Regaining Control? Capital Controls and the Global Financial Crisis

Kevin P. Gallagher

Introduction

A key characteristic of the Global Financial Crisis (GFC) has been the mass swings of capital ﬂows across the globe. Indeed, international investment positions now surpass global output. Developing and emerging markets were no strangers to theseﬂows. When the crisis hit, capital rapidly left the devel-oping world in a ﬂight to the “safety” of the US market. In the attempt to recover, many industrialized nations, including the United States, have re-sorted to loose monetary policy with characteristically low interest rates. Rela-tively higher interest rates and a stronger recovery have triggered yet another surge in capitalﬂows to the developing world. The result has been an increas-ing concern over currency appreciation, asset bubbles, and even inﬂation.

In a marked difference from previous crises, to tame excessive capitalﬂows, many emerging markets have deployed capital controls. To John Maynard Keynes, Harry Dexter White, and the other architects of the Bretton Woods system, capital controls were seen as an essential feature of a well-functioning global ﬁnancial system. Beginning in the 1980s, however, capital controls became shunned by the International Financial Institutions (IFIs), the private sector, and many Western governments. During the GFC, capital controls have regained their legitimacy in academic circles and in actual policy.

This chapter will examine the role that capitalﬂows have played in the GFC, trace the political economy of capital controls from the Bretton Woods era to their resurgence during theﬁnancial crisis, and conduct a preliminary analysis to evaluate the effectiveness of the controls thus far deployed. Finally, the

chapter will sketch the challenges of managing global capital ﬂows in the twenty-ﬁrst century.

Beyond this short introduction, this chapter has four additional parts. The second part (“Great (and Not So Great) Transformations”) of the chapter traces the rise, fall, and resurgence in thinking about capital controls since Bretton Woods. Part three (“Capital Flows, Capital Controls, and the Global Financial Crisis”) outlines the speciﬁc use of capital controls by various governments during the GFC. In part four (“Just One Rock in a Swiftly Flowing Stream?

A Preliminary Analysis”) is a preliminary analysis of the effectiveness of those controls. Partﬁve (“Twenty-First-Century Challenges”) examines the challenges in terms of designing effective capital controls at the national and global level.

Great (and Not So Great) Transformations

During the Bretton Woods process that established a ﬁxed but adjustable pegged exchange rate system, the International Monetary Fund (IMF), and the World Bank, Britain’s chief negotiator John Maynard Keynes and his US counterpart Harry Dexter White both agreed that a distinction should be made between“speculative”capital and“productive”capital, and that specu-lative“hot money”capital was to be scrutinized (Abdelal, 2007). Indeed, at those meetings, Keynes argued that, “control of capital movements, both inward and outward, should be a permanent feature of the post-war system”

(quoted from Helleiner, 1994: 33). Capital controls (on capital account trans-actions) were made fully permissible under the Articles of the IMF and remain so, despite efforts to the contrary, to this day. As Keynes said,“What used to be a heresy is now endorsed as orthodoxy”(Helleiner, 1994: 25).

From the late 1970s until the GFC, thinking about capital controls was drastically revised, with neoliberal ideas about politics and economic organi-zation dominating thinking about capital movements. In the wake of the GFC, there are a variety of perspectives on capital controls. This section of the chapter traces these swings in thinking and practice over the last seventy years. The parts that follow are organized around Figure 7.1.

Bretton Woods

Previous to the construction of the Bretton Woods system, the world economy was hinged by the gold-exchange standard. All that changed with the estab-lishment of Bretton Woods, formalized immediately after World War II. Barry Eichengreen describes three signiﬁcant changes in global monetary policy from Bretton Woods: pegged exchange rates became adjustable, capital con-trols were permitted to limit capital ﬂows, and the IMF was established to

monitor the global economy and provide balance of paymentsﬁnancing for countries in need (Eichengreen, 2007).

Eric Helleiner convincingly argues that this decisive change was due to four political–economic factors. These are depicted in theﬁrst column of Figure 7.1 under“Bretton Woods.”First, the construction of the Bretton Woods system reﬂected the prevailing mode of thought (at least in the United Kingdom and the United States where the institutions were framed) of“embedded liberal-ism”—the dominant thinking about political and economic organization at the time that stressed that markets were imperative but they needed to be

“embedded”in proper institutions for them to be welfare enhancing. “Embed-ded liberals argued that capital controls were necessary to prevent the policy autonomy of the new and interventionist welfare state from being under-mined by speculative and disequilibrating international capital ﬂows”

(Helleiner, 1994: 4). Helleiner stressed that this thinking was backed by a coalition of Keynesian-minded policymakers, industrialists who gained from such policy, and labor leaders. In more recent work, Helleiner stresses how Harry Dexter White and John Maynard Keynes wanted to formalize this way of thinking about states and markets in the Bretton Woods agreements.

Indeed, they “saw the goal of bringing internationalﬁnance under greater public control as a central objective of their blueprints”(Helleiner, 2011: 2).

Second, by the time of the Bretton Woods era, the“Keynesian Revolution”

was in full swing, with the US and UK governments both seeking a version of Keynes’s ideas at the actual Bretton Woods conference and in economic policymaking in general (Skidelsky, 2000).

Third, Helleiner argues that the United States remained permissive regard-ing capital controls, leavregard-ing policy space for nations to deploy them. The United States at the time endorsed an embedded liberal framework, and economists in the country also had concerns about the impossible trinity.

Perhaps more importantly, however, the United States permitted capital

Idea of government Varietes of liberalism

Economic thinking Macroprudential

management

Geopolitical concerns US mixed approval

IMF supportive

Figure 7.1 Political Economy of Capital Controls

Sources: Helleiner (1994), Cohen (2008), Chwieroth (2010), Abdelal (2009), Eichengreen (2007), Wade (1998), and author.

controls in other nations because of Cold War concerns. Policymakers in Japan and Europe saw controls as essential to their growth strategies and the United States saw enabling growth and maintaining alliances with those nations as a high priority.

Finally, according to Helleiner, was the specter of 1945–7 when the United States pushed hard for capital account liberalization. This in part was seen as leading to the 1947 economic crisis in Europe. Immediately after Bretton Woods went into force, the Roosevelt Administration was replaced by Tru-man’s and led to some signiﬁcant changes in policy. Truman brought in members of the New York banking sector who sought to gain more access in Europe and elsewhere for capitalﬂows. The backﬁre put the United States back on a course that was more accepting of controls until the 1970s.

A number of criticisms have been levied toward the Bretton Woods system.

However, for at least two decades after the agreements were signed, the system worked fairly well—though in large part because they were embedded in a broader institutional framework. To quote Eichengreen:

Capital controls were the one element that functioned more or less as planned.

Observers today, their impressions colored by the highly articulated ﬁnancial markets of the late-twentieth century, are skeptical of the enforcement of such measures. But circumstances were different in the quarter-century after World War II. This was a period when governments intervened extensively in their economies andﬁnancial systems. Interest rates were capped. The assets in which banks could invest were restricted. Governments regulatedﬁnancial markets to channel credit toward strategic sectors. The need to obtain import licenses complicated efforts to channel capital transactions through the current account. Controls head back the ﬂood because they were not just one rock in a swiftlyﬂowing stream. They were part of the series of levees and locks with which the raging rapids were tamed.

(Eichengreen, 2007: 92)

In later years, it would come as a shock that an international agreement, let alone the articles establishing the IMF, unambiguously sanctioned capital controls. The coalition described by Eichengreen and others, along with its insistence on capital controls as an essential part of the global ﬁnancial system, began to deteriorate in the 1970s.

The Neoliberal Era

Enter the neoliberal era, rising with the arrival of Ronald Reagan and Margaret Thatcher in 1979–80 and cresting with the “Washington Consensus” advo-cated by the United States, Europe, and the IFIs throughout the 1990s. In general, this era could be characterized as seeing an extremely limited role for the state in economic affairs, and the principal role of politics was to carry out

that economic view. Corresponding with Figure 7.1, this period is character-ized as a shift from embedded liberalism to neoliberal thought in general, and the dominance of a particular brand of neoclassical economics that supported a very limited role of the state in economic affairs in particular. In addition, whereas the United States and the IMF had seen it as advantageous to support capital controls in the earlier era, with the Cold War no longer driving US ﬁnancial strategy, the United States was now gaining a comparative advantage in globalﬁnancial services and saw capital account liberalization as advanta-geous to key constituencies in the United States. The very lucrative Euromar-ket, in hindsight, had served as a pilot project to show just how beneﬁcial open capital markets could be for USﬁnancial services industries.

Perhaps Mark Blyth’s analysis of the rise of neoliberalism is most lucent.

Blyth’s book,Great Transformations: Economic Ideas and Institutional Change in the Twentieth Century (2002), traces the shift from embedded liberalism to neoliberalism in the 1970s. He writes:

In sum, just as labor and the state reacted to the collapse of the classical liberal order during the 1930s and 1940s by re-embedding the market, so business reacted against this embedded liberal order during the 1970s and 1980s and sought to

“disembed liberalism”once again. In this effort, business and its political allies were quite successful, and by the 1990s a new neoliberal institutional order had been established in many advanced capitalist states with remarkable similarities to the regime discredited in the 1930s. (Blyth, 2002: 6)

What makes Blyth’s analysis so insightful is that he shows how such a key role was played by the political uses of economic ideas by organized business. In signiﬁcant detail, Blyth shows how the US business community, which in many ways earned its wings under the embedded liberal era, now sought toﬂy away from regulation, and from the United States. In addition to setting up ofﬁces in Washington DC and creating political action committees, Blyth traces how business funded think tanks to promote the neoliberal ideas.

Together these efforts managed to almost completely erode the compact Helleiner discusses as uniting US economic politics and the international institutions that the United States helped form.

During this period came a rise in neoclassical economics in general and monetarist macroeconomic thinking in particular. Milton Friedman’s rival (to Keynesian) explanation of the causes ofﬁnancial crises gave rise to a host of theoretical developments and corresponding policy recommendations that fed perfectly into the new regime described by Blyth. One such case was developments in neoclassical economic theory that saw capital account liber-alization as beneﬁcial. Drawing on the“law of variable proportions,” advo-cates for capital market liberalization argued that, by liberalizing theﬂows of international capital, developing countries would beneﬁt by getting access to

cheaper credit and investment from developed markets, promoting growth and stability. Because poorer nations have less capital per worker, the law of variable proportions states that the real return on capital would be higher in the industrialized countries where capital is relatively more scarce. This new capital would deepen credit markets, diversify availability of credit (and thus reduce risk), and so forth. Indeed, conventional theory implied that invest-ment tends toﬂow to developing countries, where the marginal returns may be higher (Barro, 1997).

US strategy changed as well. Whereas the Cold War drove US ﬁnancial interests in this regard in the aftermath of the Bretton Woods agreements, the 1980s saw the emergence of USﬁnancial servicesﬁrms as major global players.

The United States, or New York in particular, was determined to become the world’s globalﬁnancial capital. Cohen (2007) attributes the US’s stance as a combination of ideology and domestic politics. Regardless of the party in power in the United States, Treasury ofﬁcials and Presidential advisors largely held neoliberal training and beliefs beginning in the 1980s. Perhaps more impor-tantly, Cohen illustrates that while the costs of capital controls are directly felt by a handful of politically organized US constituents—Wall Street—the bene-ﬁciaries are diffuse and do not feel the direct effects. Thus, a collective action problem persisted where Wall Street organizes around capital account liberal-ization. Voices as diverse as Robert Wade (1998) and Jagdish Bhagwati (1998) went on to coin the term a“Wall Street-Treasury complex”(analogous to the

“military industrial complex” coined during the Eisenhower era to describe politics of that time). These authors argued that the US Treasury and Wall Street investment houses pushed for the freedom of capital movements wherever possible, including forcing the IMF into pushing capital account liberalization worldwide and working to mint such a policy in the IMF articles.

It is true that the United States and the IMF were staunch advocates of capital account liberalization during this period. In the case of the IMF, however, some authors argued that IMF behavior was driven by more than just US pressure and veto power. Abdelal (2007) argues that this change was imported to the IMF from the French. French socialists were originally big advocates of capital con-trols. However, controls on outﬂows in 1983 adversely affected the middle class and led to a change in the party stance. When Michel Camdessus (a prominent French Socialist at the time) became IMF Managing Director, he began changing the culture at the IMF toward the liberalization of capital controls.

Chwieroth (2010) acknowledges that the French connection was important, but stresses how the agents—the IMF staff—were the key advocates that had the most inﬂuence on the change. In its early days, most IMF staff were Keynesians who supported capital controls, but slowly the IMF became popu-lated with US-trained neoclassical economists who believed capital controls to be counterproductive. Chwieroth ﬁnds, however, that there were tensions

between“gradualist” and“big-bang” camps at the Fund. Gradualists advo-cated for gradual capital account liberalization and the selective use of capital controls, and big-bang advocates wanted rapid liberalization of the capital account. The IMF is largely seen as a big-bang advocate, especially to casual observers who saw the IMF looking to change its charter to mandate capital account liberalization and those who observed IMF country programs where capital controls often had to be eliminated on condition of an IMF loan.

Chwieroth shows that this was not necessarily the case. Gradualists and big-bang advocates at the IMF struck a compromise on capital controls. By the end of the 1990s, the IMF was pushing for capital account liberalization but tacitly supporting limited and temporary controls as safeguard measures in crisis mitigation on the road to liberalization.

If the example of the adverse affects of attempted capital account liberaliza-tion between 1945–7 was the reason why the United States and IFIs backed off from prohibiting capital controls during the Bretton Woods era, the lucrative-ness of the Euromarket in the 1970s was a pilot project pointing to the need to accelerate ﬁnancial globalization—from a US standpoint at least. In part to circumvent US controls on outﬂows in the 1960s, US banksﬂed to the Euro-dollar market—the“offshore”market where US dollars can be used to invest in Europe. New York bankingﬁrms lobbied hard to ensure that foreign currency loans of foreign branches of US banks were exempt from the capital controls, as were offshore dollar loans (Helleiner, 1994). The entry into the Eurodollar market by US banks and multinational corporations not only became lucra-tive for individualﬁrms but also“Transformed the Eurodollar market from a short-term money market into a full-ﬂedged international capital market”

(Helleiner, 1994: 89). US ﬁrms saw this example as something that should be imported home to secure the US as a capital for globalﬁnance.

Global Financial Crisis

It is clearly too early to provide a full characterization of thinking about capital controls during the wake of theﬁnancial crisis, as it is still inﬂux. This section therefore discusses what the presentis notrelative to the previous two periods rather that whatis. It is true that the ideas surrounding neoliberal political economic organization and neoclassical interpretations of capitalﬂows have come under great scrutiny given the central role that both played in the crisis.

However, the political forces that played such a strong role in transforming thinking about capital controls during the neoliberal era are still intact and regaining political and economic strength. Nevertheless, numerous countries have deployed capital controls in the run-up to and in the wake of the crisis, including Brazil, Colombia, Indonesia, South Korea, Taiwan, Thailand, and

others. Moreover, the G20 and IMF have proposed creating a new global regime to regulate capitalﬂows.

Corresponding to Figure 7.1, this section of the chapter argues that there are now a variety of liberalisms that have political weight in the global economy;

that there is new thinking in economics regarding capital controls, not the least of which is empirical evidence from neoclassical economists themselves on the efﬁcacy of controls; that the United States has softened its stance on capital controls and has less standing on the issue than before; and of course that the GFC, and the Asian crisis before it, looms large in terms of capitalﬂows.

First, there are now a variety of models of liberalism that have gained dominance and that may pose an alternative to the US brand of neoliberalism.

The most obvious examples are China, along with India and Brazil. These three emerging markets have had remarkably strong economic growth rates for a decade and after a temporary shock have been able to recover from the crisis more robustly, at least for now. These countries, to varying degrees, could be classiﬁed as“neo-developmental states.”The developmental state is the vari-ant of embedded liberalism for developing countries, whereby developing country states embedded markets in a national drive toward industrialization and higher standards of living (Woo-Cummings, 1999). All three of these nations have been reluctant to liberalize their capital accounts and frequently (or permanently in China’s case) deploy capital controls. These nations are

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