Home > The Economy > Capital Controls: Not Just for Developing Countries

Capital Controls: Not Just for Developing Countries

by Kevin Gallagher and Stephany Griffith-Jones

Ben Bernanke has been criticised from different sides and perspectives for quantitative easing. From one side, inflation hawks prefer austerity over expansion. Those who favour expansion and growth have valid concerns that it may not work and, instead, have negative global effects. At the G20, the United States got criticised – rightly – by emerging countries for the negative impact of QE2 on their economies. 

The results of the recent US elections make it very difficult for the US to pursue the first best policy to keep its economy recovering: further fiscal expansion, for a time. As Keynes taught us, and we have seen during numerous crises, private investment and consumption will not recover on their own (due both to over-leveraging and lack of confidence), without the stimulus of aggregate demand, which only governments can give in these particular circumstances. Once the recovery is on track, fiscal policy needs to contract, to avoid both overheating and excessive public debt.

The Fed has already brought the short-term interest rate to zero, so Bernanke, to his credit, has ventured into the emergency toolkit. The Fed chairman should be applauded for his willingness to think past convention. As one of the last policy-makers in developed countries with significant economic power, he is now almost the sole voice for expansionary economic policy.

However, on its own, QE2 may, indeed, not be enough to restore the US economy to growth; and it will contribute to further overheating of asset prices in the emerging economies, which could not just complicate macroeconomic management for them now, but also increase the risk of future crises.

To ensure QE2 helps the US economy to grow, mechanisms need to be found to channel the additional liquidity created by the Fed to the real economy. The key is to expand credit to small and medium-sized enterprises, starved of funds at present, and to finance large investments in infrastructure, including that required to generate clean energy.

Policy-makers must exercise creativity to help achieve this. The Europeans have a massive institution, the European Investment Bank (EIB), which last year lent more than $100bn; the US needs to create similar mechanisms quickly, or use existing institutions to lend more to the private sector. The Europeans, in turn, should further expand EIB lending.

Internationally, if the US dug into the emergency toolbox again, it could place prudent capital regulations on the outflow of speculative capital from the US via the carry trade; this might help avoid future crises in those countries, which would harm not only them, but also the US and the world economy. More broadly, it is time policy-makers stopped letting the financial sector tail wag the real economy dog.

Before and at the G20 summit, many emerging market politicians and well-known economists voiced serious concern over the global effects of quantitative easing. Increased US liquidity may pull dollars out of the US and invest them in nations with higher interest rates for rapid speculative return. Known as the carry trade, such speculative flows push up the value of emerging market currencies and create asset bubbles.

It is for this reason that the US was criticised at the G20. Brazil, with interest rates over 10%, has seen an appreciation of over 30% due in part to the carry trade, and was most vocal in Seoul.

One remedy to the problem already under way is the use of capital controls in emerging markets. Many nations such as Brazil, India, China, Argentina, Taiwan, Thailand, South Korea, Peru and Indonesia have put in place controls to limit excessive inflows. Such controls have been sanctioned by the IMF – a landmark shift.

The problem is that – on their own – controls from recipient countries may be overwhelmed by the sheer scale of the inflows, with investors often finding ways to evade them. Given that the majority of the carry trade effect will come from the US, the United States could start regulating the outflow of capital due to the carry trade.

Controls on short-term outflows would facilitate the liquidity created by the Fed to stay in the US and have a better chance of going toward productive investment. Such investment could help developing countries via trade, rather than causing speculative capital to flow to emerging markets and cause havoc to their financial systems and their economies.

By stemming criticism from emerging markets, the US may find more allies for a global growth agenda. Developing countries have deployed expansionary policy in the wake of the crisis, and it is working. It is important that their efforts are strengthened, and not undermined, by hot money. Together, they could pose a legitimate alternative to the austerity-ridden Europeans and new members of the US Congress.

Originally published in The Guardian, 11/18/2010

for more on the QE2 and reactions to the G-20 see http://www.triplecrisis.com

  1. November 18, 2010 at 5:41 pm

    If gold were money world-wide, with free-market banking, we would not need capital controls. Problems with money and interest rates arise with fiat money that will ultimately be valued at its cost of production.

  2. theyenguy
    February 7, 2011 at 4:52 am

    The World Central Bank Leaders, and Government Finance Ministers have lost their monetary seigniorage, that is their debt sovereignty to the bond vigilantes as established by the fall lower in US 30 Year Government Bonds, EDV, US 10 Year Notes, TLT, World Government Bonds, BWX, and International Corporate Bonds, PICB.

    I believe that there will come a day when, out of soon coming financial chaos, that a World Chancellor, the Sovereign, and a World Banker, the Seignior, will rise to power and provide credit and moneyness, but at a cost, that being the loss of national sovereignty. The word, will, and way of the Sovereign and the Seignior will be sovereign globally. Austerity will be required of all. Eventually, there will be a one world currency, that is a global currency, and unified regulation of banking globally as as referred to in the James Politi and Gillian Tett Financial Times article NY Fed Chief In Push For Global Bank Framework,

    Could it be that world central bank leaders are now preparing to go beyond traditional capitol controls and are preparing for a world wide federal reserve system, that is a global banking system? Might it be that Leaders’ Framework Agreements, whether formally announced, or agreed upon in private, will serve as the basis for a unified one world banking system to deal with global instabilities? Perhaps so, as Robert Wenzel of EconomicPolicy relates in article Geithner Jets To Brazil: “On Sunday morning, Treasury Secretary Geithner will depart for Sao Paulo, Brazil where he will meet Monday with senior government officials, local business leaders and economists to consult, according to the Treasury on “shared bilateral and G-20 objections and highlight the importance of economic and financial cooperation with the Government of Brazil.””

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