Each of these programs imposes costs on U.S. business and financial
institutions and, through them, on the economy as a whole.
The programs were enacted and have been maintained despite these costs on the
grounds that they achieve a result: an improved balance-of-payments position
for the United States.
Some have argued that the costs are such as to suggest relaxation of the
programs despite the presumed result. This point of view highlights the
importance of the costs.
There are additional arguments against retaining the controls. The ability of
these programs to achieve substantial and desirable results is questioned.
If this argument is correct, then the balance of payments argument is
irrelevant and, in view of the undoubted costs, the programs should be
abandoned. Material presented in the attached memorandum leads me to that
point of view.
Attachment
CAPITAL CONTROLS: QUESTIONABLE RESULTS AND UNDOUBTED
COSTS
Controls on capital outflows from the United States were designed as
temporary measures to deal with short-term problems in the U.S. balance
of payments during the mid-1960s.
Three programs are now in effect:
- 1.
-
The Interest Equalization Tax, designed
to restrict the sale of foreign securities in the United
States;
- 2.
-
The Voluntary Foreign Credit Restraints
Program, designed to restrict the availability to
foreigners of banking services in the United States; and
- 3.
-
Foreign Direct Investment Program,
designed to restrict U.S. financing of foreign direct
investments by U.S. firms.
The President has pledged himself to “bring an end to self-defeating
controls on investment at the earliest possible time.”
This memorandum reviews the reasons why I believe it is timely to redeem
the President’s pledge.
Estimates of Effectiveness of Individual Programs
The balance of payments is not necessarily determined by trade and
capital flows in the direct and predictable way which casual reasoning
suggests.
As a result of the format in which the accounts are conventionally
arranged, the flow of reserves happens to be the last item listed in the
international financial accounts. The assumption that this residual
account will be the one to absorb the impact whenever there is a change
in some other account is unwarranted. It is equally plausible that one
of the other accounts will respond.
For example, it is by no means clear that a reduction in the outflow of
U.S.-owned capital will have any effect on the flow of reserves. A
priori, any number of accounts could absorb the change. In particular,
economic reasoning suggests that the closest substitute category
(foreign capital flows) will take up the slack. To the extent that
capital from one source is a close substitute for capital from another,
the reduction in U.S. capital outflows should be offset by an equal
reduction in foreign capital inflows. There is no reason to expect that
capital controls would, in any significant sense, actually reduce the
net outflow of reserves.
Compliance with the administrative regulations under the control program
appears to have been satisfactory. However, the Office of Foreign Direct
Investment believes that the longer the controls are in effect, and as
costs of compliance to U.S. business rise, compliance problems will grow
more serious. In any case, nominal compliance with regulations is not
the major test of effectiveness of the programs. Effectiveness is best
measured by:
- —The degree to which balance of payments gains are offset by
losses resulting from nonregulated transactions induced by the
control;
- —The relevance of the controls, given the role of the United
States in the international monetary system.
I am aware of three direct attempts to estimate the balance-of-payments
effects of specific parts of the U.S. capital control programs. These
studies are summarized below:
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The Interest Equalization Tax
In his study, Cooper2 compared
movements in controlled and uncontrolled capital flows before and after
the inception of the IET. He found that
net purchases of taxable securities fell by $500 million between the
half year just preceding proposal of the tax and a year later. This
effect was completely offset by increases in U.S. direct investment,
long-term lending by banks, and short-term lending by banks and others.
As it happened, the U.S. balance of payments hardly improved despite a
$2.7 billion increase in the surplus on goods and services. Cooper therefore concluded that the
IET “failed in its broader objective
of improving the U.S. balance of payments.”
The Voluntary Foreign Credit Restraint Program
Laffer3 developed two empirical relationships relating
capital flows to economic variables using monthly statistics prior to
the inception of the VFCRP. Under test, these two relationships proved
to be accurate predictors of both private U.S. short-term capital
outflows and foreign private short-term capital inflows.
Based on data for the sixteen months following the inception of the
VFCRP, the same relationships were then used to estimate the effects of
the program on short-term capital flows.
The graph below displays the cumulative balance-of-payments effects
reported by Laffer. According to the graph, outflows of U.S. private
short-term capital were definitely retarded. These favorable
balance-of-payments effects were, however, by early 1966, almost
precisely offset by compensating unfavorable movements in private
foreign short-term capital flows.
[Omitted here is the graph illustrating the conclusion.]
This led Laffer to conclude that:
… The net effects of the VFCRP on the U.S. balance of payments
seem to be quite negligible. In fact, for a long time, the VFCRP
appears to have cost the United States in terms of foreign
exchange, and only after a year or more in operation were the
net effects on the U.S. official settlements balance of payments
non-negative. Therefore, the ostensible success of this program
with respect to U.S. capital flows appears to have been negated
by foreign capital flows.
[Page 130]
The Foreign Direct Investment Program
The CPR4 Study came to the following conclusions:
The available statistics regarding the OFDI program … cast doubt
on the extent to which the program actually restricts direct
foreign investment today. The figures set forth show that U.S.
firms have never invested the full amount permitted by OFDI
quota….
Of course, not all of these allowables can be utilized by
individual firms. However, even after taking this wastage into
account, it is clear that generous investment allowables are
available in most cases to U.S. firms wishing to expand their
investments abroad….
These facts naturally raise questions as to why we need a direct
investment control program, costing about $3 million per year to
administer, plus much larger amounts in compliance costs
incurred by the firms subject to OFDI controls.
The Cost of Capital Controls
Although there is no precise measure of the costs of maintaining capital
controls, the type of costs and their significance in the aggregate are
evident:
- —The prestige costs to our country of unsuccessful attempts to
manipulate our balance of payments via controls;
- —The administrative costs to the Government in running the
program, and to the private sector in complying with it;
- —The economic costs resulting from the inefficient
reallocation of resources by business and financial institutions
as they respond to the program;
- —The commercial costs of lost business for U.S. financial
institutions as other countries develop their own financial
intermediaries;
- —The political costs to the Administration of continuing an
unpopular program.
An Overall Assessment
- 1.
- From an economic point of view, there is no reason to expect the
capital control programs to succeed. When Americans are inhibited
from transmitting capital abroad, it is logical that foreigners will
do the investing in their place. As a consequence, foreigners will
reduce their U.S. investments. There is no reason to expect that net
capital flows (or reserves) will change one way or the other as a
result of these programs.
- 2.
- Detailed studies of the capital control programs have uncovered
absolutely no evidence of any effect on the balance of
payments.
- 3.
- The programs impose severe administrative costs on both government
and business; they misallocate resources; and they penalize
[Page 131]
Americans for transacting
freely with foreigners. Ironically, they have no demonstrable
favorable effects.
- 4.
- The common and primary purpose of the capital control programs is
to stem the net outflow of U.S. official reserve assets by
obstructing American investments and loans to foreigners. All
available evidence suggests that these programs cannot and have not
accomplished or even worked towards this purpose.
