Hayek on Argentina’s Capital Controls

This article appeared on Forbes.com on September 2, 2019.
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Yesterday, President Mauricio Macri chose to impose capital controls on Argentina. Since being elected, Macri has been reluctant to reform — a gradualist, “do-nothing” president. But, when backed into a corner of his own making, he acts as if he is bent on committing political suicide. First, he called in the firemen from the International Monetary Fund — a rightfully despised organization in Argentina. And now, he has pulled the trigger on capital controls.

What would Nobelist Friedrich Hayek say about the imposition of capital controls and restrictions on the convertibility of Argentina’s junk currency—the peso?

Currency convertibility is a simple concept. It means residents and nonresidents are free to exchange domestic currency for foreign currency. However, there are many degrees of convertibility, with each denoting the extent to which governments impose controls on the exchange and use of currency.

The pedigree of exchange controls can be traced back to Plato, the father of statism. Inspired by Lycurgus of Sparta, Plato embraced the idea of an inconvertible currency as a means to preserve the autonomy of the state from outside interference.

So, the temptation to turn to exchange controls in the face of disruptions caused by hot money flows is hardly new. Tsar Nicholas II first pioneered limitations on convertibility in modern times, ordering the State Bank of Russia to introduce, in 1905-06, a limited form of exchange control to discourage speculative purchases of foreign exchange. The bank did so by refusing to sell foreign exchange, except where it could be shown that it was required to buy imported goods.

Otherwise, foreign exchange was limited to 50,000 German marks per person. The Tsar’s rationale for exchange controls was that of limiting hot money flows, so that foreign reserves and the exchange rate could be maintained. The more things change, the more they remain the same.

Before more politicians come under the spell of exchange controls, they should reflect on the following passage from Hayek’s 1944 classic,The Road to Serfdom:

"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."

Hayek’s message about convertibility has regrettably been overlooked by Argentina’s economists, who have a fatal attraction to nutty ideas. Exchange controls are nothing more than a ring fence within which governments can expropriate their subjects’ property. Open exchange and capital markets, in fact, protect the individual from exactions, because governments must reckon with the possibility of capital flight.

From this it follows that the imposition of exchange controls leads to an instantaneous reduction in the wealth of the country, because all assets decline in value. To see why, it is important to understand how assets are priced. The value of any asset is the sum of the expected future installments of income it generates discounted to the present value. For example, the price of a stock represents the value to the investor now of his share of the company’s future cash flows, whether issued as dividends or reinvested. The present value of future income is calculated using an appropriate interest rate that is adjusted for the various risks that the income may not materialize.

When convertibility is restricted, risk increases, because property is held hostage and is subject to a potential ransom through expropriation. As a result, the risk-adjusted interest rate employed to value assets is higher than it would be with full convertibility. Investors are willing to pay less for each dollar of prospective income, and the value of property is less than it would be with full convertibility.

This result, incidentally, is the case even when convertibility is allowed for profit remittances. With less than full convertibility, there is still a danger the government will confiscate property without compensation. That explains why foreign investors are less willing to invest new money in a country with such controls, even with guarantees on profit remittances.

Investors become justifiably nervous when they expect that a government may impose exchange controls. Settled money becomes “hot” and capital flight occurs. Asset owners liquidate their property and get out while the getting is good. Contrary to popular wisdom, restrictions on convertibility do not retard capital flight, they promote it. Macri’s capital controls have destroyed vast amounts of Argentina’s wealth and further damaged the country’s dead-beat reputation.

Steve H. Hanke

Steve Hanke is a professor of applied economics at The Johns Hopkins University and senior fellow at the Cato Institute.