THE LIBERTARIAN ENTERPRISE
Number 511, March 22, 2009
"The Mother Of All Demos"
Special to The Libertarian Enterprise?
"As promised, I have some thoughts following on from the talk given by Kevin Dowd, a professor at the Nottingham University Business School and a noted advocate of what is called "free banking". He gave his talk at the annual Chris R. Tame Memorial Lecture as hosted by the Libertarian Alliance. (The LA was founded by Mr Tame, who died three years ago at a distressingly young age after losing a battle against cancer.)
"Professor Dowd covered some territory that is already pretty well-trodden ground for Samizdata's regular readers, so I will skim over the part of the lecture that focused on the damage done by unwisely loose monetary policy of state organisations such as central banks, or the moral-hazard engines of tax bailouts for banks.
"Instead, I want to focus on those aspects of Professor Dowd's talk in which he tried to sketch out what a laissez faire, free market banking system would actually look like. This is essential; a great deal of commentary so farwhile it is very goodhas mainly focused on how we got into this fix and why the fixes being attempted by Western governments are proving so stupid. As PJ Rourke said recently, the attempt by the Obama administration to flood the market with cheap money as a "solution" is a bit like the case of when your Dad has burned the dinner, so you ask the dog to cook it instead. No, what Professor Dowd did this week was lay out three broad areas for reform.
"Firstly, he says we should remove many of the existing regulations, government-mandated deposit protection schemes, bank capital adequacy rules and other restrictions on what banks can do and how they work. For example, government support for depositorswho are also effectively creditors to their banksmeans that there is a moral hazard problem; the banks have less incentive than they would otherwise have to act prudently if there is always the government, acting like a sort of 7th Cavalry, able to ride to the rescue. That has to go. Professor Dowd also wants to hack away at the morass of rules and regulations that violate client/banker confidentiality, or those rules that force banks to lend to people, as is the case in the US, where banks are forced to lend to certain groups or else violate laws about racial discrimination, etc.
"Secondly, Professor Dowd addresses the issue of letting banks fail. At the present, policymakers adopt a sort of "too big to fail" doctrine; this doctrine, while not explicitly laid down in any form of statute or operating manualas far as I knowis a rule that says that some institutions are so large, and the attendant systemic risks posed by their failure so catastrophic, that they should not be allowed to go out of business. The problem of course is that this rule of thumb is often arbitrary and subject to political horse-trading. To wit: the US government's decision to let Lehman Brothers go down last September, followed shortly by the $85 billion bailout for AIG, showed a total lack of clear message to the markets, and to bankers, one way or the other.
"Professor Dowd believes that banks should be allowed to fail and furthermore, if modern limited liability laws were weakened or abolished completely, then such massive conglomerates would be economically and legally unsustainable in the first place.
"As a result, banks would probably be smaller, and there would be a lot more of them, so the failure of any individual bank, while unpleasant for some, would not wreck the system as could happen if a mega-bank goes wrong. Also, instead of wide-ranging and hideously expensive bailouts, Professor Dowd favours putting banks into administration, writing down, in full, the value of their loan books, and getting depositors to exchange their status as creditors for that of an equity holder.
"This "debt for equity swap" arrangement, while it would anger depositors who lose money, would come with the promise, and hopefully the reality, of a rise in the capital value of their equity stake in a bank if confidence returns to a more robust banking sector, as the debt/equity swap recapitalisation is designed to achieve. And of course banks are entirely free, as are their clients, to take out deposit insurance in a commercial market.
"The third leg of his solution is broader, and more long-term, although there are some immediate measures that could be taken. Professor Dowd is against fiat moneymoney not backed by actual commodities or real assets of any kindand in moving to a commodity-based/asset-based system. He is not, by the way, necessarily arguing for the gold standard or some gold-based system, although he points out that in the 200 years up to the First World War, the UK enjoyed a remarkable period of stable prices, with the odd blip. What he is arguing, however, is that the message on a banknote that says "I promise to pay the bearer on demand the sum of X" should be an enforceable legal contract, not what amounts to the jeering joke that it now is.
"In the subsequent Q&A session afterwards, one person made the excellent point that a simple reform would be to ban legal tender laws. Such laws currently require a person to accept as legal tender a currency that the state has mandated for a particular region. Instead, if a person wants to refuse to accept sterling and only wants to accept dollars, euros or Swiss francs instead, he can do so. He can also choose to trade in whatever medium of exchange he wants, and with whoever wants to accept it.
"Inevitable questions arise. First of all, in thinking about free banking, private monetary systems and the like, the first objection will be is that this will be very messy; there has been no real experience of such monetary systems in the past, etc.
"But this is incorrect. Free banking, as defined by Professor Dowd, in fact operated in Scotland, for example, up until legal changes in 1845. South of the River Tweed, the English system had operated under what amounted to state-controlled banking under the Bank of England, set up in 1692. In the 18th and 19th centuries, England saw a number of booms and recessions, such as the 1840s railway boom and the downturn of 1870s. One should remember that the BoE was established by the-then post-Glorious Revolution government as a way to raise money for wars without having to keep asking a fractious public for taxes, and without having to borrow at expensive rates in the money markets. N.A.M. Roger has explained this issue of financing for naval warfare brilliantly. Indeed, it reminds us that state monopoly money systems typically arose in order to finance wars, while the welfarist aspects came later.
"There are also current, not just old, examples of banks that operate with unlimited liability partnership structuresPictet, the Swiss bank, and Lombard Odier, are just two examples. There are dozens of such banks using these structures in Switzerland and by no coincidence; they have avoided the worst of the credit crunch. These banks are typically for the rich but it seems to me that there is no logical reason why such an approach could not be used more widely. So there are different ways of doing banking right now. And do not forget the humble UK mutual building society: they have their limitations, but as a business model they had a lot to recommend them.
"Another objection might be that the debt-for-equity swap way of restructuring failed banks under bankruptcy protection laws would be politically unfeasible, since depositors would be hit. I understand that, but Professor Dowd is not trying to imagine what sort of reforms would appeal to David Cameron, say, but what sort of reforms would be workable. That is a rather massive difference, as I am sure readers will agree.
"Another objection is that "real money", as opposed to the state-arranged fiction that we have now, cannot work for as long as governments take such a large slice of GDP. That is probably correct. One of the reasons why so many advocates of Big Government regard "gold bugs" or free bankers as dangerous nutters is that they realise their welfare states would be unworkable under such monetary arrangements. The Ponzi schemes of most welfare states would not be able to function. Even so, as long as governments retain the ability to tax, they have the ability to raise debt in the financial markets in the knowledge that their collateral can be collected at the point of a gun. But a real-money system still hampers such activity considerably.
"In the longest run, the best hope of avoiding such financial disasters in the future is to wean the public and policymakers off the seductive delusion that one can create wealth by turning on a printing press. Sooner or later, if you try to fake reality, it bites you hard in the arse. Of course, it is a mark of the kind of man Professor Dowd is that he is too polite to put it as bluntly as that.
"I await comments!"