A Sensible Policy Tool for Pareto Improvement: Capital Controls

Abstract

This article analyses the fact that managed capital flows under capital controls are superior to free capital flows with market distortions and exposes the empirical invalidity of the orthodox theory, which has become a prevailing ideology but with misleading policy implications. We reformulate the issue of international capital flows by taking into account their inherent volatility and disruptive effects. This article finds that capital freedom may benefit capital-exporting countries at the expense of capital-importing countries due to the financial risk of volatile capital flows. We prove that, as a Pareto improvement policy tool, capital controls, if carefully chosen and properly managed, can make both parties better off by reducing the instability of those flows. It is shown that the source of this Pareto improvement lies in the favourably changed composition of capital flows (more of foreign direct investment (FDI) and less of speculative hot money) under interventions. Thus capital controls should be kept into perspective and cannot be weakened further in developing countries such as China.