Money and the Market

Essays on Free Banking

Kevin Dowd

• Publisher: Taylor & Francis
• Year: 2013
• Print ISBN: 9780415758420
• eBook ISBN: 9781136371882
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

Kevin Dowd asserts that state intervention into financial and monetary systems has failed, and that we would be better off if financial markets were left to regulate themselves. This collection will appeal to students, researchers and policy makers in the monetary and financial area.

1 Introduction

The essays in this book share a common concern with the impact of government intervention in the financial and monetary areas: not just the banking system, but the financial services industry more generally, as well as the issue of money and the control of inflation. Some of the essays investigate what unregulated financial systems would look like; others examine some of the justifications given for particular forms of state intervention, such as deposit insurance and capital adequacy regulation; while still others look at rules to govern the issue of currency in the absence of discretionary monetary policy; and the remaining essays look at a variety of monetary and financial policy issues from a free banking perspective.

My outlook is essentially very simple, even simplistic. I believe that markets generally work and governments generally fail: the invisible hand of the market is better than the visible hand of the state. This is not to say that market solutions are ‘perfect’, but I have often been impressed by the ability of markets to find ingenious solutions to complex problems that no economic planner could ever have found. Over the years, I have also been struck again and again by the way in which the invisible hand strikes back and superficially plausible justifications for government policies tend to unravel under close scrutiny. Add to that many years of observing government in action – sometimes at very close quarters – and I developed a strong sense of the pervasiveness of government failure. Indeed, the only time government seems to achieve its objectives is when the powers of the state are hijacked by powerful special interest groups who use them for their own ends, and this strikes me as more an argument against government intervention than for it.

Much of my research has been, in effect, no more than a continuing effort to think through these issues as they apply to the financial and monetary system. To be frank, I have always been baffled by the resistance of most economists to the idea of free banking: I have never understood how most of them can be content to argue for the principle of free trade in general, and then argue against free banking, which is after all no more and no less than free trade in financial services. If free trade is good, then what is wrong with free banking; and if free banking is undesirable, how can they advocate free trade? Do they support the principle of free trade or don’t they? At the same time, government interventions in this area – financial regulatory systems, deposit insurance, bank bailouts and so on – seem to have a track record at least as dismal as government interventions elsewhere. The personalities and circumstances may change, but the underlying issues stay much the same, and the same old mistakes are repeated again and again. Everything changes, and everything remains the same. Not surprisingly, the fundamental remedy for many of our problems also remains the same as it always was: to work with market forces, rather than against them, and establish free banking.

The theory of financial laissez-faire

These essays fall quite naturally into three main main groups. The first of these deals with the theory of financial laissez-faire: what financial laissez-faire might look like, arguments for and against state intervention, the historical evidence on the relatively unregulated financial systems of the past, and so forth. The opening chapter in this section – Chapter 2, ‘The case for financial laissez-faire’ – originally appeared as part of a controversy on the theme of ‘Should we regulate the financial system?’ in the May 1996 issue of the Economic Journal. It begins by setting out a vision of a laissez-faire financial system: how banks would arise and issue currency under laissez-faire; how they would compete for business and be as safe and sound as their customers demand; and how the banking would be stable, even though individual banks would inevitably experience difficulties from time to time and might even be run out of business. It then discusses the ways in which state intervention into the financial system – in particular, lender of last resort policies and deposit insurance – can undermine the stabilizing mechanisms on which the laissez-faire system depends and lead to a weaker and less stable banking system. It also suggests that these speculations about free banking are entirely consistent with the empirical evidence from less regulated financial systems of the past. Finally, the chapter addresses some specific criticisms of financial laissez-faire made by the other participants in the Economic Journal controversy: George Benston and George Kaufman, who argue for a lender of last resort and deposit insurance; and Sheila Dow, who argues, among other things, that laissez-faire would be unstable.

The next two chapters deal with arguments for and against specific interventions into the banking system. Chapter 3, ‘Bank capital adequacy versus deposit insurance’ was first published in the Journal of Financial Services Research in 2000. This chapter deals with the highly influential justification for deposit insurance provided by the work of Diamond and Dybvig (1983). To analyse this issue, they set out a theoretical framework in which financial institutions arise to provide individual agents with the opportunity to make liquid investments, but are prone to self-fulfilling fears of failure. If individual investors think their financial institutions will fail, they will run on them, and in so doing actually cause the institutions to fail: their fears of failure become self-fulfilling. The banking system is thus inherently unstable, and Diamond and Dybvig suggested that this instability could be remedied by a government guarantee or some form of deposit insurance.

Chapter 3 attempts to question this analysis by presenting a theoretical counter-example: a model environment similar to that of Diamond and Dybvig, but in which banks arise that are stable without any form of government guarantee. I argue that my model is more plausible than theirs: their model makes every individual identical ex ante and leads to strange-looking financial institutions that we do not observe in the real world, whereas my model allows individuals to be different and leads to financial institutions that look much more like real-world banks. Unlike theirs, my model also provides a natural role for bank capital – bank capital is a device to give investors rational confidence in their bank – and so helps explain why bankers have traditionally placed so much importance on their capital. The moral of the story? Banks do not need deposit insurance, provided they have adequate capital.

Should the government then ‘help’ banks to maintain adequate levels of capital? This takes us to capital adequacy regulation – the imposition by regulators of minimum acceptable capital levels for banks – which attempts to shore up the financial strength of the banking system and counter the moral hazard problems created by lenders of last resort and deposit insurance systems. Capital adequacy regulation is without doubt one of the most important features of modern systems of central banking and financial regulation. Yet, despite its importance, there have been relatively few attempts to provide it with a theoretically solid foundation. Most writers merely argue that we need capital adequacy regulation to counter the moral hazards created by other state interventions (e.g. Benston and Kaufman), or else argue for it on vague paternalistic grounds (for example, Dewatripont and Tirole 1994). To my knowledge, the only clear attempt to justify capital adequacy regulation from first principles is by David Miles (1995). He suggests that an information asymmetry between bank managers and deposits can lead to a market failure, and that state intervention in the form of capital adequacy regulation can correct this failure: the regulator would assess the capital the bank would have maintained in the absence of the information asymmetry, and then force the bank to maintain that level of capital. Miles’ work is important because it provides the first rigorous attempt to justify capital adequacy regulation by reference to the (alleged) failure of laissez-faire. Naturally, I could not resist the urge to respond to such a challenge, and the result is Chapter 4, ‘Does asymmetric information justify bank capital adequacy regulation?’, which was first published in the Spring–Summer 1999 issue of the Cato Journal. In replying to Miles, I argued that his justification for capital adequacy regulation is inadequate. It fails to provide a convincing rationale for the distinctive regulation of banks – to explain why banks should be subject to this form of regulation but other firms should not be, as we both agree. In addition, the premise of Miles’ argument – that depositors cannot assess bank capital strength – is both implausible and empirically falsified. Finally, Miles’ suggested solution is not feasible in his model anyway (that is, the invisible hand has its revenge). Laissez-faire wins again, I think.

I then turn to consider a different line of attack against free banking. This comes from work in the 1980s by Gary Gorton and Donald Mullineux in the US and Charles Goodhart in the UK concerning what might be described as the microfoundations of banking regulation. Though their arguments differ considerably – Gorton and Mullineux use a contractual theory approach and Goodhart relies on the theory of clubs – these writers all maintain that information problems in financial markets pose problems that unregulated markets cannot properly handle, and argue that ‘regulation’ arose spontaneously to meet these problems. The emergence of banking regulation and central banking was therefore a natural response to problems inherent in financial markets, and the free banking view of them as damaging intrusions to financial markets should be rejected. Chapter 5, ‘Competitive banking, bankers’ clubs, and bank regulation’, was my attempt to respond to these arguments, and was first published in the May 1994 issue of the Journal of Money, Credit, and Banking.

I readily concede that information problems play a large role in financial markets, and I also concede that these can sometimes lead banks to form ‘clubs’ or other hierarchical arrangements that restrict (that is, regulate, if you will) the freedom of member-banks. However, this spontaneous ‘regulation’ does not provide a justification for real-world systems of central banking and state-imposed financial regulation, because the two types of regulation – spontaneous and state-imposed – differ in a number of important ways (for example, ‘spontaneous’ regulation is very limited in scope and is still under the banks’ collective control, and so on). A second problem with the spontaneous regulation argument is that the alleged benefits of regulation are in reality economies of scale; this type of argument therefore implies that banking is a natural monopoly. The problem, of course, is that the empirical evidence clearly indicates that banking is not in fact a natural monopoly. In any case, arguments for spontaneous regulation are also refuted by the abundant evidence that the relatively unregulated banking systems of the past developed little or none of it; and there is a plausible argument that the nineteenth-century US cases often cited as examples of ‘private’ regulation only arose in response to the branching and other amalgamation regulations that prevented US banks from appropriating economies of scale in more natural ways. In short, the free bankers appear to have been right all along: central banking and financial regulation did not arise to counter market failures, and cannot be justified by market failure arguments.

Chapter 6 looks at laissez-faire from a very different perspective. This chapter, The invisible hand and the evolution of the monetary system’, first appeared in John Smithin’s edited collection of essays, What is Money?, which was published by Routledge in 1999. Instead of looking at the desirability of laissez-faire using neoclassical analysis, it examines laissez-faire using a conjectural history: it investigates how it might plausibly evolve from some initial primitive state, driven by private self-interest in the absence of any form of government intervention. A conjectural history provides a simple but useful way of explaining how laissez-faire might work, and also provides a useful benchmark to examine our current system. If we start off in barter, say, we go through the standard Mengerian analysis of the evolution of commodity money; we then take the analysis forward to look at the development of coinage, the evolution of banks and bank currency, the changing role of the unit/medium of account, the evolution of currency convertibility, and the eventual development of a fully mature laissez-faire monetary system, based on an indirectly convertible commodity-basket standard. We can then examine this system in more detail – what it looks like, how it functions, and so on – and investigate its efficiency and stability. To my mind, this system is as efficient and stable as we could reasonably wish, and certainly a vast improvement over our current system, with its proliferation of different currencies, gyrating exchange rates, bank weakness, financial instability, and the like. If we could choose, why on earth would we not choose the patently superior system?

The last chapter in this section considers another important question: whether free markets can be blamed for financial market instability. The theme of this chapter was originally suggested by Steve Horwitz, and Jeff Friedman subsequently invited me to address it in an essay in the Critical Review. In doing so, they gave me an opportunity to think through more systematically issues I had been discussing for years with Dave Campbell, a very close friend who is now professor of law at Cardiff University. I wanted to get at the inappropriately polarized way in which many people tend to debate these issues: on the one hand, there are leftist critics, who tend to look at how financial markets appear to operate – how they appear to produce excessive volatility, and so on – and then reach for interventionist ‘solutions’; on the other hand, there are freemarket economists who all too often respond by denying point-blank that there could be anything much wrong at all with financial markets, more or less regardless of the empirical facts. These two sides tend to talk right past each other, and I felt there were merits and faults on both sides: the critics are right about there being problems with financial markets, but are far too ready to invoke the deus ex machina of state intervention to resolve them; the free-marketeers are right to be sceptical of interventionary ‘solutions’, but far too ready to defend the indefensible in existing financial markets.

The root of the problem, I concluded, was that both sides were too ready to identify the existing world financial system with laissez-faire. To investigate this issue further, the chapter compares a hypothetical laissez-faire system to the system we actually have, and, in effect, tries to drive a massive wedge between the two. One system has an excessive number of different currencies, is prone to currency crises and inflationary instability, and so on, and the other is not. The differences between the two systems are extremely significant. Freemarket economists should therefore not feel under any obligation to defend the status quo. However, some speculations about the future also lead to the conclusion that these differences are likely to disappear over time as market forces become even stronger and existing currency regimes are forced to accommodate them. Maybe some of us may yet live to see financial laissez-faire.

The monetary regime

The second group of essays deals in more detail with this same subject: the monetary regime under laissez-faire. My own starting point is a long-held belief that a laissez-faire system would provide sound money, because I believe that the public fundamentally want sound money and that market forces would find some way of ensuring that they got it. I also take sound money to mean price stability: that our target price index (for example, the RPI/CPI) should remain stable over time. I have always believed that aggregate price-level movements are not only bad, but often very bad, particularly when they are difficult or impossible to predict in advance, and that our currency unit should provide a stable value-yardstick on which the private sector can safely rely as it goes about its business.

We come then to the all-important question: what rule(s) of currency issue would ensure that the currency would maintain its soundness? I struggled with this question for a long time, and my attempt to answer it is provided in Chapter 8, ‘A proposal to end inflation’, which was published in the Economic Journal in July 1994. (For pedagogical and diplomatic reasons, the suggested rule was couched there as one for the central bank to follow, but the mechanics of the rule apply equally to a free-banking system.) The idea can be thought of as a generalization of the gold standard. Under the gold standard, the currency issuer(s) buys and sells gold at a fixed nominal price, but the resulting price level is only as stable as the relative price of gold against goods and services in general. However, we can make the price level more stable by pegging the price of a broader basket of goods (and perhaps, services), rather than the price of a ‘basket’ only of gold. The broader the composition of the basket, other things being equal, the more stable the resulting price level. Given our objective of price-level stability, we would ideally like to choose that broad basket of goods and services whose price is reflected in the price-index we are seeking to stabilize. The problem is to make this idea operational, given that the basket in question is not transactable – and that people cannot buy and sell this basket the way they can buy and sell a ‘basket’ of gold.

The suggested answer is to replace the physical basket by an appropriate financial derivatives instrument, and the particular instrument proposed is similar to a financial futures contract based on (that is, has a payoff contingent on) the realized value of the RPI/CPI. The central bank would buy or sell this contract on demand at a fixed price, at regular intervals, and rely on market forces to ensure that the quantity of money was consistent with zero expected inflation. The system would also exhibit negative (that is, stabilizing) feedback in the face of incipient deviations from equilibrium: if prices were expected to rise, private agents could expect to make a profit by buying these contracts from the central bank, the supply of base money would fall, and expected prices would drop; and if prices were expected to fall, agents could expect a profit by selling these contracts to the central bank, the supply of base money would rise, and expected prices would rise. In equilibrium, the expected price level would be on target, and the realized, actual, price level would equal the expected price level plus or minus an unpredictable random error. This error should be fairly small, so the resulting price level could reasonably be described as fairly stable. The rest of the chapter then goes through various technical conditions and compares the proposed rule to alternatives.

This proposal got a very mixed reaction. The most amusing was that of another old friend, John Whittaker, of the University of Lancaster, who commented drily that he knew there was something wrong with it, but could not quite put his finger on what it was. However, some others were more confident that they could. One of these was (the, sadly, late) Brian Hillier, who published a critical comment on it in the May 1996 issue of the Economic Journal. Brian tackled it by building a version of the Lucas tree model and claiming that this showed that the arbitrage mechanism I was relying on did not work. He also claimed that my monetary rule was unsustainable in an unpleasant monetarist arithmetic world where fiscal and monetary policies were inconsistent in the long run and the fiscal policy was effectively set in stone. Chapter 9 is my response, which was also published in the same Economic Journal issue. The argument about the arbitrage process boils down to whether the discount rate used by private-sector arbitragers would move closely with the short-term market interest rate, and I felt I was right on this issue, based on what I knew of the discount-rate practices of City firms trading comparable instruments. His second argument was correct but irrelevant. If fiscal and monetary policies are inconsistent in the long run, and if fiscal policy is not going to be changed, then the monetary policy must eventually give way. This logic is cast-iron and applies to any monetary policy or monetary policy rule. However, I ...

Table of contents

• Cover
• Half Title
• Title Page
• Copyright Page
• Table of Contents
• List of tables
• Preface
• Permissions acknowledgements
• 1 Introduction
• PART 1 The theory of financial laissez-faire
• PART 2 The monetary regime
• PART 3 Policy issues
• Notes
• References
• Index