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.
