Another free market myth

This is my latest comment from Fund Strategy.

Brazil’s imposition of capital controls last week has a broader significance than is generally appreciated.

Not only does it show the destabilising consequences of slow growth in the West, it also illustrates how marginal free market economics has become.

Economic atrophy in the West has created a strong incentive for speculative capital to flow to the fast-growing emerging economies. It is far easier, ­particularly for those with a short-term time horizon, to make quick profits in the developing world than in the West.

This trend has helped create the conditions for a financial bubble to inflate in emerging economies. Many developing country currencies have surged against their western counterparts. Other emerging economies, most notably China, have intervened to stop a rapid appreciation of their currencies.

Western countries are also taking unilateral action to stimulate their economies and therefore weaken their own currencies. This has created a dangerous spiral of competitive devaluation in which each country holds its own currency down.

It was as result of these trends that Guido Mantega, Brazil’s finance minister, declared in September 2010 that an “international currency war” had broken out. Many of his foreign counterparts no doubt thought the same thing but he stood out for his willingness to say it openly.

Brazil’s imposition of controls on short-term capital flows also illustrates the marginal influence of free market ideas. Although many authorities would claim to support the free flow of capital in theory, they are willing to see it curbed in practice.

Back in September 1997, just as the Asian financial crisis was beginning, the International Monetary Fund declared it would write opposition to capital controls into its articles of association. When in the same month Mahathir Mohamad, the Malaysian prime minister, implemented controls on short-term capital he was roasted by the media. The Times (London) declared in a leader that: “Neither central bankers nor politicians nor kings can turn back the tide of the global markets”.

But by the following year the IMF was arguing in its annual report on international capital markets that, at least as an interim measure, controls on capital flows could be justified. Over a decade later the notion that capital controls are legitimate has become completely mainstream.

World leaders seem only capable of pragmatically reacting to events. They lack a broader vision of what a vibrant world economy should look like.