The return of capital controls

The potential for a Jeremy Corbyn-led government brings with it the prospect of growing state intervention in the country’s finances. Simon Wilson asks: should we be worried?

What are capital controls?

They are legal measures taken by the government to limit the flow of capital into or out of the country. They have been in the news recently because John McDonnell – the hard-left shadow chancellor – raised the risk of capital flight, and how to counter it, should Jeremy Corbyn ever be elected prime minister, at a meeting at Labour’s conference in September.

Such measures include exchange controls (placing restrictions on the buying and selling of currency) or caps on the sale or purchase of different kinds of “portfolio capital” (that is, financial assets).

Haven’t we been here before?

MoneyWeek readers with long memories will know that, in the past, Britons were limited to taking £50 out of the country on holiday, and, under the 1947 Exchange Control Act, were required to have these sums recorded in their passports. Equally, it was very difficult to invest in overseas assets.

Under a byzantine system known as the “investment currency market” – overseen by a staff of hundreds at the Bank of England – the authorities only allowed a fixed pool of overseas investment: the purchase of foreign assets by one UK resident had to be offset by a sale by another. These restrictions seem almost comically bizarre today, but prior to 1979 they were part of everyday life.

What was the rationale?

The idea behind capital controls is to protect the domestic economy from excessive volatility caused by rapid inflows of capital, and from the negative effects of huge capital outflows during crises. In Britain, they were introduced as a wartime measure in late 1914. The government banned the import of foreign securities and the raising of loans for foreign investment. It also made it very hard to export gold, and commandeered foreign-currency securities held by Britons.

At the start of World War II, the UK introduced even more comprehensive controls, and in the aftermath, capital controls became an accepted part of the global financial architecture. During this Bretton Woods era, economists believed that capital controls protected ordinary people from the ravages of international capital and the volatility of the 1930s, and aided free trade by keeping protectionist measures in check. 

When were they lifted?

Margaret Thatcher and her chancellor, Geoffrey Howe, scrapped them in 1979. As the economic orthodoxy moved from Keynsianism to free-market liberalism, big Western economies started abolishing controls in 1973-4, starting with the US, Canada, Germany and Switzerland. The case in favour of free movement of capital is similar to that for free trade. Voluntary exchange across borders should make everyone better off: it boosts economies by channelling money to where it will be most productive and it gives borrowers access to cheaper credit, and lenders access to higher returns and/or more diverse opportunities.

Scrapping capital controls also enables flows of foreign direct investment, which boost developing economies in particular. In 1979, many economists warned that Howe’s measures would lead to a flight of capital. Instead, they laid the ground for an investment boom and the establishment of London as a global financial centre. There was also a boom in Britons investing overseas – from a total of £12bn in holdings in 1979 to around £100bn by 1985.

Are capital controls always bad?

A 2016 International Monetary Fund (IMF) paper on the history and efficacy of capital controls begins with a brief epigraph taken from a speech by the governor of the Bank of Mexico. “I have only eight seconds left to talk about capital controls,” Agustin Carstens told his audience. “But that’s OK. I don’t need more time than that to tell you: they don’t work, I wouldn’t use them, I wouldn’t recommend them.”

The IMF paper itself paints a more nuanced picture. Its authors (Atish Ghosh and Mahvash Qureshi) argue that, while controls on outflows are undesirable – and associated with “autocratic regimes, failed macroeconomic policies and financial crisis” – controls on inflows can be useful. Evidence from a series of financial calamities, including Latin America in the 1980s and East Asia’s 1997-8 crisis – suggests that unimpeded access to foreign capital can allow developing countries to get into bigger messes.

What about closer to home?

Ireland shows the benefits of foreign direct investment, which transformed its economy in the 1990s and 2000s. But it also shows the destabilising effects of short-term capital flows, which fuelled the speculative bubble that burst so devastatingly in 2008 (a lack of control over its own monetary policy didn’t help).

Elsewhere in Europe, Iceland had to adopt capital controls in the wake of its banking collapse in 2008, and only lifted them this year. Controls have also been an intermittent feature of the Greek crisis. If Britain, under the economic governance of McDonnell, had to resort to such measures, then these recent parallels are hardly inspiring ones.

  • The History Man

    So what will happen to all the UK pensioners living in EU countries after Brexit if the UK is forced to introduce capital controls due to an abrupt economic collapse or a run on the pound? Will this mean these pensioners will suddenly find themselves without any income or amounts severely limited? How will they live?