Coordinated Capital Controls: A Further Elaboration

This guest post is by Arvind Subramanian, a senior fellow at the Peterson Institute for International Economics.  His recent proposal that countries consider coordinated capital controls has stimulated a great deal of discussion, and here he explains how discouraging capital flows relates to arguments about the attractiveness of a Tobin-type tax. 

Paul Krugman, in his Friday column for the New York Times, endorsed a tax on financial transactions, proposed recently by Adair Turner, Britain’s top financial regulator.  It is important to distinguish this Turner proposal from the original Tobin tax on international flows and these two taxes in turn from the kind of coordinated capital controls I proposed in this blog post two weeks ago.

Tobin’s original idea was to discourage speculation by taxing flows of international capital.  The Turner variant is to tax all financial transactions, domestic and international.  What they have in common is that both are seen as structural measures to be applied regardless of the state of the macroeconomic cycle.

In contrast, the capital controls that are now being proposed are more in the spirit of “macroprudential” measures, to be taken in response to surges in international capital flows (and not to steady and permanent flows) to emerging markets that have the potential of creating bubbles in asset prices, including exchange rates.  Such measures are therefore intended to be taken during the upswing of the cycle and not at all times.

The case for a number of emerging market countries coordinating such measures under the auspices of the G-20 is to avoid the stigma of being labeled market-unfriendly, a stigma that is a consequence of the strong—but misguided—belief system that all foreign capital in all quantities is always good.  This is important because the magnitude of the tax that emerging market countries may need to impose could be substantial in magnitude and not-so-short-term in duration. Effectively deterring inflows would require a tax that has to substantially narrow the return differentials that drives flows in the first place.  With near zero interest rates in the US, these differentials could be as high as 5-7 percent for a typical emerging market country and could persist because the US Fed is likely to keep rates low for some time.  Few countries would be willing, on their own, to risk imposing such “drastic” measures.

A second argument for coordination is that if only a few countries threw “sand in the wheels” (to use Tobin’s famous phrase) of international finance, the flows could simply be diverted to other emerging market destinations, aggravating the problem for them.

Clearly the magnitude and type of action should vary across countries depending on their macroeconomic situation and the alternative policy choices available to them: for example, if capital inflows are creating a housing bubble, then one country may be able simply to take prudential measures such as higher provisioning requirements for real estate lending but another may have to stop or moderate the flows in the first place.

But a third argument for coordination is that the magnitude of the tax that any one country imposes will also depend on actions taken by other emerging markets. For example, the more China persists with its exchange rate policy, the less willing other emerging market countries will be to allow their currencies to appreciate, and therefore the stronger the brakes that they may have to apply.  Coordination will also serve as an accountability mechanism for emerging market countries. To prevent indiscriminate controls, countries should be able to justify their actions to each other. For example, Korea may have less basis for applying taxes than say Brazil, whose currency has appreciated more significantly.  

Fourth, an important risk with taxing inflows is that it simply leads to the tax or restriction being evaded (through under or over-invoicing of trade) or to transactions shifting offshore.  Coordination, including the cooperation of industrial country jurisdictions to which these transactions could shift, could then become a way of minimizing this risk (it can never really be eliminated) of such circumvention of controls.  The possibility of evasion or circumvention of restrictions on inflows cannot in itself be decisive in rejecting restrictions. We do not abandon levying income or other taxes just because they can be evaded, we just design and implement them in a manner that maximizes their impact while minimizing the risks of evasion.   

Paul Krugman noted in his column that United States officials are dead set against the financial transactions tax. For the same reason, they are likely to oppose actions by emerging market countries to impose and coordinate controls on foreign flows. Another test for the G-20 looms. If it, and the old G-7 within it, can respond to emerging market concerns we can be hopeful. Otherwise, it will just be the G-7 (plus who?) all over again.

By Arvind Subramanian

8 thoughts on “Coordinated Capital Controls: A Further Elaboration

  1. Thank you Mr. Subramanian for two extremely interesting and informative posts on capital controls. The lesson I take from your two posts is that while liquidity can be a good thing, individual investors, and even entire countries, should be wary of where that liquidity comes from. Recently, Mike Konczal over at Rortybomb made a similar point about liquidity coming from TBTF institutions.

    Steve Randy Waldman over at Interfluidity also had an interesting discussion about the pros and cons of liquidity a little over a year ago.

    I’ve always been quite ambivalent about the benefits of liquidity. After all, some of the most intense periods of economic growth in the history of the United States came during eras when banks were much more conservative about providing liquidity. It’s nice to see an international perspective on this subject. Again, thank you.

  2. Coordinated capital controls: Sound in theory, inapplicable and worthless in practice. Let the race to the bottom begin.

  3. There has been much discussion on protecting innovation (but rather than more financial products) innovation to bring “good order” to the financial system is the way to go.

  4. I have proposed a financial transaction tax on my blog, years ago. There are many deep reasons for it. One of the reasons is to create a speed limit on financial transactions. The cause of that speed limit would be the same as the cause for having the speed of light in physics. Namely the necessity to distinguish between cause and effect.

    In other words, some of the reasons for having such a tax are much deeper than those usually found at the conceptual level familiar to economists. The financial transaction tax is necessary, otherwise the financial universe will keep on making no sense.

    Patrice Ayme

  5. Intriguing post and commentaries. Taxation would also help to better define, and account for certain socalled “innovative” products and transactions. The murky world or ‘innovative products”, opened the pandora’s box of potential abuses, deceptions and catastrophic crisis. Taxing these products and transactions would demand a clear, or at least much improved definition and quantification of these products and transactions. Of course the finance oligarchs bent on shielding thier PONZI scheme operations, products, and transactions will resist any attempt at taxation or more detailed accounting, transparancy, or disclosure, and since we all know too well, that the finance oligarchs own and control the government, – all these sound and wise idea’s will be smothered die a quick death. There is no hope for relying on any legal or tax system to curb the financial system that owns the lawmakers and operates under the cloak of lawlessness.

  6. A Tobin-type tax is actually a Pigou tax. We need to tax all the negative externalities of the finance industry. There are a number of externalities ranging from undesirable and sudden appreciation of a currency (capital controls) to systemic risks (too big to fail banks) to gambling with derivatives to moral hazard of CDS, etc. In general one can consider that banks are also “polluting” (while supplying money) and that is the case particularly with obvious “toxic assets”. There is much scope for financial transaction and windfall taxes and it’s time for the finance industry to contribute more and at least to the extent it and has polluted. Shift taxation to capitals instead of income, production or consumption makes the system more progressive and equitable. On the other hand if, as somebody claims, there is some added value (let alone social value) of certain activities (e.g. speculation and frequent trades) and transactions involving CDS, it’s fair to tax it along the same line of VAT on consumption.

  7. I agree with the bump tax that reduces the speed of the financial decision making especially when compared to capital requirements for banks based on perceived risks that are so much more dangerous because that acts more as a channel that pushes the flows in different directions.

    I have also for decades defended capital controls on inflows, never on outflows, following the Chilean model. And I still do since small bathtub-sized economies cannot afford to expose themselves to the tsunamis of global financial oceans without any protection.

    But, let´s face it, a tax that slows, only means that the funds will stay longer where they are, and that can also be wrong.

  8. This is a good discussion of the Brazilian case…

    Note the differentiation between FDI (productive, longer term) and financial investment (liquid, short term). Also, note the extent of the naysaying, and the line of argument which essentially goes: “markets will try to evade controls/taxes, so you shouldn’t even try”.

    This was the same line of argument used by those who claimed that China could not _possibly_ censor internet content effectively. Hmmm…'s_Republic_of_China

    Many people seem to argue states are powerless simply because they wish it were the case.

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