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Book Review: In Defense of Free Capital Markets


In Defense of Free Capital Markets: The Case against a New International Financial Architecture
by David F. DeRosa (Princeton, N.J.: Bloomberg Press, 2001); 230 pages; $27.95.

IN THE 1930s, during the high watermark of aggressive economic nationalism in Europe, one of the most effective political weapons of regulation used by governments was control over the buying and selling of currencies on the foreign exchange markets. Howard Ellis, in his book Exchange Control in Central Europe (1941), made a detailed study of the methods used in Germany, Austria, and Hungary during this period and their effect.

Under foreign-exchange controls, the government artificially sets the price at which its national currency may be bought and sold for other national currencies. Invariably, the government sets its own currency’s foreign-exchange price above the international market’s estimation of its value, resulting in an excess supply of its own currency and an excess demand for other currencies by that government’s citizens. The government then rations access to the underpriced foreign currencies that its citizens would like to buy on the exchange market. Corruption and a black market soon develop as people devise extralegal ways to obtain quantities of the desired foreign currencies.

Austrian economist Ludwig von Mises pointed out in the 1940s,

Foreign exchange control is tantamount to the full nationalization of foreign trade…. Where every branch of business depends, to some extent at least, on the buying of imported goods or on the exporting of a smaller or larger part of its output, the government is in a position to control all economic activity…. Besides, the government has the power to interfere in all the details of every enterprise’s internal affairs; to prohibit the importation of all undesirable books, periodicals, and newspapers; and to prevent everybody from traveling abroad; from educating his children in foreign schools; and from consulting foreign doctors.

Thus, foreign-exchange controls were considered as an effective political tool for economically and culturally isolating the citizens of one country from the commercial opportunities and competing ideas available in other countries.

Through foreign-exchange control, governments attempted to direct the social and economic development of their countries by limiting and determining the forms of interactions their citizens could have with the rest of the world. It was a highly prized policy tool, especially, though not exclusively, in authoritarian and totalitarian states.

Even after the Second World War, under the influence of Keynesian and socialist planning ideas, foreign-exchange control remained an active weapon in the policy arsenal of governments. It survived in Western Europe, in the form of controls on the import and export of capital, until the 1970s and 1980s.

In the late 1990s, in the face of the Asian financial crises, the call for foreign-exchange controls and restrictions on the import and export of financial capital across international borders was once again loudly heard.

This new threat to the emerging international capital and financial market is the theme of David DeRosa’s new book, In Defense of Free Capital Markets.

His study is divided into three parts. In the first section of the book, he explains the purpose and forms of foreign-exchange transactions. National currencies are bought and sold and, just like any other commodities traded on the market, supply and demand establishes their prices in terms of each other.

Therefore, DeRosa supports a regime of freely floating foreign-exchange rates that reflect current valuations and future appraisements of their respective market worth. Fixed or pegged foreign-exchange rates of any kind are seen as the villain behind much of the currency and financial crises of the last 10 years.

In the middle part of the book, DeRosa presents a detailed account of how the governments of Western Europe, Mexico, and Thailand officially set the value of their national currencies at levels that were found over time to be unsustainable given the domestic economic policies they followed over several years.

Excessive foreign debt, politically manipulated capital investments, distorted interest-rate structures, and inflationary monetary policies resulted in downward pressure on these countries’ exchange rates as foreign creditors and investors and domestic businessmen grew increasingly worried about whether all international financial payments would be met at the promised rates of foreign exchange.

Scrambles to sell the national currency for other currencies on the foreign-exchange market drained these governments’ reserves of foreign currency, finally forcing an admission of defeat and sharp devaluations, i.e., a collapse of the fixed-exchange rates.

In the autumn of 1999, the prime minister of Singapore, Mahathir Mohamad, declared that his country’s currency crisis was due to greedy speculators attempting to manipulate exchange rates for personal profit by investing large capital funds in the domestic financial markets and then withdrawing from them, with little thought for the impact on the economic well-being of the host country’s people and economic stability. He fixed the exchange rate at which capital transfers out of Singapore would be legally permitted.

In the final part of the book, DeRosa makes a forceful and effective argument concerning the harmful effects the imposition of such foreign-exchange and capital controls will have for the economies of these countries. Foreign investors will be increasingly reluctant to invest in a foreign market from which they cannot freely and openly repatriate their invested funds and profits.

Borrowers in the host country will be forced to pay a costly interest premium to attract foreign investors to lend their savings in a political environment in which any future attempt to withdraw their own funds might be viewed as a punishable and prohibited “crime.”

The real criminals, DeRosa argues, are the political controllers in their countries who impose regulations and planning of various sorts on their own citizens and who spend bloated government budgets far above what most developing economies in Asia, Africa, or South America can support. He also effectively criticizes the International Monetary Fund by pointing out,

If central planning at the local level is bound to fail, then why would central planning from an institution located in Washington, D.C., and funded from government sources do any better at trying to reform broken economies?

DeRosa rejects currency boards or dollarization as viable monetary alternatives for these underdeveloped countries. At the same time he gives no thought either to any form of the gold standard or to private competitive free banking that would do away with government national currencies altogether.

Instead, he says that each national currency would be economically and politically independent, with a call for the governments that control these currencies to manage their domestic political and economic affairs in a more reasonable and market-oriented manner.

But this still remains a plea that the fox should not raid the hen house over which he is in charge. The only real solution to both domestic and international monetary and financial crises is the privatization and depoliticization of the money and banking sectors of the market economy.

This requires an end to legal-tender laws, the abolition of central banking, the establishment of standard market-based contract law to all banking and financial intermediaries, and the freedom for the participants in the market to choose the media of exchange they find most profitable and efficient in the pursuit of mutual gains from trade.

Unfortunately, DeRosa seems unwilling to call for the end of monetary central planning, in spite of his articulate arguments against other forms of government control and regulation.

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    Richard M. Ebeling is a professor of economics at Northwood University. He was formerly president of The Foundation for Economic Education (2003–2008), was the Ludwig von Mises Professor of Economics at Hillsdale College (1988–2003) in Hillsdale, Michigan, and served as vice president of academic affairs for The Future of Freedom Foundation (1989–2003).