Capital controls are still ruining Iceland after half a decade

ONE aspect of the Cypriot crisis resolution is of particular concern. As authorities fear that anyone with money in Cyprus will want to take it out as soon as banks open, capital controls are being put in place. We are told they will be limited in scope and temporary. Hopefully that is true.

Another European country was forced to implement “temporary” capital controls during its crisis – Iceland. Authorities said they would last a few weeks, or a month or two at worst. They were thought necessary because foreigners and wealthy Icelanders had lost faith in the economy and wanted to take their money out. While these people were considered misguided, their exit would have disastrous consequences. But five years on, controls are still in place and are getting more and more restrictive.

When a country implements capital controls, it signals that the authorities have lost control over the economy. Anyone with money will seek to abandon the sinking ship as quickly as they can, and they will persist in that desire until things look better. But while controls last, things cannot look better, so their abolition becomes a necessary condition for improving the economy. This is why official declarations on the duration and the scope of controls were always too optimistic in Iceland.

Icelandic controls have proven to be damaging for its economy. Investment has collapsed, and is about the lowest in Europe at 14.4 per cent of GDP in 2013 compared to an EU average of 18 per cent. Foreign direct investment almost completely dried up, and any domestic resident with money prefers to keep funds liquid, ready to be exported when an opportunity presents itself. The Icelanders are now pinning their hopes on finding oil.

And while capital controls are meant to prevent outflows, those wanting to take money out will find a way, legally or not. The result is a cat and mouse game between the government and capital owners, where the authorities are at a disadvantage. This leads to ever-tightening of controls. Conditions are ripe for corruption. Anyone with access to the licensing for capital exports stands to benefit.

Capital controls also violate EU law and the principle of the four freedoms – free movement of goods, capital, services and persons. Cypriot controls will go against at least two of these. The free movement of capital is prevented. But more seriously, it also violates the free movement of persons, and hence human rights. If you can’t sell your house and use the money to buy a house abroad, movement across borders is restricted. If you can’t remove money from the country, the ability to live where you want in the EU is undermined. Trying to restrict outflows for “legitimate” reasons will not work. You can always find someone with a legitimate reason to export money.

Icelandic capital controls were only meant to last a few weeks. Because it was an emergency, a temporary drastic solution was needed. It has now been five years. But the longer a country maintains capital controls, the harder they are to abolish. An economy adapts to them and they become a part of the permanent landscape. We can only hope, for the sake of the Cypriots, that their controls are truly temporary.

Dr Jon Danielsson is director of the ESRC-funded Systemic Risk Centre at the London School of Economics.