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Krugman Plays Pharaoh to Capital's Exodus

Gary M. Galles

In every case where foreign money leaves a country, it’s because something is wrong in that country. – Anna Schwartz

In “Hot Money Blues,” New York Times columnist Paul Krugman has used Cyprus’s crisis to endorse controls on international capital flows, arguing that “unrestricted movement of capital is looking more and more like a failed experiment.” Unfortunately, his scapegoating of investors as the problem, while offering government control as the solution, confuses cause and effect.

Krugman’s core argument against unrestricted international capital markets is that they are too free. As a result, capital can be too easily withdrawn from a country, so “speculative” financial withdrawals could cause domestic and international crises. He proposes more “wisely conceived and managed” government regulation (the normal euphemisms for restrictions) of the capital market in order to prevent any more cases of what one critic termed “the free market gone absolutely wild.”

But open capital markets are part of the solution, not the problem. For instance, a National Bureau of Economic Research (NBER) study by Geert Bekaert and two co-authors found that the “perception that foreign capital not only increases volatility in the financial markets, but also in the real economy” is inconsistent with the evidence.

Those, such as Krugman, who blame open capital markets for volatility and crisis confuse symptoms and pathology. International financial market gyrations are not the cause of domestic crises. Rather, both financial and domestic difficulties are a consequence of failed government policy. Financial turmoil is exacerbated as investors see more bad government policies designed as band-aids and anticipate the likely perverse effects of these ad hoc measures sometime in the future.

The increased speed with which global integration allows capital and currency markets to respond to changed policies (or expectations of changing policy) has led many to scapegoat open markets themselves, deflecting blame from where it really belongs. A more precise understanding would be that open markets are enhancing investors’ ability to avoid being forced to bear the burdens of adverse policies. Capital finds good climates. This reduced cost to investors of moving threatened investments elsewhere has served to limit governments’ ability to hold those investments hostage. Policy blunders are therefore punished more quickly and utterly than in the past.

It is increasingly true that if a government’s exactions are too severe or its policies too adverse, investors who would have formerly been stuck with the burden can now more easily exit. This situation forces governments to inch closer to respecting property rights and the rule of law, disciplined by the worldwide competition for capital (though that discipline is routinely undermined by implicit and explicit government guarantees and debt forgiveness programs). All countries’ residents benefit from free movement of capital, as the threat of capital flight constrains governments’ power to burden both citizens and investors without giving them sufficient value in return.

Attempts to change these dynamics—not only as in the Cyprus crisis, but in other cases Krugman cites as failings of free markets—compound the government failures.

For example, the Mexican peso and Thai baht crises resulted from governments trying to maintain both fixed exchange rates and inflationary monetary policy, combined with the prospect of bailouts should things collapse. Absent capital controls, such policies drive capital away more quickly than before, making them increasingly self-defeating. And when crises ensue, they are not caused by competitive capital markets per se, but are the (socially costly) result of trying to ignore the messages of the market speaking out against the flawed policies. The solution is not to restrict international financial markets, muffling the messenger of government mistakes, but to end the policies that force capital to flee for safety to begin with.

That governments and statists wish to blame investors for the problems caused by their policies and shift the burden onto them by imposing capital controls is hardly surprising. But that is all the more reason to favor open international capital markets. As Nobel Prize-winning economist Robert Munnell put it, “It is a myth that capital flows are destructive and destabilizing.” Monetary historian Anna Schwartz made it even clearer: “In every case where foreign money leaves a country, it’s because something is wrong in that country.”

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