As negotiated by the Bush administration, the United States-Colombia Free Trade Agreement could cause or accentuate a financial crisis. Such a possibility would not only harm Colombia's development prospects and further politically destabilise an important US ally, but also jeopardise the very US exporters and workers that the agreement at least in theory would boost.
The US-Colombia pact is stalled in Congress as the Obama administration rethinks the Bush approach. Obama has cited Colombia's atrocious human rights record as one item that needs to be improved before the US can support the deal.
Another condition should be ensuring that no US trade deal accentuates financial crises.
The investment rules in the US-Colombia pact would effectively make Colombia liberalise its capital account – direct investment, stocks and bonds, loans and currency trading by and with foreigners.
This strategy is dangerous, outdated and out of touch with most of the trade agreements in the world.
Two recent studies by the National Bureau of Economic Research (NBER) confirm and expand these findings. NBER is the most mainstream and highly regarded economics thinktank in the US, boasting that "16 of the 31 American Nobel prize winners in economics and six of the past chairmen of the president's council of economic advisers," have all been NBER economists.
First, Ayhan Kose of the IMF, Eswar Prasad of Cornel University and Ashley Taylor of the World Bank confirm that capital account liberalisation is not correlated with economic growth in developing countries. These authors expand such findings to show that capital account liberalisation only works for those nations above a certain threshold of economic and institutional development – and that most emerging markets and developing countries are below the threshold.
Colombia is below that threshold. Liberalising the capital account before Colombia's financial system is equipped to handle massive inflows and outflows of capital could cause or accentuate another financial crisis.
Since 1993, Colombia has deployed innovative policies to smooth capital flows. Referred to as an unremunerated reserve requirement (URR), Colombia has required a percentage of all short-term "hot money" inflows be kept as a deposit in local currency, at zero interest for a certain percentage of the loan and a stated period of time. The goal of the programme – which is turned on when capital flows start to overheat and turned off when things cool – is to prevent massive inflows of hot money that can appreciate the exchange rate and threaten the macro-economic stability of the nation.
Econometric evidence has shown how Colombia's URR has repeatedly reduced the volume and composition of net capital flows away from short-term capital. Colombia was less hard hit by the economic crises in Latin America and east Asia during the 1990s. Nor has it suffered like nearby Mexico under the current crisis.
Nations such as Chile, Malaysia and to some extent China and India have all used similar controls on capital. In another NBER report, Carmen Reinhart and Nicholas Magud assess the most rigorous studies on capital controls and conclude "in sum, capital controls on inflows seem to make monetary policy more independent, alter the composition of capital flows and reduce real exchange rate pressures."
The US-Colombia FTA would essentially ban instruments like the URR in Colombia. Not only would such an instrument be frowned upon, but a US firm could sue the Colombian government for anticipated losses to US firms stemming from the use of the instrument.
Such measures in US FTAs are out of step with most trade treaties. Rachel Denae Thrasher and I found that at the WTO, most trade agreements signed by the EU and by developing country governments all have a special safeguard that allows for the use of URR and similar measures to prevent or mitigate financial crises.
Even the IMF permits the use of these measures. According to a recent IMF report, the IMF supported URR-like measures in Chile, Colombia, Slovenia, Thailand and the Philippines during the 1990s.
The US-Colombia agreement negotiated by the Bush administration is out of touch with mainstream economic research, the IMF and most trade treaties across the globe. As the Obama administration rethinks trade policy in general and this deal in particular, it should grant nations the policy space to deploy prudential measures that ensure financial stability.