Krugman Dead Wrong on Capital Controls

I am a bit late to the game in addressing Krugman's comments several days ago when he said:

But the truth, hard as it may be for ideologues to accept, is that unrestricted movement of capital is looking more and more like a failed experiment.

This was in response to the implosion of Cyprus banks, which was exacerbated (but not necessarily caused) by the banks being a home for a lot of international hot money - deposits so large they actually dwarfed the country's GDP.

I generally rely on Bastiat's definition of the role of the economist, which I will quote from Wikipedia (being too lazy on this Friday morning to find a better source):

One of Bastiat's most important contributions to the field of economics was his admonition to the effect that good economic decisions can be made only by taking into account the "full picture." That is, economic truths should be arrived at by observing not only the immediate consequences â€“ that is, benefits or liabilities â€“ of an economic decision, but also by examining the long-term second and third consequences. Additionally, one must examine the decision's effect not only on a single group of people (say candlemakers) or a single industry (say candlemaking), but on all people and all industries in the society as a whole. As Bastiat famously put it, an economist must take into account both "What is Seen and What is Not Seen."

By this definition, Krugman has become the world's leading anti-economist.  Rather than reject the immediate and obvious (in favor of the larger picture and the unseen), he panders to it.  He increasingly spends his time giving intellectual justification to the political predilection for addressing symptoms rather than root causes.  He has become the patron saint of the candle-makers petition.

I am not naive to the fact that there are pools of international hot money that seem to be some of the dumbest money out there.  Over the last few years it has piled into one market or another, creating local asset bubbles as it goes.

But to suggest that international capital flows need to be greatly curtailed merely to slow down this dumb money, without even considering the costs, is tantamount to economic malpractice.

You want to know what much of the world outside of Western Europe and the US would look like without free capital flows?  It would look like Africa.  In fact, for the younger folks out there, when I grew up, countries like China and India and Taiwan and Vietnam and Thailand looked just like Africa.  They were poor and economically backwards.  Capital flows from developed nations seeking new markets and lower cost labor has changed all of that.  Over the last decade, more people have escaped grinding subsistence poverty in these nations than at any other time in history.

So we have the seen:  A million people in Cyprus face years of economic turmoil

And the unseen:  A billion people exiting poverty

By pandering to those who want to expand politicians' power based on a trivial understanding of the seen and a blindness to the unseen, Krugman has failed the most important role of an economist.

Other thoughts:  I would offer a few other random, related thoughts on Cyprus

  • Capital controls are like gun and narcotics controls:  They stop honest people and do little to deter the dishonest.  In the case of Cyprus, Krugman obviously would have wanted capital controls to avoid the enormous influx of Russian money the overwhelmed the government's effort to stabilize the banks.  But over the last several weeks, the Cyprus banks have had absolute capital controls in place - supposedly no withdrawals were allowed.  And yet when the banks reopened, it become increasingly clear that many of the Russians had gotten their money out.  Capital controls don't work as a deterrence to money that is already corrupt and being hidden.
  • No matter what anyone says, the huge capital inflows into Cyprus had nothing to do with the banking collapse.  The banks had the ability to invest the money in a range of international securities, and the money was tiny compared to the size of those security pools.  So this is not like, say, a housing market where in influx of money might cause a bubble.   The only harm caused by the size of the Russian investments is that once the bank went bad, the huge size of the problem meant that the Cyprus government did not have the resources to bail out the bank and protect depositors from losses.
  • Capital controls are as likely to make bubbles worse as they are to make them better.  Certainly a lot of international money piling into a small market can cause a bubble.  But do capital controls really create fewer bubbles?  One could easily argue that the Japanese asset bubble of the late 80's would have been worse if all the money were bottled up in the country. When the Japanese went around the world buying up American movie studios and landmark real estate, that was in some sense a safety valve reducing the inflationary pressure in Japan.
  • Capital controls are the worst sort of government expropriation.  You hear on the news that the "haircut" taken by depositors in Cyprus might be 20% or 80% or whatever.  But in my mind it does not matter.   Because once the government put strict capital controls in place, the haircut effectively became 100%, at least for honest people that don't have the criminal ability or crony connections to beat the system.  Cyprus basically produces nothing.  Since money is only useful to the extent that it can buy or invest in something, then bottling up one's money in Cyprus basically makes it worthless.
  • Capital controls are a prelude to protectionism.   First, international trade is impossible without free flow of capital.   No way Apple is going to sell ipods in Cyprus if they cannot at some point repatriate their profits.  Capital controls can also lead to export controls.  If I can't export money, I might instead buy jets, fly them out of the country, and then sell the jets.
  • Let's not forget that the core of this entire problem is a government, not a private, failure.  Banks and investors treated sovereign euro-denominated debt as a risk-free investment, and banking law (e.g. Basil II) and pension law in most countries built this assumption into law.  Cyprus banks went belly-up because the Greeks, in whom they had (unwisely) invested most of their funds, can't exercise any fiscal responsibility in their government.  If European countries could exercise fiscal responsibility in their government borrowing, 80% of the banking crisis would not exist (housing bubbles and bad mortgage securities have contributed in some countries like Spain).  There is a circle here:  Politicians like to deficit spend.  They write regulations to encourage banks to preferentially invest in this government paper.  When the government debt gets iffy, and the banks face collapse, the governments have to bail them out because otherwise there is no home for their future debt.  The bailouts get paid for with more debt, which gets crammed back into increasingly over-leveraged banks.    What a mess.
  • All of this creates an interesting business school problem for the future:  What happens when there are no longer risk-free investments?  Throughout finance one talks about risk free rates and all other risks and risk premiums and discussed in reference to this risk-free benchmark.  In regulation, much of banking capital regulation and pension regulation is based on there being a core of risk free, liquid investments.  But what if these do not exist any more?
  • I have thought a lot about a banking model where the bank accepts deposits and provides basic services but does no lending - a pure deposit bank with absolute transparency on its balance sheet and investments.  I think about a web site depositors can check every day to see exactly where depositors money is invested and its real time values.  Only listed, liquid securities with daily mark to market.   Open source investing, as it were.  In the past, deposit insurance has basically killed this business model, but I think public confidence in deposit insurance just took a big-ass hit this week.

Postscript:  I don't want to fall into a Godwin's law trap here, but I am currently reading Eichmann in Jerusalem and it is impossible for me to ignore the role strict capital controls played in Nazi Germany's trapping and liquidation of the Jews.

PS#2:  Oops,

The extent of the control over all life that economic control confers is nowhere better illustrated than in the field of foreign exchanges. Nothing would at first seem to affect private life less than a state control of the dealings in foreign exchange, and most people will regard its introduction with complete indifference. Yet the experience of most Continental countries has taught thoughtful people to regard this step as the decisive advance on the path to totalitarianism and the suppression of individual liberty. It is, in fact, the complete delivery of the individual to the tyranny of the state, the final suppression of all means of escape—not merely for the rich but for everybody.


  1. mesaeconoguy:

    Excellent analysis.

    I would argue that the billion + people exiting poverty are in fact also visible (in a variety of metrics and visually, too), making Krugman even more dense and unobservant.

    I would also point out that Krugman seems to be ignoring history, specifically the Smoot-Hawley Tariff, almost universally recognized by economists* as a contributing factor to the Depression.

    It’s hilarious when he does this –

    “But the truth, hard as it may be for ideologues to accept,…“

    A more accurate statement would be

    “But the truth, hard as it may be for ideologues LIKE ME to accept,…”

    I’m certain I could go combing thru his past writings, and find many examples where he states that free capital movement works (his Nobel Grammy was for international trade, I believe), but I have better things to do with my time, and multiple others have already illustrated the Krugman vs. Krugman effect ™.

    Geez Coyote, why are Princeton economists (Krugman, Blinder, Bernanke) so factually-challenged and dim-witted?

    *Krugman is no longer an economist, so one cannot accuse him of “being outside the mainstream” on this issue here. He should know better, however, given his past experience as an economist.

  2. MingoV:

    Good discussion. Krugman should get a Nobel Prize for pandering.

    "What happens when there are no risk-free investments?"

    Investors will need to allocate their money among a variety of investments to reduce the risk of big losses.

  3. BGThree:

    The emergence of Bitcoin is an interesting response to the emergence of capital controls in Europe. Of course everyone says Bitcoin is a ridiculous concept and an obvious bubble (not me!), but it sure is an attractive way to circumvent capital controls. Even people who are worried about Bitcoin price fluctuations can just exchange to Bitcoin, transfer the bitcoins out of the country, and then exchange back to another currency all in the matter of minutes, thereby mitigating the volatility risk.

  4. joe_dallas:

    Krugman repetitively misrepresents facts to support a partisan leftist view. Two of my favorite articles are
    1) when he claimed that the USA should adopt France's social employment and other leftist policies and cited as proof that the GDP of europe was growing faster than the US - primarily due to the growth of the former eastern bloc. Though he conveniently omitted the fact that France's GDP growth was one-half of the US.
    2) His continued insistence that an increase in minimum wage will have no detrimental effect on employment. He cites a survey by CEPR (not a study and strong left leaning group at that). The CEPR is a survey of several studies on the effects of the minimum wage. Most of the surveys show that unemployment is unaffected by changes in minimum wage which is contrary to the common perception. What the studies do show is that earnings do not increase (or increase only slightly) when the minimum wage is increased - ie hours get cut. Though it should be noted how leftist the CEPR survey is - the underlying studies all show that earnings do not increase or increase only slightly when the minimum wage is raised. However, the CEPR survey claims this does not happen even though the studies it cites state otherwise.
    Econ 101 teaches that when price of labor increase, the demand for labor decreases which the underlying studies confirm.

  5. bigmaq1980:

    Krugman (and his kind) is an ideologue who has somehow (Nobel - the same organization that gave Obama a prize before accomplishing anything) gained "credibility".

    He's long since abandoned the scientific method of an "economic scientist" and nowadays weaves his "theory" to fit the desired outcome.

    He is in a position to know better. Thus, he is essentially a "paid" mouth piece for the Left, as he has veered far from simple economic discussion to partisan support of the current administration.

  6. bigmaq1980:

    It is, but for how long?

    I understand that legislation is forthcoming.

  7. mesaeconoguy:

    Not quite.

    Modern Portfolio Theory

    relies on an underlying “risk free rate” assumption, which is now shaky.

    The previous “gold standard” risk free rate (rfr) (pun
    intended) was the US Treasury 30 long bond, up until the late 1990s, when Bob
    Rubin “retired” it. And the debt “went


    Now, it is the UST 10yr, but that is very subject to interpretation, since most sovereign nation debt is now crap.

    The question is how much crap.

    Calculus would suggest that true risk aversion should be asymptotic to 0 rate; however Ben Bernanke has distorted that curve, as well.

  8. mesaeconoguy:

    Krugman is the very model of a modern major Keynesian:

    “When the facts change, I change my mind”

    That’s precisely the point: the facts of your underlying philosophy, if you have one, don’t change, nor should your opinion, ignorant as it is.

    Were “the facts” as you knew them correct before, Paul?

    Or are they “correct” now?

    Which one, dude?

    John Kenneth Galbraith is very likely the only more ignorant speechwriter economist to grace the Dumbass party than is Krugman, a full party hack, and disgrace to all economics majors everywhere.

    PS, LMFAO James Galbraith

  9. mesaeconoguy:

    J.K. Gallbreath

    For my part I think that capitalism, wisely managed, can probably be made more efficient for attaining economic ends than any alternative system yet in sight, but that in itself it is in many ways
    extremely objectionable.


    Correct. Capitalism is self-managing.

    Collectivism failed, and killed 100 million people in the process.

  10. mesaeconoguy:

    Cool, I just got a re-load with "Krugman Dead"

  11. mesaeconoguy:

    Krugman’s wrong about a lot of shit.

    Shit. Bad behavior.

    Was that my bad shit behavior, coyote?

    If so, I fucking apologize.


  12. obloodyhell:

    If you like this discussion, you'll probably find this of interest, too:

    Part 1: Maxed Out Mama: Let's Do Monetary Theory
    Part 2: Let's Do MT - Deferred Promissory Trades

  13. obloodyhell:

    I forget who pointed it out, but someone ( A search will find it) did a piece defining at least TWO cases where Krugman openly spoke in his columns as though he knew nothing of the Broken Window Fallacy.

    Clearly, this, too, is bonehead Econ 101, so it's clear Krugman no longer cares about the Truth and only cares about his agenda. Once someone does that you can't trust ANYTHING they claim without first getting secondary verification from a vastly more reliable source.

  14. obloodyhell:

    }}} That’s precisely the point: the facts of your underlying philosophy, if you have one, don’t change,

    I believe they can change with time, but you have to be prepared to defend those changes. Anyone who was a Keynesian in the 60s had sufficient reason to support the notions behind it. After the "stagflation" of the USA in the 70s, and the pure stagnation of Japan in the 90s, no rationally competent person should be a Keynesian any more. They should have changed their opinions... because new facts undermine the assumptions of an older dataset.

    This ties to the "fuzziness" of "facts" when it comes to economics, mind you. TRUE facts should never change, but economics is a bit less fixed and established as a concept than physics.

  15. Josh Kalish:

    Great post. One minor thing is that for most financial applications when they say the "risk free rate" they just really mean the rate at which you fund your positions or your repo rate. So, even if treasuries are all going to default tomorrow you only care about what you have to pay to fund your positions. So you always will have a "risk free rate".

  16. Eris Guy:

    I am interested in your thoughts on “Eichmann in Jerusalem."

  17. Zachriel:

    Coyote Blog: By this definition, Krugman has become the world's leading anti-economist.

    It seems you are using black-and-white thinking. Capital controls doesn't necessarily have to be either none or draconian. The vast expansion of the economies in the West included some capital controls.

  18. Broccoli:

    Warren hits upon a first cause of many economic woes today even though it is not a central point of this article. The classification of certain investments as risk free. Most of these investments are government backed (surprise!), and gee there is no conflict of interest when regulators force institutions and banks (and by proxy Y-O-U) to buy "risk free" investments to be safe and those risk free investments just happen to be the governments!
    There is no such thing as risk free. In fact, every single investment will fail over a long enough time frame. Governments average about 50 years worldwide. There is no exception to this rule though there are a few outliers in nominal terms (but not inflation terms) like British government debt. Yet the world prices every A or higher country as if it is the British Government.
    People at banks make hundreds of billions in trades on expected returns of 5 basis points. .05% upside. The implied risk per year of that trade even losing money (even .00001 cents) of that trade is 1 in 2000. Bank balance sheets are priced as if the only thing that can go wrong is an asteroid hitting the earth, every other scenario makes money. On top of this even if the lose a fraction of a percent, because the trades are nominally in the hundreds of billions, they bank instantly is insolvent (They already are insolvent).
    Well this is obviously absurd and why the Fed and other CBs have printed tens of trillions of dollars papering over for there friends in the financial sector.
    Wake up people.