Call it Bretton Woods deja-vu.
Gathered at the site of the 1944 conference that worked up a global financial system post-World War II, leading economists and investors this weekend revived an old ghost of economics — the use of capital controls to curb speculative money flows.
Foreseeing no let-up in the surge of investment heading into emerging economies, they predicted capital controls will be around for the long term and said policymakers need to come up with clearer rules for how they will be deployed.
The call marks the latest move in a gradual shift in mainstream thinking about capital controls which until recently were seen by many as a threat to free markets.
It comes a few days before global finance leaders gather for meetings at the International Monetary Fund and the World Bank, when capital controls will be a hot topic of discussion.
After the pro-market recipes prescribed by Western powers since the 1980s failed to avoid the near collapse of financial markets in 2008, more economists now accept the need for a stronger government hand in the economy — a system more akin to that of fixed exchange rates stemming from the Bretton Woods conference 67 years ago.
"Capital controls need to come back into the reckoning," Paul Davidson, co-founder of the Journal of Post Keynesian Economics, told the conference, packed with some 200 academic and business leaders in this New Hampshire ski resort.
"We should not believe that economies will become so mature that capital flight problems can be avoided."
Measures to restrict capital flows are preferable to the accumulation of the large foreign-currency reserves undertaken by China and other emerging economies as a protection against external crisis, which can lead to the build-up of dangerous imbalances in the global economy, he added.
Furthermore, short-term flows of capital are often a major source of volatility in the global economy, Nobel Prize-winning economist Joseph Stiglitz said at the conference, organized by billionaire investor George Soros' Institute for New Economic Thinking with the objective of "remaking" the global economy.
"Countries such as China, which did not allow cross-border flows, have done a lot better in the current crisis," he said.
Brazil's more open economy was able to withstand the financial crisis due to its hefty foreign reserves, which top $300 billion. But now it has become victim of a tide of speculative capital that has sent its currency to a 32-month high, despite government's efforts to curb dollar inflows.
"If you are Brazil today and you look out the window you see a wall of wealth coming your way," Chile's former finance minister Andres Velasco said. "I see that as terrifying indeed, as it makes your life very difficult as a finance minister."
Capital inflows into Latin America have skyrocketed to nearly $270 billion in 2010 from an average of about $40 billion between 2000 and 2005, according to IADB data.
Out of those totals, the share of speculative capital went from one-third in 2006 to about 55 percent currently, it said.
The challenge, many of the economists agreed, is to find a way to restrict those unwelcome speculative flows into emerging economies without killing vital long-term investment.
"It would be certainly desirable if we had a clear set of rules of road for countries, to guide them," Bank of England's director Andrew Haldane said.
"So far we haven't gotten those rules of road because some of the key international financial institutions have been in ideological denial about what role these measures might play. But I think we're over that now," he added.
In a historic about-face, the IMF has endorsed the use of capital controls. Last week, the fund proposed a framework to help countries manage the sudden surge of funds seeking higher returns in emerging markets.
The framework, rejected by some countries which saw it as a potential intrusion on their policy-setting powers, helps countries choose from a menu of policy options, including capital controls, to help ward off unwanted money inflows.
BIG FISH, SMALL POND
Investment in emerging markets were already growing in the last few years as investors tried to take advantage of their higher growth rates. But they surged after 2009, when developed countries such as the United States started printing money to support financial markets and the economy.
The problem is that markets in emerging economies remain relatively small, therefore strong inflows can easily create credit bubbles and distort their exchange rates — a problem that BoE's Haldane described as a "big fish in a small pond."
The question most economists are debating now is whether capital controls should be a complement to other restrictive monetary policies, or whether they should be used only as last-resort tools.
Barry Eichengreen, professor of Economics and Political Science at the University of California Berkeley, said they should be transparent and seen as a "backup."
"If you think about it in that way, it's going to be quite more market friendly," Eichengreen said.
The trouble, he said, is that capital controls are less effective when applied to sophisticated financial markets, where investors often find ways to skirt the restrictions.
Prospects for global guidelines on the use of capital controls look slim, however. In contrast to the post-war optimism that permeated the original Bretton Woods conference, participants in this weekend's meeting were mostly skeptical about global cooperation.
"We are in a very different situation today than the people sitting here in 1944," said Harold James, professor of History at Princeton University. "The first Bretton Woods conference was based on optimism and the possibility of a new order. Today we have neither the optimism nor the urgency."
© 2013 Thomson/Reuters. All rights reserved.