Guilt by Association

Author:Atish Rex Ghosh and Mahvash Saeed Qureshi

Prejudices sway the debate on using capital controls to tame the risks of fickle inflows


Guilt by Association Finance & Development, June 2016, Vol. 53, No. 2

Atish Rex Ghosh and Mahvash Saeed Qureshi

Prejudices sway the debate on using capital controls to tame the risks of fickle inflows

“I have only eight seconds left to talk about capital controls. But that’s OK. I don’t need more time than that to tell you: they don’t work, I wouldn’t use them, I wouldn’t recommend

them . . . ”

—Governor Agustín Carstens, Bank of Mexico

(Remarks made at Rethinking Macro Policy III

Conference, Washington D.C., April 15, 2015)

Capital controls have a bad name. While their usefulness as a policy tool to manage the risks associated with capital inflows is increasingly acknowledged (IMF, 2012), as the quote above amply demonstrates, they are still viewed with considerable suspicion and misgiving.­

An oft-heard argument against capital controls is that they can be evaded and circumvented. Yet no one makes that case when it comes to other policies—for example, that taxes should be abolished because they are subject to evasion. Likewise, even though macroprudential measures have been much in vogue since the global financial crisis, evidence of their effectiveness is no more compelling than it is for capital controls. Moreover, even when countries do impose controls on capital inflows, it is telling that they usually refer to them with euphemisms such as “prudential measures.”

Resentment toward outflow controls is understandable: residents may want to invest or safeguard their money abroad, and nonresidents want to be able to repatriate their funds on liquidation of their investments. More puzzling is the almost visceral opposition to emerging market economies’ use of controls to manage capital inflows—especially since such measures were integral to advanced economies’ management of speculative (“hot money”) flows when they pursued their own financial liberalization in the latter half of the 20th century.­

So whence this bad name for inflow controls?

The story beginsCapital controls have a long history, with evidence of their use stretching back to ancient times. Even during the late 19th century—the so-called golden era of financial globalization—the leading capital exporters of the day (Britain, France, and Germany) at times restricted foreign lending, albeit mainly for political rather than for economic reasons. Boom-bust cycles in cross-border capital flows were already evident, but there were few restrictions on capital imports—and mostly for strategic purposes or out of concern about “foreign domination.” Much of the capital was long term, financing productive investments in infrastructure and utilities in the emerging market economies of the day.­

Capital flows, especially from Europe, came to an abrupt halt during World War I, and the cessation of hostilities revealed deep differences among nations. At one extreme was the Soviet Union, which under an authoritarian and state socialist model had imposed tight controls on capital movement by 1919. At the other extreme were the private and central bankers of the leading economies of the day, seeking to reestablish the previous liberal—and for the great banking houses, highly profitable—international monetary order.­

Wartime dislocation and deficit financing of reparations and reconstruction costs delayed the removal of restrictions in Europe, but starting with the 1924 Dawes Plan—under which American banks made loans to Germany to help that country pay for reparations—U.S. banks entered a period of massive international lending ($1 billion a year during 1924–29). Half of that was destined for Europe, partly intermediated by British banks, and it spurred a huge economic and financial boom.­

But this resurrection of the liberal international order did not last long. When a speculative frenzy in the New York stock market drew capital to the United States, Europe suffered a sudden stop. In July 1931, unable to roll over maturing obligations, Germany declared a moratorium on foreign payments and imposed exchange restrictions, which triggered a run on the pound that forced Britain...

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