In a remarkable shift, The Economist magazine has acknowledged that controls on the movement of capital are necessary to safeguard the interests of poor nations.
In its May 3 edition, the internationally respected journal, normally a staunch advocate of free markets, calls for a revision of economic orthodoxy on capital flows.
“In negotiating new free-trade arrangements with Chile and Singapore, the United States has recently sought assurances of complete capital account liberalisation,” it says in an editorial. “Bitter experience suggests that such demands are a mistake.”
In a separate analysis in the magazine, Clive Crook concedes: “The capital market has vindicated its critics and embarrassed its would-be defenders too often of late. It has been responsible for, or at least deeply implicated in, some very costly economic breakdowns. Perhaps the anti-globalists are on to something.”
Crook cites financial crises in Latin America in the 1980s, Mexico in 1994 and East Asia in 1997/9, which had caused recessions “equivalent to years of growth foregone”.
“Financial distress is a salient ingredient of Japan’s endless economic difficulties, in Europe’s current slowdown and the fragility of America’s economic recovery.”
The Economist’s caveats lend moral weight to Third World demands for a revamp of the world’s “financial architecture”. It also provides backing for South Africa’s softly-softly approach to the relaxation of foreign exchange controls.
The Economist’s editorial continues to defend unfettered trade in goods, saying this promotes peace and prosperity and forms an indispensable part of personal freedom.
But it argues that trade in capital is different because international markets are error-prone, while punishments for mistakes can be “draconian and tend to hurt innocent bystanders as much as borrowers and lenders”.
“Recent decades, and the 1990s most of all, drove these points home with terrible clarity. Great tides of foreign capital surged into East Asia and Latin America, and then abruptly reversed. At a moment’s notice, hitherto-successful economies were plunged into deep recession.”
Crook argues that financial markets are susceptible to error because they are asset markets — for “streams of payments spread out over time”. Because asset prices were bets on a remote and unpredictable future, they were inherently volatile.
Lack of information about underlying value, exacerbated by distance and cultural unfamiliarity, made investors especially sensitive to other investor sentiment and sometimes led to mass hysteria. “In extreme cases, the views of other investors are taken seriously even when contradicted by such facts as may be available.”
Compounding this, Crook says, was the placing of bets on the future with borrowed money, meaning that losses cascaded across a series of lenders and potentially threatened the viability of banks.
The Economist warns against blocking capital outflows, which deter future inflows of all kinds, including much-needed fixed direct investment. However, it concludes that domestic and international finance must be regulated in ways that ordinary commerce does not require.
The chief danger lay with heavy inflows of short-term capital, notably bank loans. It suggests developing countries could emulate the successful example of Chile, which had imposed taxes on short-term inflows, with the rate of tax varying according to the holding period.