Copyright # 2003 John Wiley & Sons, Ltd.

INTERNATIONAL JOURNAL OF FINANCE AND ECONOMICS

Int. J. Fin. Econ. 8: 185–187 (2003)

Published online in Wiley InterScience (www.interscience.wiley.com). DOI: 10.1002/ijfe.206

SYMPOSIUM ON CAPITAL CONTROLSBARRY EICHENGREENa,*,y and HANS-JOACHIM VOTHb

aDepartment of Economics, University of California at Berkeley, USAbEconomics Department, UPF, Barcelona, Spain

JEL CODE: F0; F3

KEY WORDS: Capital flows; liberalization; growth; crises

The effects of capital account liberalization and the impact of capital controls are the subjects of large andgrowing literatures. Theoretical models have been adduced to demonstrate the consumption-smoothingand risk-sharing benefits of an open capital account (see Cole and Obstfeld, 1991). Yet the growingincidence of financial crises has also raised concerns that an open capital account can be an engine ofinstability, particularly when capital flows interact with pre-existing distortions, since the theory of thesecond best suggests that removing one distortion, namely, controls on capital flows, may not be welfare-and efficiency-enhancing when other distortions are present.

The empirical literature on recent experience with capital controls and capital account liberalization hasnot succeeded in answering these questions (see e.g. Rodrik, 1998; Wyplosz, 1999; Arteta et al., 2001;Bekaert et al., 2001). The four papers in this symposium, previously presented to a conference at PompeuFabra University (organized with the help of the Centre for Economic Policy Research and the Center forResearch in International Economics of UPF), seek to advance our understanding of these issues bybringing to bear new historical evidence. Two papers consider the long sweep of history, from the late19th century until today, analysing the lessons of that experience for the effects of capital controls. A thirduses post-World War II Europe, where controls were pervasive, as a laboratory in which to investi-gate their impact on the cost of capital. The fourth paper examines Chile in the 1990s, where controlswere applied to capital inflows, in order to assess their impact on investment and the efficiency of resourceallocation.

Dennis Quinn’s paper, ‘Capital Account Liberalization and Financial Globalization, 1890–1999: ASynoptic View’, presents and analyses a new measure of current and capital account openness. Quinn’sindex is a measure of the actual policy stance, rather than of policy outcomes that are also influenced bybroader economic trends. Until now, the Quinn data set existed only for selected years starting in the 1950s.For this paper, Quinn constructs measures of capital account openness for the earlier years consistent withhis post-1950 index. Extending the analysis in this way reveals that the political correlates of opennesschanged dramatically over the course of the 20th century. Quinn finds that in the first era of globalizationbefore 1913, open capital accounts and democracy did not go hand in hand. A number of countries thatextended the franchise early had difficulty in joining the gold standard and maintaining an open capitalaccount. Since the 1950s, in contrast, democracy and financial openness have displayed a positive

*Correspondence to: Barry Eichengreen, Department of Economics, University of California Berkeley, Berkeley, CA 94720-3880,USA.yE-mail: eichengr@econ.berkeley.edu

association. In addition, geographical proximity appears to have been an important determinant offinancial openness. Most obviously, a number of European countries liberalized their capital accounts moreor less simultaneously. But the same tendency is evident in Latin America and Asia, although there thetiming is different and the regularity is less pronounced. This finding is consistent with the recent literatureon policy contagion (e.g. Simmons, 2001), in which it is argued that policy reform in one country caninfluence policy reform in its neighbours, operating through a number of different channels.

The locus classicus of the controversy over capital controls is the Great Depression, and Quinn paysparticular attention to this episode. Ever since Charles Kindleberger (1973) argued that the withdrawal ofAmerican loans to Europe during the Wall Street boom precipitated the downturn, authors have drawn alink between the instability of capital flows in the 1920s and 1930s and the instability of the world economy.Many scholars now accept that cutting the link with gold was crucial if countries were to escape the worstof the depression. But severing the link with gold and reflating the economy could be achieved in two ways,by imposing capital controls or devaluing. Quinn compares economic performance in countries thatpursued these alternatives in the 1930s. He finds that devaluing was a superior alternative to imposingcontrols, consistent with results in Eichengreen (1992). But the two options were relatively close substitutes,in that both dominated the maintenance of a pegged currency and an open capital account in a period wheninternational markets were collapsing.

The next paper, by Barry Eichengreen and David Leblang, generalizes this point. It hypothesizes that thegrowth effects of free capital flows are time-varying}in particular, that they are conditional on the degreeof financial instability in the world at large. The authors use data for 21 countries over 120 years to showthat the growth effects of controls, as measured by most previous studies, are a weighted average of twoeffects: the impact during crisis periods, when the main effect of controls is to provide insulation fromcontagion, and their positive impact on the efficiency of resource allocation in normal times (which is onlyweakly evident after 1973). Like Quinn, they find that the insulation effect of controls was particularlyvaluable in the interwar years when instability was rife in international financial markets, while there isweak evidence that the positive allocation effects of capital account openness have dominated in morerecent periods.

In the aftermath of the Asian crisis in 1997/98, many observers saw Chile’s controls on capital inflows asan appealing example of how an emerging market could insulate itself from the destabilizing effects of largecapital inflows while at the same time retaining most of the advantages of integration into global markets.In their paper, Francisco Gallego and Leonardo Hern!aandez suggest that the costs of the country’s capitalinflow taxes may have been greater than argued in other recent studies. Using data from corporate financialstatements for the period 1986–2001, they find that firms’ funding costs increased when the central bankimposed its unremunerated reserve requirement. On average, this effect was relatively small: a typicalintervention added no more than 12 basis points to funding costs. Yet small firms faced a much highercost, up to 60 basis points. The authors also find that Chile’s encaje had a number of other unanticipatedeffects. Firms shortened the maturity profile of their debt and substituted trade credit and tax arbi-trage for financial debt. Large companies with direct access to international capital markets tended toboost their equity base by issuing shares, whereas small and medium-sized firms often saw their capitalbase shrink.

The cost of capital is also central to the fourth and final paper, by Hans-Joachim Voth. Voth examinestwo episodes when the openness to capital flows of Western Europe shifted abruptly: the late 1950s whencurrent account convertibility was introduced and the initial steps were taken towards relaxing capitalcontrols, and the late 1960s and early 1970s, when countries reintroduced controls in a bid to limitspeculative pressures. In contrast to previous studies, which have examined the effect of capital controls oninterest rates, Voth analyses the consequences for funding costs}both the cost of equity and the cost ofdebt. He finds that changes in the openness of the capital account had a significant impact on the cost ofequity in post-World War II Europe (just as in liberalizations in developing countries in the last twodecades}see Bekaert and Harvey, 2000; Henry, 2000), The effect also operates in reverse: Voth finds thatmany of the benefits that accrued to European countries in the 1960s disappeared almost immediately whencontrols were reintroduced in the late 1960s and early 1970s.

B. EICHENGREEN AND H.-J. VOTH186

Copyright # 2003 John Wiley & Sons, Ltd. Int. J. Fin. Econ. 8: 185–187 (2003)

Together, these papers show how comparative evidence drawn from the history of international financialmarkets can shed new light on contested questions about the effects of capital account liberalization andcapital controls.

ACKNOWLEDGEMENTS

Financial support by CREI, DURSI, the Spanish Education Ministry and the Levenhulme Trust for theconference is gratefully acknowledged.

REFERENCES

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51–82.Cole H, Obstfeld M. 1991. Commodity trade and international risk sharing: how much do international financial markets matter?

Journal of Monetary Economics 28: 23–24.Eichengreen B. 1992. Golden Fetters: The Gold Standard and the Great Depression, 1919–1939. Oxford University Press: New York.Henry PB. 2000. Stock market liberalization, economic reform, and emerging market equity prices. Journal of Finance 55: 529–564.Kindleberger C. 1973. The World in Depression, 1929–1939. University of California Press: Berkeley, CA.Rodrik D. 1998. Who needs capital-account convertibility? In Should the IMF Pursue Capital-Account Convertibility?, Kenen P (ed.).

International Finance Section, Department of Economics, Princeton University: Princeton, NJ.Simmons, B. 2001. The international politics of harmonization: the case of capital market regulation. International Organization 55:

589–620.Wyplosz C. 1999. Financial restraints and liberalization in postwar Europe. Mimeo, Graduate Institute of International Studies,

Geneva.

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Copyright # 2003 John Wiley & Sons, Ltd. Int. J. Fin. Econ. 8: 185–187 (2003)