Economic Myths: Capital controls

Today's City AM gleefully grabs the wrong end of the stick:

THERE is something truly terrifying about capital controls, the harsh restrictions that may soon be imposed on Cypriots. The freedom to take your money out of a country, and into another, at will and with no taxes, is an essential bulwark of a free society. It is also a central tool in a world of globalised commerce, multinational corporations, the internet and integrated supply chains.

The free movement of capital helps maximise an economy’s efficiency by allowing capital to be allocated where it is the most needed, regardless of country, and where it can generate the best risk-adjusted returns.

I am in principle against restrictions on people moving 'money' between bank accounts in different countries (provided governments are clued up enough to have a system of withholding taxes so this is not used for tax evasion), he is confusing 'money' with 'capital'.

1. To recap: 'money' doesn't really exist, it is a unit of measurement of indebtedness. Unless there is somebody somewhere prepared to run up debts (and thus create a financial liability) it is impossible for somebody somewhere else to have a financial asset. This does not apply to physical things which can be used as a convenient unit for barter transactions, like gold, but that is pretty much a red herring (you can still have debts denominated in units of gold). And if money does not exist it cannot be 'capital'.

2. 'Capital' on the other hand is real stuff, physical assets created by people; the value of your education; or the extra profits which arise (i.e. the extra capital creating capacity) when people specialise and trade with each other. So if you borrow €10,000 to buy a car, you have a real asset (a car) and a financial liability of €10,000. The hire purchase company has a financial asset of €10,000. You cannot simply add the real asset and the financial asset together to arrive at total assets of €20,000. It makes far more sense to count the car as a real asset of €10,000 and to net the financial liability and the financial asset off to nothing. Or let's imagine you borrowed the € 10,000 from an uncle who then dies and you inherit the financial asset, which you match off with your liability (you cannot owe yourself money). The total amount of real capital in the real world is unchanged when your uncle dies (depending on whether he could earn enough to pay for his own keep, it might actually be slightly reduced or increased).

3. So the only sensible starting point for looking at 'money' is the borrower himself and what the loan is secured on. In the context of Cyprus, let us assume that the government has issued bonds and wasted a lot of the money; the government has a nominal liability but no corresponding assets. Or the Cypriot banks have lent money secured on inflated land prices (they convert the rental value of land to a stream of interest payments), the loans are not secured on 'land' (which has no inherent value and does not generate cash or wealth) so the only source of income to pay the principal and interest is the borrower's real earnings (the extra amount he is willing or forced to pay to occupy if he wishes to occupy any particular site).

4. Some mortgage borrowers cannot or do not want to repay the full amount but the banks still have the nominal liability from taking in new savings or simply recycling the sales proceeds of the land as deposits again (splitting the zero). The bank's liabilities (deposits) are not some independent thing called 'money' which can be withdrawn or spent anywhere, they are a claim on the borrower's future income.

5. So while, in a perfect world, you can move your 'money' from one bank or one country to another, you cannot possibly move that borrower's source of income from one country to another, and you certainly cannot move the land value (ransom value) on which it is secured from one country to another. And if you own Cyprus government bonds, you can put them in a suitcase and move abroad, but you will still have to rely on the Cypriot government to actually pay up. Or taking the car example from 2. above, the hire purchase company can shift its head office to anywhere it likes, but the car owner is still (probably) in Cyprus.

6. So to sum up, what depositors in Cyprus banks and holders of Cypriot government bonds actually own are IOUs issued by people who can't or won't repay in full. The fact that the original nominal value of a deposit or bond was €100 is nigh on irrelevant. If the borrower (the person who issued the IOU) will only repay €80 then you do not have a deposit or bond of €100, you have a deposit or bond of €80.

7. If we accept that restrictions on moving 'money' are bad, then the corollary is that if you want to withdraw your entire deposit of €10,000 from a Cypriot bank and put it in a presumably safer German bank, you have to accept that the German bank will look at what they are really getting in exchange, which is an IOU issued by a Cypriot mortgage borrower or the Cypriot government, which is worth €8,000 and if they are acting rationally, they will offer you a deposit of €8,000 in exchange.

8. So you pays your money and you takes your choice. Do you prefer €10,000 in a Cypriot bank or €8,000 in a German bank? Or more realistically, do you prefer €10,000 nominal in a frozen Cypriot bank account which you can't access (and so it worth a lot less than €10,000, depending on how urgently you need it) or €8,000 in a German bank which is freely accessible?

9. If you take the common sense view, then the last sentence of the excerpt is complete gibberish. The real capital, in our example a car, will go to where it is most needed. So if you earn €20,000 from using the car in your window cleaning or delivery business in Cyprus but can earn €30,000 a year by taking it to Greece or Northern Cyprus or anywhere else, then that is what you will do .

10. Or taking a wider view, capital does not exist in a vacuum and pays for itself anyway. If somebody works out that it would be profitable to build a dam or a factory in Country XYZ, you need architects, engineers and workers to be in that country on the ground to build it, and you need workers and managers to run the factory, you need there to be demand for the hydro electric power which the dam generates, you need customers who will buy your output, or a delivery chain and infrastructure to get your output to the market. All the finance providers do is oil the wheels a bit and speed things up; in theory, the architects and workers could club together and do the construction "for free" in exchange for getting a share in the future income from the electricity users or the manufacturer who owns the factory etc.

It cannot possibly be a pre-condition that 'money' exists first and this allows capital to come into existence, because 'capital' was there first (the first tool or shelter fashioned by hand was 'capital') and 'money' did not exist until somebody was prepared to run up a debt.