As the Greek saga unfolds this week in advance of a planned July 5th referendum, there already are telling signs that the outcome, whatever it is, is not going to be beneficial for Greece or the euro zone. With talks on a bailout collapsing over the weekend, the finance ministry and Bank of Greece announced on Sunday night the imposition of an array of capital controls.
However, as has been demonstrated internationally again and again, capital controls are a superficial remedy for the symptoms of a country’s illness rather than the illness itself. While the Greek government may have bought itself a moment to breathe, it can now count on the deleterious effects of capital controls adding another burden to the crisis.
The tales of Greece’s woes are legion but escalated this week with Greek Prime Minister Alexis Tspiras’ decision to open up the latest deal with creditors to a democratic referendum. Perhaps understanding the signal it would send to the markets, this announcement was accompanied by a broad number of capital controls to prevent a bank run.
In the first instance, ATM withdrawals have been limited to €60 per day, a way to stop the queues and cash withdrawals that were already occurring over the weekend.
The economics literature has mostly disproven capital controls as an effective tool of macroeconomic policy management.
In tandem with the locking down of the ATMs, the government has unilaterally declared a bank holiday for the entire week, reserving the right to further shutter banks after the referendum if it deems “necessary.” At the same time that internal withdrawals are limited and access to finance halted, the finance ministry has also prohibited the transfer of euros from Greece as a further barrier against capital flight, requiring government permission before any money can be moved.
Finally, it is perhaps ironic given the bloated public sector in Greece and the fiscal policy roots of its current crisis that one of the actions accompanying capital controls was the creation of a special “Committee to Approve Bank Transactions.” This Committee will approve or (more likely) deny transactions that are “necessary to safeguard a public or social interest,” involving pharmaceuticals or other emergency medical expenses.
In the ensuing months, as the Greek government is looking for ways to save money and curtail its spending, a committee charged with deciding what medical expenses meet a “social interest” should be among the first to go.
Greece’s moves follow a long line of developing countries over the past two decades in using such controls. Indeed, capital controls have experienced something of a renaissance in recent years, ever since the Asian financial crisis of 1997-98 and Malaysia’s seemingly cost-free use of these instruments. Mainstream economists such as Joseph Stiglitz have made a nice cottage industry out of pushing capital controls on developing countries, claiming that short-term portfolio capital is destabilizing and thus governments need “breathing space.” Mr. Stiglitz has even gone so far as to argue that finance is a special creature in itself, immune from normal economic rules, and thus capital controls can be a boon to an economy if utilized correctly.
The problem is that the empirical evidence doesn’t confirm these theoretical niceties. Research I did 14 years ago for the U.S.-based Cato Institute showed how the economics literature has mostly disproven capital controls as an effective tool of macroeconomic policy management.
Capital flight may be stopped in the short term, but in the long term there may be even worse consequences, including increased political uncertainty, greater market volatility, and a diminution of FDI flows by wary investors.
As a comprehensive study by IMF staff found, these consequences are exacerbated in countries that lack sound institutions or, in other words, the countries that are most likely to use capital controls. Even in Malaysia, the poster child for capital controls, the evidence from another IMF Working Paper is that the controls did not yield benefits; in fact, the main outcome of the capital controls was to favor politically-connected firms even more.
And, like trade protection, capital controls become addictive for governments and companies who fear the consequences of their removal. Unfortunately, research also shows that firms get better at evading controls the longer they’re in place, meaning that the purpose of controls evaporates rapidly. In their place, controls leave behind bureaucracy and increased corruption, without necessarily lowering the risk of a financial crisis.
This reality also hints at the moral case against capital controls, especially in a case such as Greece. Most egregiously, capital controls are an insidious violation of property rights, as exemplified by preventing Greeks from taking out their own money from ATMs. While governments may claim that the legal tender they issue is owned by the Central Bank, the contracts behind how that tender was exchanged should be inviolable. In this case, the money that the Greek government is prohibiting people from accessing isn’t even their own in a physical sense, as it is issued by the ECB.
reventing access to a bank account also invalidates the contract between the financial institution and the account holder. Brazenly disregarding property rights in a time of crisis is no way to restore investor confidence in a country.
Greece should immediately lift its controls and focus on the hard road ahead.
Moreover, as is the case in Greece and to some extent Malaysia, capital controls are often imposed as a last resort, meaning they take effect when the worst of the crisis has already passed.
In the Greek case, as Michael Klein of Tufts University’s Fletcher School has noted, much of the money has already left the country. Capital controls thus harm those without the connections or ability to get their money out in advance, meaning pensioners and those dependent on the fragile banking sector.
The Greek government understood how bad this would look if the least-capable in society were harmed, so it made an exception in the controls for pensioners. However, many pensioners do not have access to bank cards, and thus the physical shuttering of bank doors remains a threat to the elderly; banks were “allowed” to open on Tuesday for pensioners to access their funding.
The controls that remain also act as a regressive tax on the non-politically connected and savers, exactly the sort of people that are needed to power an economy.
This effect can be seen with small businesses, necessary for creating the jobs that Greece so desperately needs. A paper I published last year showed how capital controls stifle firm creation, starving entrepreneurs of desperately-needed funding to start a business. This effect has been seen in every country that instituted capital controls, even those that are touted as a success.
Kristin Forbes of the MIT Sloan School of Management and former member of the U.S. president’s Council of Economic Advisors demonstrated empirically that capital controls in Chile led to severe financing constraints for businesses, while there is evidence that both China and India have raised the cost of capital for small firms and favored government-run businesses at their expense. If you continue to penalize savings and investment, eventually Atlas will shrug.
All of these empirical and moral issues should point to an obvious fact, one that the Greek government hasn’t understood, or possibly refuses to understand: Capital controls may be a solution to one manifestation of the Greek crisis, but it is not a solution to the crisis itself.
The problems in Greece run much deeper than some mystical issue of short-term capital flows, and are instead tied to longer-term issues of fiscal policy and the euro project. The Greek financial sector was already in a dire state before the events of this week threatened to topple it for good. Controls will not help to restructure the system. Greece’s government continues to agitate for a needlessly large public sector, one that will not be easier to finance with capital controls.
Recognizing this, Greece should immediately lift its controls and focus on the hard road ahead, an “austerity” that actually reduces spending. As CASE fellow Anders Aslund wrote in a recent piece, the difference between Latvia (and Estonia and Lithuania) and Greece is that the Baltics front-loaded their fiscal adjustment. Perhaps surprisingly, this also turned out to be popular with the voters.
Does such a course mean that a Grexit is inevitable? I believe that, much as capital controls are the wrong answer, the idea of a Grexit is the wrong question. The euro may have straitjacketed the ability of Greece to inflate its money away, but losing this bit of policy sovereignty is probably on balance a good thing.
Greece’s mistake was in believing in that it could stay within a monetary union that demanded certain fiscal requirements, while continuing to spend beyond its or Europe’s means. Whether or not Greece remains in the euro zone, the damage will take time to fix, but prolonging capital controls will only create needless additional damage.
To contact the author: firstname.lastname@example.org