The standard economic view used to be that capital controls were a damaging relic from the past. Almost all economists opposed them as they believed they discouraged foreign investment, created barriers to trade and lead to an inefficient allocation of resources. The notion that the government could restrict how people used their money was found abhorrent by many. However, since the Financial Crisis, there has been a shift in opinions. Many economists support some capital controls to reduce instability in the economy, particularly in the financial sector. 250 economists from around the world signed a petition calling on the US government to reconsider its opposition to capital controls. Even major institutions like the IMF, the World Bank, the Federal Reserve and the European Union have admitted that there may be some cases in which capital controls are beneficial.
The main argument for capital controls is they help limit the level of financial volatility in the economy. By limiting the capital inflows and outflows to a country’s economy, capital controls make the economy more stable. By regulating the supply of capital, there is no sudden and overwhelming flood of capital followed by a drought. Capital controls in particular limit the level of speculative money that is invested and can be quickly withdrawn. Capital controls reduce the risk of contagion that is, of crisis’ spreading to other countries and the failure of one, pulling down other economies in an interdependent system. It is noted that the economies most subject to globalisation and financial liberalisation were worst affected by the financial crisis, whereas the countries with capital controls were protected from the storms of the financial crisis.
One thing that should be noted about capital controls is that we cannot easily look at the evidence for a guide. The very notion of capital controls has been a taboo for so long that few countries have any controls in place. Those that have, mostly introduced them during a crisis to prevent things from getting worse, which makes them an unrepresentative example. As capital controls usually take the form of regulation, we are dealing with rules that are never the same in any two countries, making international comparison almost impossible. The degree to which capital controls are enforced would play a huge role in their effectiveness, but this too is something that cannot be measured. As a result, there is little compelling evidence on capital controls, though as I mention, some economists have drawn some conclusions.
Increasing financial integration creates many new opportunities but it also increases vulnerability to outside factors. Capital controls can be seen as promoting a more slow and steady economic model that is more reliable and predictable if less profitable. Controls are necessary when the financial market is subject to bubbles, fads and panics. Even the IMF has admitted that “it is not implausible that herd behaviour and excessive optimism on the part of foreign lenders, coupled with myopic borrowers who underestimate foreign exchange and liquidity risks, can lead to foreign borrowing that is excessive from a financial fragility perspective.” For these reasons “capital controls may be a valuable addition to the toolkit for dealing with financial stability risks”. When even the IMF is criticial of free trade, you know something needs to change.
The chart above offers visual representation of the striking correlation found between financial liberalisation and financial crisis. According to Reinhart and Rogoff’s seminal book on financial crises, This Time Is Different, “Periods of high international capital mobility have repeatedly produced banking crises.” It is notable that this is a strong correlation even without the 2008 financial crisis while the heyday of capital controls between 1945 and the 1970s was a period of almost no banking crisis at all. While correlation is not causation, it has many economists question the advantages of increased capital mobility.
In their vast analysis of financial crisis Reinhart and Rogoff find that “One common feature of the run up to a financial crisis is a sustained surge in capital inflows.” There is now a growing realisation that capital inflows can make a country more vulnerable to over borrowing and bubbles which culminate in a financial crisis. By reducing the amount of capital entering a country, the economy can be prevented from overheating.
Some argue that capital controls (even those solely on capital leaving the economy) will discourage businesses from investing from the country in the first place. However, this may not necessarily be a bad thing. Excessive influxes of capital can lead to high inflation or even speculative asset bubbles. Too much capital (especially in a small country) can distort the economy. Rather than being properly invested, the money may just go into speculative assets, possibly creating a bubble. The type of capital most likely to be discouraged by capital controls is so-called “hot money”, which is a sudden influx of capital into short term speculative assets that can be withdrawn at a moments notice. The ease and speed with which it moves means it can be highly destabilising and to have less of it in the economy may not be a bad thing.
Capital inflows played a huge role in the 2008 financial crisis. The countries that are currently in severe financial difficulty (Ireland, Greece, Spain) all experienced large capital inflows that inflated their economies. In many cases (especially Ireland) this capital was invested in speculative asset bubbles. The creation of the Euro made capital mobility much greater across Euro zone countries and thus periphery countries in particular experienced a credit based boom. However, with this increased integration came the increased risk of contagion. Financial problems in America or Greece could (and has) cause severe problems at home. Financial investment that was so easy to enter the economy was equally easy to remove. The IMF found a positive correlation with debt liabilities and financial FDI and more damaging crisis. IMF also found evidence that pre-existing capital controls were associated with less severe output drops. It seems capital controls protected countries from the financial crisis.
The financial crisis is a clear example of herd behaviour and panic in action. The global money market is the most speculative and unstable market in the world. It is for these reasons that economists are reconsidering the introduction of capital controls. The divide over capital controls is also linked to how people view financial markets. Those who believe that financial markets are the best way of ensuring an efficient allocation of resources oppose capital controls as a barrier to trade. Those who view the financial markets as governed by irrational animal spirits, prone to excessive exuberance and lethargic depression view capital controls as the best way to protect the economy from the whims of the market.
Capital controls need not solely take the form of regulations. There are proposals instead for them to take the form of a Tobin Tax or a tax on financial transactions. The idea is to reduce the number of transactions (and therefore volatility) while simultaneously raising revenue. In contrast to the trend towards making markets ever faster and ever more efficient, a Tobin tax would deliberatively aim to “throw sand in the wheels” of the financial markets. By reducing the speed of markets, it would prevent herd panic from spreading before investors had time to consider the situation. The tax would be a negligible amount, a fraction of 1%, so small that it would not affect genuine investment, but only speculators.
Neither form of capital control will be perfect and there will be attempts to circumvent both of them. However, just because a task is difficult doesn’t mean it shouldn’t be attempted. Properly funded government regulation would be able to keep a vigilant eye on capital movements and so long as the Tobin Tax was imposed on major financial centres, then transfers to and from tax havens could still be taxed. There will undoubtedly be costs associated with theses controls but are they worth it if they help prevent future financial crises?
Capital controls used to be a relic of another era, an idea almost all economists had ditched. However after the turmoil of the Asian Financial Crisis of 1997 and the Global Financial Crisis of 2008, many economists have changed their minds. Even titans of neo-liberalism have acknowledged that capital controls are no longer forbidden fruit but have a role to play in combating financial crises. The tide is turning and many economist recognise the advantages of capital controls in reducing financial volatility, instability and chaos.