THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 566

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PA R T V I

International Finance and Monetary Policy

one by one, Indonesia, Malaysia, South Korea, and the Philippines were forced
to devalue sharply. Even Hong Kong, Singapore, and Taiwan were subjected to
speculative attacks, but because these countries had healthy financial systems, the
attacks were successfully averted.
As we saw in Chapter 8, the sharp depreciations in Mexico, East Asia, and
Argentina led to full-scale financial crises that severely damaged these countries
economies. The foreign exchange crisis that shocked the European Monetary
System in September 1992 cost central banks a lot of money, but the public in
European countries were not seriously affected. By contrast, the public in Mexico,
Argentina, and the crisis countries of East Asia were not so lucky: The collapse of
these currencies triggered by speculative attacks led to the financial crises
described in Chapter 8, producing severe depressions that caused hardship and
political unrest.

CAPI TAL CO N TRO LS
Because capital flows were an important element in the currency crises in Mexico
and East Asia, politicians and some economists have advocated that emergingmarket countries avoid financial instability by restricting capital mobility. Are
capital controls a good idea?

Controls on
Capital
Outflows

Capital outflows can promote financial instability in emerging-market countries
because when domestic residents and foreigners pull their capital out of a country, the resulting capital outflow forces a country to devalue its currency. This is

why recently some politicians in emerging-market countries have found capital
controls particularly attractive. For example, Prime Minister Mahathir of Malaysia
instituted capital controls in 1998 to restrict outflows in the aftermath of the East
Asian crisis.
Although these controls sound like a good idea, they suffer from several disadvantages. First, empirical evidence indicates that controls on capital outflows are
seldom effective during a crisis because the private sector finds ingenious ways to
evade them and has little difficulty moving funds out of the country.7 Second, the
evidence suggests that capital flight may even increase after controls are put into
place because confidence in the government is weakened. Third, controls on capital outflows often lead to corruption, as government officials get paid off to look
the other way when domestic residents are trying to move funds abroad. Fourth,
controls on capital outflows may lull governments into thinking they do not have
to take the steps to reform their financial systems to deal with the crisis, with the
result that opportunities to improve the functioning of the economy are lost.

Controls on
Capital
Inflows

Although most economists find the arguments against controls on capital outflows
persuasive, controls on capital inflows receive more support. Supporters reason that
if speculative capital cannot come in, then it cannot go out suddenly and create a
crisis. Our analysis of the financial crises in East Asia in Chapter 8 provides support

7

See Sebastian Edwards, How Effective Are Capital Controls? Journal of Economic Perspectives,
Winter 2000; vol. 13, no. 4, pp. 65 84.