Global Policy Forum

By Martin Khor

The prominent American economist Paul Krugman has launched a high-profile campaign to get East Asian governments to introduce foreign exchange controls as the only way to get out of their economic crisis.

Speaking last week (26 August) in Singapore at a seminar organised by Strategic Intelligence, an exclusive business leaders group, Krugman said foreign exchange controls of the type in place in China could be the answer to get troubled Asian economies back on track. Such controls would break the link between domestic interest rates and exchange rates, thus allowing governments to lower interest rates without sending their curencies into another downward spiral.

Krugman is an internationally renowned mainstream economics professor at the Massachusetts Institute of Technology, a believer in free trade, and no wild-eyed radical. So when he made what he himself called the "radical proposal" of capital controls, he was almost apologetic and visibly pained for doing so. And that made his case even more persuasive. Whilst in Singapore, Krugman also gave interviews on CNBC cable television, and to a local business newspaper. In the same week, an article by him on the same topic was also published as a cover story in Fortune magazine. Krugman's advocacy of capital controls has already sparked a discussion in Malaysia and is likely to generate wide interest and debate in the Asian region.

This is because some of the region's economists and policy makers have been attracted to the possibility of reintroducing some regulations and controls on capital flows to reduce financial volatility, but had been constrained from advocating it as capital control has till now been a "taboo" subject.
This is the result of the dominance of the ideology of international agencies such as the International Monetray Fund and the Group of 7 countries that insist on free capital flows as a prerequisite for modern and emerging economies, and also as a condition for IMF-coordinated rescue loans.

Krugman is certainly not the first person to advocate capital controls as a part of the solution to the Asian financial crisis. Indeed he is, as he admits, a new convert. But he is such a prominent part of the economics establishment that his proposal can carry enough weight to break the taboo against considering foreign exchange controls as a serious policy option.

According to a report in the Malaysian daily, New Straits Times, Krugman in his seminar address said that Asian economies were reaching the end of the road and it was time to "do something radical", including implementing foreign exchange controls since pressures on the Asian economies were too high. He said that at the initial stage of the Asian crisis he thought the affected counties were following the right strategy, "but in the last few months I began to wonder whether Asia is on the right track."

Krugman added that after having gone to the IMF and finding that its policies (which he called Plan A) did not work, it was time now for Asian countries to adopt what he termed "Plan B," which comprised foreign exchange control. He noted that China, which had not been fully caught in the regional crisis, had currency controls through the inconvertible capital account. "Chile too has capital inflow control and that is a good idea," he added.

Krugman also said that reading articles about the inefficiencies of Asian economies "makes my blood boil." "The rhetoric now is reminiscent of 1932 in the US when there were calls to liquidate everything. But liquidation is not going to pay off unless there is expansion in demand." During a TV interview on the CNBC programme Asia in Crisis last Saturday (29 August), Krugman explained how he came to the "radical proposal" of Plan B.

"We tried Plan A (the IMF prescription of austerity)...but it didn't work, then what do you do? It's hard for the IMF and the US Treasury to admit it was wrong and to do something different. But the time has come.
"Why did I become a radical? I didn't want to be. But we are in a trap."
Krugman added: "We cannot cut interest rates because the currency may fall and we can't get more IMF funds because the IMF didn't have enough.

"The only possibility I see is imposing capital controls." These controls would require exporters to sell their earnings to the Central Bank, which in turn would sell the foreign exchange. "It's a dirty word, capital controls, but we need them to get out of the bind." In his Fortune article, entitled "Saving Asia: it's time to get RADICAL", Krugman agrees with the IMF critics that high interest rates imposed by the IMF would cause even healthy banks and companies to collapse.

Thus, there is a strong case for countries to keep interest rates low and try to keep their real economies growing. However, says Krugman, the problem is that the original objection to interest rate reductions still stands, that the region's currencies could again go into free fall if the interest rate is not high enough.

"In short, Asia is stuck: Its economies are dead in the water, but trying to do anything major to get them moving risks provoking another wave of capital; flight and a worse crisis. In effect, the region's economic policy has become hostage to skittish investors." Krugman says there is a way out, what he calls Plan B, "but it is a solution so unfashionable, so stigmatised, that hardly anyone has dared to suggest it.. The unsayable words are exchange controls."
Exchange controls, he adds, used to be the standard response of countries with balance of payments crises. "Exporters were required to sell their foreign-currency earnings to the government at a fixed exchange rate; that currency would in turn be sold at the same rate for approved payments to foreigners, basically for imports and debt service.

"Whilst some countries tried to make other foreign-exchange transactions illegal, other countries allowed a parallel market. Either way, once the system was in place, a country didn't have to worry that cutting interest rates would cause the currency to plunge. "Maybe the parallel exchange rate would sink, but that wouldn't affect the prices of imports or the balance sheets of companies and banks."

Krugman points out some problems posed by exchange controls in practice, such as abuse by traders and distortions, so that economists think these controls work badly. "But when you face the kind of disaster now occurring in Asia, the question has to be: badly compared to what?"

Asking why China hasn't been so badly hit as its neighbours, Krugman answers that China "has been able to cut, not raise, interest rates in this crisis, despite maintaining a fixed exchange rate; and the reason it is able to do that is that it has an inconvertible currency, a.k.a. exchange controls. "Those controls are often evaded, and they are a source of lots of corruption, but they still give China a degree of policy leeway that the rest of Asia desperately wishes it had.

"In short, Plan B involves giving up for a time the business of trying to regain the confidence of international investors and forcibly breaking the link between domestic interest rates and the exchange rate. "The policy freedom Asia needs to rebuild its economies would clearly come at a price, but as the slump gets ever deeper, that price is starting to look more and more worth paying."

In a note on the cover story, Fortune editor John Huey states that Paul Krugman has something very important and very un-economically correct to say, and that this piece is expected to "spark debate from Basel to Bangkok." A press release by Fortune also said that Krugman warned that if Asia did not act quickly, the crisis could worsen into a depession similar to that experienced in the 1930s, and that IMF programmes that required higher interest rates to stop a currency freefall had made the matter worse.

The statement said that being a longtime colleague of IMF deputy managing director Stanley Fisher and US deputy treasury secretary Lawrence Summers, Krugman addresses the awkwardness of proposing such an extremne measure (exchange controls). Krugman discusses the implicit "gag rule" that prevents not only officials but anyone asociated with the current strategy (bankers, major institutional investors) from being too vocal about an alternative strategy.

The Krugman campaign has already sparked public interest. Over the weekend, journalists referred to the Krugman proposal and asked Malaysia's political leaders whether the government intended to impose restrictions on capital movements. Malaysian premier Dr Mahathir Mohamad replied the country had no such intention. For many economists and serious analysts observing the Asian economic crisis, it has become obvious that the problem began with the free flows of funds moving in and out of the affected countries.

Those countries had recently liberalised their financial systems, extending the convertibility of their currencies from the current account to the capital account. Many observers point to China and India as examples of countries that have not been subjected to volatile capital flows and currency instability or speculation, because the two countries do not allow full convertibility of their currencies. The lesson is that developing countries that want shield themselves for externally-generated financial crises should retain (or regain) some controls over the convertibility of their currency.

This could reduce the conditions in which currency speculators can profitably operate. It could also reduce the exit of funds and discourage the inflows of undesirable forms of short-term capital. However, the option of reintroducing some capital controls has till recently not been openly discussed, because it is considered a "taboo" subject. The prevailing ideology held and spread by the International Monetary Fund and the Group of Seven rich countries is that countries should liberalise their capital account, and those that have already done so will suffer damage if they reimpose controls. Policy makers in the affected countries are worried that if they were to even discuss the advantages of capital control, their country would be black-listed by the IMF, the rich countries and financial speculators. But by keeping silent, their countries will continue to be subjected to the views and interests of "market players", suffer the consequences of a relatively high interest rate policy, and be prevented from speedy recovery. Krugman's open advocacy may help make capital controls a more acceptable option for governments wanting an effective policy instrument to prevent further financial turbulence.

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