Capital Controls Again

By Simon Johnson

Adair Turner, head of the UK’s Financial Supervisory Authority, has developed a flair for pushing the official conversation on banking forward.

He spoke in favor of a tax on financial services, long before that was fashionable.  This idea has been picked by both the UK and US governments – and in some amended form is likely to emerge from the G20 intergovernmental summit process later this year.

Turner also pointed out that much of financial innovation is not actually socially useful – and may, in some instances, be profoundly dangerous.  For a while, it seemed that his voice on this point might be lost in the wilderness.  But then President Obama launched the Volcker Rules, which essentially attempt to rein in certain forms of risk-taking (and arguably innovation) by very big banks.

Now Adair Turner is at it again, this time in the 14th Chintaman Deshmukh Memorial Lecture, delivered at the Reserve Bank of India in Mumbai earlier this week.

Turner lays out a more integrated – and skeptical – view of modern finance than we have heard from him before.  He also delves into new issues, of obvious interest to his hosts and – if we are thinking straight – to the rest of us: What do our recent financial crises imply for emerging markets?

He points out that the so-called Asian financial crisis of 1997-98 and the more global crisis of 2008-09 had much in common.

“… both were rooted in, or at least followed after, sustained increases in the relative importance of financial activity relative to real non-financial economic activity, an increasing “financialisation” of the economy.”

The big point here is that the standard thinking about finance is wrong.  More financial development (e.g., an increase in the size of bank deposits or credit relative to GDP) is not necessarily a good thing.  To be sure, “financial repression” in the traditional poorer country fashion – with interest rates held low, often below inflation – was never appealing as it discourages savings, and should not now be a goal.

But allowing finance to become as big as it wants, from usual market processes, is asking for trouble.  The corollary is that “financial liberalization” – just get out of the way, as Alan Greenspan used to argue, and let markets do their thing – can become very dangerous.

This is true for the United States – at one level the last 30 years have been a series of misguided and excessive financial liberalizations.  But it is also true for other countries, presumably at all income levels.

Much of what Turner is arguing on these issues is not new – as he acknowledges, the general points have been made eloquently before, in various fashion, by scholars such as Jagdish Bhagwati (in broad terms) and Arvind Subramanian (in specific form, with numerous co-authors).

But Turner has a knack for bringing officials with him.  He is ahead of the intellectual curve, but not so far divorced as to seem out of touch or irrelevant.  And where exactly is he going, on this occasion?

Turner’s language is nuanced but the thrust of his argument is clear.  We should reevaluate the usual prescription that developing countries (and anyone else) should necessarily open themselves to freer capital flows.

“… the case that short term capital liberalization is beneficial is … based more on ideology and argument by axiom than on any empirical evidence.”

“For what we saw in respect to capital flow liberalization in the 1990s (as in respect to domestic financial liberalization in developed countries) was the assertion of a self-confidence ideology which also happened to be in the direct commercial interest of major financial services firms with powerful political influence in the major and developed economies and in particular in the US.”

Turner stops short of taking the complete Bhagwati-Subramanian position.  Even the most courageous financial regulator on the planet is apparently not yet ready to endorse restrictions on capital flows between countries – presumably, the lobbying pressure on this point is still too intense.

But this is definitely the direction in which Turner is moving – and has already moved – the debate.  Restricting capital flows will imply changes in many other aspects of how we organize our economy, including our fiscal deficit (as a great deal of the short-term capital flows around the world is into and out of US government securities) and what we rely on to sustain growth (as the US has been a big net importer of foreign capital in recent decades). 

And it will have significant implications for our financial system which, in recent years, has made a great deal of easy money by moving money around the world – and, as Adair Turner continues to emphasize, has thus created serious global risks.

An edited version of this post appeared on the NYT’s Economix this morning; it is used here with permission.  If you would like to reproduce in full, please contact the New York Times.

29 thoughts on “Capital Controls Again

  1. First, isn’t this the guy who said no to a Barclay’s/Lehman combination that likely would have prevented the most acute period of crisis? Perhaps that was ideologically the right call, but it certainly was out of touch with the short to medium term pragmatic implications.

    As for the broader ideal of restricting cross-border capital flows, recognizing that I say this mostly based on instinct and personal philosophy, that sounds like a great recipe for slower economic growth around the world (and in particular in the US).

  2. Mr. Johnson wrote:

    “Restricting capital flows will imply changes in many other aspects of how we organize our economy, including our fiscal deficit (as a great deal of the short-term capital flows around the world is into and out of US government securities) and what we rely on to sustain growth (as the US has been a big net importer of foreign capital in recent decades). ”

    Capital Control

    – Wikipedia – excerpts

    “In economics, capital control is the monetary policy device that a country’s government (i.e., sovereign power) uses to regulate the flows into and out of a country’s capital account, i.e., the flows of investment-oriented money into and out of a country or currency.

    The decade since the Asian Currency Crisis in 1997-1998 has rekindled debate over the wisdom of developing markets having capital controls.

    As it became clear that countries doing this, including Malaysia, Thailand and Mexico, essentially ceded control of their economies to external forces, namely international capital movements, hot money and capital flight; and countries that did not, like the People’s Republic of China and India, retained control and were not nearly as vulnerable to the volatility of international capital movement, some argued that capital controls were advisable for smaller economies to use, and to transition away from them only over long, general evolutionary timelines.[citation needed] Malaysia is an example of a country that switched regimes, from open in the late 1990s, to closed. Economists supporting capital controls in certain cases were not only from the left, but also pro-globalization economists like Jagdish Bhagwati and news publications like The Economist. ”

  3. Serious question: do larval-stage economists ever learn control theory? Or anything about theory of computation? It seems to me that the crisis might well have been avoided if economic regulators in the developed countries had a better understanding of how systems work. (Is there anybody to whom it is not blindingly obvious that in markets like currencies and oil, where the trading volume vastly exceeds the volume of the real underlying activity, the expected outcome is to overshoot all the peaks and all the troughs? These sorts of positive-feedback systems cannot help but function as sentiment amplifiers, and it’s a wonder that they don’t oscillate faster than they already do; they are woefully underdamped. Some carefully-applied dampening would be a welcome relief, particularly if the capital tied up in this sort of nonproductive trading was reallocated to some more productive use.)

  4. Garrett: The answer is definitely no. I spent a long time trying to find one that even used differential equations and wasn’t successful until I ran into Steve Keen. Keen had a great talk talking about his model inspired by Hyman Minsky’s debt based disequilibrium theory that you can find by poking around on his page, and on the slide showing the systems of equations he just said something to the effect of, “These are differential equations, I put them up primarily so the economists will run screaming out of the room.”

    I’m not sure who said it, but there are systems oriented economic textbooks written by control engineers explaining why we have booms and busts and one of them said that if he were asked to design the worst system possible he wouldn’t be able to beat what we have. As I’m watching the carry trade start to unwind right now (which Roubini said is the worst in history) I’m just thinking about all the positive feedback loops that we’re about to be blindsided by…quite frightening.

  5. Mr Wollman,
    Is your question rhetorical and if so what is the point? I’m sure you know massive swings are _great_ if you reap the full upside of a swing in your trade’s direction but have a put option (resume put for individuals, bailout for firms) if it goes against you. If work on Wall St, you understand and benefit from this dynamic. So then now from “larval-stage” economists – those who are taught above all others about incentives and how people respond to them – what would you expect? A doomed attempt at a disruptive paper on oscillations that gets into a second-rate journal because all your reviewers have their eyes on the prize, or join the gravy train?

    Before you answer: remember, you have to put yourself in the shoes of someone who choose to be an economist rather than a doctor or a peace-core worker or a common thug or …? In my experience, young economists are often super-smart and have the basics of control theory and many other formal disciplines down cold but, in this case, how could it ever even occur to them to apply it? They won’t explicitly withhold their ideas if they have them, but well before that pint the incentive-responding part of their brain is saying “don’t think too hard about this, all downside and no upside for you”.

    I do not mean to impugn the explicit ethics of economists but I doubt anyone would serious dispute that the profession selects somewhat againt those who can see, or even could make conxeptual sense of, any wider moral picture.

  6. A thousand thanks for an informative post.

    “…much of financial innovation is not actually socially useful – and may, in some instances, be profoundly dangerous.” Herein lies the core evil. The fact that the “…“financialisation” of the economy” now accounts for 45% of our GDP is terrifying. How do we unwind these crimes and abuses without tumbling the economy into real horrorshow trauma. Well, I thought government, and that thing we call the fed were responsible for sound economic policy. So instead of funnelling $14Trillion of the peoples treasure into the offshore accounts of the predatorclass “den of vipers and thieves” that caused, cloaked, and are now profiting wantonly from the worst economic crisis since the depression, – the socalled government, and the socalled Fed ‘should’ have redirected some larger portion of those funds back into the nations infrastructure, and the people directly. We allowed our government to fork over 14 Trillion taxpayer dollars to the predatorclass swindlers and thieves that created this nightmare.

    No need to recall that these same vipers and thieves came begging the government for massive immediate bailouts, or else, when the PONZI scheme’s began to unravel in August of 2008, – but simple logic, if not morality would expect that these vipers and thieves left unscathed in their palaces, and having access to even more imponderable wealth would exhibit some contrition, some humility. But no. Not even that. All we witness and evidently tolerate is hubris, wanton greed, deception, fraud, taxevasion, bribery, abuse, and criminal conduct by the very predatorclass oligarchs and criminal enterprizes that conjured, cloaked, and are now profiting wantonly from the most severe economic crisis since the “Great Depression”!

    If there are laws, – then heads must role, come what may. It couldn’t be much worse for many Americans. Yeah the superrich are going to get pinched, but our daily lives would not be any worse if in fact the global financial system did collapse. It must collapse or be hung by the neck until dead, for there to be any hope of a new and more equitable global financial system. Let it fall. Let it fall. Let it fall!!!

  7. Can I say “DUH”???

    It is somewhat amazing to me how many people emeshed in the financial world wake up so slowly (if ever) to the obvious difference between “phantom wealth” and “real wealth.”


    *”Phantom wealth” is a term coined by David Korten:

  8. Lord Turner is and has been the UK Government’s favourite “fixer” for a number of years as well as formerly the head of the UK Confederation of British Industry. As an ex- McKinsey consultant, as you would expect he is fluent and intelligent but I would argue far too close to the Governement. he is also an ex-banker! Now as Head of the FSA he has had to address the intellectual deficiencies of that beknighted institution. The FSA failed spectacularly as part of the now derided tripartite system of regulation. He is also Chair of Clmate change committee and has pondered, also for the Government on Pension reform- he has become a sort of Lord High Everything Else, a la Gilbert & Sullivan. Whilst his ideas have atrracted great attention, like the Tobin tax, that seems to be a recipe for passing on the costs to the general public- which is what the banks will do. It is also an easier fix for the G20 passing the issue on to everyone rather than addressing core issues affecting the banks and their behaviour, because it is too politically difficult. These appointees have a habit of articulating ideas, then moving on to the next challenge WITHOUT having fixed the problems. Pensions- still no sensible scheme is evident in the UK, Climate – well we know what a policy muddle that is, let alone getting into the science. Much socailly uselesss activity is integral to societies everywhere so this is hardly an insight- what is the policy prescription then? Constraining capital flows looks another issue on which opinion not action is the outcome. This is not to say that airing the issue is irrelevant – simply that the political great and good and their advisers fail to carry through their intentions. This makes their value at best marginal; at worst it leaves a problem for someone else to clear up.

  9. Nice link btraven. The finance oligarchs create nothing but their own compensation. At the end of the day they leave nothing behind but paper, and digits. America and the entire world must expose and then begin the arduous process of unwinding or unraveling of “phantom wealth”. The predatorclass must be put back in the keep, and a new more equitable and lawful global financial system must be erected out of the purtid detritus of the current global financial system.

    The mastersoftheuniverse, are indeed masters – but in the tyrannical sense. Their wisdom and expertise on the contrary is quite obviously suspect, and their power is derived singularly and exclusively from criminal conduct.

    Why do we allow this evil to exist? Why do we tolerate blatant deception, abuse, and criminal conduct in our finance oligarchs?

    There will be a reckoning and balancing, or there will be blood.

  10. In the sense that capital flows have a significant speculative component, capital controls in the form of, for example, requiring that money that comes in stays in for a certain period of time, such as many mutual funds in the US require, make a lot of sense.

  11. An interesting case study in this respect might be South Africa, a country at the cross roads between developed and developing countries, which survived the GFC relatively well because of exchange controls.

    It has a highly sophisticated financial system, but with developing country capital problems.

    For South African’s with some wealth the excon controls have always been a major bugbear, and it really could be argued they have no place in a democracy.

    The old apartheid white government used them to stop capital flight, and while the new government has eased them over the past 16 years, they still have a tight rein which has prevented massive capital flights at least 3 times in this period.

    The old two-tier “financial rand” system, devised after the 1985 debt default, which seperated trade flows from investment, or in that case disinvestment flows, is also something worth considering.A lot fairer, but quite complicated on a global basis I would have thought.

    It was also a good way for banksters ( I was one of them!) to rip off clients because of illiquidity, so on that basis alone we might want to avoid it.

  12. IMF, reversing course, urges capital controls

    FEBRUARY 19, 2010 – Wall Street Journal – excerpts

    WASHINGTON— “International Monetary Fund economists, reversing the fund’s past opposition to capital controls, urged developing nations to consider using taxes and regulation to moderate vast inflows of capital so they don’t produce asset bubbles and other financial calamities. It said emerging markets with controls in place had fared better than others in the global downturn.”

    The recommendation is the IMF’s firmest embrace of capital controls and a reversal of advice it gave developing nations just three years ago. The IMF has long championed the free flow of capital, as a corollary to the free flow of trade, to help developing countries prosper. But the global financial crisis has prompted the fund to rethink long-held beliefs. It recently suggested the world might be better off with a higher level of inflation than central bankers now are targeting.

    “We have tried to look at the evidence and tried to learn something from the current crisis,” said Jonathan Ostry, the IMF’s deputy director of research, who wrote “Capital Inflows: The Role of Controls” with five other IMF economists.

    Money is flooding into emerging markets, producing fears that asset bubbles are forming in China, South Korea, Taiwan, Singapore and elsewhere, particularly in real-estate markets. This year, about $722 billion in private capital is expected to flow to developing nations, a 66% increase over 2009 but far below the $1.28 trillion that flowed to emerging markets in 2007 before the financial crisis, according to the Institute of International Finance, a banking trade association.”

  13. As someone noted below, some of the market participants make boatloads of money due to the volatility. If you put a bunch of bankers in a boat and gave them money based on how hard they rocked it, how long do you think it would be before they capsize and call for the the Coast Guard to save them?

    The more interesting question is how do you damp the system. Just slowing down the response(trading breaks) or limiting the gain(leverage) does not guarantee that the system will remain stable. Regulating entities(SEC, FED) tend to lose their wherewithal to be counter cyclical because doing so limits booms as well as busts (If I was a bureaucrat, what is my incentive to make the good times to end?).

    So really we are back to limiting the damage once a bubble event occurs. How do we let the boat rockers drown (so next time they are much more interested in keeping the boat nice and level) while making sure that the rest of the financial system does not get caught in the undertow?

  14. Given that all the job creation of the past 10 years in the U.S. has been wiped out thanks to the idiocy of the financial oligarchs (and Harvard MBAs in general with their comparative advantage theories dictating that we export the jobs that have been the bedrock of the middle classes for centuries) what are the odds that Governemnts could reposess their gains for the same period and invest that money into developing a new real economy based on things that nations and their people will need moving forward. You know, trivial stuff, like repaired roads, bridges, water treatment plants, sewers, high speed rail, off planet resource gathering, cleaner energy, fresh water… haven’t read much about space elevators lately.. now there’s a project that would require a few hands…

    In a culture supposedely ruled by Law those who willingly act against the interests of society must pay retribution, be jailed, or both. How much more abuse must the average citizen be subjected to before blind self-interest be recognized for what it is.. a capital sin. For those who aren’t religious let me translate. It’s wrong.

  15. I do believe wider access in general to credit and capital does have a multiplier effect on any economy. We cannot lose sight of that, but we can of course try and make sure that it is THE driving force behind sugar high growth.

  16. Recognizing Wikipedia as the definitive source that it is, is anything different for a country whose currency is the reserve currency for the world?

  17. >>>Yeah the superrich are going to get pinched, but our daily lives would not be any worse if in fact the global financial system did collapse.<<<

    What do you mean by "our daily lives would not be any worse…", Pretty-Rich Man?! My "daily life" is quite precarious, but otherwise in no ways bad. It is bound to get one heck of a lot worse if the economic system is allowed to completely collapse.

    Or are you saying that allowing the global financial system to collapse would not cause the economy to collapse?

  18. Mr. Simon Johnson, before taking your position at the Fed, some questions:

    Do you agree with the criticism by Adair Turner of the IMF Global Financial Stability Review of April 2006? If so, do you agree that the IMF has been consistantly a leading enabler of the bogus financial liberalization demands of our banking oligarchy? Do you acknowledge the validity of the Keynes/Minsky instability hypothesis, and demand the institution of controls on capital flows and limitations on derivatives trading as a necessary break on the creation of endless bubbles? Yes or No, please. And if yes, why do you suggest Greece now bend over to the IMF?

  19. If you were reply to me, I was offering a position at the fed to Mr. Wollman, not Simon.

    But given your questions, it seems the Simon is probably appropriately ideological for you. Personally, I prefer the pragmatist.

  20. When the financial sector receives consistently 20%+ of corporate profits in the US (up to 40%; further the 20%+/up to 40% is net of pay levels for that sector’s employees which are at post-war historic highs relative to the rest of the economy), and when that sector had previously received only 10% of corporate profits for an entire generation prior, and when this mere 10% occurred during a period of both greater economic growth and a higher savings rate for requisite capital allocation, then common sense dictates that the growth, profitability, and pay levels of that sector represents a wealth transfer to that sector, not wealth creation for the economy as a whole. Bail-outs then add stinging insult to an ongoing, secular, destructive injury. The events leading to bail-out considerations should have led to a complete revamping of that sector, not to yet more wealth transfer to it. But the opportunity for financial reform was lost in Sep./Oct. 2008, never to return, since TBTF is no longer implicit, but all-too-explicit and irrevocable policy.

  21. Rereading Mr. Wollman, he seems to agree with Keyenes and Minsky, so I agree he would be a marked improvement. As for Simon, his IMF and Peterson connections seem inappropriately ideological. My idea of a pragmatist is someone who bothers to watch how things work before belching out an elaborate and elegant theory, like the Washington Consensus.

  22. “Even the most courageous financial regulator on the planet is apparently not yet ready to endorse restrictions on capital flows between countries – presumably, the lobbying pressure on this point is still too intense.”
    As the post above noted, the IMF has just (timidly) endorsed restrictions on capital flows. Capital Inflows: the Role of Controls

    Click to access spn1004.pdf

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