a pragmatic approach to capital strongaccountstrong liberalization.pdfVIP

Journal of Economic Perspectives—Volume 22, Number 3—Summer 2008—Pages 149–172 A Pragmatic Approach to Capital Account Liberalization Eswar S. Prasad and Raghuram G. Rajan n the mid-1990s, mainstream economists of nearly all stripes commonly recommended capital account liberalization—that is, allowing a free flow of Ifunds in and out of a country’s economy—as an essential step in the process of economic development. Indeed, in September 1997, the governing body of the International Monetary Fund (1997) sought to make “the liberalization of capital movements one of the purposes of the IMF and extend, as needed, the IMF’s jurisdiction . . . regarding the liberalization of such movements.” But then came the East Asian financial crisis of 1997–98, in which even seemingly healthy and well- managed economies like those of South Korea were engulfed by massive capital outflows and tremendous currency volatility, and capital account liberalization became quite controversial in the economics profession. For example, Fischer (1998) and Summers (2000) continued to make the case for capital account liberalization, while Rodrik (1998) and Stiglitz (2000) were skeptical. A decade later, now that time has quelled passions and intervening research can shed more light on the debate, it appears that both the costs and benefits of capital account liberalization may have been misunderstood in that earlier debate. The major benefit of capital account liberalization was allegedly that it would help low-income countries expand investment and thus generate higher rates of economic growth. However, cross-country regressions suggest little connection from foreign capital inflows to more rapid economic growth for such countries. This suggests that the lack of domestic savings is not the primary constraint on growth in these econo- mies, as implicitly assumed in the benchmark neoclassical frame