According to a recent report in the Wall Street Journal: “International Monetary Fund economists, revising the fund’s past opposition to capital controls, urged developing nations to consider using taxes and regulation to moderate vast inflows of capital so that they don’t produce asset bubbles and other financial calamities.”

The distinguished economist, Jagdish Bhagwati, one of the leading scholars on economic development and trade, applauded the IMF and said “Better late than never”.

Perhaps, ond day the bureaucrats in the Department of Finance in Ottawa also will see the light of day and abandon the standard economist reflex response to suggestions for the imposition of a global Tobin tax.

Professor Bhagwati is right; but we must ask why it took so long for the IMF.

A number of events during the past 25 years alone should have made it quite clear that financial markets are prone to instability and excessive volatility in the absence of an external regulator. On October 19, 1987, stock markets worldwide imploded. The free-fall and possible collapse of the global financial system were halted only when the U.S. Federal Reserve in conjunction with several other key central banks stepped in on October 20 to prop up equity markets and the global financial system. In the absence of these actions, the damage would have been enormous.

Circuit breakers were introduced to prevent future market meltdowns. These circuit breakers are intended to give market participants time to re-consider their positions and prevent a stampeding herd from gaining so much momentum that nothing can stand in their way as they rush to and over a cliff, dragging the global economy with them.

The Southeast Asian crisis in 1997 raised fears of a worldwide meltdown due to financial contagion. Currencies of a number of Southeast Asian countries depreciated sharply, as did most asset prices in these countries. Economic recession spread throughout the region. The crisis moderated only after the IMF stepped in with a $40 billion program to stabilize the currencies of Thailand, South Korea and Indonesia, and the U.S. Fed stepped in to lower rates in the United States.

China, India, Singapore and Vietnam were not as hard hit because all of them had capital controls in place, and so they were able to protect themselves against the rapid inflows and outflows of “hot money” – investors with very short-term horizons and a proclivity to gamble.

In September 1998 the Federal Reserve stepped in to orchestrate an orderly sell off of the derivatives portfolio of Long Term Capital Management (LTMC), fearing that there would be a chain reaction – a contagion effect – if LTMC was left on its own to liquidate its portfolio.This would have lead to dramatic declines in asset prices, which might have pushed other financial institutions to liquidate their portfolios, exacerbating the price declines and the problem.

The most recent financial crisis is just the latest example of how volatile and potentially unstable are financial markets. Fear, panic and the herd mentality drove asset prices well below what their levels should have been, and brought Bear Stearns, Lehman and Merrill Lynch to their knees. Morgan Stanley, Goldman Sachs and maybe even Citigroup were only days away from being toppled as well, if it had not been for the massive intervention orchestrated yet again by the Federal Reserve (are we beginning to see a common theme yet?). An external and forceful regulator is imperative to insure that financial markets do not run amok.

Despite these and other examples, the IMF was very slow in recognizing the need for throwing sands in the wheels of weakly regulated financial markets. Why?

The answer lies in the myth that we economists continue to teach our students. Competitive markets are assumed to be stable. They adjust smoothly and possibly quite rapidly to a new equilibrium whenever there is a shock to the market, or so we assume. The adjustment process is assumed to be orderly, timely and of proper magnitude. The math behind these models is elegant. The logic is seriously flawed.

In the absence of some regulator (the fictitious auctioneer in the theory of competitive markets) who controls the adjustment process, instability and volatility are the order of the day. When many market participants are equally well informed, none among them having any advantage is responding to new information, and all are prone to a herd mentality, there can be no smooth and orderly adjustment process. Only governments can limit the volatility, and throwing sand in the wheels is a good starting point.

The opinions expressed in this blog are personal and do not reflect the views of either Global Brief or the Glendon School of Public and International Affairs.