Who Me? America’s efforts to restart the US economy is one of the reasons other countries are contemplating more capital controls (Nicky Loh/REUTERS)
I remember well when Malaysia’s renegade Prime Minister Mahathir Mohamad imposed capital controls in 1998 to protect his emerging nation from the ravages of the Asian financial crisis. You could almost hear the global business community gasp in horror. Even some of Mahathir’s closest advisors thought the step could send the already struggling economy into a deep freeze. Back then, the idea of capital controls was considered an affront to the basic principles of economics. But much to the surprise of the world’s economists, the capital controls helped stem Malaysia’s crisis. Even the International Monetary Fund later grudgingly conceded Mahathir’s move wasn’t all that bad.
Thanks in part to Mahathir, the world’s policymakers aren’t as ideologically opposed to the idea of capital controls these days as they were in the 1990s. In fact, amid continued turmoil in the global economy, capital controls are a bit in vogue. Governments are employing new rules to limit capital movements to protect themselves in uncertain economic times. Thailand in mid-October reinstated a tax on foreign investments in local bonds in an attempt to restrict capital inflows; Brazil has taken similar steps. Even South Korea, the proud host of the next G20 summit in November, is considering new controls to stem incoming capital. Surprisingly, in a very drastic shift in mindset, the IMF is encouraging this kind of behavior. Here’s what IMF Managing Director Dominique Strauss-Kahn said on the matter in a recent speech:
On one hand, we want capital to flow toward emerging markets. Channeled in the right direction—and guided by deepening domestic capital markets and effective supervision—capital flows can boost investment, growth, and living standards. But on the other hand, some flows can clearly be destabilizing. They can lead to exchange rate overshooting, credit booms, asset price bubbles, and financial instability…Dealing with crises is important, but it’s even better to prevent them. How can countries do this?…Countries have a number of policy options in their toolkits—lower interest rates, reserves accumulation, tighter fiscal policy, macro-prudential measures, and sometimes capital controls. The response should depend on circumstances—there is no one-size-fits-all solution…Again, we should always be pragmatic.
I must give a nod of support to the IMF, which usually tries to impose an ideological, not practical, agenda on the world. But is it a positive for the global economy that capital controls have been transformed from dangerous delusion to respectable policy tool?
I’m not so inflexible in my economics to disagree with Strauss-Kahn. Sometimes unconventional steps are necessary during unconventional times. Countries should be allowed to break from the usual wisdom to protect themselves from crises or instability imported from the unstable global economy. Even more, we learned (the hard way) that the old mantra — that when it comes to capital flows, freer is always better — doesn’t necessarily work out as planned. The Asian financial crisis of 1997 showed just how much instability can be caused when large quantities of foreign money rapidly shift in and then out of open economies. China’s experience has convinced some that capital controls can protect economies from the worst vicissitudes of the global economy without dampening growth and development. Some economists who have been questioning the wisdom of universal free-market orthodoxy see the new thinking on capital controls as a step towards policy sanity. That’s the sentiment professors Ilene Grabel and Ha-Joon Chang expressed this week in The Financial Times:
What was forgotten during the neo-liberal era is that many of these explicitly “anti-market” measures helped to promote rapid economic development by increasing financial stability…Those of us who have long advocated systematic financial reform look at current developments with excitement. Countries need the latitude to impose capital controls that meet their particular needs, and it is a relief to see that they are finally getting it after a long period of debilitating neoliberal ideology.
True enough. But at the same time, there is a hidden danger here. The primary reason countries such as Thailand and South Korea are turning towards capital controls isn’t to defend fragile economies from the evils of global financial markets, but to stage-manage their currencies. Capital controls are being used as weaponry in a widening currency war, to delay the necessary adjustments to restore the world economy to health.
Take South Korea, for example. Not only does Korea have ample currency reserves, a robust corporate sector, and a current account surplus, it was also one of the few nations in the world to squeeze out positive growth during the Great Recession. Korea is not a forlorn economy fighting off disaster. It is one of the world’s stronger, more vibrant economies. If Seoul does instate more controls on capital, it would be doing so only to preserve these advantages by preventing its currency from finding its proper, market-determined value, in order to promote its exports and discourage imports. In other words, capital controls would be used as a way to dodge responsibility for solving the ills of the world economy. Korea should be buying more from the world, not less, for the good of the global economy. Korea needs to play its part in reducing global imbalances and allowing weaker economies to benefit from Korea’s economic growth. But that’s not something Korea wants to see happen. Thus the shift towards more control of capital flows.
I can understand why South Korea, Thailand and Brazil would use capital controls. With the Federal Reserve expected to take aggressive steps to resurrect the fading recovery in the U.S., the world could well flood with dollars, pushing up currencies everywhere. If the countries of the emerging world need to protect themselves from asset bubbles or destabilizing “hot money” flows, they should be allowed to do so. The world economy shouldn’t become a defenseless victim of U.S. policy. But that’s not what’s going on, at least not yet. Instead, we’re getting protectionism by another name. The more countries that take such steps, the greater the likelihood that others will follow.
So though I’m not opposed to capital controls in principle, I am opposed to employing them as part of a free-for-all in which countries throw up barricades to capital and manipulate currencies to forward their own economic interests versus their trading partners. As I’ve mentioned before, it’s up to the G20 to stop such an ugly scenario from taking place. We’ll see what happens in November in Seoul. But with the host nation becoming part of the problem, the outlook doesn’t look good.