Asia Needs Capital Controls?
Unrestricted Financial Markets Are Not Prone to Manias or Bubbles
MARCH 01, 1999 by LAWRENCE H. WHITE
Citing the East Asian financial crisis, the well-known trade economist Jagdish Bhagwati has recently given support to retaining capital controls in developing countries. In essays in Foreign Affairs and more recently, the Wall Street Journal (“Yes to Free Trade, Maybe to Capital Controls”), Bhagwati cautions that the “overwhelmingly powerful” case for free trade does not imply an equally strong case for free capital flows because there is “a unique downside to a policy of free capital flows.” The downside is that “capital flows are subject to what the economic historian Charles Kindleberger of MIT has called panics, manias, and crashes.”
Bhagwati contends, against the well-known argument that speculators who bet against fundamentally strong economies will be disciplined by losses in the marketplace, that “the unfortunate fact is that speculation can be self-justifying.” That is, by abandoning an economy, investors can themselves weaken it. He asks rhetorically: “Is this not what most likely happened when, out of panic, investors fled from what they perceived as weakened Asian economies, weakening them when they were originally strong?”
No, this is not what most likely happened. Blaming investors for the fall of the Thai bhat or the Indonesian rupiah is like blaming umbrella-carriers for the fall of rain. Capital flows can of course be volatile, but attributing a shift in the behavior of independent and calculating investors to a self-validating “panic” or “mania” is at best an explanation of last resort. A large speculative attack on a central bank to get foreign currency before the fixed exchange rate collapses—like an old-fashioned run on a deposit bank to get cash before it is gone—could in principle be self-validating, because a central bank with fractional reserves will eventually run out of foreign currency reserves and be forced to devalue.
But in practice the speculative attacks we witness are not of this self-validating sort. Just as the historical evidence indicates that nineteenth-century runs on deposit banks were generally triggered by bad news indicating the likely insolvency of those specific banks, speculative attacks on fixed exchange rates are generally triggered by bad news about economic fundamentals. The idea that unrestricted financial markets are prone to manias or bubbles is founded on historical myth, as my colleague George Selgin has shown by re-examining the historical episodes cited by Kindleberger and others as supposed examples of bank-lending manias (Journal of Financial Services Research, August 1992).
At its root, the fall of their currencies’ exchange values, and the subsequent reversal of capital flows to Thailand, Indonesia, the Philippines, and Malaysia, were votes of no confidence in the exchange-rate and monetary policies of their governments. It is of course a challenge to explain the exact timing and size of the dramatic shifts observed. But if some sort of pure self-validating mania or panic had been afoot in the region, it would be hard to explain why Hong Kong, Singapore, and Taiwan were spared devaluations.
The countries that crashed were basically those where expansionary monetary policy was on a collision course with the supposed commitment to a fixed exchange rate against the U.S. dollar. As basic exchange-rate theory tells us, a fixed exchange rate between the local currency and the dollar cannot be maintained unless the creation of local money is limited to the amounts consistent with holding the local inflation rate down to the US. dollar inflation rate.
To generalize rather sweepingly, large amounts of capital had flowed in during the 1990s because, if the exchange rates really did remain fixed, high real returns were available from nominal interest rates well above U.S. dollar rates. Local commercial banks became loaded with poor-quality loans, in some degree because of government intervention or corruption in allocating loans, and in some degree because of excessively risky lending encouraged by implicit government guarantees to the banks. The nonperforming loans of Indonesia’s banks, for example, reached more than a quarter of total loans before 1996. International investors finally lost faith because it became clear that the central banks, when forced to choose, would print money to keep the banks afloat rather than exercise the monetary restraint necessary to maintain the fixed exchange rate.
The succession of crises in several southeast Asian countries, beginning with Thailand, has led many commentators to speak of a “contagion” by which crisis spreads from one country to another. The solution supposedly lies in global crisis management by the IMF. But as Anna J. Schwartz has noted in the Cato Journal (Winter 1998), “it was not contagion from Thailand, however, that made the countries vulnerable to a financial crisis. They were vulnerable because of their home-grown economic problems. Capital flight from countries with similar unsustainable policies is not evidence of contagion.”
Capital flight imposes a very useful, if sometimes harsh, discipline. As former Citicorp CEO Walter Wriston notes (in an interview with Wired), the flow of short-term capital “functions as a plebiscite” on a government’s economic policy. When a change in policy is observed, “by the end of the day, the market will have conducted a referendum reflecting the collective wisdom of people all around the world on what they think of [the new] economic policies. If your economic policies are lousy, the market will punish you instantly.” Wriston adds: “I’m in favor of this kind of economic democracy. There’s nothing you can do to change it, except do right.”
Governments, of course, deeply resent the discipline that the market imposes. In an interview with Business Week earlier this year, Malaysian Prime Minister Mahathir Mohamad blamed the fall of the ringgit on the “herd” mentality of currency traders, likening them to “buffaloes.” Even more notoriously, he intimates that “since most of the currency traders are Jewish, and it affects Muslim countries in East Asia, people will think this is a Jewish conspiracy.” The Prime Minister imagines that the traders, acting with one mind, can “devalue our currency at will,” and that doing so is a riskless get-rich quick scheme: “When you devalue currency and you short-sell, you make a lot of money. You just push figures on a computer screen, and you make a billion dollars.” One marvels that a conspiracy of traders would have waited until 1997 to grab this windfall.
In September, Mahathir announced new restrictions on the convertibility of the ringgit. Among other measures, Malaysian citizens may not take more than small amounts of cash out of the country when they travel abroad. Restrictions of that sort are a nuisance. Still more damaging to prosperity are the restrictions many developing nations impose on large financial outflows. Such capital controls are a cruelly effective investment repellent. No investor wants to bring wealth into an economy where it might become trapped.
It is sad enough when a politician engages in scapegoating and uses it as an excuse to restrict his citizens’ freedom to trade in financial contracts. The shame is compounded when a well-meaning economist countenances the herd-mentality view of foreign exchange markets and derives from it a counsel of hesitation in lifting capital controls.