Nonsensical arguments against capital controls

Every time somebody mentions the term "capital controls" in polite company, as Arvind Subramanian and I did in the FT recently, you get back a barrage of counter-arguments about how crazy the idea is. Policy makers should stay away from policies that try to stem the flow of capital across national borders, the chorus intones. But you look closer at those arguments, and they are surprisingly weak and mutually contradictory.

Here are the typical counter-arguments.

1. Capital controls result in corruption and rent-seeking. Well, perhaps yes, sometimes they do. But not always, and surely the type of capital controls you are talking about makes a difference. I have yet to hear anyone make the argument that the Chilean tax on capital inflows led to corruption or that long-standing Taiwanese controls have been overwhelmed by rent-seeking.  Our job as policy advisors is to design policies that minimize the risk of corruption while their primary objective is being served. Government regulations on environmental externalities, health, or consumer safety are all subject to corruption and "capture" by the private sector as well, but most economists take this as a reason to think of better-designed regulations, not as a reason not to regulate.  People who do not understand this should not be in the business of providing advice to governments.

2.  The problem is not with capital flows per se, but with the underlying market distortions that induce risky behavior by financial intermediaries and by borrowers. So policy should target these distortions directly, through appropriate prudential regulation, rather than target the flows themselves. Yes in principle, but no in practice. If one could design the perfect prudential regulatory regime, able to handle all future financial innovations, then indeed we would not need direct controls on capital flows. But if we cannot, and we surely cannot, we need to work on as many margins available to us as we can. That is where the gun control analogy is really helpful. If you could perfectly regulate the behavior of future criminals, you would not need controls on the sale of guns directly. It is people who kill people, not guns--remember?  But most of us are reasonable enough to realize that we have imperfect control over the behavior of gun owners and so we think direct gun controls make sense.

3.  Capital controls won't work because they are easy to evade. Surely, some leakage is inevitable, but it is paradoxical that the same people who make this argument are those who cry bloody murder at the mention of capital controls. If you can evade capital controls at little cost, you should simply be unconcerned. And if you can evade them only at a cost, well then capital controls are working!  Or as my co-author Arvind puts it, ask the people who make this argument whether they will deny that lifting capital controls will cause an increase in the volume of capital flows?

4. Capital controls will raise the cost of finance to some firms. Duh? That's the whole point of capital controls... 

Comments

[Justin Rietz]

Dani -

While your recommendations do seem pragmatic (as are your rebuttals) I believe there is also a more philosophical aspect to the question of capital controls:

1. Why do we trust the government to make the correct economic decisions? Government officials - even those who are economists - are not omniscient and hence are still playing a guessing game as to the correct levels and timing of capital controls. While markets are certainly not perfect and are prone to volatility, it is questionable whether this is any greater than the volatility of government policy. Markets, at least, react to real economic forces and do so quickly.

2. Granting the government the power to have such control over the economy is a slippery slope. At what level of economic "intervention" do we put the brakes on governmental power? With the risk of sounding too U.S. centric and a bit jingoistic, the original and central tenants of the U.S. government via the U.S. Constitution was to limit government power due to past abuses. I think their is ample evidence in the modern world to support the continued need for such restraint even if there are short term welfare gains to be had.

3. Your gun control argument, as I pointed out on the FT website, has a similar slippery slope flaw: it would allow the government to regulate anything that might be used in criminal activity.

4. As an example, capital controls have seemingly been successful in China. However, a large portion of the Chinese population is relatively poor, and a stronger rmb would grant them more purchasing power in regards to imported goods. Is it the place of government to decide whom may purchase what?

In your article, you make the statement "Financial globalisation has not generated increased investment or higher growth in emerging markets." Would you point to research that you believe most accurate supports this argument? Also (and I know you have answered this in the past) would you point to countries that you believe have successfully implemented capital controls?

[Dani Rodrik]

Justin --

The evidence is actually fairly clearcut. If you leave aside China, India, and Chile (all of which have used capital controls), I cannot think of many emerging market economies that have experienced higher growth and investment since 1990 than before the 1980s. Can you? To argue that financial globalization has worked would be tantamount to saying that these countries would have had even less growth and investment--which is quite implausible, given that the external and internal policy environments were both considerably better post-1990 (by conventional standards, at least).

As for the slippery slope argument, I just don't get it. Any time somebody makes an argument that is in between two extremes, you can counter that there is a slippery slope towards the extreme that you least favor. That doesn't make it a valid counter-argument.

[Gabriel]

It seems to me that looking at annual growth rates access decades settles nothing.

On what basis should we expect perpetual growth at the '80s level? (The only case where looking at this in isolation warrants a caeteris paribus comparison.) Policy aside, productivity is still a big mystery for economists.

What we do know is that the individuals on the ground, chose to make these deals because, from their vantage point, it made them better off.

And speaking of slippery slopes and reductios, when are we going to get an FT article in favor of capital controls between the US states?

Maybe financial globalisation didn't deliver Heaven on Earth but nor should it have to for us to support it. We should support it because it's just another form of freedom of association.

[Dani Rodrik]

Gabriel -

We shall never have clean ceteris paribus evidence in macroeconomics, but you cannot walk away so easily from the growth evidence. You need to make an argument as to why financial globalization was associated with lower growth and investment rates--despite most other contributors to productivity that were positive (larger convergence gap, better domestic policies etc.) And if you cannot, you are simply saying that your priors on the benefits of globalization are so strong that they will not be moved by evidence.

Yes, individuals voluntarily make deals that will make them better off. But finance is one area where the externalities to others is huge. Surely, I need to say no more on this given the subprime mortgage mess we are in.

And your point about controls within states overlooks the big difference between domestic and international finance. Within countries, you have the institutions--lender of last resort, bankruptcy procedures, common regulatory standards, labor mobility, transfer schemes--that make financial crises both less likely and their consequences less severe. You don't have those internationally--and cannot in a world that is politically fragmented.

[paine]

dani

lovely lovely lovely

this is THE KEY
policy area
for nationally self determined poli econ con policy
and it collides head on with
the limited liability
wild bulls
of this pampus earth

---------
ps viewed SM's tete a tete
with
that callow cato
lib-rotarian sophmore

nearly thru out
he looks
"at best a bit at bay "
but i'm still
very fond of his
vintage ivy tenured
econ con mouse heretic
near anchorite brand
of self made
towering meme folly building

ever since his early urpe splurge
his paper persona
has been benign
cute acute
and hopelessly
self marglinilizing

[reason]

Slippery slope arguments are just arguments for extremism. They cannot be taken seriously. Why do we have a democracy if not to strike a balance between competing interests?

[reason]

And further, historically mature democracy don't have a tendency to flow down slippery slopes. Electorates are historically conservative.

[Dani Rodrik]

Thanks, paine. I almost got you to write in prose there, so it must have realy resonated... And reason: I like the way you put it. "Slippery slopes arguments are just arguments for extremism." I will use that from now on.

[Per Kurowski]

They build levees don’t they?

If you cannot believe you are able to build good rational levees that are able to work in time of financial tsunamis when your little local bathtub gets inundated by the financial oceans then what are you supposed to do? Move up to the mountains?

[tt]

As to the lack of evidence on the effect of financial integration on growth see this:

http://tinyurl.com/3xc29t

It strikes me that the study of tariffs (when there are, at least theoretical, reasons to use them, what effects do they have and so on) is a substantial part of the standard trade literature.
On the other hand, as far as I know, in the textbook open economy macro literature there is not much study of capital controls or other second best instruments.

[Jalal Alamgir]

The government certainly has a role to play in controlling financial excess. And in cases like India and China, it has played the role better than other actors would have.

But often the capital control debate seems to use the term "capital control" as a whole. A disaggregated view on what *type* of capital controls are easier to enforce, minimize corruption, provide predictability, etc. is usually not taken.

Capital controls that simply raise the price (cost) of short-term capital inflows (somewhat like progressive taxation) may be a better *type* than those that set strict barriers (i.e., related to time, amount, etc.)

I'm skeptical about the democracy argument though. I haven't seen cross-national research, but anecdotally it looks like more authoritarian governments have been better at using capital controls since the Asian Financial Crisis.

[Justin Rietz]

(Sorry in advance for the long post).

"To argue that financial globalization has worked would be tantamount to saying that these countries would have had even less growth and investment--which is quite implausible, given that the external and internal policy environments were both considerably better post-1990 (by conventional standards, at least)."

This is exactly what I am arguing. There are a myriad of local factors that are at play in each country, political, cultural, geographical, etc. some of which I believe you yourself stated are impossible to accurately reflect in econometric analysis in your paper "Why We Learn Nothing from Regressing Economic Growth on Policies" (please correct me if I am misinterpreting your analysis). I believe you then argue that because of this, a negative correlation doesn't necessarily mean a policy does or does not work. However, I would additionally extend “policies” to include a large portion of the local factors. It is possible that one or more of these would outweigh investment.

So why might higher foreign investment not lead to higher economic growth? Countries with higher risk attract more foreign investment. These are the same countries that are more likely to be affected by one of the "local factors" - that is why they are risky. Hence, depending upon the time period and region we are considering, we would expect to see upward and downward swings.

I am not sure why you leave out China, India, and Chile. The combined population of China and India is close to 2.5 billion people, or roughly 35% percent of the world's population, developing and developed. As far as emerging markets that have done better post 1990, I would point to all of Eastern Europe. Surely their captial controls were not effective. So three of the four BRIC countries did better post 1990. What about Brazil?

Real GDP per Capita PPP
(http://www.nyu.edu/fas/institute/dri/global%20development%20network%20growth%20database.htm)

1980: $6327.00
1990: $6212.00
2000: $7185.00

FDI in Brazil in the 90's was significantly higher than in the 80's. http://www.unctad.org/Templates/Page.asp?intItemID=3198&lang=1.

I, of course, don't necessarily claim this to be definitive, but merely a counter-argument.

Lastly, I don't think the slippery slope argument is one of extremes, but limitations. I could just as easily argue that capital controls by the government is an extreme form of government intervention. It comes down to a moral position: what do you believe is the role of the government, and does the government have the right to determine what people may or may not do with their money (see my comment re: China above). As to the comment about democracy, note (as an example) that the U.S. Constitution and other state constitutions explicitly place limits on government in order to protect citizens from "tyranny of the majority". Personally, I approach with trepidation a government that may readily do what it wants as long as either a) politicians or policy makers believe it benefits the majority of the people, and/or b) the majority of the population approves.

[paine]

"anecdotally it looks like more authoritarian governments have been better at using capital controls since the Asian Financial Crisis."

so much the worse for
pre mature pluralism...
anec-totality speaking
that iz

[paine]

per k

your deluvian figure
has its source in quakes not down pours

[reason]

Justin Reitz,
now I actually agree there need to protections against mere majorities taking some drastic actions. But a democracy also has to be responsive to the will of the people.

And mostly in a healthy society people hold a range of positions, and don't collect into large ideological groupings, so a move in any direction will produce a counteracting reaction.

That America for some reason thinks pure ideology is a good thing, puzzles and rather frightens me.

Your argument, by the way, could be used to support Feudalism as well as democracy (and some think that it actually is).

[reason]

Lastly, I don't think the slippery slope argument is one of extremes, but limitations.

Then don't use a slippery slope argument, just say you are totally against so and so. Be honest and stop using a straw man.

[Per Kurowski]

paine “your deluvian figure has its source in quakes not down pours.”

Absolutely! That quake produced by for instance the financial regulators deciding that the only thing in banking that matters is short term default risks and outsources the responsibility of measuring that to some few credit rating agencies; that then haphazardly point the world to where they believe it is not risky and the world follows them, for any of many reasons.

Boy, would a levee not have been useful in the case of the subprime mortgages, though I would of course have preferred not having a credit rating agency telling us these constituted prime collaterals in the first place.

[gallagher]

Here is a link to a paper on the experience of controls in Chile and Colombia by Ffrench-Davis, perhaps Chile's foremost macro-economist.
http://www.g24.org/rfrengva.pdf

Just so we know, in all US bi-lateral investment treaties and in our free trade agreements, we require that these controls be eliminated.

Although our democratic candidates have been right to criticize these agreements I'll put it out there that the criticism could be more focused on how these agreeements are detrimental to our trading partners, rather than the US. The discussion on cap controls is nowhere on their radar screens, for one.

The agreements have little or no effect on the US. NAFTA, the biggest of them all, gave the US a one-time bump of 0.8 percent of GDP.

[Foreigner]

"It comes down to a moral position: what do you believe is the role of the government"

To follow on what another poster wrote, the tendency of many people in the US to see the question on the role of government as a moral question is frightening. The only other group of people that see the role of government in moral terms are fanatical communists.

[Derrill Watson]

Also regarding the slippery slope:

At least when I make use of the metaphor, it is a request for the other person to draw a line and indicate where they think the stop needs to be and how to implement it, not an argument in favor of extremism. The infant industry argument (for instance) sounds nice in a number of situations, but I have yet to hear someone suggest a test that lets me/the government we're imaginarily advising know when to remove the protections, with the result that most countries that have employed such protections wind up with 50-year-old cigar-smoking babies.

You answered the other parts of Justin's post, but ducked that one. At what level of economic "intervention" do we put the brakes on governmental power?

[molecule]

Like inflation, capital controls are "theft". What if someone froze your income indefinitely and vigorously enforced evasion?

[Justin Rietz]

Dani -

If you have a chance, I would be interested on your thoughts about my claims re: Russia, Brazil and Eastern Europe in my last comment (that they all experience higher growth post 1990).

[Dani Rodrik]

Justin --
Russia and Eastern Europe emerge from communism in the early 1990s, so it is difficult to compare their performance in the 1990s with anything that comes before. (I do not doubt that capitalism beats communism when it comes to generating growth.) As for Brazil, it grew significantly more rapidly in the 1950s through the 1970s than it has since (or since the early 1990s). (We really should exclude the 1980s since it was the decade of the debt crisis.) And I excluded China, India, and Chile, because they all employed capital controls, and I think their relative success owes something to that fact.

[Justin Rietz]

Growth in Brazil during the 60's looks pretty flat: In 1960, real GDP / capita was $1784 and in 1969 it was $2236, about a 2.5% annual growth rate, if my math is correct. I would also argue that the late 60's to mid 70's pick up in growth was in large part due to the pro-free market changes made in the mid 60's, along with Brazil's increase in foreign trade during this same time period.

As far as leaving out the 1980s, we might also want to leave out the later part of the 1990s given the 1997 crisis.

I am more interested to know whether or not you believe developing countries should use capital controls indefinitely, or at some point do they reach a level of economic development that makes it beneficial for the government to relinquish such controls?

To ask this another way, should the United States use capital controls to facilitate its economic growth?

[Puzzled]

A. Spuriuousness: the fact that financial integration and relatively lower growth are correlated in time hardly implies their causal connection.
B. Logic: In low-savings (K importing) societies, capital account openness raises possible investment above that possible in a closed capital account world. Not sure how growth could therefore be higher in a closed capital account world, in so far as investment is an important cause of growth.
C. Costs vs Benefits: Shouldn't one thus balance the cost of openness (risk of financial crisis times the growth consequences of a crisis) against the extra growth made possible via capital imports?
D. Isn't this cost-benefit weighting likely to lead to different conclusions for each government/society?
E. Why propose a one-size-fits-all solution that corresponds to your preferences?

[Gurnain]

Dani
You point constantly to the fact that India did better in the 1990s than in the 1980s and seem to imply that this was because the Indian government used controls. The fact is that although India still had controls in the 1990s its growth was spurred precisely from loosening of controls in the 1990s. Most Indians have reason to believe that India would grow even more, if only the government stopped interfering. Most Indians also know that Indian controls - on capital or on anything else - are pretty ineffective...and are infact violated with impunity. Of course there is a cost to that and you seem to imply that there is some economic function being served by the imposition of those costs. And that these costs are lower than the "costs" of capital account openness.
It would be a good idea to get some sort of measure of both before making the case that Indian controls are helping India.

[Geo8rge]

"Capital controls will raise the cost of finance to some firms. Duh? That's the whole point of capital controls... "

I have never heard a national leader say they were introducing capital controls to make it harder to finance business. Captial controls are normally explained as an attempt to punish speculators, control inflation, punish foreigners, protectionism (make it easier to finance local business).

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