European Center Berlin (HU/FU/TU)

Capital Controls, EMU and the Crisis
of the European Monetary System

by

 Ulrich Machold

Introduction

1. What are capital controls?
1.1 Types of capital controls
1.1.1 Controls on capital outflows
1.1.2 Controls on capital inflows
1.2 Arguments for and against the imposition of capital controls

2. How effective are capital controls?

3. Capital controls and the crisis of the EMS
3.1 Conditions for the viability of a pegged exchange rate system
3.2 Causes of the crisis
3.2.1 Inevitable policy shifts
3.2.2 Multiple equilibria and self-fulfilling speculation
3.3 Implications
3.4 Solutions
3.5 The right choice?

Conclusion

References

Introduction

For European monetary affairs, 1992 was a watershed: In January, the European Monetary System (EMS) celebrated five years of stability; by November, it was all but falling apart. Two of its members had been driven from the system, two others had experienced steep and involuntary devaluations. The EMS was undergoing the worst crisis of its existence.

When analysing these events, they inevitably lead to the issue of financial liberalisation. If the argument that the lack of control over international capital flows is at the heart of such crises is true, their costs must be weighed against the benefits of the liberalisation process.

But can the use of capital controls be in any way compatible with the process of European financial integration? Does the idea not go against the entire philosophy embodied in the project of economic and monetary union (EMU)? Some authors argue that not only can capital controls be made compatible with the integration process but that they are in fact the only option available to safeguard any pegged exchange rate system against the excesses of occasionally irrational and overwhelmingly powerful financial markets.

The resulting question, though merely speculative in retrospect, is thus two-fold: Could capital controls have helped to prevent the 1992-crisis of the EMS and would it therefore have been beneficial to allow for this instrument afterwards, instead of widening the fluctuation bands to 30 per cent? And, resultingly, could capital controls exist within a fixed exchange rate system like the EMS then and the EMSII in the future?

I shall, as preliminaries, first briefly summarise the main arguments of the discussion on the desirability of capital controls. Subsequently, I shall discuss, whether capital controls can actually achieve what they were designed for. In the main section, I shall analyse what causes for the 1992-crisis seem probable, why the post-1992 re-constitution of the system took the form it actually did and whether capital controls could have been relevant in this context or will do so in the future.

1. What are capital controls?

Capital controls are mechanisms or instruments to consciously limit the amount of capital that is flowing in and/or out of a country. Usually administered by governments, they are sometimes seen as protectionism, a way of preventing domestic savings from being invested abroad. On the other side, capital controls are also employed as a way of dealing with destabilising currency speculation, and this is the context in which they will be important for the issue at hand. Modern analyses of currency markets identify important market failures which lead to occasionally destabilising speculation and justify some form of intervention: asymmetric information giving rise to herd behaviour, and multiple equilibria which make self-fulfilling crises possible. Capital controls are put forward as one way of keeping such speculation in check and retaining room to manoeuvre for national monetary policy by effectively breaking the link between domestic and international interest and inflation rates.

1.1 Types of capital controls

Capital controls can coarsely be grouped according to the kind of capital flows they attempt to regulate: Controls on inflows and controls on outflows.

1.1.1 Controls on capital outflows

Controls on capital outflows have been advocated as a way of dealing with financial and currency crises. It is useful to further distinguish between two types of outflow controls, preventive and (temporary) curative.

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