Monday, February 8, 2016

Reconsider Capital Controls!

I was flabbergasted to read this article in the WSJ: "The hottest idea in finance: capital controls are good!"

Why flabbergasted? Because in one of the first articles in this blog back in June 2011 (and ever since) I have argued the merits of capital controls. Put differently: I argued that it was a mistake to consider the mere mentioning of capital controls a crime against freedom. And I was accused of crimes against freedom from all sides.

My views on capital controls were formed during the 7 years which I spent in emerging economies: Chile and Argentina from 1980-87. Both countries had just been indoctrinated by the free market doctrine as preached by the Chicago Boys. And, of course, both countries eliminated capital controls.

Not having capital controls is wonderful on the inbound. When economic prospects are good, capital arrives from all over the world seeking profitable investments. When such countries take the next step and implement a fixed exchange rate (like Chile and Argentina had done), Nirwana overwhelms foreign financial investors: they borrow at lower international rates, invest in higher local currency rates and have no exchange rate risk. In Argentina they called it the "Bicileta", the bicycle. With every push of your legs you became richer.

The trouble of not having capital controls becomes visible on the outbound. When economic prospects turn sour, every foreign financial investor wants to grab the cookie jar and runs for the exit door. A 'sudden stop' is the likely consequence.

Back in those years I came to the following conclusion: in the absence of capital controls, every medium-size (or even large) economy is vulnerable to the attack of ill-spirited financial investors. If George Soros and his twin brothers set out to gang up on such a medium-size economy, they would succeed. They would pour billions and billions into that economy and once that country has gotten used to using those billions and billions, Soros & Co. would call the funding due.

That can only happen to a weak country? Well, think Switzerland. In the case of Switzerland, foreign capital seems to be eternally on the inbound owing to the security which Switzerland embodies for foreign investors, the result being that the Swiss currency is eternally on an upward curve. Logic would suggest that this is a process which cannot go on forever. At some point, the Swiss economy will become so expensive that it simply won't be able to compete any longer. The result would be bankruptcies and unemployment.

In a free market without capital controls, one can rest assured that the market will always correct imbalances: an irrational boom will eventually lead to an irrational bust with great cost to society. The only problem is that markets don't think; they just react and that reaction can come at a great cost for society. No one in his right mind would suggest capital controls in order to slow down investments. But everyone in his right mind should, in my opinion, evaluate intelligent capital controls which facilitate sustained growth and reduce the risk of irrational busts and of great cost to society.

And I say this as a passionate free marketer!


  1. An economy with controls is not a free economy, but a protected (or over-regulated economy)!
    The main problem is with Institutions (banks, agencies, etc.) and its regulations...
    Reform the Institutions!

    1. A society which has traffic controls and speed limits is not a free society but a protected one... (it is society which is protected).

      Iceland is a classic case. A bunch of bankers thought they could become the Wall Street of the North Atlantic. There were no limits on capital flowing in and staggering amounts of capital flowed in. And the cost to society became quite enormous even though they were smart enough to have the banks pay part of the price.

  2. Can you touch upon the trade off? What you say might make sense once the crisis occurred. But what investors would do if they know that at any time there might be capital controls and they kiss their investment goodbye?

    No free marketer would ever support Tsipras.

    1. In a capital controlled environment, foreign investors would sign a contract with the state which would govern, among others, annual dividend paymens and capital repatriation. Suppose it said that capital cannot be repatriated within the first 5 years and only in annual instalments thereafter? Why would an investor be scared by that? The investor would only be scared if he couldn't trust contracts with the state.

      On the other hand, a hedge fund who sees a Greek spring on the rise and wants to participate in it by pouring in a few billion, only to take them out as soon as autumn approaches - well, that hedge fund would face some limitations.

      And yes, a free marketer would not support Tsipras. Ever.

    2. Fair enough. I would say though that if someone imposes this kind of constraints he will have to tolerate a higher risk premium. Not everybody would want to participate in this kind of market -some because they are opportunistic, some because they are risk averse-. That definitely make some risky states less attractive. I am not saying you don't have a point, I would want to see someone quantifying the pros and cons.

      I hope you enjoyed the live stream of Varoufakis' presentation.


  3. Mr. Kastner,

    I don't think Switzerland is a good example. In relations to what it upholds. Switzerland is the millionaires/billionaires bank. Everybody likes and trusts them and takes their money there. Nobody wants Switzerland to be a weak nation nor do they care if the cost of living there drastically increases. There will always be more millionaires and billionaires to buy ever more expensive time pieces, mobile phones, pharma products, chocalate and high end ski vacationing.
    Switzerland is supported not only in the banking industry but in the high end products they sell. Varoufakis made an interesting comment here in Greece at one point mentioning Singapore. That they import everything and manipulate it into high end products. Such nations will never will be weak. Most Greeks neglected to understand what he said and meant.

    For the remaining nations most are quite exposed to being upended by a free market. Not because of the market but due to bad management. Like Greece. With our country leaders as is and Quartreto managing us, Greece can not be a strong nation economically. At least right now. I think our narrowmindedness is our worst trait.

    As for capital controls enstilled in Greece, i guess it can be debated. For the healthy business POV, it is a nightmare and hopefully in the coming months, things will get better as far as transactions are concerned. For the every day individual, with such governments, maybe it was good as so the deposits would not continue to drop and hoarding cash elsewhere would stop as well. It also help shed clarity on small everyday transactions, where people must use plastic money to make purchases, which inturn require a receipt to be issued. This helps fight the black market of undeclared income. I see more and more little old ladies using cash cards, where up to 6 months ago was impossible to realize in their minds. Just as i saw in portugal 1 year ago.

    Even in capital controls we must find the good within the bad.


    1. I did not mean domestic capital controls, only cross-border. And instead of controls, I should have chosen a less aggressive term. Perhaps capital flows monitoring. It's not too long ago that Austrian borrowers had to secure Central Bank approval for loans from abroad.

      Yes, Switzerland has a very strong economy where they import raw materials, develop them into finished products and export those. And yet, capital flows have caused quite a few problems for Switzerland in the last years.

      In a way, Switzerland is a victim of its own success. The capital of other countries/currencies seeks the CHF because it is so strong and safe. In the process, the CHF gets even stronger.

      The Swiss Central Bank 'wasted' the equivalent of one year's GDP to keep the CHF from exploding. They purchased EUR, USD, etc. against printed CHF. The Swiss Central Bank now has a balance sheet reminiscent of a hedge fund (largest individual position: Apple). And the printed CHF went into the domestic real estate market and drove up prices. That obviously is a trend which cannot go on forever. In fact, the President of the Central Bank has often referred to 'other instruments' which are still at their disposal. He didn't mention capital controls but many people thought that that's what he had in mind.

  4. I have come across the paper "In defense of capital controls" which I link below. It was published in the "Socialist Register". Well, I guess I now know that I am a socialist thinker...

  5. Civil societies are protected by laws and rules, their citizens do not enjoy limitless freedom. It is a trade-off that most people are willing to make. Alas, Greeks think each individual person has infinite freedom, consequently the country is a jungle.