Capital Controls

Topics: Monetary policy, Bretton Woods system, Foreign exchange market Pages: 6 (1977 words) Published: April 9, 2014

1.  Read the case.  Describe the evolution of capital controls as practiced by governments around the world since WWI.  Summarize the debate for and against the use of capital controls.  An effective answer to the question will involve digging deeper into the information discussed in the case.  Specifically, the best papers will utilize arguments from the sources detailed in the footnotes of the case (say 3 of the sources).

Before World War I, there were not that many capital controls simply because of the gold standard that was used. If a country used capital controls, it was highly unusual and very costly. In 1933, the US effectively abandoned the gold standard because of the Great Depression. “Allowing the government to pump money into the economy and lower interest rates.” 1 The US Great Depression and use of capital controls instead of the Gold Standard motivated European countries to begin to adopt similar capital controls to help their economies effected by the Great Depression as well.

After most developed countries began to move away from the Gold Standard and began looking for a way that they could have monetary policy autonomy, the Bretton Woods system came into play. This system looked to have foreign currencies tied to the US dollar and “if a country's currency was too high relative to the dollar, its central bank would sell its currency in exchange for dollars, driving down the value of its currency. Conversely, if the value of a country's money was too low, the country would buy its own currency, thereby driving up the price.” 2 While the Bretton Woods standard fell apart in the 1970’s, we can see a lot of monetary policies hinge on this idea of exchanging, buying, and selling currencies as a way of capital control. The main reason for the Bretton Woods system’s failure was Nixon’s decision to abandon the Gold Standard entirely. Once the US dollar was not attached to gold anymore, countries began to adopt more liberal policies toward their capital inflows and capital outflows. The case attributes many reason for this relaxed adoption. The first, because of floating exchange rates, capital controls were deemed less necessary, because the exchange rate could adjust to accommodate inflows and outflows. Capital Controls would normally restrict or open up inflows and outflows, but floating exchange rates would do this on the principle of supply and demand. As Cohen states, “Currencies instead became increasingly deterritorialized, their circulation determined not by law or politics but rather by the dynamics of supply and demand.”3 The second reason for the loosening up of capital controls is that technology and financial instruments made it easier to circumvent regulations. Essentially, if someone wanted to exchange currencies or do business in a specific country, there was not much preventing them from doing so. Countries saw it useless and expensive to spend money regulating these financial inflows and outflows because there was not much they could do to restrict them. The third reason for their decision is the pressure from OECD, IMF, rating agencies, and portfolio investors to adopt more liberal policies of capital controls because they felt it was inconsistent with market-oriented policies. These market-oriented policies focused on opening up markets to many buyers and sellers from all over the globe. If a country attempted to restrict their currency, they would see a backlash of those who want to do business in their country and their economy would be negatively effected.

This process of liberalization continued throughout the 1970’s when the US, Germany, and the Netherlands removed their most prominent controls. Liberalization continued through the development of the European Union in 1990’s. When the EU was developed, this made a common market for the buying and selling of goods and services with no controls on capital inflows or outflows because the EU worked as one and began to use one...
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