-Caveat Lector-
THE CASE FOR CAPITAL CONTROLS
by Paul Davidson
In this decade there has been an international currency crisis every two to
three years: the European Monetary System crisis in 1992, the Mexican peso
crisis of 1994-5 and the 1997-98 Asian and Russian debacles. Does this
periodic breakdown of international capital markets mean that the movement
towards liberalizing capital markets started in the 1970s gone too far?
Have international financial markets become so fragile as to threaten the
economic health of the global economy?
Understanding the role of financial markets and the policy stance that
should be applied depends on the underlying economic theory that one
explicitly, or implicitly, relies on. There are two major theories of
financial markets: (1) the efficient market theory and (2) Keynes's
liquidity theory. The logic of the former inevitably leads to a
laissez-faire policy, while the latter recommends some form of capital
regulation.
The efficient market theory is the backbone of today's conventional
economic wisdom. Its mantra is "the market knows best; markets are
efficient and governments are inefficient". This view is epitomized in US
Deputy Treasury Summers's statement: "the ultimate social functions [of
financial markets are] spreading risks, guiding the investment of scarce
capital, and processing and disseminating the information possessed by
diverse traders...prices will always reflect fundamental values .... The
logic of efficient markets is compelling".
Since the 1970s, Summers's "compelling" efficient market logic has
provided the justification for nations to dismantle most of the immediate
post-war ubiquitous capital market regulations. Deregulated financial
markets, it is claimed, will produce lower real costs of capital and higher
output and productivity growth rates compared to those experienced between
the war and 1973 when international capital controls were practiced by most
countries of the world, including the United States.
The facts, unfortunately, do not support this liberalization argument. The
years between the war and 1973 were an era of unprecedented sustained
economic growth in both developed and developing countries. The average per
capita annual real growth rate of OECD nations from 1950 till 1973 was
almost precisely double the previous peak growth rate of the industrial
revolution period. Productivity growth was more than triple that
experienced in the industrial revolution. The resulting prosperity of OECD
nations was transmitted to the less developed nations through trade, aid,
and direct foreign investment. From 1950-73, average per capita growth for
all less developed countries was 3.3 per cent, almost triple the average
growth rate experienced by the industrializing nations during the
industrial revolution.
With liberalization, there has been as significant deterioration in
economic performance. The annual growth rate in investment in plant and
equipment in OECD nations fell from 6% (before 1973) to less than 3 %
(since 1973). Less investment growth means a slower economic growth rate
(from 5.9% to 2.8%) while labor productivity growth declined even more
dramatically (from 4.6% to 1.6 %). Instead of delivering the utopian
promises of greater stability and more rapid economic growth, the period of
liberalizing capital markets has been associated with one economic crisis
after another, e.g., stagflation and soaring interest rates in the 1970s,
the Latin American and African Debt problems of the 1980s, and the
recurrent international financial market crises of the 1990s. Since
efficient market theory has not delivered on its promises, it is time to
explore whether there may be an important role for international capital
market regulations.
Keynes's theory is that the primary function of financial markets is to
provide liquidity. The ability to readily liquidate one's position requires
an orderly financial market. Orderliness means constraining market price
movements by controlling the net cash flows into and out of the market,
just as a theatre owner sells just as many tickets as seats to control
crowd inflow into a West End hit, and laws preventing shouting fire in a
crowded theatre encourage an orderly crowd outflow. In the absence of such
flow controls, there can be a damaging crush to get in and even a greater
disorderly rush to make a fast exit if anyone smells a whiff of smoke.
Keynes argued that orderly deregulated financial markets can provide
liquidity as long as market participants accept the convention "that the
existing state of affairs will continue indefinitely, except as we have
specific reasons to expect a change". In other words, deregulated financial
market price stability is based on the flimsy foundation of an expected
inertia in future market forces. These expectations, however, can be
subject to sudden and violent changes, especially when, as Keynes noted, "
the conventional valuation is...the outcome of the mass psychology of a
large number of ignorant individuals". Forces of "irrational exuberance"
can set off a speculative bubble, while any sudden event that causes
disillusion may cause the bubble to burst.
Protecting the market value of one's portfolio of financial assets
against unforeseen and unforeseeable declines in financial market prices
weighs heavily on every saver's mind. With instant global communications,
any event occurring in a far off corner of the globe can set off rapid
changes in people's expectation of financial market prices. Every portfolio
fund manager must, in an instant, conjecture how other market players will
interpret a news event occurring anywhere in the world. Mass speculation
about the psychology of other market players interpreting any ephemeral
event can result in lemming-like behavior which can become self-reinforcing
and self-justifying. If, for example, enough market participants suddenly
form the same bear expectations, the resulting bandwagon can create a
crisis in financial markets. The first "irrational" lemmings on the
bandwagon to hit the ocean of liquidity may not drown. They may survive to
make more mistakes and lead more irrational leaps into liquidity in the
future.
Financial markets can provide liquidity only if there is an orderly
entrance and exit from the market.. Orderliness requires either a private
or a public institution, a market-maker, who regulates the net flows into
and out of the market -- just as the theatre ticket sales regulates inflows
and prohibitions against shouting fire promotes an orderly exit. The
presumption of orderliness, however, encourages each individual investor
to believe he can make a "fast exit" the moment when he becomes
dissatisfied with the way matters are developing.
Peter L. Bernstein is the author of the best-selling book entitled
AGAINST THE GODS (1996), an authoritative treatise on risk management,
probability theory and financial markets. Bernstein argues that liquid
financial markets "can never be efficient", and that an efficient market
would be one completely without liquidity. Bernstein argues, that without
liquidity there can be no fast exit and therefore the risk of making an
investment as a minority owner would be intolerable .The ability to make a
fast exit promotes the separation of ownership and management. As long as
a liquid capital market exists, therefore owners have no legal or moral
commitment to stick around long enough to make sure their capital is used
efficiently.
If, on the other hand, capital markets were completely illiquid then there
would be no separation of ownership and control. Once some volume of
capital was committed, the owners would have an incentive to use the
existing facilities in the best possible way no matter what unforeseen
circumstances might arise. Perhaps then capital markets might behave more
like the efficient markets of economists: Bernstein's homily that "an
efficient market is a market without liquidity" is a lesson that policy
makers must be taught. Judicious use of capital controls can promote
efficiency by constraining any sudden rushes into and fast exits out of a
capital market that would adversely affect the real economy.
those of you who read my London paper will recognize the argument. In light
of the debate that followed reading of my paper in London, I added the
following explanatory paragragh: (BTW the others in the debate were Lord
Nigel Lawson, John Flemming of Oxford, Lord Megnad Desai, and Lord Robert
Skidelsky.)
Jeffrey Sachs and others have suggested a return to completely flexible
exchange rates. Unfortunately whenever there is an persistent international
payments imbalance, free market exchange rates flexibility can make the
situation worse. For example, if a nation is suffering a tendency towards
international current account deficits due to its payments for imports
exceeding its receipts from exports, then free market advocates argue that
a decline in the exchange rate will end the deficit by stimulating exports
and retarding imports. If, however, the Marshall-Lerner condition does not
apply, then a declining market exchange rate worsens the situation by
increasing the magnitude of the payments deficit.
If, the payments imbalance is due to capital flows, there is a similar
perverse effect. If, for example, country A is attracting a rapid net
inflow of capital because investors in the rest of the world think the
profit rate is higher in A, then the exchange rate will rise. This rising
exchange rate creates even higher profits for foreign investors and
contrarily will encourage others to rush in with additional capital flows
pushing the exchange rate even higher. If then suddenly there is a change
in sentiment (often touched off by some ephemeral event), then a fast exit
bandwagon will ensue pushing the exchange rate perversely down.
You may remember my argument from the original SMF paper why Dornbusch's
perscription for a currency board is due to failure.
In any case, it should becoming clear to all, that the current
international financial and payments system does not serve the global
economy well and that structural reform and not merely marginal patching of
the system is necessary.
Paul
Paul Davidson
Holly Chair of Excellence in Political Economy
University of Tennessee
SMC523
Knoxville, Tennessee 37996-0550
office phone# (423)974-4221
fax# (423)974-1686
home phone # (423)573-9160
email: [EMAIL PROTECTED]
http://econ.bus.utk.edu/Davidson.html
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