Free market capitalism has faced intense criticism in recent years. Even that most basic tenet of the post-‘70s era, the free movement of capital and floating exchange rates, has its critics. Some on the left believe that a government set on fundamentally reforming capitalism might need to bring in controls to prevent capital leaving the country and a sharp currency devaluation.
I know of no major Western political party that advocates such controls. But, as we’ve seen in recent years, the unthinkable can become reality. It is in this spirit that we tackle the issue of capital controls.
In the West we take for granted the right to change our national currency into a foreign currency and spend overseas or buy foreign assets.
It was not always so. For most of the twentieth century Western governments imposed restrictions on the buying and selling of foreign currency or caps on the sale or purchase of financial assets.
War was the catalyst for Britain’s adoption of exchange controls. At the outset of the First World War in 1914 the UK government banned residents from buying foreign securities and raising foreign loans to prevent a panic-induced outflows of capital. These regulations were eased in the inter-war period. At the outbreak of war in 1939 the UK severely restricted the ability of residents and businesses to convert sterling into foreign currencies.
These powers were formalised after the war, in 1947, and a limit put on the amount of currency that could be taken out of the country. In the late 1970s if you were heading overseas on holiday you could buy up to a maximum of £50 worth of foreign currency.
To finance a hitch-hiking trip around France in the late ‘70s I went to the local bank which sold me the prescribed number of francs and recorded the purchase on the “Exchange Control Act” page of my passport. In today’s world of holiday spending using Revolut, Monzo and the rest, it sounds Soviet. But for much of the last century such controls, which aimed to keep money in the UK and bolster the value of the pound, were the norm.
It all changed in 1979. One of the first policy decisions of the incoming Conservative government under Mrs Thatcher was to abolish capital and exchange controls. Overturning a near 70 year consensus, the new Chancellor of the Exchequer, Sir Geoffrey Howe, said: “The essential condition for maintaining confidence in our currency is a Government determined to maintain the right monetary and fiscal policies. That we shall do. It is right to give an additional degree of freedom to allow the pound to operate in the world unrestricted by restraints of this kind”.
The argument that the free movement of capital boosts growth by channelling investment to where it is most productive proved attractive. In the wake of Britain’s abolition of exchange controls numerous other countries followed suite.
The free movement of capital has been a key driver, along with trade liberalisation and technological change, in the rapid globalisation of the last 40 years. Foreign exchange turnover, cross border capital flows and foreign direct investment have grown at a dizzying pace. The ownership of assets, from equities, to government bonds to prime housing, is increasingly international. Investors take for granted the ability to buy Chinese equities, Spanish property or US government bonds. Global supply chains have flourished. Multinationals operate treasury operations seamlessly across borders.
But the case for the free movement of capital is not absolute. The International Monetary Fund (IMF), a staunch advocate of the free movement of capital, has also described situations in which capital controls would be appropriate – in response to a crisis and as part of a broader set of measures to tackle the causes of the capital flight. Their purpose should be to buy time to allow other policies to work, not as a solution in themselves.
It was to buy time that Greece implemented capital controls in 2015. They included limiting withdrawals from banks to 60 euros per day to prevent bank runs. Reduced cash withdrawals depressed Greek spending and growth. But the controls also prevented a full-scale run on the banks and a collapse in the financial system, which would have been far worse.
There may also be a case for controls on capital flows in small, open, emerging economies. They are susceptible to large swings in short-term, or ‘hot’ money flowing into and out of their domestic capital markets. A sudden loss of confidence and withdrawal of foreign capital causes a currency devaluation and inflation. In response the authorities need to raise interest rates, hitting growth. Such a chain of events caused the Asian financial crisis of 1997, pushing a number of East Asian economies into recession.
China is in a special category. It applies capital controls because it wishes to maintain a fixed exchange-rate and an independent monetary policy. An open economy can have only two of the following three: free movement of capital, a fixed exchange rate or independent monetary policy. China has opted for the last two. Western countries have overwhelmingly opted for free capital movement and independent monetary policy. These countries let their currencies float.
China proves that a large trading country can control capital flows. But applying them in politically liberal, open Western economies is another matter.
In 2017 John McDonnell, the UK Shadow Chancellor, said his team had been “war gaming” the responses of an incoming Labour government to a run on the pound. Some commentators interpreted this as hinting at the possible introduction of exchange controls (To be absolutely clear Mr McDonnell did not mention capital controls and they are not Labour policy).
Still, it is interesting to consider the hypothetical. Could controls stem capital flight and a plunging pound caused by the prospect of root and branch reform of the economic system?
The IMF view is that capital controls might work as a fix to buy time for other policies to address the cause of the crisis. Yet in our imagined situation government policy is the cause of the capital flight. To make things worse the act of imposing capital controls could exacerbate the crisis by underscoring the government’s willingness to apply drastic, unconventional policies. In our hypothetical UK situation capital controls would struggle to meet the IMF’s test.
Capital controls are more easily applied in an autocratic state such as China or in less sophisticated financial markets such as Greece than in the UK’s deep and developed financial markets. Creating the systems to monitor and control vast capital movements across a myriad of transactions would be a huge task.
But let’s assume controls do stick. The question then is about second round effects. Today’s economic system has developed over 40 years on the basis that capital can move freely in and out of the UK. Trade, businesses, investments, supply chains and much else rely on this assumption. Controlling the movement of capital would represent a hugely disruptive shock for business and households. Everyday consumer activity - using Paypal to make overseas transfers and purchases, buying holiday money, using a Revolut card abroad or buying foreign equities – all count on the free movement of capital.
There’s a further snag. The UK runs a large current account deficit, largely because imports of goods and services exceed exports. This deficit is financed by inflows of capital investing in UK assets, what Mark Carney strikingly, though not accurately, characterised as the “kindness of strangers” (Foreign investors don’t build factories in the UK or buy London real estate out of kindness. They buy them because they think they are good assets which will make them money). If the UK restricted or deterred capital inflows it would have to cut back on import spending which, given the UK’s appetite for imports, could be traumatic.
I find it hard to disagree with Sir Geoffrey Howe’s judgement that the best defence against a weak currency is policies which command the confidence of markets. Capital controls can be the right solution in some circumstances – but they are the sort of extreme circumstances such as Greece experienced in 2015 that no Western country would want to be in. As the IMF has noted, restrictions on capital leaving an economy are associated with “autocratic regimes, failed macroeconomic policies and financial crises”.
PS: Last week Deloitte launched its latest 'State of the State' report, including a survey on UK public attitudes to government spending. The survey shows a marked shift in public opinion against further cuts in spending. The report also looks at views about charging for public services. Most people support fines for the misuse of public sector time, such as wrongly calling 999 or missing GP appointments. See the full report at www.deloitte.co.uk/stateofthestate
PPS: For those on our Deloitte London campus, please join us for an internal briefing on the findings from our latest CFO survey tomorrow (16th October) at 12pm on the Landing (7th floor, 1 New Street Square).