But macroprudential measures need to be resorted to with a certain degree of precaution as well, since they may actually foster capital inflows and thus run counter to macroeconomic policies. Potential output declined severely in the aftermath of the crisis. A possible resumption in capital inflows would take aggregate demand higher and hence generate an inflationary production gap. Emerging countries would resort to fewer forex market interventions, allowing their currencies to appreciate in order to contain inflation. However, the long-term financial stability gains derived from macroprudential measures entail further capital inflows. The tolerance for currency appreciation (fewer interventions) may be reversed in light of the larger capital inflows. Moreover, a stronger currency may foster further inflows of portfolio investment. This goes to prove that not all measures trying to fend off capital flows are necessarily successful in reducing the incentives for capital inflows. Let me conclude by saying that the available measures to address large capital inflows are not safe from side effects. The policy mix needs to be conceived so as to maximize the benefits of capital inflows while insulating against related risks (Zhu, 2011). In a world where sustainable economic growth hinges on free markets, capital controls should only be considered as a measure of last resort, if at all. Prudential measures should be designed to minimize the distortions they trigger and should be resorted to only after all macroeconomic options have been exhausted. 6  BIS central bankers’ speeches  4. Foreign-owned banks – asset or liability?
Controls might very well ensure the fulfillment of these criteria, but there are two problems here. First, it might happen that such controls are not effective, meaning they can easily be circumvented. Nearly two thirds of the increase in the liabilities of foreign-owned banks in Romania during 2005–2008 occurred after the reserve ratio was raised to 40 percent. Second, even assuming they cannot be evaded, controls need to be discriminatory 1, so as to allow, for instance, equity inflows and discourage debt flows. But controls come at a very high price. Capital flows were subject to controls in all countries until the end of the sixties. Moreover, controls were also in place for lending and deposit rates, the volume of private sector credit, as well as for the business scope of certain groups of intermediaries. The positive effect of these controls was enhanced stability of the financial system: no banking crisis broke out during 1945–1971 (Eichengreen and Bordo, 2003). But the negative consequences were not negligible. Banks innovated less, they limited lending to large and secure firms, and operated on a less efficient basis. Once controls provided protection against crises, central banks became less interested in financial stability and preserved minimum expertise in this respect (Goodhart, 2010). There is also the issue of anteriority. Recent research concluded that controls yielded better results in countries where controls had been in place beforehand. Should we therefore consider preventive controls? This would mean ignoring the fact that large capital inflows are temporary in nature.