Lessons from the financial crisis: a libertarian perspective

This article is an expanded version of the Second Chris R. Tame Memorial Lecture delivered by Professor Dowd at the National Liberal Club, London, March 17th 2009. A recording of the original Lecture, with an introduction by Dr Tim Evans, President of the Libertarian Alliance and CEO of The Cobden Centre, can be found here. The original paper is available here: please see that paper for appendices and endnotes.

Introduction

Good evening everyone. I would like to start by thanking my friends at the Libertarian Alliance for inviting me to give this lecture. It’s good to see so many other friends here as well. I would like to thank you all for coming.

For those of us who were fortunate to know him, Chris Tame was an inspiring mentor and a loyal friend; he showed remarkable dignity and courage in the face of the illness that ultimately cost him his life, and his death was a massive loss. I owe him an immense personal debt myself, so it’s a very special honour to speak at his memorial lecture.

Chris was a central figure in the rebirth of Classical Liberalism in this country and it is very appropriate that we meet here in the National Liberal Club. But the Liberalism that Chris espoused was not the watered down ‘liberalism’ of the 20th Liberal Party—the liberalism of Lloyd George or Jeremy Thorpe—but the Classical Liberalism of an earlier age—the Liberalism of Gladstone, and earlier still, the Classical Liberalism of the great moral philosophers of the 18th century Enlightenment.

My topic this evening is the current financial crisis. My theme is that the Classical Liberal perspective can help us both to understand the crisis and to find a way of out it.

I always like to begin with a nice quote, and we are spoilt for choice when it comes to quotes about the financial crisis. Amongst those I can quote in mixed company, my favourite one is a comment by a Wall Street passer-by when asked his thoughts about the bank bailouts: “Its like not being invited to a party and then being given the bill for it”, he said.

This comment goes right to the heart of the matter—the widespread perception amongst the public that there is something wrong with the current financial system, i.e., that it lacks legitimacy. I agree with this view entirely: the current system does lack legitimacy and I am sure every right-thinking person would agree with me that it is manifestly indefensible.

Though correct, however, this perception is also dangerous, as it provides fodder for interventionists who argue that the current crisis is due to unconstrained market forces. Free markets have failed, they argue, so let’s have more state control instead.

Such arguments are mistaken in every respect. The current system involves limited competition within the constraints of a large variety of state-mandated parameters – a managed (or rather, mismanaged) economy, but not nothing like laissez-faire. And it is this ‘managed’ economy that has failed us all so badly.

The roots of this managed economy back a very long way:

• We had the establishment of the Bank of England in 1694 and the subsequent development of centralbanking.
• We had the establishment of the limited liability statutes in the 1850s, passed against bitter opposition by those who claimed—rightly—that they were a recipe for irresponsible risk-taking at other people’s expense.2 This might sound familiar.
• We had the stage-by-stage destruction of the commodity monetary standard. The pound, which was originally—and literally—‘as good as gold’, was replaced with the current inconvertible pound, which is intrinsically worthless. One consequence of this was the horrendous inflation of the 1970s and 1980s, not to mention the danger that inflation will return again if current monetary policies persist.
• We had the development and widespread adoption of Keynesian macroeconomics from the 1930s on. Keynesianism was discredited and then abandoned in this country in 1976, but the Keynesian legacy—in essence, the belief in a managed economy—still survives and poses a grave threat to our future.
• In the late 20th century, we had the establishment of state-mandated deposit insurance.
• And, over this same period, we had the growth of vast systems of financial regulation: these included the establishment of the Financial Services Authority and the growth of international bank capital adequacy regulation. Contrary to what one
• often hears, banking is not the epitome of laissez faire, but a heavily regulated industry.

My point here is each of these pillars of the current system—central banking, limited liability, inconvertible currency, the managed economy, deposit insurance and financial regulation—represents a major and profound state intervention into the economy, i.e., the opposite of a free market.

What I would like to do this evening is give my own view of the crisis as a Classical Liberal economist. Naturally, I can’t pretend to have all the answers, but I think there is a way out: we can put together a workable reform package. We then need to be confident in it and advocate it with all the powers of persuasion that we can muster. Above all, as Chris always maintained, we need to win the battle of ideas against those who would argue that we need even more of the interventionist medicine (or rather, poison) that has already caused so much damage—and threatens to do so much more.

The stakes haven’t this high since at least the 1930s.

What we shouldn’t do

Let me begin by suggesting the policy responses that we don’t want:

• We don’t want more panic reactions by the authorities, again and again.3 The crisis needs a considered response.
• We don’t want repeated massive bailouts at taxpayers’ expense.
• We don’t want government guarantees or deposit insurance.
• We don’t want more fiscal stimulus.
• We don’t want more financial regulations or more financial regulators: we have had more than enough of those already, thank you very much.
• And, finally, we definitely don’t want loose monetary policy.

This list might sound depressingly familiar: indeed, it includes pretty much everything that the Government has been doing. It is clear that these policies are not working and are actually making matters worse. These policies are also very costly and potentially highly dangerous.

Vast spending sprees are not only costly, but also threaten the integrity of the public finances: a joke going the rounds in the US is that the Obama team would have spent a trillion dollars before they had figured out where the restrooms are in the White House. Such spending is very irresponsible against a backdrop where leading experts are openly worrying about the long-term solvency
of the United States itself, with the growth of unfunded future entitlements and the ageing population.

The prognosis for this country isn’t quite so dire, but it is still dire enough. The last thing we need is an orgy of
wild Government spending.

As for loose monetary policy to stimulate credit, this fails to address the underlying problem – that credit is tight because confidence is lacking, not because interest rates are too high. Much more important, irresponsible monetary policy—in particular, printing money—threatens the integrity of the currency. Printing money has been condemned by generations of monetary historians, and for good reason. And it doesn’t become any more respectable if you do it but tell people you are doing ‘quantitative easing’ instead. Indeed, whatever you call it, there is no surer way to lay the foundations for a hyperinflation: remember the Weimar Republic after the First World War or modern Zimbabwe.

What we should do

Turning now to the question of what we should do, I suggest that we think in terms of a journey:

• We want a clear idea of what we want the financial system to become: we want to be clear about our destination.
• Once we have this, we want to be clear how to get there: we need a route, a series of measures that takes us to our destination.

Free banking

The destination we want is a safe, stable and efficient financial system, and my main point here is that this can be attained through a system of financial laissez-faire or free banking. Before anyone objects that this is some abstract theory or unattainable pipe dream, I would point out that such systems are attainable and are firmly rooted in historical experience. (For those of you who
are non-economists, by the way, let me offer you a tip: Never believe economists bearing theories, including me. Always insist on evidence.) Long before central banks spread across the world in the 20th century, we had many experiences of unregulated or lightly regulated banking systems—in Australia, Canada and many other countries—most famously, in Scotland before 1845. There were, I believe, some 60 cases, and some of these lasted a very long time. These systems were highly successful – they were innovative and also highly stable. The key to their success is that market forces forced the banks to be strong. There was no deposit insurance or state support, so bankers operated under the fear of a run, and could only maintain the confidence of their depositors if they acted conservatively. A bank that failed to maintain its depositors’ confidence would literally be run out of business. On the other hand, if a bank was well run, pardon the pun, then there was no reason for depositors to run on it. In short, market forces forced the banks to limit their risk-taking and maintain financially strong balance sheets: the system worked.

The debates on banking reform in this period were very interesting, especially those in the early 19th century. In particular, there was a lively debate on the relative merits of the English central banking system and the Scottish free banking one. In essence, this controversy boiled down to the English economics establishment armed with lots of theories as to why free banking couldn’t work, on the one hand, ranged against Scottish advocates of free banking who argued that it patently did. So who would you believe, the economic theorists who said it couldn’t work, because their theories said so, or their opponents, who said that if they just opened their eyes they would see for themselves?

A prominent example on the English side was John Stuart Mill, who was a prominent economist as well as philosopher.
He managed to persuade himself that free banking was unworkable in theory but got fed up arguing with people contradicting him by pointing to the Scottish experience. In the end, the best he could come up with was that free banking was very good north of
the Tweed and very bad south of it—not the most convincing argument from one of the great minds of the 19th century.

A sound monetary standard

Underlying a stable financial system, we also want a sound monetary standard and again the 19th century provides a role model. This was the Golden Age of the gold standard. The gold pound was the admiration of the world and was in time eventually copied by virtually all other major countries. The famous legend on the pound note—“I promise to pay the bearer on demand the sum of one pound”—actually meant something. It meant, “I promise to pay a fixed amount of gold, a gold pound, in return for this paper note”. Now that same legend means something very different. It means, in effect, “If you have nothing better to do than ask for your pound, we will humour you by exchanging it for another pound note just like it.”

I am not suggesting by any means that the gold standard was perfect, but if we judge it by its record, it achieved much better price stability than the disastrous inconvertible paper money standard that replaced it.

Unfortunately, in the twentieth century the gold standard came to be seen as a pointless constraint against the issue—or, rather, over-issue—of currency. Economists argued that the Bank of England should be free to issue whatever amount of currency it (or its political masters) wanted. The old idea that the gold standard imposed a useful discipline against the over-issue of currency was
discarded as out of date. Keynes famously told us that the gold standard was a relic of a barbarous age, and reassured us that modern governments were much too sophisticated to debase the currency. Modern governments were not like impecunious Roman emperors or medieval kings.

The results were catastrophic, but Keynes was right about one thing. Modern governments were not like Roman emperors or medieval kings: they were much worse, and produced much greater inflation rates than their predecessors ever managed to achieve. There is a limit to how much inflation you can create by clipping the edges of your coins and putting them back into circulation, but the sky’s the limit when you can just speed up the printing press or add additional zeroes to your notes.

So coming back to my main theme, our ultimate objective—in a nutshell—is a system of free banking on a sound commodity-based monetary standard. How do we achieve this? And, more urgently, what we do about the crisis?

‘Doing nothing’

One option that should have been considered all along is simply doing nothing – literally applying laissez-faire right in the middle of the crisis: no bailouts, no deposit guarantees and no fiscal stimulus. Just hang firm and let market forces do their work to correct the economy.

Such a policy has been successfully tried before. The then-US Treasury Secretary, Andrew Mellon, applied it successfully in the face of the sharp downturn of 1920-21, to give just one example. To quote Martin Hutchinson
in a recent column:

In December 1929, as what we now know to have been the Great Depression loomed, Mellon outlined his formula for fighting recession…. “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate. … It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more
moral life. Values will be adjusted, and enterprising people will pick up from less competent people.’’ Mellon then foolishly remained at Treasury until 1932, a powerless spectator of the opposite approach taken by President Hoover,
tarnishing his reputation for the rest of his lifetime and beyond.

There are a couple of points in Mellon’s prognosis that have resonance today. “Purging the rottenness out of the system” is precisely what’s required to sort out the banking mess, while “leading a more moral life” is fairly clearly also required after the over-consumption and excess of the bubble period. “High costs of living and high living will come down” is, however, directly contrary to the Keynesian majority view, which holds that deflation is the most serious possibility to fear, and that restoring consumption through government spending is a prime objective. (Hutchinson, 2009)

Mr Hutchinson is spot on. ‘Doing nothing’ would probably have been a lot better than what the Government actually did: the economy would have experienced a very sharp but short shock. But it would have lanced the boil and the economy would have been on the road to recovery by now—and a lot less of our money would have been wasted in the process.

A market-based bank recovery programme

Nonetheless, I believe we can do better than this. A better option, I believe, is a bank recovery programme, but one based on market principles—a recovery programme with no state guarantees, no subsidised bailouts or any of that.

Such a programme needs to address the fundamental structural problems of the banking system—which government
policies so far have signally failed to do.

The key to such a programme is to be found in the way that the market system deals with financially distressed firms.

Suppose that washing machine manufacturers are in financial difficulty. They ask for a bailout but the Government (for once!) wisely refuses. So the firms call in the receivers. The receivers take control and seek to restructure the firms’ balance sheets so that they can hopefully be returned to normal operation in a new, financially healthy, state. In essence, what would happen is that the firm’s assets get written down. The value of the firms’ assets is no longer enough to pay the firms’ creditors, so the firms’ shareholders pretty much lose everything, and the firms’ creditors—the people who hold the firms’ debt—also take a hit. If the firm is still potentially viable, it is then recapitalised with new shareholder capital and returned to normal operating mode in a financially healthy state.

The first key point here is the need for losses on the firm’s assets to be realised and for the assets to be written down. The second key point is the need for the claims on those assets to be restructured so that the firm is adequately
recapitalised.

We need to go from this situation to one where the firm’s assets have been written down in value, the firm’s liabilities (that is to say, sum of the firm’s share capital and its debts) have been reduced in line with the fall in asset value, and where those liabilities have been restructured so that the debts are much lower and the share capital substantially higher. The combination of the three—asset writedowns, debt reduction and greater share capital—ensures that the firm is then financially healthy again.

I would suggest that this same approach be implemented regardless of whether we are dealing with distressed banks or washed out washing machine manufacturers. Of course, I can hear the objections already: “You can’t do that because banks are different?”

My response is that, of course banks are ‘different’. Every type of firm is different from any other. Bakers are different from washing machine manufacturers, and both of these are different from garbage removers, and so on. And they are all different from banks.

So all firms are ‘different’, in one way or another, but the legal system has never acknowledged that these differences are materially relevant when it comes to the laws of receivership or bankruptcy. There is no law of bankruptcy specific to banks, and a different law of bankruptcy that applies to all other firms. And, indeed, before the present crisis, the authorities themselves were
telling us the same thing.

My point here is that neither the law of bankruptcy nor the pre-crisis policy framework calls for distressed banks to be treated any differently from distressed washing machine manufacturers. There should be—and is—one (bankruptcy) code for all.

However, any receivership solution to a distressed firm should also take into account the nature of the firm’s business. If the firm concerned was an electricity producer, the receivers wouldn’t want to switch off the electricity generation process whilst they figured out what to do. Nor would you want to do the same to a financially distressed hospital. The way receivership is implemented
needs to take account of the type of business concerned.

And, as far as banks are concerned, a successful bank receivership needs to take account of two very important
aspects of banking that are critical to the successful functioning of the broader economy:

• The first of these is the credit system—banks play a central role in the provision of credit to the broader economy.
• The second consideration is that they are central to the operation of the payments system, on which the economy also depends.

Banks are central to the plumbing, as it were, of the economy itself. We certainly don’t want to destroy the plumbing while we sort the banks out! But fortunately, we don’t have to.

However, the Government itself has placed an obstacle that prevents bank receivership operating as it should. This obstacle is the Government’s own guarantee to bank depositors. Ironic as it may sound—most people think a Government deposit guarantee must be a good thing because it reassures depositors—it is this very guarantee that prevents receivership from operating properly.
Remember that the receivership model requires the creditors—in this case, the depositors—to take a hit, and it is exactly this that the guarantee rules out. The guarantee therefore has to go.

The way forward, I would suggest, is for the Government to rescind this guarantee but as part and parcel of a bank recovery programme based on the receivership model.

The gist of this would work as follows. On close of business on a Friday in the not-far-off-future, let’s say, the Government would quietly inform the banks that all government guarantees on bank deposits are to be immediately rescinded and the banks would have to fend for themselves. Any bank that felt confident about its prospects would then be able to weather the public reaction—the danger of a run. Many others would not, and would have no alternative but to go straight into receivership. Teams of receivers would quickly move in overnight to implement a pre-prepared plan of action.

They would then work fast over the weekend: it is important to do the job quickly to minimise economic disruption. Their first task would be to limit withdraws from bank assets and cash withdrawals would be limited for the duration of the operation. As much as reasonably possible, they need to keep the banks’ assets in the banks for the duration of the operation.

The next task would to write down the banks’ assets. The only way to do this in a short time would be to apply pre-prepared writedown formulas: assets would be sorted into different classes, and assets in class x would get written down by y%. Fortunately, it is not necessary for the writedowns to be ‘realistic’ or accurate. In fact, it is best if the writedowns are harsh and valuations biased
on the conservative side. So, for example, if those who prepare these formulas are not sure what the valuations for a particular asset class should be, it is best that they go with worst case valuations to be on the safe side.

The third stage of the operation would be recapitalisation. The original shareholders would lose pretty much everything, and the new capital would come from depositors: the value of their deposit claims would be reduced, and some of their deposits would be converted into shares—a ‘debt for equity’ swap.

So, for instance, if a bank’s assets are reckoned to be £80 and there is £100 in deposits, then the depositors will need to take a loss of £20. At the same time, some of their remaining £80 in deposits would be converted into shares. The exact amount converted into shares would depend on the receivers’ judgements about how much share capital was needed to ensure that the bank could
reopen safely.

In practice, we might also wish to ringfence the smaller depositors to project them – and this would make the package easier to sell politically.

When the banks reopen on the Monday morning, they would be financially strong again, and their financial strength would give the public renewed confidence in them.

And, with a bit of luck, when the banks reopen, the markets would realise that the banks’ assets were actually worth more than the £80 at which they were valued. The banks’ share prices would rise, the new shareholders would make a capital gain and the banks’ financial health would improve further. This would help kick start a virtuous circle in which the banks become stronger, public confidence returns and the credit squeeze comes to an end.
This solution would not be costless—depositors would need to take a loss, but who else should bear the losses if there is not enough shareholder capital?

This package has some major attractions:

• Confidence would return quickly and the economy could start to adjust and recover.
• There would be no further losses inflicted on the long-suffering taxpayer.
• There would be no need to lumber us with more useless, costly, financial regulation.
• There would be no need for the waste associated with fiscal stimulus.

Longer-term reform

Once the immediate crisis had been dealt with, some thought could be given to ensuring the long-term stability of the economy. This would boil down to rolling back the core pillars of hundreds of years of state intervention which I outlined earlier. I would suggest a reform package along the following principles:

• The abolition of deposit insurance and financial regulation.
• Reform of corporate governance based on the repeal of the limited liability statutes.
• The abolition of the central bank and the restoration of some form of commodity-based monetary standard. For instance, we might return to some form of gold standard, although I believe that we can do better than that.

I am not disguising the fact that a lot of work would need to be done to work out how best to design and implement such reforms, but the important thing is to have a clear objective: No more FSA, no more financial regulation, no more Bank of England, no more inconvertible fiat money. Instead, a true system of financial and monetary laissez-faire: a stable financial system on a sound commodity-based monetary standard.

Concluding comments

Let me now make a few closing comments. I appreciate that the idea of financial and monetary laissez-faire might come across to many as strange at first sight. The idea shocked me too when I first came across it—in fact, it was mind-shattering and it took some getting used to. However, it was also liberating and I eventually came to see it as entirely natural.16 After all, if free trade is a good thing in principle, which I believe it is, then what is wrong with free markets in financial services and money? So the fact that the idea might seem strange at first sight merely reflects the fact that we have been conditioned to be prejudiced against it. There was a time, after all, when everyone thought the world was flat. We should also remember that the historical record is very much on the side of those who support free banking and sound money. The 19th century was much less prone to financial crisis and the price level in the UK in 1914 was pretty much the same as it had been a century before at the Battle of Waterloo, or a century or two before that. That is a pretty good record and better than anything achieved since.

To paraphrase Keynes, the difficulty lies not so much in seeing new ideas, but in escaping from the hold of the old ideas that permeate into every corner of our minds.

But we also need to escape from the hold of Keynes himself. A hundred and fifty years ago, the great Classical Liberals such as Gladstone advocated that the government should manage its finances prudently, like any responsible household. Indeed, they did so in this very building. Then along came Keynes, who explicitly put himself in the dubious tradition of the monetary cranks of old who had been dismissed before then. He sneered at the Gladstonian notion that the government should manage its finances like a household and instead offered a macroeconomics founded on paradox—in particular, the paradox of thrift the gist of which is that we can somehow spend ourselves rich. The paradox of thrift is an interesting curiosity, but to build a whole school of macroeconomics on it is to lose perspective and throw common sense out of the window. It also leads to blinkered thinking and an excessive focus on aggregate demand and the alleged ‘need’ for stimulus. Instead, I prefer a more commonsense view of the macroeconomy that addresses the root problems—most especially, the need for structural adjustment—not the counterproductive sticking plaster of more government spending or yet another bailout. Gladstone would have agreed. So would Chris.

What a contrast with politicians today! I am reminded here of President Obama in a recent interview. When asked whether the latest spending package would involve money wisely spent, he responded by saying, in effect, that that didn’t particularly matter because it was a stimulus package, i.e., anything to boost spending for the sake of boosting spending. At the same time, Mr Obama exhorts Americans to show financial responsibility whilst his own Administration throws all financial responsibility to the winds. This cannot be right. And it is Keynes, most of all, who has given this way of thinking a spurious respectability that it does not warrant. Keynes’s ultimate legacy is the macroeconomics of the madhouse.

We have reached the point where current economic policies have become so ludicrous that cold analysis is no longer enough to do them proper justice. The best we can then do is resort to satire. And on this cheery note I would like to end with a disarmingly apt piece on the US bailouts. This deals with the infamous Tarp—the Troubled Assets Relief Program, and also makes some reference to the Federal National Mortgage Association (FNMA), more commonly known as Fannie Mae, a corrupt state-sponsored enterprise which played a notorious role in creating the subprime mess. So here is Bill Zucker’s Tarp song, available on the web here:

Thank you all.