Are macro-prudential policies prudent?

Gianluca Benigno, Huigang Chen, Christopher Otrok , Alessandro Rebucci, Eric Young, 16 August 2010



Economy-wide controls on capital inflows are back in vogue. Concerned with the latest surge in capital inflows, Brazil recently introduced a tax on international portfolio flows, and Taiwan imposed a ban on foreign funds investing in local time-deposits. Other emerging markets are either preparing or considering similar measures.

The IMF is backing the trend. Faced with several member countries adopting or considering capital controls, the IMF changed its traditional position of opposing such controls. Ostry et al. (2010) review the rationale for capital controls and the available empirical evidence on their effectiveness. While recognising that the empirical evidence is mixed, they conclude that, under certain circumstances, capital controls are warranted and may be effective, albeit more on the composition of capital inflows than on their total volume.

A new strand of academic research also strongly advocates economy-wide capital controls on macro-prudential grounds. Bianchi (2009), Korinek (2010), and Korinek and Jeanne (2010) focus on the possibility that countries may borrow excessively or inefficiently (i.e., they may over-borrow) in economies in which people only make consumption decisions (i.e., endowment economies).

The rationale for over-borrowing in these economies is an externality; when individual borrowers take on collateralised debt, they fail to take into account the effect of their decisions on the collateral of other borrowers. In other words, in these economies, when access to foreign capital is unconstrained and plentiful, the social marginal value of saving is higher than the private value because of this externality. All else being equal, this mechanism induces lower saving (higher borrowing) than socially desirable. The unambiguous recommendation is therefore to counter over-borrowing with a Tobin tax or economy-wide controls on international capital inflows.

Over-borrowing, however, is not a general feature of financially integrated economies. The logic of the argument in economies in which agents take only consumption decisions (i.e., endowment economies) is appealing and intuitive (The Economist 2010), but the resulting over-borrowing is very fragile to seemingly innocuous assumptions. In related research (Benigno et al. 2009 and 2010), we show that, in economies with both consumption and production decisions (i.e., production economies), an opposite force arises. With both production and consumption decisions, the same externality may lead to excessive saving and hence to under-borrowing: in production economies, the relatively lower private value of saving may generate a lower private value of supplying additional output compared to the social one when access to foreign capital is unconstrained. Lower private production and consumption of domestically produced output can then lead to lower borrowing relative to what is socially desirable, and thus generate the possibility of under-borrowing.

The relative strength of the two effects at work in production economies depends on the parameter values of the model. For example, the second channel dominates the first when the model is tuned to a typical emerging market economy, thus inducing under-borrowing rather than over-borrowing. But the first channel dominates the second when the shocks are larger and the agents are more impatient relative to the typical economy. In contrast, over-borrowing always arises in endowment economies, because the second effect is not present.

Such lack of robustness is sufficient to warrant a more cautious approach to economy-wide prudential controls on capital inflows, especially in light of the mixed empirical evidence available on the effectiveness of such policy tools (Ostry et al. 2010). Simply put, policy recommendations from endowment economies need to be taken with caution as they assume that over-borrowing exists from the outset. On the contrary, more realistic production economies lead us to believe that over-borrowing itself might not even exist.

But even when they are appropriate, capital controls do not eliminate financial crises. They simply lower the probability of their occurrence or their severity by a margin that is difficult to quantify accurately. Thus, even with prudential controls, safety net policies to respond to financial crisis still need to be kept in place, as Caballero (2010) stresses. Moreover, our research shows that nationally or internationally financed bailouts are always socially desirable regardless of the specific type of economy considered or the specific values of the model parameters. It follows that the appropriate combination of prudential controls and bailouts must be analysed in models in which both kind of policy interventions are allowed for. Indeed, under the system of capital controls, policymakers in an endowment economy would not be able to mitigate the effects of a financial crisis with a bailout as the economy cannot alter its production possibilities. This would overstate the social value of capital controls as they would be the only option available in such an economy.


It is well known that bailouts can induce moral hazard. But it is also important to keep in mind that prudential regulations and capital controls can hamper efficiency and lower long-term growth. Sometimes these distortions can be justified and are indeed beneficial, but in order to advocate such distortions economists must be fairly certain of their costs and benefits.

Our research shows that, at this point in time, the case is too weak to recommend unambiguously economy-wide capital controls. Indeed, different economies may require very different policy regimes, depending on the presence of either under- or over-borrowing.


Benigno, G, H Chen, C Otrok, A Rebucci and E Young (2009), "Optimal Policy With Occasionally Binding Credit Constraints," Unpublished manuscript.

Benigno, G, H Chen, C Otrok, A Rebucci and E Young (2010), “Resisting over-borrowing and its policy implications”, CEPR DP 7872

Bianchi, J (2009), "Overborrowing and Systemic Externalities in the Business Cycle", Working Paper 2009-24, Federal Reserve Bank of Atlanta.

Caballero, R J (2010), "Sudden Financial Arrest," IMF Economic Review, forthcoming.

Jeanne O and Korinek, A (2010), “Managing Credit Booms and Busts: A Pigouvian Taxation Approach”, unpublished manuscript, University of Maryland, March.

Korinek, A (2010), "Regulating Capital Flows to Emerging Markets: An Externality View", Unpublished manuscript.

Ostry, JD, AR Ghosh, K Habermeier, M Chamon, MS Qureshi, and DB Reinhardt (2010), "Capital Inflows: The role of Controls", IMF Staff Position Note 10/04.

The Economist (2010), “Policymakers are experimenting with Ways to stop a property boom”, 8 May.

Topics: Global crisis, Global governance
Tags: financial regulation, global crisis, international finance

Gianluca Benigno
Associate Professor in the Department of Economics at the London School of Economics
Huigang Chen
Director of Econometrics at the Power Information Network, J.D. Power and Associates
Christopher Otrok
Associate Professor of Economics at the University of Virginia
Senior Research Economist in the Research Department of the Inter-American Development Bank
Eric Young
Associate Professor of Economics at the University of Virginia