Treasurer Peter Costello made a timely warning about international flows of private capital at International Monetary Fund meetings in Washington this week. Mr Costello warned about money flowing “”across optic fibres in milliseconds in volumes that dwarf official flows, where the private sector is pumping much more capital into the economy that the government sector”. He argued for mechanisms that can seal with such a flow.
However, he did not give any details about what controls he would like to see. The major concern has been the speed with which capital can be withdrawn from economies that show evidence of falling performance. The concern is that the flight of capital makes the situation worse for the target economy. That was illustrated sharply in the past year in several Asian economies, particularly Indonesia. Indeed, a comparison can be made between the Asian economic crisis and that of the developed world in 1929 which was precipitated by the same mania for fear and greed which caused the Wall Street crash. Since 1929, developed nations have been able to institute some regulation and other mechanisms to prevent or at least ameliorate downward spirals of confidence.
It requires the exercise of sovereignty by governments. In the case of preventing another crisis like that which hit Asia a year ago, it might have to be a global exercise.
Mr Costello should develop the ideas that he put to the IMF. Mechanism should be put in place to prevent sudden flights of capital. Markets on their own do not always necessarily produce the best result. They may correct in time, but not before causing huge amounts of human suffering as we saw in Asia in the past year and as we saw to a lesser extent in Eastern Europe before that.
Nations should not rely on these mechanisms to bail them out or save them from the rigours of market all the time. There is no substitute for sound national economic policy. Indeed, Mr Costello’s economic management in Australia is an illustration of how that can immunise a nation against exaggerated flights of capital. After all, the flying capital has to land somewhere, and where better than to a well-managed nearby economy. But even fairly well-managed economies are not immune from panic flights of capital.
The big question is what sort of mechanisms should be put in place. The mechanisms should not be so restrictive as to prevent a reasonably free flow of capital. The relatively free flow of capital can generate investment and wealth in places which would otherwise be left in poverty. So regulatory mechanisms should not discourage flows of capital into countries, particularly those in the developing world. The concern is the outflow.
A suggestion floated in the past has been a tax on international movements of capital. It would require a deal of world co-operation and would require restraint on the part of some nations to prevent them opting out of the tax scheme to make themselves an island of investment and speculative opportunity while taking advantage of the sea of stability created by other nations taking part in a co-operative regime of transaction taxes.
The transaction taxes need only be small to provide an effective deterrent against rapid capital outflow. Moreover, the tax regime could be imposed in a way that hits sudden and large outflows harder than outflows notified in advance.
Aside from providing a brake on sudden withdrawal of capital, an international tax regime would help fight tax avoidance in developed economies.
The seriousness of the threat of sudden capital outflow is perhaps best illustrated by the fact that some of Mr Costello’s reputation as a deregulator is now calling for regulation. He has put his finger on the problem. Now the financial world needs to seek solutions.