Dealing with financial risks of international capital flows: a theoretical framework

This article discusses a number of significant negative externalities generated by free capital flows and analyses certain justifications for regulating the capital account regime as an efficiency-enhancing tool used to limit externalities. This interventionist tool may limit the deviation of private equilibrium from social optimization by both improving the composition of capital flows and mitigating the accompanying distorted incentive that creates externalities. To avoid financial turbulence or economic crisis, countries (in particular, emerging economies) are urged to avoid the damaging influences of free-market ideology.