When the International Monetary Fund recently suggested that capital controls might quell turbulence in emerging markets, the fund only created more nervousness on a global scale. That did not help countries like Brazil, now threatened by the spread of the international financial crisis. Behind misguided proposals to control capital lies the idea that governments must sometimes take desperate measures to correct the “irrational” behavior of investors.

Yet policymakers do have the ability to influence investors without introducing restrictions on capital. Investors today are behaving as they do precisely because of policymakers’ decisions. Indeed, all national financial crises of recent years have been due to some combination of the following bad policies: loose fiscal or monetary policy, government-directed credit, no clear separation between government and the private sector, government-pegged exchange rates, lack of transparency in government institutions, and bailout guarantees by national governments and the IMF.

In trying to control investors’ reactions to policy-induced instability, countries that impose capital restrictions treat the symptoms rather than the disease. As an example, Johns Hopkins University economist Steve Hanke notes that “hot money flows are principally associated with pegged exchange rates.” Capital controls, contrary to notions currently popular, only make matters worse.

Chile is often cited as a country that has enjoyed stable growth because of capital controls. It is argued that if the Asian countries had imposed such controls like those Chile has had since 1991, they would have been able to avoid or minimize the current turmoil. But all the evidence points the other way.

[A]ll national financial crises of recent years have been due to some combination of the following bad policies: loose fiscal or monetary policy, government-directed credit, no clear separation between government and the private sector, government-pegged exchange rates, lack of transparency in government institutions, and bailout guarantees by national governments and the IMF.

Chilean economist Sebastian Edwards suggests that those who use his country as a positive example ignore history. There is an interesting parallel between today’s Asia and Chile of the early 1980s, when the country was among the most severely affected by the Third World debt crisis. Unlike the rest of Latin America, Chile owed mostly private-sector debt. Similarly, Asia’s debt crisis is mostly in the private sector as a result of large, government-insured loans to industrial conglomerates.

There is one big difference: Chile in the early 1980s had capital controls that were virtually identical to the ones it has had in place recently. Capital controls, it turns out, did not help the country avoid crisis. No wonder Chile has begun reducing those restrictions this year.

Since the 1980s debt crisis, Chile has liberalized its market further, deregulating and privatizing most of its economy. It has become clear that the Chilean economy has succeeded despite capital controls, not because of them. For further evidence Edwards points to Argentina, a country that abolished all capital controls in the early 1990s. Argentina has enjoyed both currency stability and the lowest interest rates in the region while Chile’s currency has come under pressure since the outbreak of the Asian financial crisis, and the volatility of Chilean interest rates has been five times greater than that of Argentina’s.

Restricting capital may not guarantee economic stability, and it is a very expensive way to develop. Over the past four decades, Hong Kong has become prosperous with an open economy, though it has sometimes experienced large economic fluctuations. India, by contrast, has until recently shielded itself from foreign capital and impoverished its people as a result. Chile has suffered visibly from policies that restrict the use of outside funds. Local businessmen have been complaining that the scarcity of foreign capital has forced up domestic interest rates to inordinately high levels. The policy has thus discriminated in favor of multinational corporations that have access to credit on the international market where rates are much lower.

Countries that restrain capital often do so because there is something wrong with their economic fundamentals. If they impose controls on the assumption that they will then have breathing space in which to reform, they will more likely use those restrictions to delay or stop necessary policy changes. It is far more likely that countries like Brazil will implement serious reform measures if the market is allowed to provide signals to policymakers through the free flow of funds.

Sadly, the idea of restraining those flows has gained respectability with the endorsement of academics and international organizations, spreading investor uncertainty around the globe. Irrational government controls, such as those on capital, continue to be the real source of contagion, making literally billions of people poorer.