Capital Controls Through the Lense of the Exporting Country:

18 July 2005

  Howard Wachtel

Capital Controls Through the Lense of the Exporting Country:
Some Preliminary Thoughts
Howard Wachtel
Contribution to an International Workshop on Capital Flows:
Arresting Speculation and Volatility
organised by ARENA
Hongkong, 12-14 February 2001

Many of the structural distortions in capital markets exposed by the 1997 Asian financial crisis and its predecessors apply as well to the United States and Europe, to the dollar and the EURO. There is, first, the ascendancy of a monetary stability policy objective over growth in the real economy. Second, the problems of moral hazard and "too-big-to-fail" have pervaded the last two decades in the capital-exporting countries (as they now have appeared in Asia since 1997): the bailouts following the two Mexican debt crises after the bank bailout during the first debt crisis in the late 1970s, the Savings and Loan debacle of the 1980s, and individual bank failures in Europe and the United States. The banking system on a conservative estimate has probably been supported with at least $750 billion for all these lapses in prudent management of the financial system. These are not "free" markets as their celebrants proclaim but very expensive ones for taxpayers. Contrast this episode of financial underwriting by the state, with efforts in the Great Depression of the 1930s when the real economy - manufacturing and employment - received financial support, and the financial system was placed under tight regulatory control. In the epoch of globalization and the preeminence of finance this has been reversed. Now the real economy is left to fend for itself within a doctrine of free markets while the financial system receives financial guarantees from the state and, with apologies for some exaggeration, has almost become a ward of the state.

Therefore, it is just as important to examine financial regulations and international capital flows in the advanced industrial capital-exporting countries as it is in the recipient capital-importing third world countries. There is a symmetry and controls will be less effective in the third world if there are not also regulations placed on the capital-exporting regime.

I find the word "controls" problematic, because in the capital-exporting countries this conjures up an image of customs officials conducting body searches in airports to find contraband currencies trying to the leave the country. Such Hollywood imagery is not helpful to the debate, and I prefer to use a term such as prudential regulation, PR for short.

The challenge for policy poses the following question: Is it possible to secure the benefits of a flexible and liquid financial system, capable of mobilizing capital on a large scale, while at the same time ensuring that national economies and the world economy are protected sufficiently from the systemic risks which financial liberalization produces? There is a trade-off between risk and flexibility, so no one wants to create a structure in which risk is so minimized that it cuts off international financial and investment flows. Nevertheless, there is a broad consensus today, in virtually all circles, that the trade-off is imbalanced toward too much flexibility and not enough risk reduction.

Reform proposals range from the minimalist, those being discussed in Basle at the Financial Stability Forum, to the maximalist among independent scholars and NGOs, a call for a new World Financial Authority. The minimalist measures include greater transparency, bailing in banks to confront moral hazard, enhanced monitoring and supervision, more orderly debt workouts, and uniform accounting practices. The call for a World Financial Authority (WFA) involves a higher degree of management of systemic risks, a lender of last resort, internationally managed financial regulation, risk-weighted capital and reserve requirements on all financial institutions and all financial instruments, and in some presentations, a new international currency. There are some overlaps between the two, as for example the idea of risk-weighted policies and the maximalists subsuming all of the minimalists' policies. The minimalist project has been whittled down to probably no more than transparency, accounting standards, and the call for development of financial regulatory capacities in the capital-importing countries.

My own position lies somewhere between these two and includes structural reforms not covered by either. I am not persuaded by such grand schemes as the World Financial Authority, its scope or its content. The central question is why would this new financial authority be run any differently and by any different people than the present international financial institutions? The proponents of the WFA imply without stating directly that such a new institution will reflect different ideologies, different governing constellations of power, different policies, and different people running it? But why does this follow? Where is the evidence a WFA would be run any differently from today's IMF with roughly the same distribution of voting power? In fact, in today's political climate such an institution with such sweeping powers may, in fact, end up doing more harm than good. I can easily imagine a presentation for a WFA at Davos and it commanding much interest and support. And as to the minimalist menu, much in it is of value but it is not something independent public intellectuals or third world NGOs should devote much time to. It will be done in some form, probably a minimal minimalist one (minimalist-lite), so why bother with it.

I am a radical incrementalist and suggest this posture for independent public advocates, someone who attempts to think in a policy frame that structurally affects outcomes in a progressive way but in a step-wise fashion that begins from where we are and knows where we want to go. Of the range of options offered by the minimalists and the maximalists I would focus on risk-weighted reserve requirements that are comprehensive, covering all financial instruments and all financial institutions, along with the obvious minimalist agenda of transparency, improved auditing, and a harmonization of accounting practices. To this I would add other reforms, starting with the Tobin tax on foreign exchange turnover for the following reasons:

  • it probably will have some impact on short-term speculative flows of hot money
  • even if the moderation of such flows is less than anticipated by Tobin tax advocates, it has another and equally salutary result: The tax can be used to underwrite a well-financed, perpetually replenishable stabilization fund
  • this stabilization fund can be mobilized in the event of another crisis in capital exiting thin markets
  • the very existence of the stabilization fund may be a deterrent and itself reduce risk in the system
  • in extremis it can be mobilized effectively to stabilize global financial flows
  • it is self-financing in that the tax is extracted from the source of the potential problem and used to mitigate the consequences of a rush to the exits
  • the tax is small on each transaction but raises sufficient resources to make the stabilization fund credible

The Tobin Tax need not be introduced simultaneously worldwide as many think. The notion that this tax requires universality before being tried does not hold up against the evidence or the views of important analysts, including Tobin himself. As for a regional version, say in Asia, it is quite feasible.

What about the dramatic transformation of international capital markets wrought by the revolutionary changes in information technology, communications, and information systems in the past quarter century? Is this determining in shutting down all possible alternatives? Do we live in a TINA - there is no alternative - world? Without arguing a technological determinist position, divorced from the social and political construction and contingency of these new systems, one cannot ignore their significance. Space and time has been shrunk and therefore so has the ability of crisis managers to respond. In a crisis of any sort, the language used is one of "buying time", time being the best ally of a crisis manager. But in the new technological world time is reduced, it is scarcer and, as for any commodity, its "price" rises when it becomes scarcer. So the cost of time is higher precisely when it needs to be lower. But how does one buy more time, increasing the demand for it just at the moment when mangers need a greater supply of time, without increasing its cost? This is the dilemma in which crisis managers find themselves when a financial implosion starts. The speed at which the crisis builds on itself exceeds the time-resources available to managers of the crisis.

There are precedents for dealing with the problem of time shrinkage and they fall under the policy construction of circuit breakers, which buy time in an automatic way by announcing explicitly in advance what the rules of the game are and how the game is to be played. For example, following on the 1987 stock market collapse in the US, the New York Stock exchange has adopted a circuit breaker rule, such that when the market falls by some percentage within some period of time, it simply shuts down. Our policy imaginations should be mobilized to think of comparable circuit breakers in international short-term capital markets.

Financial regulation of the not-too-distant-past also included the erection of fire walls, solid barriers between different financial institutions and operations so the risk of contagion is reduced. The very term contagion, drawn from the medical world, offers the answer: immunization. Fire walls quarantine contagious viruses. This is a second dimension of international capital regulation that has not been given attention and suggests a second avenue for creative policy construction.

The third pillar of this category of a radical incrementalist position is automatic stabilization, another element of financial regulation that has been lost in the rush to deregulate and operationalize the ideology of free markets, though not really free because of the enormous financial underwriting by states to keep financial institutions solvent. Automatic stabilizers are designed to kick in without discretionary action by policy makers which can take time and become compromised. Added to circuit breakers and fire walls, automatic stabilizers can reduce volatility and deter financial crises.

This short list is deliberately short. A longer one will not be easily digested by policy makers or the public. But if realized it will radically change global financial markets, redistribute power and risk, and incrementally produce important structural change. These proposals can be effectively defended under the umbrella of prudential management of financial risk without reducing liquidity in the system so much as to limit unduly international capital flows.

I conclude by restating my premise: adequate prudential regulation of international capital markets requires a symmetry between the capital-exporting and capital-importing countries. Rather than grand new mega-institutions, a radical incrementalist approach seeks to break the crust of the debate, neither resigning it to minimalist measures or grand schemes. Alongside a few reforms under review, especially risk weighted reserve requirements on all financial instruments and institutions, the new thrust is in posing the question as to how to design circuit breakers, fire walls, and automatic stabilizers, all of which will reduce volatility. A compelling feature of the Tobin tax is that it embodies several of these objectives.


About the authors

Howard Wachtel

Howard Wachtel is a former TNI fellow and an expert on the financialisation of the global economy who foresaw the financial crisis long before it struck in autumn 2008. His book in 2003 Street of Dreams. Boulevard of Broken Hearts: Wall Street's First Century (London: Pluto Press) is a widely respected history of the infamous New York street.  Howard was the first co-ordinator of TNI's Global Economy Programme and currently a Professor Emeritus of Economics at American University in Washington DC.