaking up banks?  According to the traditional narrative, large banks are too vulnerable to unseen risk.  If all the models are calibrated, and something outside those models surfaces, the entire machine could break down.  This puts the entire market in jeopardy.  Large banks, knowing this, are then willing to take on more risk, as they know that the government will intervene to save them.  This combination of factors then creates a "too big to fail" phenomenon, and society pays the price while the bankers continue picking up pennies off of the train tracks.

Yet small banks are very vulnerable as well.  What sometimes can be forgotten from discussions of banking is that big banks is why they are so problematic.  Systemic risk is at the root of the problem.  With their high frequency Gaussian models to hedge alphas, betas, deltas, gammas, a single tail even can cause a the largest bank to collapse, sending ripples through the entire financial system.  An analysis of the Fed's interbank lending system showed that 75% of the payments involved 0.1% of the nodes and 0.3% of the linkages between nodes in the banking network.  From this image, it's very easy to imagine an explosion causing one bank causing a cascade throughout the network.

But is size the only issue?  Not necessarily.  Some earlier studies about bank resiliency actually indicated that larger banks should actually decrease bank failure!  Bank, as a result of their size, are able to diversify more and limit their exposure to sector-specific volatility.  Notably, the United States actually has relatively low bank concentration compared to other countries.  The three largest banks in the United States only controlled 19% of the industry in 2003, while the corresponding numbers for Finland and New Zealand were 85% and 77% respectively.  Research from the NBER found that a one standard deviation increase in bank size resulted in about a 1 percentage point decrease in bank failure proportions.  Considering the percentage risk of bank failure was only 4% in the whole sample, the 1 percentage point would have been a significant decrease in bank failure rates.

Of course, this does not suggest that large banks were better; the fact that many of them collapsed in the recent financial crisis suggests that this isn't the case.  Additionally, the focus on the probability of bank failure glosses over the issue of magnitude; the smaller number of bank failures most likely had massive effects.  But this does suggest that the relationship is not as simple as one might think, and that the true relationship likely has a severe non-linearity.

Moreover, a market populated by small banks is prone to a crisis because there's "too many to fail".  If the market is fed on the same monoculture of debt priced with bad models, there's still the risk that a systemic crisis could run through the system.  With VaR models that are ill suited for complex environments and hyperspeed algorithmic trading models, it's not unthinkable that traders could feed on themselves and trigger stock market shocks.  This system would be difficult, if not impossible to effectively monitor, especially when any given bank can have large systemic effects.

As a result, some have called for an increase in the diversity in financial systems.  The voxEU article specifically outlines four positive externalities from diversity:

1. Bailout/Moral Hazard Externality - banks tend to pursue the same investment as they are consequently more likely to be all bailed out.
2. Systemic Risk Externality - as banks have a hard time taking into account the effect of its actions on other firms, this leads to inefficient levels of systemic risk with homogenity
3. Herding/Momentum Externality - as markets tend to herd, whether for psychological or principal-agent reasons, increasing diversity would limit the swings in the market.
4. Insurance Externality - higher diversity makes cross-insurance more robust, reducing risk

With the discussion framed in terms of externalities, the natural answer is a pigouvian tax.  The authors propose a system of capital requirements based on how much a given bank's profits or share prices correlate with the market as a whole.  The government would "tax" banks who "go with the flow".  This would take into account both "too big to fail" as well as "too many to fail".  Large banks would be required to hold more capital as they, by virtue of their size, are highly correlated with the market.  Small banks would be also pushed to try different strategies to avoid higher capital requirements.  The simplicity in the rule is also incredibly elegant; a heuristic, and not a model error sensitive parameter.  Thus, in an inverse of Taleb's criticism of the current financial system, this kind of macroprudential regulation may promote a certain level of antifragility as individual banks could play for the lottery tickets with undefined payoffs.  It may not be enough, but coupled with robust layers of monetary policy, there may yet be hope for complex economies in an unpredictable world.

Fragile Finance - A Look at Macroprudential Regulation

Modern finance is fragile, so what should we do?

Last year, Olivier Jean Blanchard wrote a "Seoul paper" on macro and financial issues, calling for a rethinking of the way macroeconomic policy is conducted.  In the old approach:

We thought of monetary policy as having one target, inflation, and one instrument, the policy rate. So long as inflation was stable, the output gap was likely to be small and stable and monetary policy did its job. We thought of fiscal policy as playing a secondary role, with political constraints sharply limiting its de facto usefulness. And we thought of financial regulation as mostly outside the macroeconomic policy framework.

This shift was significant, as previous financial regulation was primarily concerned with the micro picture.  But with the realization that there are serious systemic risks that permeate markets, interest has shifted to trying to look at financial regulation from a macro perspective.  Since then, macroprudential policy has been integrated into the G-20 framework and there is a large and growing literature on how to implement it.

This is an especially thorny issue because we're not quite sure what we're looking at.  Unlike monetary policy, macroprudential policy does not have the equivalent of a DSGE for analysis.  Moreover, what measures of risk should be used?  Capital ratios?  Loan-to-value ratio?  Does one follow a rule based approach or allow for more discretion?  This has been the fundamental problem with more formal analyses of macroprudential policy, as "both theoretical and empirical work linking the financial sector to the macroeconomy is far from a stage where it can be operationalized and used for risk analysis and policy simulations."  There simply isn't enough data to thoroughly analyze macroprudential effects.

A recent study has suggested that certain macroprudential policies, such as caps on loan to value ratios or dynamic provisioning have been effective in reducing the procyclicality of credit growth.  As debt is very fragile and promotes unpredictable complexity, any way to reduce its use in times of economic growth is good to hear.  Ideally, debt can be limited to digging oneself out of holes, and not trying to get to extreme heights of economic euphoria.

Note that this kind of regression analysis, although it is dealing with debt, which increases the probability of black swans, is still appropriate because it's looking at the growth of debt versus the growth of GDP.  Models aren't dependent on the exact magnitude of these parameters, rather we use changes in the parameters to determine if a given policy is appropriate.

However, this macroprudential approach is not without concerns.  It is not sufficient, and safety net policies will still be necessary.  Additionally, capital controls in and of themselves may have severe harm for long run economic growth.  As we're dealing with systemic risk, it may be that the regulations to limit systemic risk only ends up replicating it elsewhere, in industries that are not as easily regulated.  This would be even more worrisome, as previously known risks go on to evolve into unknown unknowns: the realm of Extremistan.

In spite of this, I feel that macroprudential policy will be increasingly important for the future, especially if we move to a more nominally stable NGDP targeting regime.  When aggregate demand is stabilized, the largest welfare costs will arise from aggregate supply shocks.  And as the financial sector is one of the critical industries for system wide credit, the question of how to regulate finance is fundamentally an aggregate supply issue.  In the market monetarist framework of Scott Sumners, macroprudential policy will be critical for shaping the composition of NGDP growth in a post market monetarist world.  This will be also very important for developing nations, as they are disproportionately harmed by large swings in real growth.  A massive drop in export and natural resource demand can let their capital stock deteriorate, damaging their prospects for development.  This move towards "increasing transaction costs" in order to improve global finance echoes Dani Rodrik's arguments for a more sustainable version of global trade.  Much as a better trade does not equal more integration, better finance may not entail more transnational capital flows.  And without stable and robust finance, there shall be neither stable nor robust growth.  That forms the basis of macroprudential regulation.