Capital controls as a response to the global financial crisis

Capital controls were an integral part of the Bretton Woods system which emerged after World War II and lasted until the early 1970s. This period was the first time capital controls had been endorsed by mainstream economics. In the 1970s free market economists became increasingly successful in persuading their colleagues that capital controls were in the main harmful. The US, other western governments, and the international financial institutions (the IMF and WB ) began to take an increasingly critical view of capital controls and persuaded many countries to abandon them…

At the end of World War II, international capital was “caged” by the imposition of strong and wide ranging capital controls as part of the newly created Bretton Woods system- it was perceived that this would help protect the interests of ordinary people and the wider economy. These measures were popular as at this time the western public’s view of international bankers was generally very low, blaming them for the Great Depression.Wikipedia

It is fair to say that the driving force for dropping capital controls were the big banks and insurers, they all wanted to grow and the argument went “if you don’t let us compete, then that other country will take over the world and make us their colony” along with heaping amounts of self-interest and grease money.  It just so happened that the biggest growth area was tax evasion, money laundering, and other illegal/alegal enterprises.  Part of the push was also to make it easier for organized crime to launder money in your currency(e.g. large denomination Euro notes), so that at least the money would stay in your own economy instead of being converted to US dollars. It was easy to push through because no one was keeping watch, and it was done through a process of incrementalism continually eroding the barriers in rapid succession.

Once capital controls were dropped, it was a race to the bottom, where bad regulation in one country would force another country to follow suit with bad regulation, lest they be entirely taken advantage of.  This thinking drove the complaints of US banks and multinational corporations after imposition of Sarbanes Oxley that the world financial center would shift to London, with its lax regulation.

A relevant paper from the St Louis Fed (An Introduction to Capital Controls) begins with:

Currency controls are a risky, stopgap
measure, but some gaps desperately
need to be stopped.
—Paul Krugman, “Free Advice:
A Letter to Malaysia’s Prime Minister,”
Fortune, September 28, 1998.

and strangely states:

“Unlike many topics in international economics,capital controls—taxes or restrictions on international transactions in assets like stocks or bonds—have received cursory treatment in textbooks and scant attention from researchers.”

This lack of attention may explain the lack of coverage in the financial press of national capital accounts with respect to international trade and foreign exchange.

Capital controls can be as simple as requiring holders of capital to prove they are paying corporate income tax elsewhere and not just taking the money out to avoid domestic taxation, because we don’t subsidize freeloader companies domestically.

Alternatively, capital controls can be used to limit the rate of credit growth, so that you don’t end up with another Asian financial crisis like 1998 where money had flowed in, prices skyrocketed as everyone took on debt, and then at the breaking point of the crisis there was a massive capital outflow, leaving countries with increased unemployment and a lot more debt.  In other words, don’t let capital rush in, spike the currency up, collapse interest rates, crash exports and the economy, and leave behind debt wreckage from the tsunami of credit.

At one time, Swiss banks had agreements among themselves, probably in consultation with their central bank but this was a gentleman’s agreement, to charge fees for deposits in CHF instead of the normal interest paid to savings deposits whenever it was thought that there was more money in CHFs than could responsibly be lent or used.  This is exactly what they are trying to get back to, to save their exporters given that open interventions by the SCB have only cost them money and not lowered the franc for more than a moment.

Capital controls shouldn’t be taboo, because they are effectively used throughout history. It’s just that money center banks don’t like them as it reduces fees.   As a result there is no funding or promotion of  economists at the FRB or in academia that would bring this up.

So Professor Krugman, if you are really a Keynesian, how about advocating capital controls?


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