With first Iceland and now Cyprus under “emergency” capital controls designed to “temporarily” restrict outflows of funds, it seems like a good time to revisit the International Monetary Fund’s December statement endorsing the use of capital controls as a policy tool. The statement was significant not so much because of any penetrating theoretical or empirical insights, but because of where it came from. The evils of capital controls were one of the key planks of the so-called “Washington Consensus” of policy recommendations from the IMF, the Treasury Department, and the World Bank, and they most clearly fit into the IMF’s remit. The December statement is essentially an admission that this aspect of the consensus has completely and utterly collapsed.
The key point, however, is that what’s happened in Iceland and Cyprus is exactly what you don’t want to do.
These island countries essentially pursued a strategy of underregulation as a way to attract huge inflows of capital. Those inflows allowed for some profitable banking activities and also greatly inflated the value of local assets like land. But capital that flows in can easily flow out, leaving you with a fiscally unmanageable banking panic. The story ends with partial defaults and the imposition of capital controls to prevent all the money from leaving. What you want to do, however, is impose the capital controls on the front end to limit the quantity of funds that are pouring in. That way you don’t inflate the bubble in the first place and don’t end up needing to greatly inconvenience your citizens and local firms with restrictions on outbound capital flows later.
But of course an interesting aspect of both the Icelandic and the Cypriot cases is that it’s not totally clear that capital controls would have been needed to achieve the policy goal. Both countries deliberately sought inflows of hot money via lax bank regulation. It’s certainly possible that even a better-regulated banking system would have attracted huge inflows, but it’s also quite possible that it wouldn’t. Were foreigners really all that interested in investing in Iceland? Now Spain is a different matter. Spanish banking regulation is actually pretty tough, and their enormous mortgage and property bubble occurred without much in the way of the sort of “innovative” new products that we had in the United States. It’s just that money flowed in, pushing up the price of land and houses and the wages of construction workers, and then the money flowed out, leaving the Spanish economy beached. It’s a great case of a scenario where limiting inflows to keep the economy more balanced would have helped. Except Spain is in the eurozone so they can no more block an inflow of hot money from northern Europe than Arizona can block an inflow of investment from the northeastern United States.
The major practical applications of the IMF’s new tune, therefore, seem to be in Asia, where everyone stopped listening to the Washington Consensus on this point more than a decade ago. That’s what the “currency manipulation” Congress likes to complain about is all about. China—followed by most of its Asian peers and competitors—restricts how much foreign money can pour in, which has the result, among other things, of preventing its currency from appreciating on international markets.