Why Keynes Opposed Free Capital Flows—and Why We Should Too
Dogmatic beliefs about open capital markets must give way to policies that support the national interest.
By Michael Pettis, senior fellow at the Carnegie Endowment and finance professor at Peking University
In today’s global economy, the free movement of capital—with financial flows moving across borders without legal constraints—is often celebrated as a cornerstone of prosperity. Policymakers and economists alike argue that liberalized capital accounts allocate resources efficiently, deepen financial markets, and promote global integration. Yet many of the most influential economists of the 20th century—including, most notably, John Maynard Keynes—were deeply skeptical of these claims. In fact, he proposed that capital controls be a permanent feature of the international monetary system.
As we confront a world of persistent trade imbalances, volatile capital movements, and rising geopolitical tensions, it is worth revisiting Keynes’s caution. His rejection of capital mobility was not rooted in nationalism or autarky, as free-traders sometimes claim, but in a sophisticated understanding of how international finance can distort domestic economies, transmit imbalances from one country to another, and undermine global cooperation. He understood that a country’s external imbalances must align with its internal imbalances, but unlike many economists today, he also understood that causality could flow in either direction. For that reason, in a world in which some countries had greater control over their external accounts and others less control, the distortions in the former could be transmitted through the capital account into the latter.
Keynes’s opposition to unrestricted capital flows emerged most clearly during the negotiations that led to the Bretton Woods system in 1944. Having lived through the interwar years—years marked by financial speculation, competitive currency devaluations, and the economic devastation of the Great Depression—Keynes understood the extent to which free capital mobility could distort a market economy. In his proposals for a postwar monetary system, he insisted on preserving national autonomy over monetary and fiscal policy, including the right to use capital controls when necessary. Unfettered capital flows, he argued, warped currency valuations, drove domestic credit creation, and distorted domestic interest rates. In this sense, free capital flows did not foster efficiency in a market economy; they constrained sovereignty and distorted efficiency.
The Reality of Capital Flows
In theory, constraining domestic policy sovereignty might not be a bad thing. If international investors allocated global capital efficiently, moving savings from rich, saturated economies and sectors to economies or sectors with greater growth potential, the resulting loss of control by policymakers might actually benefit the global economy. It could force governments to submit to economic reality.
But Keynes understood that we don’t live in such a world. In our world, much international capital is driven not by long-term investors moving capital from less productive to more productive uses, but rather by speculation, herd behavior, central bank intervention, changes in leverage and risk appetite, geopolitical uncertainty, capital flight, and, most importantly, industrial policies in countries that control their external accounts—usually by putting restrictions on trade or on capital inflows and outflows. But whether capital moves across borders for “good” reasons or for “bad” reasons, countries on either side must nonetheless adjust.
When Beijing directed hundreds of billions of dollars each year into U.S. Treasury securities, for example, it was not to fund much-needed American infrastructure or innovation. It was to recycle China’s trade surpluses and prevent currency appreciation that would threaten export competitiveness. When German banks funneled capital into Spain in the 2000s, to take another example, it was not because Spanish households had become more creditworthy—it was to export excess German savings generated by wage suppression under the Hartz labor reforms. In 1997, massive capital outflows from South Korea were triggered not by declining investment opportunities in South Korea, but rather because currency collapses in Thailand and Indonesia a few months earlier set off a self-reinforcing run on the South Korean won.
Each of these episodes shares a common thread: capital flows, driven by non-productive motivations, forced recipient countries to undergo domestic economic adjustments that had nothing to do with their domestic economic needs. In South Korea, a financial crisis erupted. In Spain, a credit bubble inflated. In the United States, foreign savings fed unsustainable consumption and deepened inequality. In each case the costs were borne not by the originators of these capital flows, but by workers, small businesses, and taxpayers in the recipient economies.
Global Imbalances and Asymmetric Adjustment
Keynes argued that trade and capital imbalances must be corrected symmetrically and that surplus countries should bear as much responsibility as deficit countries for global adjustment. If nations can pursue a policy of an export surplus without limit, Keynes warned, the resulting imbalances can suppress global demand in ways that are balanced by higher unemployment or higher debt.
Under today’s conditions, however, surplus countries deploy industrial and wage policies that suppress consumption to sustain export-driven growth. These policies include restricting capital inflows, controlling the domestic allocation of credit, and intervening to avoid currency appreciation. Deficit countries like the United States, by contrast, keep capital accounts open, allowing foreign surpluses to be recycled into domestic asset markets.
It is through the capital account, in other words, that surplus countries can avoid domestic adjustment and force their imbalances onto their trading partners. The result is a system that structurally disadvantages open economies. The United States, in particular, ends up absorbing much of the world’s excess savings, with the U.K. and Canada absorbing much of the rest—not because their economies need foreign savings, but because their stocks, bonds, businesses and property sectors are the safest and most accessible assets foreigners can acquire with their excess savings. This undermines industrial competitiveness and policy autonomy in these economies by forcing their own economies to adjust to the imbalances of their trade partners. Instead of investing in productivity-enhancing assets, the U.S. financial system accommodates these imbalances by rewarding the offshoring of industrial production and channeling foreign capital into real estate, consumption, and speculative finance.
This is not a case of markets efficiently allocating global capital. It is a case of asymmetric intervention: where one set of countries is permitted to shape global flows through mercantilist policies, while another is expected to remain passive in the name of “free markets.” There is nothing natural in this outcome—it is a policy failure, and one that actively undermines economic policymaking in many of the deficit countries.
What makes free capital flows especially pernicious is their tendency to constrain democracy itself. When capital is mobile and policymakers are forced to adjust to external imbalances, democratic choices—the policies voters actually want—become subordinated to the wiles of financial markets. Elected governments are pressured to pursue fiscal austerity, encourage industrial offshoring, suppress wages, deregulate labor markets, stimulate household debt, or raise fiscal deficits—not because these policies promote sustainable growth, or benefit their workers and consumers, but because they must meet the demands of foreign investors.
Keynes saw this clearly. He warned that when governments abandon control over capital movements, they lose the ability to implement the economic policies needed for full employment and sustainable growth. His view was not ideological, but pragmatic: domestic policy should be determined by national priorities, not by the demands of international finance.
Keynes for the 21st Century
The solution is not to retreat from globalization, but to reshape it. Keynes’s vision for a managed global economy—embodied in the original Bretton Woods framework—offered precisely this balance. It allowed for trade and cross-border investment while preserving national autonomy over macroeconomic policy. Capital controls allowed each country to pursue its own economic development path without having to absorb the imbalances of its trade partners.
We need to return to that logic. One promising avenue is the introduction of a “Tobin tax”—a small levy on capital inflows into the economy that would penalize short-term, speculative flows while leaving long-term productive investment mostly unaffected. This kind of tax—much like the “market access charge” proposed by Senators Tammy Baldwin and Josh Hawley in 2019—would make it more expensive for countries that want to externalize the cost of weak domestic demand by running trade surpluses to acquire U.S. assets. It would throw the cost of managing imbalances in the global system squarely onto those who most benefit from capital mobility.
Keynes’ rejection of free capital flows was grounded in pragmatism. In 1933, in an article in which he explained why he had finally turned against the free-trade dogmas of his youth, he wrote: “It is a long business to shuffle out of the mental habits of the pre-war nineteenth-century world.” Now, a century after Keynes first warned of the dangers of mobile capital, we are still mired in those mental habits.
The time has come to abandon the devotion to free capital flows as ideological necessity, and to reconsider and manage them, recognizing the conditions under which they benefit the global and U.S. economies as well as the conditions under which they don’t. We must build a global financial system that supports national development, reduces inequality, and promotes long-term stability.
That means recognizing, as Keynes did, that capital mobility is not a natural right—it is a policy choice that affects the direction of an economy and the distribution of wealth and power within that economy. And in the current global context, it is a choice we should reconsider.