naked capitalism

When Jim Rogers taught classes at Columbia, he liked to tell students that the US had a proud history of implementing capital controls, and warned them against going on the merry assumption that it would ever and always be easy to make cross-border investments. For instance, taxes on foreign securities transactins are a soft form of control and have been used to facilitate or restrict cross-border capital flows. The US lowered them when it abandoned Bretton Woods in 1971 to aid in adjustment of the price of the greenback.

Despite the hue and cry that we must keep trade and capital flows open, I have long believed that they would be restricted as financial reforms moved forward. The Carmen Reinhart-Kenneth Rogoff work shows convincingly that periods of high international capital mobility are associated with frequent banking crises. They do not assert that the relationship is causal, but I suspect it is. Capital that can move easily across borders is by nature difficult to regulate. It would require a considerable sacrifice of national sovereignity to devise rules and organizations that could do an adequate job of supervision. So a high level of international investment flows means lawless or seriously underregulated financial firms and activities. And we have just seen that this lawlessness eventually exacts unacceptably high costs to the real economy.

Thus, measures to increase stability that will be effective can only take place on a national level, and they further require at least some restriction of cross border flows. But how that would come about remained a mystery to me, hence my silence on this topic. Everyone seems wedded to the prevailing ideology of “fewer international restrictions are better.” Indeed, some have decried how awful it would be if the world were to revert to largely national pools of capital, depicting it as a financial Dark Ages. But would it be a Dark Ages for the economy, or merely for bankers?

Russell Napier in today’s Financial Times, describes how capital restrictions might come about, and his case is entirely plausible. The interest of high finance are increasingly opposed to those of governments. Capital will want to flee to havens which are not suffering from the need to work off enormous bank rescue costs. But those very same governments will find it necessary to keep funds at home to earn a return to work down those very same expenses. Hence capital controls.

From the Financial Times:

One consequence of the financial crisis is that fund managers are increasingly going to come into conflict with governments…

Developed world governments are desperate for finance; they will attempt to constrain private-sector credit growth and are likely to ease the economic pain with inflation and exchange-rate depreciation.

This differs from the environment of the past few decades when investors were happy to save in their own currencies, buy government debt and participate in credit-fuelled domestic asset booms. Will fund manager fiduciaries now be prepared to finance record fiscal deficits? Will they buy domestic assets in an era of sub-par credit growth? And will they buy shares in banks stuffed with government credit and loans aimed at securing employment rather than sound returns?

If they don’t, how much capital will they export? Indeed, might they consider it prudent to short government debt to protect their clients’ wealth? To protect against inflation, might they buy commodities?

This may all look necessary to fiduciaries, but governments will view it as speculating against their currencies and driving up the cost of government financing. Governments will not stand by and watch what they might come to term “capital behaving badly”.

Until 2008, capital colluded in maintaining the myth of prosperity, by providing the credit for excessive consumption. Capital supported the illusion of savings by pumping up equity valuations to ridiculous levels; and it supported the need to speculate, most notably in the housing market, by manufacturing savings that could not be earned. This support ended with a bang, and governments stepped in to prevent the deflation that would have brought poverty all too quickly.

The first emergency step was to partially nationalise commercial banks, but government interference with capital allocation will not end there. The need to bail out the banking system accelerated the public debt crisis that was coming anyway, due to the baby-boomers’ failure to save for their retirement. Once known as the ‘Grateful Dead’ generation, their demand for pensions and healthcare will mean they will increasingly be seen as the ungrateful undead. The political necessity of supporting their claims will drive government further into the capital allocation business.

Governments still need the support of capital to ensure that the myth of prosperity dies slowly. If that support is not provided willingly, history shows that governments can conscript capital to the cause. So what sort of “national service” can we expect ?

A transaction tax on financial instruments is very likely… A suitably high transaction tax would force investors to hold shares for much longer periods and to engage management to control risk. This would reduce the need for governments to police risk-taking in corporations. What could be more laudable than a tax that turned everybody into Warren Buffett?

Capital controls are also more likely than investors believe….There is an inherent conflict between western governments’ need for finance to sustain living standards and capital’s need to seek out the greater growth opportunities in emerging markets. Whatever the long-term benefits in boosting returns on savings, the short-term political necessity of public financing is likely to necessitate slowing capital outflows.

Capital controls seem impossible to many, but when a choice has to be made between economic principle and government bankruptcy, they are a likely political response

Japan is a case study in the cost of losing control of capital flows. The government made it easy for retail investors to buy foreign currency investment, with the logic being that yen-based returns were so low, savers needed to be allowed the opportunity to earn higher yields overseas. Unfortunately, a cadre of retail FX traders, every bit as manic as US day traders and holding even more funds in aggregate, now dominates yen trading. The government now has more impediments than it otherwise would have in influencing the level of the yen thanks to this self-inflicted wound (not that currencies are easy to manage even in the best of circumstances, but this policy has made a difficult task even more fraught).