analysis | It's all Greek to me. Capital controls explained

The government of Greece is considering drastic measures such as the use of capital controls to stabilize its economy should the country default on its debts and begin to leave the European Union. As bailout negotiations between Greece and Eurozone leaders continue to stall, financial analysts and experts are considering the once untenable idea of capital controls.

The term saw airplay in headlines as recently as December 2014, when Russia considered (but ultimately did not implement) capital controls after the Russian Rouble tumbled in value, sparking a crisis so large that multinationals like Apple temporarily ceased its sales in the country. Capital controls were used to great effect in Cyprus when it experienced a financial crisis in 2013. Now, capital controls have become a part of the Greek "doomsday" scenario if it were to leave the European Union and its common currency.

What is it?

In the most broadest sense, a capital control is simply that, a restriction on the flow of capital. The controls are used as a bandage, to prevent money from flowing freely out of the country, in effect artificially stabilizing the country's finances. Capital controls ensure the government has money at hand to work out an economic solution.

Controls can be enforced on multiple levels, ranging from international business transactions down to restrictions on everyday finance. For instance, a transaction threshold can be set; any transaction exceeding this limit would require government approval. The government may choose to impose a cap on bank account withdrawals, preventing bank runs. Investors may be prohibited from withdrawing from the country without government approval.

What's the problem?

Obviously, such controls create an impasse to the free flow of goods and services. Large business transactions are at the mercy of the government, adding unpredictability and thereby increasing the costs of doing business with that country. Capital controls applied to citizens, such as a withdrawal cap or taxes on certain foreign transactions, are likely to incite anger at the government.

When applied to a free-market system, capital controls tend to hamstring the economy, leaving it unable to react quickly to changing market conditions. This is why governments like Greece are loath to apply such measures except in dire emergencies, and even then as a last ditch effort at solvency.

Where do we stand?

If Greece exits the Eurozone, whatever currency the Mediterranean nation introduces will fluctuate in value until the markets can decide what it's worth. Generally, people are aware of this and will want to make withdrawals denominated in Euros while it's still possible, leading to a massive outflow of money from financial institutions. Businesses will likewise want to keep their money in other, "safer" currencies, or even in offshore accounts. Such withdrawals mean insolvency, as more money is going out than is coming in.

The application of capital controls, while fraught with risks, would hopefully give the Greek government enough time to restart the economy. But with a checkered history of success, capital controls require a patient and willing market—something in increasingly short supply.