III Capital Controls and Monetary Policy
- Age Bakker, and Bryan Chapple
- Published Date:
- September 2002
Capital controls in advanced economies have often been established in an attempt to increase the room for maneuver of monetary policy by allowing monetary policy instruments to focus on domestic objectives. In the face of the “incompatible triangle” of simultaneously achieving an autonomous monetary policy, freedom of capital movements, and a stable exchange rate, the authorities have generally considered capital controls to be the lesser evil, creating the fewest economic distortions and implying the least political costs. In theory, by driving a wedge between domestic and international interest rates, capital controls allow the exchange rate to be maintained irrespective of external developments. Exchange rate pressures can be countered by introducing or tightening capital restrictions, avoiding the need to adjust interest rates when that is judged inappropriate in the light of domestic policy goals. Monetary policy can thus be directed at achieving domestic objectives while other policy instruments, including fiscal policy, are left to take care of the external balance.
In this chapter, monetary policy considerations in the use of capital controls are illustrated by the experiences of a number of advanced economies. First, lessons are drawn from the attempts, both in the United States and in Europe, to preserve domestic monetary goals in the face of the large speculative capital flows in the final years of the Bretton Woods system, starting in the mid-1960s. The United States, as the major reserve currency country, had generally not imposed exchange controls in the postwar period. When confronted with speculative outflows in the 1960s, however, it sought to maintain a low interest rate policy by taking restrictive domestic measures and eventually introducing capital controls. At the same time, European countries tried to stem the resulting inflows, first by indirect measures aimed at discouraging nonresidents from acquiring domestic assets (for example, through reserve requirements or the prohibition of payment of interest on such assets) but eventually also through direct capital controls. Even previously liberal countries, such as the Federal Republic of Germany and Switzerland, tightened their exchange control regimes. Most of these capital controls were abolished soon after the end of the Bretton Woods system.
Second, the use of capital controls as a supplementary policy tool in countries using direct mechanisms of monetary control is illustrated by the experience of the Netherlands in the 1970s. Such direct mechanisms have usually involved limiting credit growth to the private sector by putting ceilings on the growth of commercial bank assets (for example, in France and the Netherlands) or, less commonly, on bank liabilities (for example, in the United Kingdom under the “corset,” which provided for marginal reserve requirements to be applied on increments of interest-bearing deposits with the intention of curtailing funding for credit—see Section V for details). In this way, monetary objectives could be achieved at lower interest rates than would otherwise have prevailed—by effectively requiring financial institutions to ration credit. Capital controls were required to ensure that offshore borrowing did not circumvent domestic credit ceilings and also to restrict cross-border outflows seeking higher yields. Finally, attempts by Spain in the late 1980s to stem the targe capital inflows following its accession to the European Union, to avoid monetary destabilization and undue upward pressure on the exchange rate, are analyzed.
Regulation in the United States and Emergence of the Euromarket
The United States has had a relatively liberal approach to capital flows, with the exception of the 1960s. At that time, the authorities sought to maintain low domestic interest rates to encourage economic activity, using the Board of Governors of the Federal Reserve System’s Regulation Q, which specified ceilings on deposit rates that were not fully adjusted in line with market rates. Tighter monetary conditions (and therefore higher interest rates) in other countries, however, resulted in a capital outflow (particularly to the Federal Republic of Germany, but also to some other European countries and Japan). This capital outflow exceeded the current account surplus, leading to a reduction in official reserves. Under the Bretton Woods system, a devaluation of the U.S. dollar was not seen as an option, so the authorities turned to capital controls.
The first capital control announced was the Interest Equalization Tax in 1963, which sought to reduce the attractiveness of foreign borrowing in the United States (or, equivalently, the purchase of foreign securities by domestic residents) without increasing U.S. interest rates. The tax was imposed on U.S. residents’ purchases of foreign securities and shares, and added approximately I percentage point to the cost of raising funds in the United States. In 1965, the tax was extended to offshore lending by U.S. banks. Exemptions for some countries (including Canada and, to a lesser extent, Japan), however, considerably reduced the effectiveness of the tax. The authorities varied the rate of the tax in subsequent years in response to balance of payments conditions.
As concerns about outflows continued, the Federal Reserve announced in 1965 a program involving the voluntary restriction of lending and investing abroad. For lending, guidelines were adopted to limit the increase in outstanding lending by bank and nonbank financial institutions. Institutions were requested to give priority to lending to finance U.S. exports or to meet the needs of developing countries. In subsequent years, the guidelines were progressively tightened, leading to a reduction in allowable net foreign credits covered by the guidelines. Exceptions were made for long-term lending to Canada and Japan (reflecting their reliance on U.S. capital markets) and to developing countries.17 Despite their voluntary nature, most banks adhered to these guidelines; and total foreign assets of the banking system covered by the program were consistently below the ceilings set.18 For example, banks’ total foreign credits fell from US$9.7 billion at the end of 1965 to US$9.3 billion at the end of 1968, which was some US$0.5 billion below the 1968 ceiling. The foreign assets of nonbank financial institutions were also below the ceiling. The voluntary program lo limit direct investment abroad became mandatory in 1968, placing regional limits on capital outflows for direct investment and introducing the mandatory repatriation of a prescribed share of earnings. Exemptions were allowed for investments of less than US$100,000 and for investments financed by offshore borrowing. The capital controls were abolished in 1974, soon after the end of the Bretton Woods exchange rate system.
In practice, the impact of the controls was limited, since foreign assets not subject to the lending guidelines continued to increase. l9 Foreign assets of non-bank financial institutions not subject to the guidelines increased by about 5 percent in 1968 (and were more than six times the size of assets subject to the guidelines). Capital flows continued to vary in response to monetary conditions, both in the United States and overseas. This episode illustrates the difficulty of trying to differentiate between countries and types of lending when imposing capital controls. To be effective, controls have to apply to all countries and to all lenders (although adherence to this principle is no guarantee of effectiveness).
Nevertheless, by reducing the competitiveness of the U.S. financial system, the various controls that were designed to maintain low domestic interest rates did have an important impact on world financial markets. With U.S. interest rates held below market rates, the Eurodollar market became attractive for investors seeking a higher return and a source of funds for those unable to obtain credit in the United States. The Eurodollar market was also less regulated in other aspects than domestic financial markets in many countries, adding to its attractiveness.20. The U.S. experience therefore shows that partial capital control systems are vulnerable to the exploitation of loopholes and the diversion of capital flows to unregulated financial markets.
The emergence of unregulated financial markets, first for the U.S. dollar (that is, the Eurodollar market) and later, increasingly, for the currencies of European countries and then Japan has prompted reform of domestic financial markets so that they can remain competitive. These international markets have encouraged innovation and the spread of more sophisticated financial instruments. The existence of these markets and the new financial instruments they have helped develop, however, have made the application of capital controls less effective.
Episodes of Speculative Inflows into Germany and Switzerland
In the early and mid-1960s, some European countries, including France and the Federal Republic of Germany, had taken measures to curb inflows of funds moving out of the U.S. dollar and threatening domestic monetary stability. These measures included the prohibition of interest payments on nonresident accounts, and in Germany the introduction of a withholding tax (Kuponsteuer) on proceeds of deutsche mark bonds held by nonresidents. Because these measures affected capital flows only indirectly, they did not contravene EEC obligations or the agreements in the OECD liberalization code. On the whole, these measures were not considered to be very effective and were withdrawn, although the Kuponsteuer was maintained until 1984 (mainly for budgetary reasons). In the face of the large speculative inflows in the beginning of the 1970s, indirect and eventually also direct capital controls were reintroduced. The strains in the Bretton Woods system had led to a significant reappraisal of the usefulness of capital controls by the advanced country authorities, bringing to an end a period of gradual capital account liberalization during the 1960s.
Throughout the 1960s, the Federal Republic of Germany maintained restrictions on the purchase by nonresidents of money market paper and on the payment of interest to nonresidents on deutsche mark deposits. These indirect restrictions were aimed at discouraging “hot money” flows fueled by increased interest rate differentials when monetary tightening in Germany coincided with an easing of monetary policy elsewhere, particularly in the United States (Figure 3.1). These measures were abandoned when the deutsche mark was revalued vis-à-vis the U.S. dollar in 1969. The revaluation was accompanied by a tightening of German monetary policies aimed at curbing inflationary pressures. High interest rate differentials continued to attract speculative inflows, however, and the deutsche mark became the safe haven for funds moving out of the U.S. dollar. These inflows inflated the money supply, which the Bundesbank was trying to control.
Figure 3.1.Federal Republic of Germany: Interest Rate Differentials, 1960–74
Source: Thomson Financial.
Serious differences of opinion emerged regarding how to react to the continuing inflows. Some, including the Bundesbank, advocated the imposition of direct capital controls on inward flows while others advocated a revaluation or the floating of the exchange rate. Eventually the deutsche mark was unilaterally floated on May 10, 1971. At the same time, the prohibition of the sale of German money market paper to nonresidents and the ban on interest payments on bank deposits held by nonresidents were reintroduced.21 In March 1972, as a complement to the reserve requirements for banks, which had been introduced to limit the growth of domestic liquidity, the authorities established the Bardepot (cash deposit) system that called for non-interest-bearing deposits at the central bank of part of the proceeds of credits taken up by residents abroad. These market-oriented measures were circumvented, however, and proved unable to stem capital inflows.
The effectiveness of the Bardepot was reduced by the diversion of capital flows to other financial instruments that were not subject to the Bardepot. The prohibition of certain capital flows by Switzerland led to fears that speculators would increasingly focus on the Federal Republic of Germany. Accordingly, to close some loopholes, direct measures to control cross-border inflows were eventually introduced. These included the introduction of a prior approval procedure for certain categories of capital inflows and the restriction of other categories, such as the sale to nonresidents of fixed-interest-rate bonds denominated in deutsche mark. Further tightening of the capital controls became necessary as new loopholes were found and actively exploited.
Capital restrictions were maintained in the Federal Republic of Germany for some time following the longer-lasting transition to a floating exchange rate regime that began in May 1973. The Bundes-bank had come to the conclusion that the controls were ineffective in the face of speculative attacks and did not significantly influence the size of capital inflows at other times, given the high interest rate differentials between Germany and the United States. Short-term domestic interest rates were raised to unprecedented levels in order to disinflate, reaching a peak of 15.8 percent (8.5 percent in real terms) in July 1973. Nevertheless, the government initially decided to keep the controls in place throughout 1973, illustrating the difficulty of removing controls once they have been imposed. Restrictions on inflows were to a large extent dismantled when the first oil crisis changed the fortunes of European currencies, including the deutsche mark. Some minor controls on short-term inflows were retained to discourage the development of the deutsche mark into an international reserve currency. The controls were not effective in preventing this development, however, and proved to be a hindrance to the development of a well-functioning domestic money market. Eventually, the authorities no longer resisted a growing international role for the deutsche mark. In a drastic overhaul of its monetary strategy, the Bundes-bank in 1974 charted a new course, which came to be known as the “new assignment.” Under the new policy, a target for the growth of the money supply was announced and interest rates were used to influence monetary growth. Germany’s brief experimentation with direct capital controls had not been successful, and it resumed its traditional preference for freedom of capital movements.
Switzerland also experienced bouts of speculative flows, since the strong Swiss franc was regarded as a safe haven. Temporary measures were taken to make cross-border flows into Swiss franc deposits less attractive and thus to regain control over monetary aggregates (and to limit the appreciation of the currency). These measures were mostly indirect and included the prohibition of interest payments on deposits held by nonresidents and other disincentives or penalty rates for increasing such deposits. In 1972, when international speculative flows were at their peak, direct controls were also introduced, including limits on the sale of Swiss franc-denominated bonds to nonresidents and the imposition of negative interest rates on increases in nonresident franc deposits. After intensive experiences with a wide range of administrative measures, the Swiss authorities came to the conclusion that they had never acted as more than a temporary brake on speculative inflows and consequently on the appreciation of the Swiss franc.22 Switzerland progressively dismantled capital controls in the first half of the 1980s.
The attempts of European countries to limit speculative capital inflows in the final days of the Bretton Woods system, exemplified here by the experiences in the Federal Republic of Germany and Switzerland, were not successful. When European countries resisted an appreciation of their currencies and maintained higher domestic interest rates for monetary policy purposes, capital flight out of the United States continued. The imposition of capital controls reduced confidence in the international monetary system and was not able to stem capital flows, given the underlying fundamental problems. These problems went well beyond the difficulty of conducting a stability-oriented monetary policy under a fixed exchange rate regime, since the fundamentals on which the postwar international monetary system was built were also crumbling. Given this significant difference in circumstances between the 1970s and now, it is necessary to be cautious about applying the lessons from the experiences discussed in this paper. Nevertheless, some conclusions can be drawn regarding the effectiveness of controls.
For the Federal Republic of Germany, neither direct nor indirect control measures were capable of resisting speculation at times of currency unrest, since they were circumvented on a large scale and enforcement was insufficient. In 1973, the Koffer-geschafte (illegal physical cross-border transactions) were estimated at DM 4 billion and illegal borrowing abroad at DM 7 billion, jointly totaling 1.2 percent of GDP, Another loophole was provided by shifts in leads and lags in current account transactions. Although measures were taken to curtail such shifts, their effect was limited because minor changes in payment patterns, which could not be controlled, had a large impact on cross-border financial transactions, given the openness of the German economy. The authorities also were discouraged by the fact that new loopholes were continuously being exploited by German industry and commercial banks, requiring yet more controls. The diversion of capital to unrestricted financial instruments required the imposition of more encompassing controls. The German experience shows that the effectiveness of capital controls (aimed at limiting short-term inflows) tends to erode over time.
Another lesson from the German experience is that the imposition of unremunerated minimum cash reserve requirements tends to shift financial activity to other centers. In particular, these measures contributed to the growth of deutsche mark deposits in Luxembourg, (Tax motives also played a role.) This points to a practical problem with respect to the imposition of minimum reserve requirements. It is normally not so much the proprietary trading of banks themselves that generates large capital movements (open foreign exchange positions being limited by prudential regulations) but rather transactions on behalf of banks’ clients that can be diverted or carried out directly by other financial institutions. Regarding the latter, there generally is no authority that can impose minimum reserve requirements on nonbank institutions. Therefore, the effectiveness of capital controls tends to be lower in a more developed financial system.
Liberalization and Transition to an Indirect Monetary Strategy in the Netherlands
The imposition of capital controls in industrial countries has often been rationalized by the desire to use scarce domestic savings to finance investment and generate jobs at home rather than abroad. Long-term capital outflows were regarded as a drain on domestic resources, particularly given the postwar scarcity of capital in European industrial countries. In addition, a policy of cheap money for reconstruction and investment was pursued by applying interest rate controls. Domestic credit ceilings aimed at controlling domestic monetary expansion were also applied. With monetary policy based on such direct instruments, interest rates did not play their full role in credit decisions. Capital controls on both inflows and outflows were applied as a supplementary instrument in order to prevent the circumvention of the credit ceilings by borrowing abroad and to restrict the access of nonresident borrowers to domestic financial markets. In the immediate postwar period, such strategies—albeit in varying shades and sometimes partly motivated by industrial policy concerns—were followed in France. Italy, the Netherlands, the Nordic countries, Japan, and Australia. The Dutch experience provides an interesting example of the policy considerations that are associated with such a strategy. Related situations in France and Japan are discussed in Section IV.
Throughout the 1950s and the 1960s, the Netherlands operated a unique system of capital controls applied to short-term inflows and long-term outflows. These two-sided walls of defense were motivated by the desire to control domestic monetary expansion, protect the domestic capital market, and maintain low interest rates at the same time. Capital outflows were restricted by severely curtailing foreign borrowers’ access to the Dutch domestic capital market. The cheap money policy, supported by relatively cautious fiscal policies, was complemented by direct credit controls on bank lending so as not to thwart price stability. Controls on short-term inflows supplemented these domestic credit restrictions in order to preserve internal monetary stability. In 1971, in order to limit speculative inflows, further capital controls were imposed by introducing a closed bond circuit (the “O-circuit”) aimed at curtailing foreign demand for Dutch guilder paper. Further restrictions imposed in 1972 included the prohibition of the payment of interest on nonresident accounts, followed by a negative interest rate and the prohibition of cross-border intercompany loans by Dutch multinationals (a notorious loophole). As occurred in the German and Swiss cases, these controls were not motivated solely by monetary policy considerations but also by a desire to avoid an undue appreciation of the guilder and a loss of competitiveness.
Following the oil crisis in late 1973, the direction of speculative flows reversed. The closed bond circuit was abolished, and other restrictions were relaxed as the current account deteriorated sharply. In 1977, the Netherlands switched to a positive system of exchange control. Nevertheless, and in contrast with the Federal Republic of Germany and Switzerland, prohibitions on certain categories of capital inflows were maintained for monetary policy reasons until 1981. when they were finally completely abolished, along with domestic credit ceilings. This coincided with a reformulation of the monetary strategy aimed at maintaining exchange rate stability vis-à-vis its main trading partner, Germany. In this way, the Dutch authorities sought to import the stability-oriented policies pursued in Germany. This change of direction was followed by an important deregulation of the capital market, partly inspired by the wish to maintain Amsterdam’s position as a financial center. As a logical consequence, all remaining restrictions on outflows were lifted in 1986.
The effectiveness of the Dutch controls, although relatively successful in the immediate postwar period, gradually eroded as the Dutch economy opened up and financial markets modernized. The value of the controls on inflows in the 1970s is questionable. Historical data suggest that restrictions on borrowing from offshore banks (as a supplement to domestic credit ceilings) had, at most, affected 10 percent of total capital imports. In addition, the restrictions could be easily circumvented by specially created short-term paper, swaps, or intra-multinational group credits. The monetary effect of such controls therefore became limited over time as capital mobility increased. Toward the end of the 1970s, the growth of monetary aggregates and inflation reached double-digit figures and the exchange rate had to be devalued vis-à-vis the deutsche mark at intervals. The authorities had to concede that, in an open economy such as that of the Netherlands, it was no longer possible to control domestic liquidity. Accordingly, in the early 1980s, the focus of monetary policy was shifted toward exchange rate targeting (by linking the Dutch guilder to the deutsche mark), followed by a complete overhaul of monetary instruments, including the abolition of direct credit restrictions. The costs associated with direct monetary instruments had begun to weigh more heavily over the years as credit controls limited competition between financial institutions and encouraged disintermediation.
As the credibility of this policy increased over time, slight deviations from the exchange target led to offsetting speculative capital flows. In the face of these stabilizing speculative flows, the central bank did not have to intervene in the exchange markets in order to maintain the exchange rate peg. Such stabilizing behavior on the part of financial market participants was also supported by the existence of a sound, internationally oriented financial sector that was capable of intermediating capital inflows into profitable investment. With the exception of one realignment in March 1983, when the guilder was devalued by 2 percent against the deutsche mark, the parity was maintained until the establishment of the EMU in 1999 and interest rate differentials between the Netherlands and Germany remained very small.
Controls on Inflows in Catching-Up Countries: The Case of Spain
Large-scale inflows have been a special phenomenon in countries that are catching up to more advanced industrial countries. At times, these inflows have exceeded the absorptive capacity of the countries concerned and thus have threatened to undermine monetary stability. A good example is the experience of Spain, which was confronted with very substantial capital inflows after becoming a member of the European Community (EC) in 1986. Prior to that, Spain had maintained a relatively tight control system on both capital outflows and inflows.
Attracted by rapid economic growth spurred by heavy foreign direct investment and high nominal interest rates, sizable inflows threatened to undermine domestic monetary stability after Spain’s accession to the EC. In these circumstances, controls on capital outflows were progressively phased out. Moreover, temporary controls on short-term capital inflows were introduced in 1987 to dampen upward pressures on the exchange rate of the peseta. These measures sought to provide policymakers with breathing space until the macroeconomic and exchange rate situation became more favorable. Thus, the short-term domestic interest rate was maintained above the corresponding Euro interest rate. The measures included restrictions on foreign borrowing by residents and a ban on interest payments on nonresident peseta accounts that was later replaced by imposition of non-interest-bearing reserve requirements on these accounts.
Although inflows on nonresident peseta accounts stagnated, the controls were circumvented through currency swaps between Spanish banks and nonresidents. Consequently, the controls had to be tightened. Ceilings and deposit requirements were imposed on the banks’ short positions in foreign currency to offset this loophole. Nevertheless, the relatively high discount, which originally had been established between the Euromarket and domestic interest rates, temporarily reached 500 basis points, but it quickly diminished, especially after Spain joined the EMS in June 1989. Although the peseta continued to be strong within the exchange rate band, expectations of an actual appreciation, which would have implied an upward adjustment of the central rate within the EMS, were tempered. The controls on inflows were lifted in 1991, and in February 1992, Spain abolished its remaining capital controls on outflows, in line with its European obligations, substantially ahead of schedule. As described in Section II. Spain was to reintroduce controls temporarily on outflows when the peseta came under heavy pressure during the 1992–93 EMS crises.
On the whole, the Spanish experience with controls on capital inflows was mixed. Some observers (for example, Galy, Pastor, and Pujol, 1993), on the basis of spread figures for domestic and Euromarket interest rates, come to a relatively positive assessment, since capital mobility was apparently negatively affected. Since the Euro peseta market was relatively thin, however, it is doubtful whether actual spread figures—while indicating market segmentation—accurately indicated the authorities’ effectiveness in achieving their policy goals. Moreover, the controls were evaded on a large scale and needed to be constantly tightened. An analysis of the main items of the capital account suggests that substantial substitution occurred between regulated items in the capital account and nonrestricted items. For instance, although foreign borrowing by residents and Spanish banks declined sharply after the controls on inflows were tightened in 1988, unrestricted long term capital inflows expanded sharply. Bacchetta (1996), focusing both on the degree of market segmentation and the possibilities for circumvention, concludes, on the basis of empirical estimations, that the independence given to the Spanish monetary authorities by capital controls in this period was limited.
Judged from a policy perspective, the breathing space that the controls may have provided did not result in a speeding up of macroeconomic adjustment. Inflation remained above the EC average, and it proved especially difficult to rapidly lower domestic inflation expectations, which continued to be based on a history of relatively high inflation. Tighter fiscal policies might have been more effective in lowering inflation expectations and moderating wage demands. At the same time, although they ran counter to the spirit of deregulation that had characterized Spanish financial sector policies, the controls did not result in the reform process losing momentum. Coming from a heavily regulated environment, the transition to a market environment was carried out in a relatively short period. In this sense, the controls on capital inflows may have provided some breathing space during which to transform the institutional setup and strengthen the regulatory framework of the financial sector.
The application of exchange restrictions under the Bretton Woods system reflected a preference for trying to isolate domestic money and capital markets from international developments. If this were done, domestic monetary policy could be conducted in a relatively autonomous manner. Under conditions of generally limited capital mobility, capital controls may have shielded domestic monetary policy to some extent when exchange rate expectations were stable. This could have occurred in France and the Netherlands, which may explain in part the longevity of their controls. Moreover, capital controls complemented domestic credit control mechanisms. Restrictive domestic financial regulations and the application of capital controls resulted in a relatively low volume of cross-border capital flows during most of the 1960s.
In the face of diverging economic developments manifesting themselves in current account imbalances, however, the system of fixed exchange rates came under increasing strains. Attempts to preserve exchange rate stability by tightening controls on capital outflows in the face of speculative “hot-money” flows were generally unsuccessful in the face of clear underlying imbalances. The German and Swiss experiences show that the effectiveness of market-oriented controls that tried to limit inflows through price incentives tended to erode over time (especially when the perceived gains in the event of any exchange rate adjustment were likely to be high) and eventually needed to be complemented by direct controls, including outright prohibition of certain capital transactions.
Toward the end of the Bretton Woods system, a new motive for the imposition of capital controls emerged. Large outflows from the United States and strong resistance among European countries to adjusting their exchange rates prompted the application of controls on inflows. Capital restrictions applied in European countries showed only limited effectiveness. Typically, differentials between domestic interest rates and Euromarket interest rates declined rapidly, suggesting that arbitrage operations took place as loopholes developed. The effectiveness of United States’ controls on outflows was undermined by the fact that they did not apply to all countries or lenders.
The abolition of capital controls for monetary purposes coincided with a renewed and widespread appreciation among policymakers of the benefits of deregulated markets and with the increasing use of market-oriented monetary instruments by central banks. Moreover, domestic financial reform, including the deregulation of capital and money markets, generally preceded or coincided with the liberalization of the capital account, leading to improved conditions for financial intermediation. Countries with a healthy financial sector and deep and liquid financial markets, such as the Netherlands and Switzerland, generally proved more capable of absorbing large capital inflows without destabilizing the domestic economy. The growth of unregulated international financial markets (beginning with the development of the Eurodollar market) may also have encouraged financial sector deregulation and fostered the spread of more sophisticated financial instruments.
Frequently, the abolition of controls on inflows was accompanied by a major reorientation of the monetary strategy. This is reflected in moves toward money-supply targeting in the Federal Republic of Germany (1973) and France (1977) and exchange rate targeting in the Netherlands (1981), as policymakers recognized that financial markets performed best when price and volume signals were distorted as little as possible by uncertainty regarding the future actions of the budgetary and monetary authorities. This link between the liberalization of capital movements and the goals of monetary policy has been particularly important in Europe, where countries typically have close trade ties. It was felt that monetary policy acting in support of government policies to achieve domestic economic goals (which can shift over time and may differ among countries) would lead to exchange rate instability, thus endangering the EMS. By establishing domestic price stability as the common primary goal of monetary policy, an important element of divergence would be removed, and the chances of combining free capital movements with stable exchange rates would increase. Over time, disillusionment with stimulatory monetary policies in some industrial countries, such as France, Italy, and the United Kingdom, and the apparent success of German policies predicated on stability-oriented policies have fostered the acceptance of price stability as the primary goal of monetary policy. The shift toward institutional independence of central banks reflects the increased attention given to the need to preserve price stability in economies characterized by freedom of capital movements.