Financial crisis could turn the tide against unrestricted capital flows

The idea that capital must be allowed to flow unchecked around the world – is coming under sustained attack.

The theory says that free capital flows allow savings to be directed – by the invisible hand of the financial markets – to wherever they will be most profitably employed. In this way, savers get a better return on their nest egg, while underdeveloped economies receive the financial leg-up they as well as help new ideas to be adopted rapidly worldwide. And as firms from one country take over those of another, they bring much-needed expertise.

Except that isn't what's been happening: instead, for the past decade and more, savings have been pouring uphill from poor countries to rich. Whether you call it a savings glut or a borrowing binge (two sides of the same coin), it has led to a flood of money going through financial markets, looking for a home. These vast flows of money have created a repeated pattern of boom, bust and financial crisis.

A recent paper by thinktank the Bretton Woods Project, Time for a New Consensus, enumerates five major threats of unregulated capital flows.

There is currency risk, because large inflows can push up a country's exchange rate (you need to buy Turkish lira if you want to buy a firm in Istanbul). An overvalued currency undermines domestic exporters and leaves them unable to compete.

There is flight risk, because funds often leave as rapidly as they arrive, pulling the rug out from under local businesses and stunting economic growth.

Contagion risk is the threat that close financial links between economies means a shock in one can drag everyone down.

Fragility risk occurs when an economy becomes heavily dependent on borrowing from overseas, often in foreign currencies.

Finally, sovereignity risk, familiar to a string of crisis-hit countries across the world in the past two decades, is the threat that instead of overseas investment giving governments the resources they need to improve the livelihoods of their population, politicians are left with little or no control over their own economies.

Two recent research studies suggested cross-border flows of capital will increase radically in the coming years as developing countries grow in size; that the UK will be particularly vulnerable to future sudden reversals in these flows, because of its vast external balance sheet; and that the international community should consider drawing up a set of rules governing how and when countries can act to protect themselves.

If there's one thing policymakers should have learned over the past four years, it's that financial markets can't be left to run the world themselves.