The global integration of financial markets seems irreversible under the current circumstances and, most likely, will further progress in the next ten years or so. The two biggest emerging-market economies, China and India, are expected to fully open their capital accounts and liberalize their financial sectors at some point. This creates a necessity to adjust economic theory and policy at the national as well as the global level to unrestricted capital movements, rather than the reinvention of capital controls and the isolation of individual countries from the turbulence of international markets. This is a task for academia, market analysts, policy-makers and international institutions.
Economic theory must undertake an effort to elaborate a global monetary model which will offer more than the sum of national monetary conditions (e.g., including cross-border monetary and fiscal multipliers and spillovers). Consequently, this should create a conceptual ground for understanding mechanisms and instruments which determine global liquidity as the precondition to any successful attempts to regulate it. Researchers, analysts and policy-makers should come to an understanding of all the consequences of unrestricted capital movement for macroeconomic analyses and policies. This concerns, in particular, the largely exogenous character of changes in capital and current account balances (with the former determining the latter), the real exchange rate, the limited sovereignty in the area of monetary policy, and so on. Instead of mechanically seeking a return to balanced current accounts within national boundaries as the proof of macroeconomic health, it is more desirable to analyse indepth factors which determine the actual BoP position and flows, try to assess their sustainability, and design policies which make countries more immune to sudden and excessive fluctuation in global capital flows.
There is no single instrument which would allow accomplishing this goal. Rather, a package of various macro and micro policies is required to increase a country’s macroeconomic safety and ensure sustainable growth prospects. However, such a package should not include a return to capital controls, as they are largely ineffective and breach the international obligations of many countries.
Still, even the best-designed national policy mix in a small open economy cannot guarantee complete immunity from external shocks triggered by policy decisions of other countries, especially the biggest players. This is the price which must be paid for numerous benefits stemming from the globalization process and free capital movement. However, the realization of this risk as well as of the limited room for decision-making at the country level (due to constraints imposed by international markets) should encourage national policy-makers to seek greater international cooperation and coordination in macroeconomic, particularly monetary, policies.
This is a formidable task and there is a long way to go, but it is worth a try. It requires overcoming various political constraints, building new legal and institutional frameworks, and developing a theoretical background and analytical tools for global coordination and decision-making. Smaller countries have an obvious incentive to participate in such an effort: they have already lost a substantial part of their sovereignty in macroeconomic management. However, the big players should also understand and accept the advantages of a collaborative approach and of sharing their policy-making sovereignty; even the largest economies are not isolated from the rest of the world. If their authorities are concentrated too much on narrow domestic agendas they risk exporting problems and distortions to others (beggar-thy-neighbour policies) with the probability that the external damage done will affect them sooner or later. The role of an economic superpower, including the issuance of a global reserve currency, does not only come with extra privileges, it also comes with responsibilities.