As India Considers Further Liberalization, A Debate on Capital Account Convertibility

Economic and Political Weekly (India) debates what is perhaps the most crucial step in unfettering the power of capital, capital account convertibilityMost of the pieces oppose convertability or at least counsel delaying the move towards it; some are pro. L. Randall Wray offers the argument that capital controls are necessary for sovereignty, with reference to Argentina’s disasterous experience with its currency board.

A nation like the US (as well as countries like Japan and Turkey, and Argentina after it abandoned the currency board) creates a currency for domestic use (and ensures its use primarily by demanding payment of taxes in that currency, although some go further by adopting legal tender laws). The government, itself (including the treasury and the central bank – the Fed in the case of the US), issues and spends high powered money (HPM – cash and reserves at the central bank) as its liability. The US government does not promise to convert its HPM to any other currency, nor to gold or any other commodity, at any fixed exchange rate.The flexible exchange rate is key to maintaining fiscal and currency independence – what I call sovereignty, although governmental sovereignty certainly has other dimensions as well. But there is more to it than a flexible exchange rate. The sovereign government spends (buys goods, services, or assets, or makes transfer payments) by issuing a treasury cheque, or, increasingly, by simply crediting a private bank deposit. In either case, however, credit balances (HPM) are created when the central bank credits the reserve account of the receiving bank. Analogously, when the government receives tax payments, it reduces the reserve balance of a bank. Simultaneously, the taxpayer’s bank deposit is debited. While we commonly think of a government needing to first receive tax revenue, and then spending that revenue, this sequence is not necessary for any sovereign government. If a government spends by crediting a bank account (issuing its own IOU – HPM) and taxes by debiting a bank account (and eliminating its IOU – HPM), then it is not as a matter of logic, “spending” tax revenue. In other words, with a floating exchange rate and a domestic currency, the sovereign government’s ability to make payments is neither revenue-constrained nor reserveconstrained… This fundamentally simple point is difficult for some to grasp because we are used to thinking about government as if it were not sovereign.