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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