Beginning in the mid-2000s, a wave of new thinking overtook the economics profession on the question of the flow of capital across borders. According to what has been called the new welfare economics of capital controls, unstable capital flows to emerging markets can be viewed as a negative externality on recipient countries. Therefore, regulations on cross-border capital flows are seen as a tool to correct for market failures that can make markets work better and enhance growth, rather than worsen it. This is a marked departure from the accepted view during the 1990s, when the IMF (and others) put pressure on borrowing countries to liberalize their capital accounts with the same vigor that they liberalized trade.

According to the new research, externalities are generated by capital flows because individual investors and borrowers do not know what the impacts of their financial decisions will be on the financial stability of any particular nation. A common analogy for this effect is the case of an individual firm not taking into consideration its contribution to (and the costs of) urban air pollution when pricing its products. Just as, in the case of pollution, the polluting firm can accentuate the environmental harm done by its activity, in the case of capital flows, a foreign investor might tip a nation into financial difficulties and even a financial crisis. This is a prime example of a market failure, which calls for policy interventions to correct it and make markets work more efficiently.

This idea is not entirely new, of course. Even during the formation of the World Bank and the IMF, Keynes and his colleagues acknowledged that capital flows must be regulated in order to prevent crises and “maintain an independent monetary policy.” Exercising control over capital flows allows for more policy space to increase employment and financial stability. The new research, however, brings those mid-twentieth-century calculations up to date and models global capital flows and controls in a broader context. As a result, it has gained credence with international financial institutions who view it as offering a more rigorous justification for policy action on capital flows.