Capital controls are restrictions on international capital flows which may include taxes, prohibitions, or approvals. These restrictions were used extensively in the post-war era but progressively lost support in the international community in the 1970s. By the 1990s, most policymakers, economists, and political commentators agreed that controls were politically difficult to defend and economically ineffective. Controls became associated with developing countries and, in particular, with authoritarian regimes. At the same time, as financial markets became internationally more integrated, officials concluded that market actors would circumvent controls rendering them increasingly ineffective.

This blog post will challenge these widely held assumptions about capital controls. It will show that controls were used by advanced market economies into the 1990s, that they were effective in significant ways despite the rise of capital mobility, and that they were essential for the economic and democratic management of Western economies/societies. Based on my most recent research article and insights from the British economist John Maynard Keynes—one of the founding fathers of the post-war international monetary system—I will outline three critical reasons why we should consider a freer use of capital controls today: 1) capital controls can prevent financial crises, 2) controls can avert the accumulation of funds in the financial sector at the expense of the industrial sector and 3) controls expand economic policy autonomy.

1) Capital controls can contribute to financial stability

In the 1910s and 1920s, capital flows had become increasingly internationalised and of a speculative nature and had contributed to a series of financial crises which culminated in the Wall Street crash of 1929 which fed into the Great Depression.

Keynes and Harry Dexter White, two of the architects of the post-war international financial system—the Bretton-Woods system—concluded from the political and economic devastations of the 1930s that laissez-faire capitalism had failed and argued in favour of capital flow restrictions. Thus, the newly formed International Monetary Fund (IMF) implemented an “Article of Agreement” which allowed domestic governments to use capital controls relatively freely throughout the post-war era. As governments in advanced market economies restricted capital flows (more or less along Keynes’ suggestions) financial crises became significantly less frequent.

The IMF supported restrictions on free capital flows until the 1980s. Since then, this organisation has advocated for the full liberalisation of the capital account. Consequently, financial markets have become increasingly more integrated internationally, and moments of financial distress have become more numerous again—the number of financial crises has doubled between the post-war era and the time since the 1970s, and the severity of financial crises today increasingly resembles the crisis-ridden 1920s and 1930s. Financial crises do not only adversely affect the stability of our financial systems, but also the stability of our democracies. Research shows that financial crises instigate rising vote share for parties of the far-right.

During the Global Financial Crisis of 2007/2008, large and destabilising capital flows between developed and less-developed economies sparked debates on how to tame such capital movements. In response, the IMF endorsed an “Institutional View” on controls which argues that the full liberalisation of capital controls is not always right for all economies at all times. However, control use has only been endorsed for cases in which all alternative instruments to stabilise financial markets have been exhausted. Thus, flow restrictions are still rarely used and generally viewed as undesirable. As an alternative, the IMF and other international financial institutions have increasingly recommended macroprudential regulation. This is an important step towards more financial stability as macroprudential tools may restrict domestic overborrowing. However, capital controls may be significantly more effective in restricting capital flows from foreign capital sources.

2) Capital controls may limit the concentration of funds in financial market

Keynes also suggested that free capital flows instigated a concentration of capital in the realm of finance at the expense of productive investments; i.e., investments in the realm of industry. He viewed this concentration of funds in the financial sector as detrimental to output and employment and, thus, economic development.

My research shows that OECD countries removed capital controls differently since the 1980s and that this differential liberalisation of capital flows had important effects on the development of financial sectors across OECD economies. While governments in the Anglo-Saxon world removed almost all controls by the 1980s, Continental and Northern European economies retained a significant set of controls into the late 1990s. This was particularly the case for controls on capital-market related flows which include transactions related to equities, bonds, money-market products, and derivatives. Thus, restrictions were geared toward controlling some of the most dynamic realms of financial markets.

Those governments which removed controls swiftly in the 1970s instigated a boom in financial activity and facilitated financial innovation. In the UK, capital was channelled from industrial to financial assets and from domestic to overseas assets turning the City of London into a global financial hub. However, those governments which retained significant controls on financial capital flows limited the international integration of certain domestic financial markets and vibrant financial centres could not evolve. This was notably the case in Germany; and it is conceivable that the curtailed financial market development facilitated the retention of funds in the realm of productive investments, in turn, aiding German manufacturing markets.

3) Capital controls generate economic policy autonomy

Finally, capital controls may expand governments’ (and central banks’) economic policy space. Internationally mobile capital flows can make it more difficult for governments to pursue policy choices which financial market actors disapprove of. Expansive sovereign debt, for example, is disliked by financial investors because it can negatively affect the value of the exchange rate or trigger inflation and, in turn, curtail the return on certain investments. Thus, if capital is mobile, policies which drive up inflation or diminish the value of the currency may trigger capital outflows or speculative attacks on the exchange rate.

Keynes observed this dynamic in the 1910s and 1920s. As capital became more mobile, governments were less able to pursue policies which enhanced consumption and output. For example, social transfers or policies which channelled savings into nationally productive investments instigated rapid capital outflows. On the flip side, economies which implemented policies that financial market actors perceive as prudent (lower government spending, or restrictive monetary policy) attracted capital inflows. Such inflows could destabilise the domestic monetary sphere by expanding credit creation—driving up domestic prices. Keynes concluded in his 1933 essay “National Self-Sufficiency” that so long as capital flowed freely, foreign capitalists to a certain extent dictated domestic economic policies to the detriment of stable economic development and political stability. Controls, therefore, could function as macroeconomic tools which enabled governments to pursue domestic economic goals freely.

My research shows that the German Bundesbank chose to retain a considerable set of controls to counter the loss of policy autonomy it experienced as capital mobility increased in the 1970s. Since the post-war era, unusually stable macroeconomic conditions and low government spending had attracted capital inflows into German markets. Controls enabled officials to curb credit expansion and regain monetary stability.

Nowadays, governments are once again exposed to market pressures which constrain their policy space. Consider a recent example. In September 2022, then British Prime Minister Liz Truss and her Chancellor of the Exchequer, Kwasi Kwarteng, proposed a mini budget which contained tax cuts which would have significantly expanded sovereign debt levels. In response, capital left the British economy, and the value of the pound fell steeply. The government was forced to step away from the budget plan because financial markets did not like it. The mini budget was decidedly not Keynesian, but this incident demonstrates the lack of economic policy autonomy officials experience as capital mobility increases. This is not just problematic for the economic sphere: if governments cannot freely expand government spending to offer policies which voters/workers desire/need then trust in representative democracy falters.

In conclusion, there are three critical arguments why the international community should consider allowing governments to use capital controls more freely again. First, capital controls can contribute to the stability of financial systems by restraining the expansion of speculative investments. Second, capital controls can aid governments in retaining capital in the industrial sphere with benefits for employment. Finally, capital controls can protect governments’ policy space and keep financial market influence on domestic policy choices at bay with positive effects on the stability of our economies and our democracies.

 

Inga Rademacher is a Lecturer in International Political Economy at City St. George’s, University of London. She holds a PhD from the Max Planck Institute for the Study of Societies and her research deals with monetary and fiscal policy, finance and democracy.