Federal Reserve

Two ways to actually cure the financial crisis

A huge amount of air time has been given to how to fix the financial crisis. Within this we’ve heard lots of hot air, sound bites but few real answers. Lots of the most prominently featured recommendations come from those who, as Nasim Taleb quips, ‘crashed the plane’ in the first place.

There is one man who you should really listen to though. He’s called Professor Kevin Dowd.

You might have come across him via his various academic seats past and present, or more likely seen his work promoted by various think tanks and financial sites.

Professor Dowd is still actively contributing to today’s economic debate, but I’ve just finished reading one of his older research pieces – Private Money: The Path to Monetary Stability – written in 1988.

Even though it was published before most Bitcoin aficionados where born, I think this is the financial paper I’ve enjoyed most.

What does he say though?

Professor Dowd’s research career has been spent looking at what is the optimal financial system.

Private Money looks specifically at banking arrangements and whether we need a central bank, whilst also addressing the nature of money and which monies serve us best.

When it comes to banking, Professor Dowd is highly concerned that state or central bank intervention to prevent and solve crises actually makes things worse. This is very much at odds to theorists arguing for central banks like Walter Bagehot.

Professor Dowd’s recommendations here are not born out of economic theory, morality or philosophy, but out of pure utility.

After looking at systems of relatively Free Banking in Scotland in the 18th century, in the pre-revolutionary US states and Canada in the 19th century, we are shown how these systems were actually more stable than banking systems with greater state meddling, such as the English banking system of the 19th century with a powerful Bank of England.

The professor’s analysis is compelling and we finish the first half of the paper with a paragraph that will be warmly received by anyone cynical about the state’s creeping intervention into financial markets and its insistence on burdening tax payers with bankers’ losses.

A major weakness of policies to ‘protect’ banks is that they often attempt to treat a symptom of the problem rather than its underlying cause. The classic examples are where an ostensibly ‘lender-of-last-resort’ policy is adopted to prevent bank runs, or where the state sponsors a system of deposit insurance to achieve the same goal. As the earlier discussion of bank runs suggested, however, runs perform a useful role in closing down insolvent institutions, and the threat of a bank run is a major factor serving to discourage a bank’s management from pursuing excessively risky policies. Remove these and insolvent banks will continue in operation possibly long after they should, and managements will be encouraged to take risks they would otherwise have avoided. Banks will therefore adopt policies more likely to lead to failure, and this will aggravate banking instability rather than reduce it. Bank runs are therefore best regarded as a symptom of banking instability rather than a major cause of it, and attempts to cure the symptom by discouraging runs are more likely than not to aggravate the underlying disease.

Booting central bankers out the door

Having read this far into Private Money you will be asking what this means for banking, and especially for central banking.

Essentially Professor Dowd would remove the central bank from the scene, replacing it with a clearing house where private banks, continuing in their normal operations, would use the clearing house to “arrange regular clearing sessions at which the banks would return each other’s notes and cheques and settle up with one another.”

The clearing house is said to offer a vital means of retaining health and stability within the banking system, as banks within the market exert influence and discipline over one another via their interactions at the clearing sessions.

Risky banks that issue too many notes, thus becoming over-leveraged, cause their note holders to turn in their notes, which is spotted in the clearing sessions. If this run is deemed unproblematic other clearing banks lend to the affected bank, providing capital to future stability.

Or, if the bank run is deemed problematic, other banks will freeze the offending bank out, extending the run with the eventual collapse of the guilty bank. Capital in the form of notes and cheques flees to other, sounder banks with some risk of losses to depositors.

This private banking system, centred around the clearing house, appears like an organic ecosystem, constantly correcting itself from within. Another favourite of ours, Nasim Taleb, would love this – a system echoing nature’s love for the ‘anti-fragile’.

So, there we have it – step one is to remove central banks.

But what about the bleeding money?

Professor Dowd also finds that a private solution to money is again the best system.

Driven by concerns for price signals in the economy to be accurate messaging systems for market participants we are encouraged to seek a monetary standard conducive of stable prices.

Professor Dowd explains his preference for a commodity backed monetary standard which removes the supply of money from man to nature. Sir Robert Giffen and Hayek are cited to explain why inaccurate price signals caused by bad monetary standards can result in grievous economic malfunctions.

Within this discussion we are shown the costs that come with a fiat, government controlled, standard and how monetary policy can be used as a form of taxation. The inevitability of the politicisation of money and prices is shown throughout history and careful explanation is given to the problematic economic effects of variable and erratic rates of inflation.

The idea of a central banker managing our money system is dismissed with the suggestion that public servants ‘not betting with their own money’ are less accountable, effective and responsive market participants not needing to be involved in establishing the value on money and inflation rates.

When it comes to money Professor Dowd draws two main conclusions:

  • The healthy functioning of an economy rests on a properly functioning price system, which in turn requires a stable monetary standard.
  • It is impossible to achieve this price stability with a highly politicised, inconvertible standard, suggesting that currency convertibility should be restored to depoliticise money.

Professor Dowd’s second step in our financial recovery is to return to a sound money standard and keep politics out of our money.

Would this sort out today’s financial world?

We are being recommended Free Banking and sound money as the marigolds and Cillit Bang in this great economic clean up, but would these ideas help us solve today’s financial crisis?

Well, you might say that the scale and impact of this current crisis was caused by the policy responses Professor Dowd cautions against – decades of distortive meddling building ever greater problems. This argument is gaining increasing acceptance in today’s markets.

Since World War Two it can be shown that money and banking have been subject to constant intervention – whether it be the London Gold Pool and currency agreements such as Bretton Woods, bailing out the South American lending crisis, closing the Fed’s Gold Window, the ‘managed’ collapse of Long Term Capital Management or the post-2000 housing bubble and Credit Crunch induced mass bail outs.

It has been a preferred policy response to step in and reduce the effect of the market’s self-corrections, than allowing the odd Lehman-like (token?) failure. During these decades you might also identify a trend of crises increasing in size and effect with banks becoming too-big-to-fail.

Professor Dowd insists that the burden of proof should sit with those who claim that money and banking should operate differently to other markets, with their task being to explain why intervention, special privileges and central planning give rise to more desirable outcomes than those generated by normally functioning free markets.

We whole-heartedly agree.

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About the Author

Will BancroftWill Bancroft is Co-Founder of The Real Asset Company, a market place for individuals to invest in gold, silver and precious metals. Will also contributes commentary and analysis to the Research Desk. His interest in financial markets and investment led to a keen interest in monetary economics, gold and silver. Will is passionate about gold’s role in a portfolio and his views appear on sites and media such as Kitco, Market Oracle, Seeking Alpha, Stockopedia, The Telegraph and Yahoo Finance. Follow Will on Google+, and get his commentary via our RSS feed.View all posts by Will Bancroft

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  • CollyOlly

    Simply revalue the price of gold, instead of revaluing the debt burden. That way you get to bring the value of gold reserves onto a par with the debt burden, which then gives a solid backing to the debt, which can then be wiped clean so we can start again with a clean balance sheet. c $10,000 gold would do ….seemples ..!!

    • whbancroft

      Hi CollyOlly,

      Thanks for reading and stopping by.

      Revaluing gold to recalibrate the financial system is indeed an interesting one. There is quite a range of valuation points in terms of the gold price. Jim Rickards used to suggest $5,000/ounce, but I think now he prefers a gold price of $6,000/ounce.

      Certainly not a bad idea. Anyone else have thoughts about what price of gold should be used for this?

      • therooster

        Hey guys, I think you’re on the right track but I also think too many people default to a top-down process for the re-evaluation and monetization of bullion. After all, we’ve been supply driven since “the apple was shoved in our faces, haven’t we?. It has to be organic and market driven now that we are trading in real-time. It’s a market responsibility, not an elite one. All the elite do now is “carry the stick”. Rate of change is critical.

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  • therooster

    Why kick the bankers out as long as they are creating a perfectly fine real-time measure that suits real-time gold-as-money very nicely ? Get out of the debt paradigm by resisting the bad habit of only seeing the dollar as a currency. It is a currency within the debt paradigm but in the lovely debt-free gold-as-money paradigm , something has to bridge us from the legacy system to the new real-time gold settlement system. That something is the real-time tool of “USD/oz”. It’s a measure. The dollar and gold were severed from their FIXED relationship for more reasons than the average bear may know.

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  • Melvin Taggart

    I do not think the large debt should be used to set the gold price by academic government background persons. I suspect, Dr. Rubin and ex president — evidently removed the old gold bar #s from Fort Knox, KY. IMO, they had/ have no foresight.

    • whbancroft

      Hi Melvin,

      Thanks for the comment. I worry about ‘experts’ resetting gold prices as well, generally being in favour of a more democratic, wisdom of the crowd, market based outcome based on international gold buying.

      Given how liquid the gold market is, and how it’s becoming increasingly international with major and growing liquidity hubs outside of the West, perhaps we might find a market solution after all.

      If the buying pressure keeps up in Asia, we could see all sorts of new market and gold price dynamics evolving.

    • therooster

      Why have anyone set the price other than the market ??? The economy is a real-time event, after all. Fixing a gold price has been gold’s problem all along. Besides, now that gold and the dollar trade in real-time (float) , it’s not feasible to “plonk” a higher price on gold in some special instant. It would create devastation for so many. The fair thing to do is the organic thing and let the price find itself , organically. The elite role is to “carry the stick” by way of more and more paper stimulus. Perhaps, now, the printing “insanity” will begin to make sense. There are “necessary evils” written into “the script”. Follow “the script”. The process of this shift has to be bottom-up. The impetus can not come from the apex of power, only from the grass roots. Academics, such as economists, never seem to take this crucial “rate-of-change” reality into consideration. They default to top-down thinking and assumptions. That’s why “this time is so different”. You cannot pour new wine into old wineskins.

  • StephanLarose

    This system doesn’t seem to address international trade very well. Also, it still allows banks to legally counterfeit money through fractional reserve lending, increasing both inflation and indebtedness, factors which act like black holes draining wealth from the people who actually create it. Governments should simply issue currencies, debt-free, instead of issuing bonds bought by banks which simply print their money out of thin air. If private banks print money out of thin air and then charge us interest on it, the fraud costs taxpayers trillions, money better spent freeing consumers/taxpayers of these onerous, fraudulent “national debts” to be invested in social equity, green energy, hospitals, schools and international development. Private banks, with their sinking of the world economy, manipulations of LIBOR and other multi-trillion dollar frauds, have proven themselves far too incompetent, greedy and criminal to be put in charge of something as important as money. The system should be totally transparent and owned by the citizens on whom the value of currency is based.

    • Juraj Seffer

      Private money would most likely be a commodity, or several commodities. Banks would issue notes based on their reserves (whether 100% or fractional). International trade would be handled through clearing houses, just like the internal one. Remember, there is no fiat currency anymore, no one can decree what money must be used.

      Banks cannot create too many notes because of competition. Any competing bank holding their notes can redeem them for specie. This has been explained in the article.

      Interest rate would be set not by the central planning bureau but by the market. State could not create money out of nothing and force everyone to use it, they would have to raise taxes.

      You are, essentially, a greenbacker, who ignored all the pointes raised in this article and Dowd’s paper. Dowd described your kind of argumentation:
      “A major weakness of policies to ‘protect’ banks is that they often attempt to treat a symptom of the problem rather than its underlying cause”

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