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Sunday, August 25, 2013

Capital controls: what might sound nice at 40,000 feet is a big mess on the ground

Every now and then, some people get enamoured about capital controls as a tool for macroeconomic policy. The actual operation of capital controls on the ground is a mess.

As an example, consider the recent decision to hinder outbound capital flows by individuals and firms. At first it sounds fair and plausible. We are hindering outbound capital flows by households by interfering with their purchase of gold, and in similar fashion we should intefere with their outbound capital flows through other routes.

Vatsal Gaur and Sidharrth Shankar review this capital control in the Financial Express and everyone must read their analysis as a demo of what goes on in this field.

Their article shows that these capital controls are riddled with numerous microeconomic effects. As an example, Gaur & Shankar say: "Additionally, through a rather innocuous tweak to the July 1, 2013, master circular on Miscellaneous Remittances from India, RBI had effectively closed the LRS window for resident individuals looking to acquire securities of unlisted offshore companies."

Every time a government indulges in microeconomic meddling, this introduces distortions. The basic hygiene test of public policy is that detailed microeconomic interventions are only justified in order to address market failures (externalities; asymmetric information; market power) subject to two tests : (a) We are able to figure out a public administration strategy to overcome the principal-agent problem of citizens versus State and (b) We are able to do a cost-benefit analysis and demonstrate that the costs imposed by the intervention is exceeded by the benefit.

Every time a government meddles in the economy at a microeconomic level, this proposal must pass the following tests:
  1. What is the market failure? Can you demonstrate that what you are worrying about is a market failure?
  2. What's your proposed intervention?
  3. Does your proposed intervention address your market failure?
  4. What is the incentive structure through which policy formulation and enforcement is being done in the best interests of the people of India?
  5. Can we show that the costs are outweighed by the benefits?
No such analysis is visible in RBI's action. There is no demonstration of market failure. There is no accountability mechanism that holds RBI in check when meddling like this. There is no cost-benefit analysis. Until analysts like Gaur and Shankar write about this in public domain, there is not even a thorough enumeration of all the microeconomic impacts of this regulation, which ensures that these five questions have not been answered for all these effects.

It is easy to slam RBI for what they have done, and to a significant extent they can do better. But the trouble is, almost everything in the field of capital controls suffers from these problems. Capital controls are detailed microeconomic meddling in the economy. They do not address market failures and hence they cannot be justified or analysed. It is not possible to clearly articulate objectives, or construct accountability mechanisms, for a public agency that would do capital controls. This generates the worst outcomes with a State apparatus that does not serve the interests of the principal.

In order to pursue the goals of macroeconomic policy, we need macroeconomic levers which affect the broad economy without introducing narrow microeconomic distortions by dealing with things like LRS windows and unlisted offshore companies. In monetary policy, the macroeconomic lever is the policy rate. Capital controls, in contrast, are microeconomic levers. Their use is always messy. People find other ways of getting their work done, so the desired macroeconomic outcome is not obtained. But along the way, GDP growth is adversely affected owing to the deadweight cost that people have to incur in getting past the restriction.

There is an extensive literature on the microeconomic distortions caused by capital controls. While they are effective in the sense of achieving distortions at a microeconomic level, they fail to deliver on the goals of macro policy. You may like to see Did the Indian capital controls work as a tool of macroeconomic policy?

1 comment:

  1. I remember how during the 1997 Asian Crisis, Malaysia was the first to put up capital controls. Everyone was crying hoarse about how Malaysia will suffer the consequences forever. But the Malaysian economy was the one that stabilized first and it hasn't done shabbily since.


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