“Loose funds may sweep round the world disorganizing all steady business.
Nothing is more certain than that the movement of capital funds must be regulated”
Keynes, J.M.
Already Keynes warned against a free movement of capital. Those warnings were taken seriously by the international community and the IMF allowed in its articles the use of capital controls. The attitude towards those controls changed remarkably during the 1980`s when a general trend towards deregulation occurred. This trend peaked in an attempt to include the purpose of liberalizing capital movements in the Articles of Agreements of the IMF. Coinciding with the Asian Crisis, parts of the academic profession heavily opposed this idea and eventually, some of the fund`s representatives revised their general opposition against capital controls. Nonetheless, in big parts of the academic profession, capital controls carry a negative smack and the ultimate goal of free capital flows is promoted. With the financial crisis, however, capital controls came into vogue again. Recently, Brazil introduced a tax on foreign portfolio investment. Also at the G20 level, ways on how to regulate international capital flows are discussed.
Whether this should be seen as a desirable development or not, boils down to the question if capital controls are a useful instrument of economic policy? In general capital controls are any kind of policy that limits or redirects capital account transactions. So, the above mentioned question can be answered by looking at the situation of a fully liberalized capital account with its associated cost and benefits and see if state intervention in form of capital controls would be able to improve the situation. This discussion shall first rest on theoretical considerations and outline possible benefits of free capital flows. Thereafter, an important assumption, namely the Efficient Market Theorem, which allows for the prediction of those benefits, will be discussed. Subsequently, by dropping the EMT and introducing Keynesian uncertainty an alternative scenario is drawn and the effect of capital controls within this framework is examined. After this, some of the empirical research regarding the benefits of free capital flows will be examined and some of the areas where capital controls can play a beneficial role are introduced to the reader. Finally, the insights gained in the course of this paper will be summarized and an answer to the stated question will be given.
Table of Contents
1. Introduction
2. Are capital controls a useful instrument of economic policy?
3. Conclusion
Objectives and Topics
This essay explores whether capital controls serve as an effective instrument of economic policy. It investigates the theoretical and empirical arguments surrounding the liberalization of capital flows, contrasting the Efficient Market Theorem with Keynesian perspectives on uncertainty and financial market behavior.
- The theoretical debate between free capital flows and regulated markets.
- Critique of the Efficient Market Theorem (EMT) and the role of liquidity.
- Empirical evidence on the relationship between capital openness and economic growth.
- Macroeconomic policy benefits of capital controls, including crisis prevention.
- Policy implications for sovereign states regarding financial market integration.
Excerpt from the Book
Are capital controls a useful instrument of economic policy?
In economic theory capital controls have received only scant attention. Mostly, it is assumed that controls of capital work similar as tariffs on goods – they are harmful for economic efficiency because they lead to a misallocation of resources. Therefore, freeing a country from those controls should be beneficial in various ways. Those benefits, similar to those to expect from free trade, rest on the differences between countries, such as different saving rates, age structures, investment opportunities or risk profiles.
From an individual country’s perspective, free capital flows should enable citizens to decrease their consumption volatility relative to output volatility. The idea here is that output cycles are generally not perfectly correlated over different regions and countries; financial asset trading can therefore decouple output and consumption. A more stable consumption is seen as welfare enhancing. Similarly, it enables societies that age faster than others to trade consumption today against future consumption. One country’s residents could therefore save for retirement, while residents of another country have more resource available today. For investors, free capital flows mean that the choice of investment opportunities increases. Hence, higher portfolio diversification is possible what allows for higher risk adjusted returns. Likewise, domestic borrowers can raise funds internationally and should therefore be able to pay lower interest rates. Further, open capital accounts would prevent local government from reckless macroeconomic policies, since international capital markets would punish imprudence.
Chapter Summaries
1. Introduction: The introduction outlines the historical context of capital flow regulation and identifies the central research question regarding the utility of capital controls.
2. Are capital controls a useful instrument of economic policy?: This main section provides a critical analysis of the theoretical arguments for and against capital mobility, examines the limitations of the Efficient Market Theorem, and reviews empirical evidence concerning growth and market stability.
3. Conclusion: The conclusion synthesizes the findings, arguing that the costs of capital controls are often overstated and that they represent a valuable policy tool when utilized effectively.
Keywords
Capital controls, economic policy, financial liberalization, Efficient Market Theorem, Keynesian uncertainty, liquidity preference, consumption volatility, foreign direct investment, macroeconomics, crisis prevention, speculative attacks, financial markets, capital accounts.
Frequently Asked Questions
What is the central focus of this essay?
The essay evaluates the economic utility of capital controls, questioning whether they act as a harmful interference or a necessary instrument for maintaining economic stability in an globalized financial environment.
What is the primary research question?
The primary question is whether capital controls are a useful instrument of economic policy, specifically considering their impact on welfare, growth, and crisis management.
Which theoretical frameworks are compared?
The author contrasts the mainstream Efficient Market Theorem (EMT), which favors deregulation, with a Post-Keynesian framework that emphasizes uncertainty, liquidity preference, and the potential for herd behavior in financial markets.
What is the methodology employed?
The work utilizes a literature-based theoretical analysis combined with a review of empirical studies to examine the actual benefits and costs associated with the liberalization of capital accounts.
What are the core arguments regarding free capital flows?
Arguments for free flows include improved portfolio diversification, lower borrowing costs, and the consumption-smoothing effect. Counter-arguments highlight increased volatility, potential for speculative attacks, and the failure of markets to deliver promised growth.
Which key concept characterizes the discussion?
A central concept is the "impossible trinity" of macroeconomics, which dictates that a country cannot simultaneously have a fixed exchange rate, free capital movement, and an independent monetary policy.
How does Keynes' view on liquidity influence the author's conclusion?
The author uses Keynes' perspective to argue that financial markets can be inherently unstable; therefore, controls can play a positive role by constraining abrupt shifts in demand that would otherwise disrupt the real economy.
Why might developing countries benefit from capital controls according to this text?
Beyond crisis prevention, the text suggests that capital controls can help reduce the need for accumulating large, low-yield foreign currency reserves, which serves as a form of "crisis insurance."
- Quote paper
- Daniel Detzer (Author), 2010, Are capital controls a useful instrument of economic policy?, Munich, GRIN Verlag, https://www.grin.com/document/153652
