The Case for Capital Controls, Again

If you are in charge of monetary policy in an up-and-coming Asian economy (say India, China, or Korea), you have a problem.

The world’s financial markets have decided that Asia is rebounding more quickly than most other parts of the world, and capital is rushing to get into those countries before asset prices rise too much.

The monetary policy authorities know this and – given what we have all seen over the past few years (or is that two decades?) – they are rightly worried about new “bubbles” of various kinds that can destabilize their financial systems and undermine their economies.

What should these central banks do?  If you fear that your economy is growing too fast, and thus inflation is on the rise, responsible central bank mantra dictates that you should raise interest rates.  The same mantra was, in the era of Alan Greenspan, less clear on whether interest rates should be increased to forestall unsustainable financial bubbles.  With the puncturing of the Great American Bubble, including the fall of Greenspan as an icon, most central bankers are quietly quite willing to tighten monetary policy if they see real estate prices take off like a rocket.

But this is exactly where the problem lies.

If you raise interest rates in an economy open to capital flows, at the same time as the world’s money centers have low or almost zero interest rates, what happens?

Almost certainly, you will attract more capital from overseas.  This capital inflow will likely feed into your domestic credit boom and further the run-up in asset prices, housing construction, and other bubble-related phenomena.

Some of these consequences can be offset if you let your currency appreciate, i.e., rise in value as the capital comes in.  But most Asian countries, most particularly China, generally resist such appreciation, in order to protect their export industries; so this “feedback” or dampening mechanism is removed.  And the more you resist appreciation by accumulating foreign exchange reserves, the more investors believe they will make money on a future rise in the value of your currency.  So the more they want to pile into your markets.

What should Asian central bankers do and why should we care?

One view, increasingly part of the mainstream consensus, is that these central banks should tighten up on lending standards and otherwise lean on banks to lend less as capital comes in.  This is not a terrible idea – the US, of course, loosened lending standards during its real estate boom, and we know how that ends. 

But are such ad hoc adjustments around the edges of the regulatory system likely to be enough, given the scale of capital inflows?

Much more likely is what is now being whispered about in the corridors of financial power – begin to consider ways to tighten capital controls, i.e., limit the amount of capital that can come into a country, or force investors to commit to stay in the country for longer periods of time.

Such capital controls are unlikely to be announced explicitly, but watch for tightening the rules around inflows.  And expect discussion increasingly at the level of the G20 about the extent to which various kinds of capital controls can now be considered “best practice.” 

The US has historically pushed the view that all capital controls are bad and should be abolished – in fact, this was a major international policy initiative of the Clinton administration, led in this regard by Messrs. Summers and Geithner (who both came up through the international side of Treasury). 

But given our more recent record of mismanaging financial markets and dealing with instability, as well as new retrospectives on the string of international financial crises we have experienced since the 1980s, the Obama administration is not in a strong position to block further moves towards capital controls.

For better or worse, we are likely heading towards a world in which capital no longer flows so freely across borders.  Look for the start of this in Asia.

By Simon Johnson

This post is reproduced with permission from the New York Times Economix blog.  Anyone who would like to reproduce this post in its entirety should seek permission from the New York Times. Standard fair use rules apply for short quotations; please link back to the original post on Economix.

15 responses to “The Case for Capital Controls, Again

  1. There’s reason for hope, since China seems to have a better grasp of financial markets than we do. Hence, they use a tax on stock trades to help limit bubbles and restore confidence (when needed). It’s a combination Pigou/Tobin tax!!! (raises revenue, limits non-productive behavior, is a tool to control bubbles, stops excessive short term liquidity).

    Sometimes they raise it:
    http://www.nytimes.com/2007/05/30/business/worldbusiness/30cnd-yuan.html

    Sometimes they lower it:
    http://www.bloomberg.com/apps/news?pid=20601087&sid=anrG7MXuH4eI

    Such a tax might help in the US, as well, but preventing certain wall street firms from taking advantage of faster-than-normal information on trading activity using flash-execution trading programs… which apparently accounts for a large portion of increases in “trading profits” over the last 5 years at places like Goldman Sachs…

    http://www.nytimes.com/2009/07/24/business/24trading.html

    It will be interesting to see the outcome of this one. There is a natural alliance between certain factions of Wall Street who don’t use the high-frequency trading programs and using a Pigou/Tobin tax on trades (like China).

    But in the other corner of the ring we have Super Heavy Weight Champion of the World, Goldman “The Insider” Sachs.

  2. I posted this over on the Economix blog, but I think another good way to look at this is the way Padma Desai puts it:

    1. A capital account open to foreign inflows (no capital controls)
    2. A fixed exchange rate
    3. Independent monetary policy (ability to adjust interest rates at will to curb bubbles)

    Pick two of the three.

    It’s not just the United States under the Clinton Administration that pushed the combination of 1 and 3—let’s not forget the IMF (including during Professor Johnson’s tenure). It seems to work pretty well for very well established economies with low to moderate growth rates and stable industries. Not so much the victims of the East Asian financial crisis in 1997, for instance.

    China, notably, has been doing quite well with 2 and 3. The disappointment from US critics of Chinese currency policies is largely due to the fact that they are missing out on the investment opportunities here.

  3. I am not worried about capital flooding into china. I am worried about having to bail out Goldman again after it loses all the money it flings into china in order to capitalize on another asset bubble there. Lloyd, I simply cannot afford to pay another two hundred billion, but I hope this speculation works out better for you than the credit swaps did.

  4. Would capital controls abroad force the US to remain the global capital sink hole it has been for so long? This would appear to enforce the very global imbalances people seek to reduce.

  5. From the viewpoint of labor and the environment, this is probably a very good thing: if it’s harder for capital to move to areas of cheap labor and poor environmental regulation, labor gets paid a little more and environmental regulations have more bite. (Only CO2 crosses borders.)

  6. David Nowakowski

    Most economists think one can add capital controls, and that’s that, speculators will leave you alone or behave rationally and never panic. Just as the 2nd and 3rd of the “trinity”, the FX rate and local i-rates, need to be flexible and managed properly, capital controls are not just ON/OFF, but need to be calibrated and adjusted.

    What is the right way for authorities to manage inflows and outflows on the capital account, Simon? For how long should money be required to stay onshore before penalties are lifted? When should the Tobin Tax be raised? How much should they allow repatriation? To what extent ought the government allow locals to invest abroad?

    I totally agree that some limits on hot money (especially short-term external debt that is used by local banks to fund domestic investment) is a great idea. But the best way for advanced, large financial systems to be run is not the way Argentina or Venezuela or Russia or China do it — by dictat — but to develop deeper local markets, have an appropriate exchange rate (which BS has commented on recently) and coordinate fiscal and monetary policy properly. At least try orthodox tools before going down the unconventional route!

  7. Patrice Ayme

    Deeper local markets, as in the USA, as a prevention against Goldman Sachs?

  8. A separate but related phenomena is the recent Chinese propensity to enter into what are in effect bilateral currency support agreements, mostly with other Asian countries, but, also, I believe, Argentina. It’s also worth remembering that the ‘new’ voices at the G20 table, having been on the receiving end of the unpleasantness of a decade ago, have a distinctly different perspective from that of the old G7 countries, even if they refrain from braying anti-semitism, a la Malaysia.

    I do wonder what form those capital controls might take, since deterring inflows is rather a different business from arresting outflows. And the overseas Chinese are an opaque group, to put it mildly.

  9. These are all good points, particularly the one about local borrowing in foreign currencies (short term is bad, but even medium term can be dangerous).

    Also, as China has demonstrated, the existence of a tobin tax (which like all good Pigovian taxes actually raises revenue while discourage bad behavior instead of good behavior) can be used both to both decelerate and accelerate money in asset markets – meaning it will need to be controlled by an independent agency (and insulated from political forces).

  10. Krugman had a good post on this a decade ago:
    http://www.slate.com/id/35534/

    I think other comments here imply the same question, but I’ll make it explicit: how does a country impose capital controls and retain the credibility that (a) the controls will not be operated entirely for the benefit of select insiders; (b) the controls will not be turned into a ratchet, where money simply cannot get out?

    One of the lessons I would hope people take of the events of September is that even the US, with deep markets and a stated fidelity to the rule of law, will throw all of that over the side in a perceived crisis. The steps the Fed/Treasury took would have been considered absurd a year earlier.

    How does a nation with less of a reputation – in the case of three of the BRICs, not even a reputation for governmental stability – implement this?

  11. The tax on stock trades seems like a good idea for the more basic reason that it’s a very easy way to raise revenue. For years we survived on essentially a 12.5 cent tax per share, back when stocks were traded in eighths. People still invested, people still made money.

    Now that the tax does not accrue to the broker-dealer market, apparently it’s un-American.

  12. Krugman’s post is on stopping capital outflows in a “run on the bank” analogy; Simon is concerned about capital inflows. I confess to be missing a key piece of his argument. The result (through capital inflows) of the increase interest rate is said to be “further the run-up of asset prices” etc. This must mean either (a) the capital inflow has the effect of shifting the asset demand curve out, or (b) there is credit rationing in the initial state, which is reduced or eliminated by the capital inflows. Would like to understand which and the underlying mechanism.

  13. Clarification – if the point is just that capital inflow will defeat any attempt to control asset prices with increase rates, that’s straightforward enough. The wording “further the run-up” seems to go further and say it will actually make matters worse – if that’s what’s intended, my question stands.

  14. If bankers and investors are systematically too stupid to avoid too much speculation, banking itself must be done by government; or short-time speculation profits must be taxed heavily enough to make it much less appealing.

    Too much capital inflows? Tax them. Tax them heavily enough that speculation (short time profit) simply stops. Or tax short time profit, say, like 90%. That way governments will have plenty of cash to deal with potential problems speculators create. Also losing 90% potential profits simply means that it is probably not worth taking risk.

    Most of the problems come from everyone rushing to gain short-time profits. This is what must be stopped, it will only violently go worse over time. Tax short time investment / speculation profits. Very heavily.

    Yes, make the money stop once it invested for a while. Then you will see true risk assessments for longer periods.

  15. Martyn Strong

    Capital markets are unstable. In the past there was no way to make them stable. But today we have computer power that can be used to make them stable.

    By using the greater computer power of today we can have a much higher turn over of capital in the capital market. This higher turnover will make the market harder to game or control and the market will no longer have the unstable run ups or declines. Who can change or control the market when say 20% of the capital is trading each day?

    So now that we have the compute power to provide for all these transactions that will smooth out the market how do we force people to turn over at a rate of 20% a day? Easy, put a cap gains tax of 0% (zero) on all gains of 7 days or less and put a cap gains tax of 90% of all gains of more than 7 days.

    The likes of Yahoo, Micosoft and/or Sun Micro Systems will give us the systems that will provide automated software agents to support turning over one’s investments every 7 days (based on the specs you give the agent).

    A system like this will make the financial markets work as smoothly as the local fruit market.