I am in the final stages of completing the manuscript for my next book (this one with co-author, Italian journalist Thomas Fazi) which traces the way the Left fell prey to what we call the globalisation myth and started to believe that the state had withered and was powerless in the face of the transnational movements of goods and services and capital flows. Accordingly, social democratic politicians frequently opine that national economic policy must be acceptable to the global financial markets and compromise the well-being of their citizens as a result. In Part 3 of the book, which we are now working on, we aim to present a ‘Progressive Manifesto’ to guide policy design and policy choices for progressive governments. We also hope that the ‘Manifesto’ will empower community groups by demonstrating that the TINA mantra, where these alleged goals of the amorphous global financial markets are prioritised over real goals like full employment, renewable energy and revitalised manufacturing sectors is bereft and a range of policy options, now taboo in this neo-liberal world, are available. Today, I discuss capital controls.
As a hint of where we will be going in Part 3, the following chapters will emerge:
1. Exposition of Modern Monetary Theory (MMT) – of course!
2. The use of regulation versus the price system to engender resource allocation changes – for example, Carbon Taxes (price system) against bans on polluting activities (closure of coal mining etc).
3. Employment guarantees versus income guarantees.
4. The entrepreurial state – the role of government in the innovation process. The concept of brainbelts replacing rust belts and the revitalisation of manufacturing (away from cheap towards smart).
5. Capital and import controls – trade protection.
6. Free trade myths and the gains from fair trade.
7. Financial market regulation and bank reform – reducing the scope for unproductive waste.
8. Dealing with climate change and other environmental problems – changing the growth paradigm into green growth.
9. Wage and productivity policies – redressing the growing gap between real wages growth and productivity growth and the increasing reliance on private credit growth for growth.
10. Reversing income and wealth inequality.
Other topics will emerge soon.
Are capital controls the answer?
In June 2016, the IMF’s in-house journal Finance and Development carried an article – Neoliberalism: Oversold? – which eschewed the notion that self-regulating markets – the catchcry of the free market lobby – deliver optimal outcomes.[Reference: Ostry, J., Loungani, P. and Furceri, D. (2016) ‘Neoliberalism: Oversold?’, Finance and Development, 53(2), June, 38-41.]
The IMF authors defined neo-liberalism as resting “on two main planks” (p.38):
The first is increased competition—achieved through deregulation and the opening up of domestic markets, including financial markets, to foreign competition. The second is a smaller role for the state, achieved through privatization and limits on the ability of governments to run fiscal deficits and accumulate debt.
These are the sort of policies that the IMF and the OECD have championed for several decades now without evidence that they actually help advance the well-being of people instead of concentrating income growth at the top end of the distribution (rising inequality).
The IMF authors now admit that “the neoliberal agenda … [has] … not delivered as expected”, particularly in the area of free capital flows and “austerity” (aka “fiscal consolidation”) (p.38).
They reach “three disquieting conclusions” in relation to the neo-liberal period (p.39):
– The benefits in terms of increased growth seem fairly difficult to establish when looking at a broad group of countries.
– The costs in terms of increased inequality are prominent.
– Increased inequality in turn hurts the level and sustainability of growth.
Their focus is on two aspects of the neo-liberal agenda: (a) capital flow liberalisation; and (b) fiscal austerity.
On the latter, they conclude that (p.40):
Austerity policies not only generate substantial welfare costs due to supply-side channels, they also hurt demand—and thus worsen employment and unemployment … In sum, the benefits of some policies that are an important part of the neoliberal agenda appear to have been somewhat overplayed.
But, our focus here is on the alleged benefits of capital flow liberalisation and the refusal of governments to countenance capital controls as a major policy vehicle to defend their nations against unproductive and venal currency speculation, which the financial markets consider to be their right.
What are capital controls?
No single definition is possible given the plethora of controls that are possible and have been deployed by nations in the past.
When we talk of capital controls we are considering policies that aim to impose restrictions on the free movement of financial capital flows either into or out of the country or both.
A nation’s relationship with the rest of the world encompasses trade in goods and services, measured by the so-called current account of the Balance of Payments, and financial inflows and outflows which include loans and direct investment to productive firms and speculative purchases of financial assets and property, etc, measured by the capital account of the nation’s Balance of Payments.
Sometimes economists talk about capital account liberalisation to refer to policies that allow for increased flow of financial capital across borders.
The opposite is capital account regulation, which includes capital controls, The latter, typically, aims to place limits on the downward movements in the nation’s currency (to prevent inflationary surges) by preventing unproductive speculative financial flows which cause currency instability and reduce the foreign exchange reserves held by the central bank.
Ariyoshi et al. (2000: 6) define “two broad forms” of controls: (a) “’administrative’ or direct controls”, which just impose limits or banks on capital flows between nations; and (2) “’market-based’ or indirect controls”, which seek to impose extra costs (via taxes or charges) on speculators to reduce their incentive to shift funds across borders.[Reference: Ariyoshi, A., Habermeier, K., Laurens, B., Otker-Robe, I., Canales-Kriljenko, J.I. and Kirilenko, A. (2000) Capital Controls: Country Experiences with Their Use and Liberalization, Washington, International Monetary Fund.]
Under the fixed exchange rate Bretton Woods system that operated after the Second World War until the early 1970s, capital controls were seen as being a policy tool that could free the central bank monetary policy somewhat from having to defend the exchange rate value and, instead, pursuing domestic policy objectives (such as full employment and price stability).
If a nation’s currency was under attack from speculative sell-offs driven by a belief that the currency would be forced to devalue then capital controls could mute the flows of currency in the markets without leaving the central bank vulnerable to depletion of foreign reserves.
Even under flexible exchange rates, where markets are free to set the value of the nation’s currency against other currencies, capital controls can be used to isolate capital inflows. which aids the productive sector from speculative or ‘hot money’, which can undermine prosperity.
Ariyoshi et al. (2000: 5) note that capital controls can “protect monetary and financial stability in the face of persistent capital flows”. This is especially if a nation is already struggling with high inflation (thus avoiding the inflationary effects of depreciation) or if the nation’s private sector (banks and firms) have built up excessive risk in the form of “unhedged foreign currency positions”, which could cause widespread bankruptcies in the case of a substantial depreciation.
Mainstream economists traditionally take the view that capital controls are costly and cannot discriminate between “desirable capital and current transactions along with less desirable ones” (Ariyoshi et al., 2000: 6).
They are also alleged to impose heavy administrative costs on the nation (p.6) and shelter local private firms from the efficiency gains of international competition which they argue reduces the long-term prosperity of the nation (p.6). Finally, the IMF claim they generate “negative market perceptions, which may in turn make it costlier and more difficult for the country to access foreign funds” (p.6).
Capital account liberalisation was seen as an essential element in the integration of global capital markets to coincide with the globalisation of supply chains and production processes.
The mainstream view provided by the current IMF chief economist, Maurice Obstfeld was expressed in his 1998 paper where he says (pp.2-3):
[Reference: Obstfeld, M. (1998) ‘The Global Capital Market: Benefactor or Menace?’, Journal of Economic Perspectives, 12(4), 9-30. LINK]
Economic theory leaves no doubt about the potential advantages of global financial trading. International financial markets allow residents of different countries to pool various risks, achieving more effective insurance than purely domestic arrangements would allow. Furthermore, a country suffering a temporary recession or natural disaster can borrow abroad. Developing countries with little capital can borrow to finance investment, thereby promoting economic growth without sharp increases in saving rates. At the global level, the international capital market channels world savings to their most productive uses, irrespective of location …
The other main potential positive role of international capital markets is to discipline policymakers who might be tempted to exploit a captive domestic capital market. Unsound policies–for example, excessive government borrowing or inadequate bank regulation–would spark speculative capital outflows and higher domestic interest rates. In theory, a government’s fear of these effects should make rash behavior less attractive.
There is no doubt that access to a broader array of investors can help a nation to develop. But, note that the advantages that Obstfeld notes in the first paragraph typically relate to what we call Foreign Direct Investment (FDI) where a foreign investor provides funds to a productive enterprise in another nation.
This might take the form of building a factory, purchasing land for a firm to locate to, or providing plant, equipment, and skills to aid an firm.
Clearly, once this investment is in place, the notion of capital flight becomes difficult to sustain. Productive capital is in situ and as we saw in the case of Argentina in the early 2000s, if the owners walk away from the enterprise, workers can take control and continue producing if legal approvals are forthcoming (see Magnani, 20[Reference: Magnani, E. (2009) The Silent Change: Recovered Businesses in Argentina, Buenos Aires, Editorial Teseo.]
We distinguish FDI from Foreign Portfolio Investment (FPI) which represents foreign investments in a nation’s financial assets which bear no interest in an underlying productive activity in the real sector of the economy.
FPI includes purchases of shares, corporate and government bonds, and other local currency-denominated assets which are typically easy to liquidate. Real estate is included in this category if held for speculative purposes, although it is less liquid than the array of financial assets that the ‘hot’ money is attracted to.
Clearly, this capital can be withdrawn very quickly and can be the source of financial instability.
Obstfeld’s description of the benefits of financial liberalisation appear to exclude the ‘hot’ money flows.
Finally, we note the ideological leaning in the second paragraph of the Obstfeld quote. The argument that capital markets “discipline governments” who they think are overspending has been used as the principle reason to resist the imposition of capital controls in the neo-liberal period.
What constitutes “rash” behaviour by a government should be assessed against the principal objectives of fiscal policy, to advance the well-being and security of its citizens through high employment levels and strong wages growth relative to productivity, in addition to the provision of first-class public services (including education and health).
There is no evidence that the ‘financial markets’ value these objectives at all and plenty of evidence that they react badly when governments prioritise these objectives.
In that sense, capital controls can place a sort of ‘reverse’ discipline on the financial markets by forcing them to exhibit behaviours that support the government’s objectives in relation to its citizens.
The recent case of Iceland is instructive. Please read my blog – Iceland proves the nation state is alive and well – for more discussion on this point.
To be fair, Obstfeld (1998) did point out that international capital markets can play “a potentially disruptive role” (p.19) by encouraging excessive private sector borrowing. He pointed to the “foreign exchange crises … [that] … disrupted exchange markets in Europe, Latin America, and east Asia” (p.22) in the 1990s.
The so-called “gnomes of Zurich” who destablised Britain in the 1960s gave way to George Soros in the 1990s and the Wall Street banskters more recently.
The standard IMF line was restated emphatically on July 28, 2007, just before the GFC, by the then IMF Managing Director and former Spanish Finance Minister, Rodrigo de Rato.
In a speech to the a gathering of bankers, entitled Capital Flows in an Interconnected World, Rato spoke on the theme of the “risks from capital inflows” and “what central banks can do to manage and reduce these risks”.
He noted that Asia was experiencing “very large capital inflows … [and] …outflows” which were part of the “worldwide phenomenon of financial globalization”.
He said that substantial increase in “financial globalisation … since the mid-1970s”:
… has been associated with a wide range of benefits, including to businesses and citizens in Asia. It has given businesses access to a much broader market for savings and has lowered their cost of capital. Higher foreign direct investment has the potential to accelerate technology transfer, improve productivity, and provide greater employment opportunities. And increasingly … giving Asia’s savers access to a wider pool of investments, and the opportunity to diversify risks across borders. In addition, financial globalization can play a catalytic role in encouraging development of capital markets and financial sectors, improving the quality of institutions, and promoting the adoption of stronger macroeconomic frameworks. Financial globalization can have many benefits, and policies directed to it should be careful to preserve these benefits.
He suggested that “countries which are the recipients of large capital inflows can protect their economies from the consequences of market disruptions” through tight fiscal policy supporting a monetary policy focused on inflation targetting.
He rejected the view that “direct limits or controls on capital inflows” can “exchange market pressure” and concluded that:
[Reference: de Rato, R. (2007) ‘Capital Flows in an Interconnected World’, Speech at SEACEN Governors Conference, Bangkok, July 28, 2007, LINK.]
… they also have important disadvantages. They tend to set central banks and private financial institutions against each other. And since private institutions are generally imaginative and well resourced, they generally find ways around the restrictions, often very quickly. Indeed, recent studies conclude that capital controls rapidly become ineffective after their imposition. Capital controls can also create distortions in the behavior of firms and individuals, and when imposed on short-term flows they can cause particular problems for companies that cannot get long-term finance—usually small businesses and start-up firms.
As an aside, Rodrigo de Rato left the IMF just before the crisis and took over the Spanish lender Bankia, which filed for bankrupcty in May 2012. He was arrested in April 2015 on charges of fraud, embezzlement and money laundering as part of Bankia’s collapse and the huge Spanish government bailout (Source). Other charges have emerged since. His name also appeared in the Panama Papers in April 2016. He was named by Bloomberg as one of the The Worst CEOs of 2012. Generally, an all round nice guy!
Further discussion of the IMF position in past decades can be found in – Capital Controls: Country Experiences with Their Use and Liberalization (Ariyoshi et al., 2000).
However, even that stout defender of capital account liberalisation – free capital flows – is developing a more nuanced view in the aftermath of the GFC.
In February 2010, the IMF released a research paper – Capital Inflows: The Role of Controls (Ostry et al., 2010) which argued that under certain circumstances “capital controls … is justified as part of the policy toolkit to manage inflows” (p.5)[Reference: Ostry, J.D., Ghosh, A.R., Habermeier, K., Chamon, M., Qureshi, M.S. and Reinhardt, D.B.S. (2010) ‘Capital Inflows: The Role of Controls’, IMF Staff Position Note, SPN/10/04, February, Washington, International Monetary Fund.]
This research paper focused on capital inflows only and concluded that short-term speculative surges can compromise sound macroeconomic management – by pushing the exchange rate up and undermining trade competitiveness. They also acknowledge that “large capital inflows may lead to excessive foreign borrowing and foreign currency exposure, possibly fueling domestic credit booms (especially foreign-exchange denominated lending) and asset bubbles (with significant adverse effects in the case of a sudden reversal)” (p.6).
Ostry et al. (2016: 39) have evolved this position further and conclude that FDI which “may include a transfer of technology or human capital” can “boost long-term growth”.
But the flows associated with FPI – “such as portfolio investment and banking and especially hot, or speculative, debt inflows — seem neither to boost growth nor allow the country to better share risks with its trading partners” (p.39).
This distinction between FDI and FPI is important and was discussed in detail by Ostry et al. (2009).[Reference: Ostry, J.D., Prati, A. and Spilimbergo, A. (2009) ‘Structural Reforms and Economic Performance in Advanced and Developing Countries’, IMF Occasional Paper 268, Washington, International Monetary Fund..]
They recount “150 episodes” across 50 countries since 1980 where large capital inflows have led to financial crises (p.39).
They suggest that these “international capital flows” not only increase the likelihood of “a crash” but also increases inequality and reduce growth.
Ostry et al. (2016: 39) conclude that short-term capital flows have questionable legitimacy and that:
[Reference: Ostry, J.D., Ghosh, A.R., Chamon, M., and Qureshi, M.S. (2012) ‘Tools for Managing Financial-Stability Risks from Capital Inflows’, Journal of International Economics, 88(2), 407-21.]
Among policymakers today, there is increased acceptance of controls to limit short-term debt flows that are viewed as likely to lead to—or compound—a financial crisis. While not the only tool available—exchange rate and financial policies can also help—capital controls are a viable, and sometimes the only, option when the source of an unsustainable credit boom is direct borrowing from abroad (Ostry et al., 2012).
So our initial position can be summarised as:
1. The imposition of country-by-country capital controls can help eliminate the destructive macroeconomic impacts of rapid inflows or withdrawals of financial capital but may not be sufficient.
If we adopt a progressive view that the only productive role of the financial markets should be to advance the social welfare of the citizens then it is likely that a whole range of financial transactions, which drive cross-border capital flows, should be made illegal rather than controlled through capital restrictions.
In this context, capital controls may be an interim strategy while the nation sorts through the legislative tangle that would be involved. We will discuss this point further in the next instalment.
2. Capital inflows that manifest as FDI in productive infrastructure are relatively unproblematic. They create employment and physical augmentation of productive capacity which becomes geographically immobile.
However, financial flows that are speculative (especially short-term flows) and which are not connected with the real economy are unproductive and should be declared illegal.
This approach would best be introduced on a multi-lateral basis spanning all nations rather than being imposed on a country-by-country basis. The large first-world nations should take the lead. However, given that such leadership is unlikely to be forthcoming a single nation could still act unilaterally in this regard.
3. Local banks should play no role in facilitating the entry of speculative short-term flows. In this context, the only useful thing a bank should do is to faciliate a payments system and provide loans to credit-worthy customers.
We will consider the role of banks in more detail in the chapter on financial regulation.
In the next instalment I will consider some case studies of the use of capital controls in Europe and during the Asian financial crisis in 1997.
That is enough for today!
(c) Copyright 2016 William Mitchell. All Rights Reserved.