When Capital Flees: the Case for Exchange Controls Is Not out Of This World

Listener 17 October, 1998.

Keywords: Globalisation & Trade; Macroeconomics & Money;

While I was recently analyzing a government report for a class, a student (who apparently worked on it) became increasingly agitated, asking what was my alternative proposal. Not worrying about analysis, but pursuing policy, is a characteristic Wellington foible. The same fallacy applied to the economists who criticized economist Paul Krugman when he was here. They did not suffer from the disadvantage of having read his analysis, which was considerably more subtle and sophisticated than the critics thought. You dont successfully spend time in top US university economics common rooms and the US economics circuit, without developing powerful defences to the elementary points the New Zealand critics made.

More recently, Krugman has shocked much of the economics world by making a case for exchange controls. New Zealand abandoned them in 1984. Today anyone can buy or sell New Zealand dollars for foreign currencies. Our politically correct economists will jump upon anyone advocating exchange controls for New Zealand, which prohibited some transactions – say speculative capital movements.

At the heart of Krugman’s argument is that current policies have failed in the case of the current Asian financial crisis, although he acknowledges they worked during the 1995 Mexican crisis. This time the IMF and US strategy – of lending to the afflicted countries to help them tide over the crisis, demanding economic reform, requiring high interest rates, and wait for confidence to return – has not worked. Krugman dismisses the conventional – hard money and soft money – criticisms and focuses on interest rates.

The bind the crisis countries face is they require high interest rates to prevent capital flight (foreign investors withdrawing their funds), while they need low interest rates to stimulate economic demand and offer some hope for businesses with high debt to equity ratios. Exchange controls prevent the capital flight when interest rates are cut.

Krugman frankly admits all the defects of exchange controls – he gives a far better list than his critics would. His commentary on the dangers of the recent Malaysian imposition of exchange controls is the best I have seen. But he argues that despite the difficulties the advantage of stopping capital flight, stabilizing the exchange rate at a competitive level, and keeping low interest rates offsets the clumsiness of the controls – for a while anyway.

There seems to be a subtle shift going on in economists’ thinking. There has been a tendency for those who support free trade (such as no protection of domestic industries) to also support free capital movements (and no exchange controls). I was astonished when economist Jagdish Bhagwati – a staunch advocate of free trade – said in relation to the Multilateral Agreement on Industry (MAI), “the claims for enormous benefits from free capital mobility are not persuasive.”

The economist’s theory of international trade does not exactly replicate the facts of the real world. However most judge that the gap between the theory’s assumptions and reality is small enough to make the theory usable. (Scientists do the same thing, when they assume the earth is a perfect sphere.) Because capital markets spin much faster – at least fifty times – than commodity markets, the gap is greater. It is like having a shotgun which is subject to aiming error, but works passably, while an equally accurate machine gun could do a lot of damage.

Will we see a return to greater use exchange controls? I cannot tell, but I do know there is a very powerful international financial sector which demands free capital movements, even if they collapse the world economy.

I dont think there is a strong case for exchange controls for New Zealand – not yet, not while interest rates and the exchange rate are low. Admittedly capital speculation has done a lot of damage to the tradeable sector over the last decade, and we need to be wary when it becomes hyperactive again. I would favour an independent study of the case for and against a financial transactions tax, like that advocated by the Alliance, aiming to dampen down the financial spinning and substitute for the GST the sector does not pay. It would not be a major revenue earner. No doubt there are those who already have policy views, without having the handicap of doing any analysis.


At the Crossroads?

As the Australians move to post-election economic reality, they may look at economist Fred Argy’s Australia at the Crossroads, which contrasts the case for “radical free market” (what we call “rogernomics”) to an alternative of “progressive liberalism”, which uses market mechanisms as a component of the pursuit of social objectives. Elsewhere it might be called the “third way” although there are many “ways”.

The not very flattering, but measured, chapter on New Zealand comments “it should have been possible to greatly attenuate some of the reforms without throwing out the whole baby. Value judgements are unavoidable here, but a strong case can be made that the economic and employment gains from at least some of the reforms (on wage deregulation, welfare and taxation) were not substantial enough to justify the cost.”

It might be worth our looking at the book, pre-election.