When Margaret Thatcher took power in Britain in 1979, one of her first decisions as prime minister was to scrap capital controls. It was the beginning of a new era and not just for Britain. Free capital movement has since become one of the axioms of modern global capitalism. It is also one of the “four freedoms” of Europe’s single market (along with unencumbered movement of people, goods and services).
We might now ask whether the removal of the policy instrument of capital controls may have contributed to a succession of financial crises. To answer that, it is instructive to revisit a debate of three decades ago, when many in Europe invested their hopes in a combination of free trade, free capital mobility, a fixed exchange rate and an independent monetary policy — four policies that the late Italian economist, Tommaso Padoa-Schioppa, called an “inconsistent quartet”.
What he meant was that the combination is logically impossible. If Britain, say, fixed its exchange rate to the Deutschmark, and if capital and goods could move freely across borders, the Bank of England would have to follow the policies of the Bundesbank.
In the early 1990s, Britain put this to the test, joining the single European market and pegging its currency to Germany’s. The music soon stopped; after less than two years in the exchange-rate mechanism, sterling went back to a floating exchange rate. Other European countries took a different course, sacrificing monetary independence and creating a common currency. Both choices were internally consistent. What has changed since then is the rising importance of cross-border finance. Many emerging markets do not have a sufficiently strong financial infrastructure of their own. Companies and individuals thus take out loans from foreigners denominated in euros or dollars. Latin America is reliant on US finance, just as Hungary relies on Austrian banks. With the end of quantitative easing in the US and rising interest rates, money is draining out of dollar-based emerging markets.
Theoretically, it is the job of a central bank to bring the ensuing havoc to an end, which standard economic theory suggests it should be able to do so long as it follows a domestic inflation target. But if large parts of the economy are funded by foreign money, its room for manoeuvre is limited — as the French economist Hélène Rey has explained.
In the good times, Prof Rey finds, credit flows into emerging markets where it fuels local asset price bubbles. When, years later, liquidity dries up and the hot money returns to safe havens in North America and Europe, the country is left in a mess. There is very little the central bank can do to moderate inflows and outflows of foreign money.
Unless you accept financial instability as inevitable, then, you may soon be thinking about imposing capital controls of a particularly stubborn variety — the kind that involves telling foreign investors you do not want their cash. The point is to prevent hot money flowing in during the good times, and to stop it from draining out in the bad times.
This is not yet a subject of polite conversation among policymakers. Central bankers have instead been peddling a concept known as macroprudential regulation, a cuddly version of capital controls. The idea is to tweak incentives: when a housing bubble builds up, the central bank imposes some ceiling on lending, for example by capping loan-to-value ratios. It might also ask its government to raise stamp duties or other transaction taxes. Spain tried such measures during the pre-crisis years. It did not stop the build-up of one of the biggest house bubbles in history.
More drastic action, such as leaving the euro or imposing capital controls, might have prevented the calamity. Spain did neither but before long someone surely will. Free movement of capital surely cannot be sustained as a point of principle when the economic costs are so devastating. Capital controls were common in our pre-Thatcherite past. They might come back.
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