The Dismal Science

Capital Control Freaks

How Malaysia got away with economic heresy.

I didn’t want to go to Malaysia. The Malaysian government would surely expect me to deliver a stronger endorsement of its heterodox economic program than I was prepared to offer. And, of course, it would try to use me politically–to provide a veneer of respectability to a regime that has lately developed the habit of putting inconvenient people in jail. But sometimes an economist has to do what an economist has to do. Since I had been the only high-profile economist to advocate the economic heresy that Malaysia had put into practice, sooner or later I would have to face the music. And so last month I agreed to spend a day–including a 90-minute “dialogue” with the prime minister–at the Palace of the Golden Horses, a vaguely Las Vegas-style resort outside Kuala Lumpur.

Some background here: Malaysian Prime Minister Mahathir Mohamad has been the wild man of the Asian crisis, blaming all his problems on manipulations by Jewish speculators, denouncing the prescriptions of the International Monetary Fund as part of a Western conspiracy to recolonize Asia, and so on. In the early days of the crisis, his position seemed absurd, and it was easy to make fun of him–which I did, right here in Slate. But eventually it stopped being so easy to dismiss Mahathir’s views. For one thing, the crisis turned out to be worse than anyone had imagined possible, and anyone with an open mind began to suspect that the IMF’s initial policies had been misconceived. For another, while the vast conspiracy Mahathir envisaged was a figment of his imagination (I know the supposed conspirators, and they aren’t that smart), a few hedge funds really did engage in concerted manipulation of Hong Kong’s markets in the summer of 1998. Mahathir still has a distorted view of the way the world works–more on that below–but then so do the free-capital-market faithful.

Where do I fit in? In the summer of 1998, I began to reconsider my own views about the crisis. The scope of global “contagion”–the rapid spread of the crisis to countries with no real economic links to the original victim–convinced me that IMF critics such as Jeffrey Sachs were right in insisting that this was less a matter of economic fundamentals than it was a case of self-fulfilling prophecy, of market panic that, by causing a collapse of the real economy, ends up validating itself. But I also concluded that the threat of further capital flight would prevent Asian economies from simply reflating, that is, increasing public spending and cutting interest rates to get their economies growing again. And so I found myself advocating temporary restrictions on the ability of investors to pull money out of crisis economies–a curfew, if you like, on capital flight–as part of a recovery strategy.

Now, it turned out that just at the time that I went public with those views, Mahathir and his advisers were secretly working out a plan to impose capital controls as part of a recovery strategy. According to what I have been told, my own public statement played a small role in the final decision; essentially, some of Mahathir’s advisers were worried by the absence of any support for such controls among mainstream economists, but the appearance of my August manifesto in Fortune silenced the doubters. Almost surely, Malaysia would have gone ahead with the plan anyway; but I had, inadvertently, found myself one of the few outsiders to express any kind of support. I quickly put out an open letter to Mahathir warning that the controls should not be abused, used as a cover for; but I know from friends in Washington that people started referring to the “Krugman-Mahathir strategy” of recovery via capital controls. And so I really could not avoid going to Malaysia to discuss those controls, a year after they had been imposed.

I  arrived at a moment of celebration. When the controls were put on, many Western analysts predicted disaster: a collapse of the economy, hyperinflation, rampant black markets. It didn’t happen. Two days before I arrived, the latest statistics had confirmed that Malaysia was in fact experiencing a fairly strong economic recovery. The actual implementation of the controls had been careful and selective, and important economic reforms–such as strengthening the banking system–had, if anything, accelerated after the new policy was introduced. A few days after my visit, restrictions on removing money from the country were eased and hardly any money was pulled out. So, I guess the Malaysians expected me to join them in a mutual admiration society. Surely they were disappointed when I expressed some skepticism about the payoff from the controls.

But the truth is that while Malaysia’s recovery has proved the hysterical opponents of capital controls wrong, it has not exactly proved the proponents right. For there is a recovery in progress throughout Asia. South Korea, which did not impose controls (though it did get an early and crucial rescheduling of its foreign debt) has bounced back with stunning speed; Thailand is growing, too; even Indonesia has bottomed out. In general, the market panic of 1997-98 was, it turns out, coming to an end just about the time that Malaysia decided to make its big break with orthodoxy. You can argue that the controls may have allowed Malaysia to recover faster, with less social cost, than it would have otherwise. But the vindication that Mahathir probably imagined for himself–a triumphant recovery in Malaysia, while its more orthodox neighbors continued to languish–hasn’t quite played out.

What, then, are the lessons of Malaysia’s recovery? In our staged “dialogue”–which was played out in semi-public, in front of a disturbingly obsequious audience of a hundred or so businessmen–Mahathir continued to sound a minor-key version of the conspiracy theme, insisting that capital controls were necessary to protect small countries against the evil designs of big speculators. That’s an unfortunate emphasis: While there are big speculators, and they do sometimes make plays against vulnerable economies, they are not the main reason that controls sometimes make sense. In general, controls should be imposed to prevent panic rather than conspiracy, and the investors who panic are, if anything, more likely to be respectable bankers and wealthy domestic residents than nefarious rootless cosmopolitans. (Indeed, even the occasional market manipulation by big speculators wouldn’t be possible if it weren’t for the possibility of generating a panic among other investors; it is a familiar point in the academic literature that Hong Kong-type speculative plays can work only if the economy is vulnerable to self-fulfilling crisis in the first place.) And the emphasis on big foreign speculators may encourage Malaysia to control too much for too long. Panic is a sometime thing, but hedge funds ye will always have with you.

Nonetheless, Malaysia has proved a point–namely, that controlling capital in a crisis is at least feasible. Until the Malaysian experiment, the prevailing view among pundits was that even if financial crises were driven by self-justifying panic, there was nothing governments could do to curb that panic except to reschedule bank debts–part, but only part, of the pool of potential flight capital–and otherwise try to restore confidence by making a conspicuous display of virtue. were the watchwords. The alternative–preventing capital flight directly, and thereby gaining a breathing space–was supposed to be completely impossible, with any attempt a sure recipe for disaster. Now we know better. Capital controls are not necessarily the answer for every country that experiences a financial crisis; sometimes confidence can be restored without the need for coercive measures, and even when calming words fail, “burden sharing” by banks and other lenders will often be enough. But it would now be foolish to rule out controls as a measure of last resort.

Mahathir can therefore claim a partial vindication for his economic heresies. That is not a political endorsement. Some right-wingers have claimed that anyone with a good word for Malaysian capital controls (me in particular) is also in effect an accomplice in the imprisonment, on what certainly sound like trumped-up charges, of Mahathir’s former heir apparent Anwar Ibrahim–an advocate of more conventional policies. Well, I still remember the days when left-wingers used to claim that anyone with a good word for Chile’s free-market reforms had bloodstained hands, because he was in effect endorsing Gen. Augusto Pinochet. The point is that economics is not a morality play. Sometimes bad men make good policies, and vice versa. And the job of economic analysts is, or ought to be, to assess the policies, without regard to who makes them.

The objective fact is that whatever you think of Mahathir, Malaysia has gotten away with its economic apostasy. You can question whether that apostasy was necessary, but you cannot claim that it has been a disaster–and you cannot disguise the fact that those who predicted disaster were letting politics and ideology cloud their judgment.