In Praise of Capital Controls
The shifting winds of market-based monetary policy in the wake of the global financial crisis.
In December 2012, the International Monetary Fund (IMF) officially endorsed the use of capital controls, which can be used to restrict the flow of funds into and out of a country and its currency. This was an historic shift that has served to de-stigmatize the use of such restrictions as part of a tool kit available to stop a monetary crisis. If anything, the IMF was just catching up to reality; an increasing number of countries are finding that the restrictions do much less harm than good.
Capital controls have a long and controversial history. Malaysia used them to good effect — and against the IMF’s advice — to recover from the financial crisis that swept through East Asia in 1997. More recently, Argentina deployed them to stop outflows of dollars and other hard currency, yet the peso still lost value steadily while the economy stalled.
But Iceland was perhaps the best test case. In 2008, after the Lehman Brothers bankruptcy destabilized the global financial system, Iceland’s three largest banks came under insurmountable pressure. They had assets in excess of 1,000 percent of Iceland’s gross domestic product and were thus out of reach for any explicit backstop from the Icelandic government. The banking system collapsed in a heap, forcing the government to impose capital controls, which prevented the Icelandic currency from falling any further (critically important to the many Icelanders who had taken out mortgages in foreign currency).
The IMF launched an economic stabilization program for the country soon afterwards. The IMF’s mission chief for Iceland, Poul Thomsen, said the IMF was forced to accept that capital controls were necessary and helpful in dealing with Iceland’s economic crisis. But in December 2008, he told the IMF’s Survey magazine that it was a priority to get back to a situation where capital controls were not necessary:
“Capital controls have de facto been in place since the three banks collapsed in early October as only payments for priority imports and other current account transactions have been permitted since then. It is a priority under the IMF program to eliminate all restrictions on both the current and capital accounts so that Iceland can return to the freely convertible currency it had for many years. Indeed, all restrictions on the current account have now been lifted as a first important step towards normalization.”
Only now, some seven years later, are capital controls being removed in Iceland. And so Iceland’s transition from economic basket case to poster child for crisis-fighting success has made the use of capital controls less a necessary evil and more an important bulwark against hot money flows when a country finds its economy under pressure.
Since Iceland’s successful use of capital controls, they have also been used in Cyprus, when its banking system was restructured. Now many believe it is only a matter of time before Greece is forced to implement capital controls. Capital controls may, in fact, become a staple of future economic crisis fighting. But why?
We have to look back into the past to understand the future, because capital controls were an integral part contributing to the stability of the postwar Bretton Woods financial system that ended in 1971, when President Richard Nixon ended the dollar’s convertibility into gold. Up until then, the global financial system, cosseted by fixed exchange rates, capital controls, and stringent regulation, was a paragon of financial stability, with no major global financial crises to speak of. But in the 1970s, the industrialized world was shaken by inflation and economic under-performance. Market-based economic policies became seen as key to reigniting economic growth, and an elimination of capital controls was in line with this thinking.
But, today, in the wake of multiple destabilizing financial crises, market-based policies are no longer seen as the only route to economic success. Globalization of financial markets has reached a point where the pool of money that can leave a country at a moment’s notice — for example, during a crisis — has become so enormous that it is destabilizing.
Greece is a case in point. A Greek euro is no different than a German euro or a French euro; the European monetary system is all one big integrated financial system that works across national boundaries. So what’s to prevent a Greek corporation or citizen from withdrawing money from a Greek bank and putting it in a German or French one, weakening the liquidity of the Greek bank and strengthening the German or French one? This is precisely what has happened. And the Greek banks are now so weak that capital controls may soon be deemed necessary to prevent a collapse of the entire Greek banking system.
But, of course, capital controls are also being considered elsewhere, even when no crisis is present. In the wake of zero rates and quantitative easing across the developed economies, emerging markets have found their economies at the center of hot-money flows as investors sought higher yields. This money leaves just as quickly as it flows in, creating massive swings in currency valuation that have added unwanted volatility to the economies in emerging markets. Brazil, for example, has for a time put a tax on financial transactions by foreigners. Taiwan has restricted foreigners from being able to make time deposits.
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It’s likely that many countries — especially emerging economies — will soon decide that placing restrictions on capital flows is not just a necessary evil but an important way to safeguard the economy in normal times as well as during crisis. The IMF, having endorsed capital controls, will support restrictions on money flows, but only in exigent circumstances. Overall, markets may end up more efficient due to less volatility. We have reached a critical inflection point in our thinking about the efficacy of market-based policies in creating stability, growth, and economic wellbeing. After more than four decades of moving toward ever more liberalization and deregulation of capital flows, I expect we will see an increasing number of mainstream economists and countries endorse major restrictions on capital flows. And when their economies benefit, others will follow.