Toward Free Exchange Rather Than Capital Controls

In Capital Controls: Against the Tide, the Economist’s Free Exchange (R.A.) described this week how macroeconomists are getting more and more comfortable with the idea of capital controls.

Unfortunately, it’s true.

One sign of this trend is that capital controls have been given a euphemistic name: macro prudential financial regulation, which sounds less threatening.  Another is the change in tone at the IMF: Instead of arguing in favor of gradually reducing capital controls over time, as has been its traditional orientation since its founding, it has been arguing in favor of increasing capital controls at least in some situations. Even Fed chair Ben Bernanke suggests increasing capital controls despite their harmful effects, channeling the IMF in a speech last March saying “the International Monetary Fund has suggested that, in carefully circumscribed circumstances, capital controls may be a useful tool.” Yet another example is that few of the economists at the recent Jackson Hole conference objected when capital controls were suggested as a way to deal with the international monetary and financial spillovers documented in Helene Rey’s paper.

I wish the Economist would exercise its traditional free exchange principles and argue against that tide of opinion.  The term “capital controls” itself is a euphemism for government officials restricting where and in what form people or firms can borrow or lend or invest or save in exchanges with other people or firms, mainly in other countries.  It’s not free exchange!

As with any other government restriction on trade, capital controls create market distortions and lead to instability as borrowers and lenders try to circumvent them and policy makers seek even more controls to prevent the circumvention.  Capital controls also conflict with the goal of a more integrated global economy and higher long-term economic growth. As Kristen Forbes has shown in a recent paper with many convincing examples, “evidence on capital controls suggests that they have pervasive effects and often generate unexpected costs. Capital controls are no free lunch.”

Getting back to Helene Rey’s Jackson Hole paper, she finds increasingly large and volatile international capital flows in recent years. But she also finds that monetary policy is a significant factor in these flows across borders. For example, she shows that large swings of the federal funds interest rate are associated with large swings in the VIX. For example, in 2003-05 both the funds rate and the VIX were very low. (I summarized other evidence here.) She also finds, as she states in the paper, that “Low values of the VIX, in particular for long periods of time, are associated with a build up of the global financial cycle.”

The recent unconventional monetary policy (UMP) likely creates similar effects, as I discussed at the annual BIS meetings this year.  Indeed, capital has flowed into emerging markets during the past several years and is now is flowing back out with expectation of an end or slowing of UMP.

Thus, an attractive alternative to capital controls would simply be to adopt monetary policies which avoid these large swings, a point I made at Jackson Hole. Whether this takes international coordination or not, I think it is a more sensible way to combat the spillover issue than harmful government prohibitions or restrictions, and the monetary policy would be more effective in stabilizing the economy anyway.

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