The free flow of money across national borders: That’s the soul of the modern global economy. It puts capital where it’s most useful, maximizing prosperity. What’s not to like? The disastrous busts that can come after giddy booms. To fight back, countries put restrictions in place either to stop too much money from flowing in during good times or to keep capital from leaking out during a crisis. From 1995 to 2010, 37 countries blocked the outflow of money. Sometimes it seemed to work, sometimes not. It’s hard to control the flow of capital without scaring away foreign investors. In 2015, doubts about Greece’s future in the euro triggered a record flight of bank deposits, forcing the government to shut down the financial system to stave off a collapse. No wonder capital controls retain their appeal.
Greece closed its banks and stock exchange in June, limited cash withdrawals and halted most transfers abroad after a breakdown of rescue talks with international creditors triggered long lines at ATMs. The country surrendered to European demands two weeks later, after crisis-weary citizens had stocked up on food and milk powder and pharmacies began to run out of medicines. Only then could it begin to lift restrictions. Cyprus took similar steps in 2013, when it became the first country in the euro area to impose capital controls during a banking crisis. Other countries put controls in place in 2014, including Ukraine, which imposed curbs on purchases of foreign currencies as its conflict with Russia expanded. Countries rolling back limits included Argentina and Venezuela, where a currency crunch caused shortages of food and drugs and fueled the world’s fastest inflation. Iceland took steps in December 2014 to unwind six-year-old restrictions on the krona. In China, the government is starting to relax controls that have anchored the economy for three decades, though its move to prop up the stock market in mid-2015 tarnished the idea that it’s ready to embrace free markets.
To discourage foreign money from flooding a national economy or leaving it high and dry, a government can restrict withdrawals from banks, limit foreign-exchange transactions or tax the purchase of stocks and bonds. These measures were uncommon until the 1930s, when countries started using them to keep scarce resources from flowing away during the Great Depression. After World War II, rules restricting capital flows became an established part of a world financial system. Only in 1971, when U.S. President Richard Nixon abandoned the dollar’s peg to gold, did major currencies start floating and countries lift controls. A new consensus favoring open capital markets lasted until the Asian financial crises of the late 1990s provided provisional evidence that capital controls could work: Malaysia recovered swiftly after imposing restrictions in September 1998. (South Korea recovered too, without them.) By 2010, the IMF was ready to acknowledge that capital controls can forestall financial crises.
Many economists now say there’s a time and place for limited capital controls. Still hotly debated is how well they work. Few doubt that capital flows across borders usually provide financing for high-return investment and bring technology, innovation and growth. Nor that the dismal economic performance of countries such as Venezuela and Argentina over the past few years shows that enduring capital controls distort allocation of resources and discourage investment. Limited controls on capital inflows are thought to prevent currency overvaluation and financial bubbles. In a financial crisis, restrictions on outflows give policy makers some breathing space to address the shortcomings in their economies and ward off panic selling. However, controls are neither foolproof nor cost free. Investors find ways around them through financial innovation and bribery and they can prevent productive foreign investment. Then there’s the impossible trilemma — one cannot simultaneously have free capital flow, control of interest rates and manage foreign exchange levels. Something has to give.
The Reference Shelf
- Federal Reserve Bank of St. Louis reviewed the history of capital controls in 1999.
- Economist Paul Krugman went against the conventional wisdom by endorsing Malaysia’s capital controls during the Asian Financial crisis.
- The IMF revealed its historical shift in its view toward capital controls in 2010.
- Economists including Kristin Forbes study the spillover effects of capital controls.
- A QuickTake on China’s currency controls.
First published March 20, 2014
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Ye Xie in New York at email@example.com
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