The Return of Capital Controls

In a classic essay following the Asian Financial Crisis, Paul Krugman laid out what he called the "Unholy Trinity" (which derives from the famous Mundell-Fleming model)*: it is not possible for a country to have a fixed exchange rate (and thus a stable currency), free capital movement, and an independent monetary policy. Countries may pick two of the three, but must sacrifice one. In recent months, we've seen the collapse of the independence of central banks all over the world. Some countries, especially export-biased countries, have also engaged in exchange-rate manipulation, but generally capital movement has remained free. But in the wake of the current crisis, many countries may decide that it is in their long run interest to accept some capital controls in order to re-establish the strength of their currencies and the independence of their central banks to fight recessions.

Krugman fell short of calling for capital controls in his most recent column, but others have been more vocal. Guillermo Calvo has called for the institution of capital controls in a VoxEU piece [pdf], and Bob Geldorf (!) has called for the institution of the Tobin Tax, a transaction tax on international capital movements. Whether or not we should be listening to Bob Geldorf (!) is certainly up for debate, but other academics (including Krugman and Dani Rodrik, among others) had been openly sympathetic to capital controls before this crisis occurred. Of course, there is still large resistance to capital controls in many of the neoliberal regimes, but if there is going to be institutional changes to the international financial system, some sort of capital controls would likely be the least painful option. No mention of this in the recent G20 statement, of course. But everyone knows that there isn't a free lunch; if you want less volatility, you'll have to accept less flexibility.

*Mundell-Fleming only applies to small, open economies, so it's application to larger OECD countries isn't perfect. But there is still some applicable intuition.

(ht: Dani Rodrik, for Calvo and Geldorf)