Until recently, respectable opinion frowned on all barriers to money flowing across borders. Today, the old thinking has been overturned. Sometimes, it’s agreed, capital controls are necessary.
The old consensus was wrong and won’t be missed. The new view, however, lacks clarity and, when it comes to application, effective oversight. Capital controls may sometimes be necessary—but they’re always dangerous and open to abuse. These policies need to be better considered and subject to more careful global supervision.
Since 2008 interest rates in the U.S. have fallen to almost zero, and international investors have looked elsewhere for a good return. Some developing economies have seen enormous capital infusions and a corresponding appreciation of their currencies, which makes their exports less competitive and threatens to cause bubbles in domestic asset prices. Brazil, for instance, responded with a control that once would have been strongly opposed: a tax on foreign investors’ holdings of Brazilian assets. Lately the pressure of inflows has abated, and the controls have eased.
A new study by Olivier Jeanne, Arvind Subramanian, and John Williamson of the Peterson Institute for International Economics goes further, arguing that the use of capital controls needn’t be confined to incipient asset bubbles. A country with a persistent current-account deficit, such as India, might also find controls useful for avoiding a chronic overvaluation of its currency.
That argument, however, highlights a danger. An instrument that can be used to stop a currency from appreciating too much can also be used to keep it undervalued. China has used capital controls—severe restrictions on the domestic assets foreigners can buy—for exactly this purpose. What China does is equivalent to subsidizing exports and putting tariffs on imports, policies that would be forbidden under the promises it has made as a member of the World Trade Organization.
The current nonsystem on capital controls allows a case like China’s to continue indefinitely, where the purpose is not to prevent a currency distortion but to create and perpetuate one, at great cost to others.
Just as global trade rules insist on tariffs, not import quotas, a rule-guided system for capital controls should prefer market-based restrictions, such as taxes, over administrative barriers, such as prohibitions or discriminatory regulation. Market-based measures make it easier for other governments to see what’s going on and to judge the effects. In a spirit of cooperation, this is something any government can reasonably ask of another. To curb excesses, the rules on instruments should also specify a maximum rate of tax on capital flows. The academic literature suggests that a moderate rate of, say, 15 percent, is optimal. In addition, governments resorting to capital controls should have to say why—and convince a representative international body with oversight powers.
Now that we better understand the close connections between currency valuations, flows of capital, and flows of goods, we need a global effort to codify and oversee the limited use of capital controls. Do it before bad habits become too hard to break.