Kevin Dowd

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Kevin Dowd is an emeritus professor at the Nottingham University Business School and a visiting professor at the Pensions Institute. He also taught at the University of Sheffield (as department chair 1997-1999), Sheffield Hallam University, and the University of Nottingham. Dowd holds a B.A. (first class honours) from the University of Sheffield, a M.A. in economics from the University of Western Ontario, and a Ph.D. in economics from the University of Sheffield.

As well as free banking, monetary economics and the current financial crisis, Dowd's interests include financial economics, risk management, pensions and longevity. In addition to his many publications in scholarly journals, he is the co-author (with Martin Hutchinson) of Alchemists of Loss: How Modern Finance and Government Intervention Crashed the Financial System (Wiley, 2010), Measuring Market Risk (Wiley, 2002, second edition 2005), An Introduction to Market Risk Measurement (Wiley, 2002), Money and the Market: Essays on Free Banking (Routledge, 2000), Beyond Value at Risk: The New Science of Risk Management (Wiley, 1998), Competition and Finance: A New Interpretation of Financial and Monetary Economics (Macmillan Press, 1996), Laissez-Faire Banking (Routledge, 1993), and The State and the Monetary System (Philip Allan Publishers, 1989), and Private Money: The Path to Monetary Stability (Institute of Economic Affairs, Hobart Paper No. 112, 1988). He is the editor (with Richard H. Timberlake, Jr) of Money and the Nation State: The Financial Revolution, Government and the World Monetary System (Independent Institute, 1998), The Experience of Free Banking (Routledge, 1992), and (with Mervyn K. Lewis) Current Issues in Monetary Theory and Policy (Macmillan Publishers, 1992).

Professor Dowd is an andjunct Scholar at the Cato Institute, a research fellow at the Independent Institute, a senior fellow at the Cobden Centre, and a member of the academic advisory council at the Institute of Economic Affairs. He serves as associate editor of The Journal of Risk and The Journal of Risk Model Validation and serves on the editorical board of the Cato Journal, the Journal of Accounting and Finance, the International Journal of Intelligent Systems in Accounting, Finance, and Management, The Journal of Portfolio Management, the Journal of International and Global Economic Studies, and Qualitative Research in Financial Markets.

He lives in Sheffield, England, with his wife and two daughters.

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Should a Bank in Difficulties Receive Assistance?

by Kevin Dowd January 24th, 2015 5:44 am

This was the question put to me by [UK] Treasury Committee Chairman Andrew Tyrie MP when I appeared before the Committee on January 6th to give evidence on the Bank of England’s latest Financial Stability Report.

This is a question to which many of us on our side have given much thought and I believe it to be the single most important question in the whole field of bank regulatory policy.

I was nonetheless caught off-guard when Mr. Tyrie asked it at the beginning of the session – I was expecting questions on the Bank’s latest nonsense, the results of its new stress tests – and my initial response was less than it should have been. But no excuse: it was a perfectly reasonable and entirely foreseeable question – the obvious question, even – and I still didn’t see it coming. Reminds me of the blunders I would occasionally make when I played competitive chess: I obviously haven’t improved much.

Thankfully, he asked me the same question again at the close of the session, and his doing so allowed me to give the correct answer clearly, an emphatic ‘No’. However, by this point there was no time to elaborate on the reasons why a bank in difficulties should be denied assistance.

These reasons go straight to the whole can of worms and my follow-up letter to Mr. Tyrie should, I hope, help to set the record straight.

My message to other advocates of free markets is that leaving aside the usual bailouts-are-bad stuff, we really should give more thought to what an Armageddon Plan B might look like: Yes, no bailouts would be best, even in our intervention-infested system, but in that case why do we humour lender-of-last-resort and, more to the point, if the government is even considering intervention in what it (rightly or wrongly) sees as an emergency in which something-really-ought-to-be-done-NOW, then what should we advise it to do - other than ‘Don’t’?

Mark my words: if we don’t give the government constructive advice, it will do what it always does when a crisis breaks out: it will panic and the chances of any sensible policy response will be zero.

So here is the text of the letter, dated January 12th:

“Dear Mr. Tyrie,

I would like to thank you for the opportunity to give evidence to the Treasury Committee at its meeting on January 6th.

At that meeting you asked me if the authorities should assist a bank that gets into difficulties.

My answer is ‘No’ but I should like to elaborate.

Consider first a free or laissez-faire banking system in which there is no central bank, no financial regulation and no other state interventions such as deposit insurance. In such a system, competitive pressures would force the banks to be financially strong; bankers who ran down their banks’ capital ratios or took excessive risks would eventually lose their depositors’ confidence and be run out of business, so losing their market share to more conservative and better-run competitors. Bankers themselves would have serious skin in the game and therefore have strong incentives to keep their banks sound: for them, bank failure would be personally costly. Banks would then be tightly governed and conservatively risk-managed, and the banking system as a whole would be highly stable.

There would still be occasional failures due to the incompetence of individual bankers, but these would be few and far between, and not pose systemic threats.

These claims from free-banking theory are broadly confirmed by the historical experiences of the many free or loosely regulated banking systems of the past, most notably the experiences of Scotland pre-1845 and 19th century Canada.

In such a system, there is no good case for official assistance to any bank in difficulties. A bank failure would be painful to those involved, but the possibility of bankruptcy is unavoidable in any industry in a healthy capitalist economy, and this includes the banking industry. Letting a badly run bank fail also sends out the right signals – it encourages other bankers to avoid the same mistakes, it encourages depositors to be careful with the banks they choose and it avoids the moral hazards inevitably created by any policy of assistance.

Modern banking systems differ from these systems because of the presence of extensive systems of state intervention, including a central bank, a central bank lender of last resort function, deposit insurance, capital adequacy regulation and other forms of financial regulation. In different ways, each of these interventions makes the banking system less stable: central banks through erratic and usually loose monetary policies, which create inflation and fuel asset price cycles, and generally destabilise the macroeconomy; the lender of last resort and deposit insurance by creating moral hazards that lead to excessive risk-taking by bankers; capital regulation by creating short-termist incentives for banks to reduce their capital (e.g., by playing games with risk models and risk weights); and financial regulation generally by its large compliance costs and its stifling of innovation. Over time, these interventions have made the banking system weaker and weaker, even though their usual stated intention was to strengthen the banking system rather than to weaken it.

However, even with the banking system already seriously weakened by a long history of misguided government interventions, the best policy response is still to refuse assistance to banks in difficulties. I say this for two main reasons:
• the systemic effects of bank difficulties tend to be exaggerated even in a systemic crisis, sometimes grossly so; and
• interventionist policy responses tend to make matters even worse.

The ideal response by policymakers is to refuse assistance point-blank – and to announce such a policy in advance so the bankers know where they stand.

Policymakers should follow the advice of Lord Liverpool, who was PM at the time of the last systemic banking crisis pre-2007, that of December 1825. In May that year, he foresaw the looming crisis and warned the House of Lords about the “general spirit of speculation, which was going beyond all bounds and was likely to bring about the greatest mischief on numerous individuals.” He wished it to be “clearly understood” that those involved “entered on their speculations at their own peril and risk” and he thought it his duty to declare that he would “never advise the introduction of any bill for their relief; on the contrary, if any such measure were proposed, he would oppose it” and he hoped Parliament would reject it.

In our current system such a response would require political leadership with uncommon vision and nerves of steel. When the next crisis occurs, it will explode unexpectedly, taking policymakers off guard. They will be under extreme pressure to respond quickly – probably within hours – on the basis of inadequate information, whilst bankers lobby intensely for immediate assistance: if we don’t get bailed out, the world will end, etc., the usual scare mongering. Under such circumstances, it would be extremely difficult for even the best political leadership to avoid being dragged into making the same mistakes made repeatedly in previous crises.

These mistakes include:
• panicky rescues, which are later shown to be unnecessary, ill-judged and in some cases illegal;
• the abandonment of previous ‘commitments’ to let badly run institutions fail;
• bankers being rewarded for their failures by being made personally better off than they would have been had their banks been allowed to fail; and
• more regulation or regulatory reshuffles accompanied by the usual empty promises that ‘it’ won’t happen again, made by the very people who had no idea what they were doing when they were in charge the last time round.

So how can we avert such outcomes? A good start would be an Act to prohibit future assistance: as much as possible within the confines of our constitution, we should seek to tie the government to the mast. “Much as I would like to help you”, the PM can say, “my hands are tied.”

But even with this Act in place, there is still the difficult question: if the government does respond to the next crisis, then what should it do?

To that question I would propose a publicly disclosed Plan B, whose main features would include:
• a programme to keep the banking system as a whole operating at a basic level to prevent widespread economic collapse;
• fast-track bankruptcy processes to resolve problem banks and, where possible, return them to operation as quickly as possible;
• a prohibition of cronyist sweetheart deals for individual banks or bankers;
• provisions to ensure that senior managers of any failed banks are made strictly liable to severe personal financial penalties;
• a holding-to-account of senior bankers, regulators and policymakers, including the opening of criminal investigations into the activities of any banks that fail;
• the establishment of a legal regime that imposes high standards of personal liability on senior bankers;
• the restoration of sound accountancy standards; and
• a radical programme to deregulate the banking industry.
This programme would include the abolition of the current regulatory structure including the PRA and FCA, the ending of deposit insurance, the UK’s withdrawal from the Basel system of capital regulation, and the reform (and preferably, abolition) of the Bank of England. These reforms would rein-in the out-of-control moral hazards that permeate our current banking system and restore the personal responsibility, tight governance and conservative risk-taking that are the keys to a sound banking system.

Contingency planning for the next crisis should also provide for only two possible responses by the authorities: either Plan A (i.e., do nothing) or Plan B as just set out. Any intermediate response should be prohibited, as that would merely open the door to the usual mistakes that the authorities are prone to make in such circumstances.

In short, in response to your question about whether a bank should receive assistance, my answer would be ‘No’, but if we are to avoid another bungled policy response when the next crisis occurs it would be wise to have a credible Plan B in place to address upfront the Armegeddon scenario of a possible systemic collapse. And if it does intervene, the government should use the opportunity to clean up banksterism once and for all and restore a sound banking system based on the principles of personal responsibility and laissez-faire.

Yours Sincerely

Kevin Dowd,
Durham University/Cobden Partners [etc.]”

There is a lot more to say on this subject, but one of the points that emerges most clearly for me is the pressing need for free-market narratives of the financial crisis, blow-by-blow accounts of how it should and might have been. In this context – and off the top of my head – I would particularly recommend the following (with apologies to those whose work I have overlooked):

John A. Allison, The Financial Crisis and the Free Market Cure, McGraw-Hill 2013, esp. chapters 14-17.

Richard Kovacevich, “The Financial Crisis: Why the Conventional Wisdom has it All Wrong”, Cato Journal Vol. 34, No. 3 (Fall 2014): 541-556.

Vern McKinley, “Run, Run, Run: Was the Financial Crisis Panic over Institution Runs Justified?” Cato Policy Analysis 747, April 10, 2014

George Selgin, “Operation Twist-the-Truth: How the Federal Reserve Misrepresents its History and Performance”, Cato Journal Vol. 34, No. 2 (Spring/Summer 2014): 229-263.

These are all US-oriented of course and we badly need to work on similar narratives for the UK, Ireland and Europe.

But going back to the Treasury Committee, most of the discussion was on the regulatory risk models – or more precisely, on what is wrong with regulatory risk modelling and in particular, the Bank’s stress tests. I have to say, too, that I was greatly heartened to see the skepticism of the MPs towards the models and their openness towards our ideas, much of which is obviously down to the pathbreaking work that Steve Baker is doing on the Committee. But let me come to all that in another posting.

[Slightly adapted from a blog published on the Cobden Centre website, January 20 2015.]


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Bitcoin Will Bite the Dust

by Kevin Dowd November 18th, 2014 2:33 pm

At the 32nd Annual Monetary Conference on November 14, 2014, I presented my paper "Bitcoin Will Bite the Dust", which was co-written with Martin Hutchinson. Below is the transcript of my talk and PowerPoint slides. I welcome your comments. A video of the panel is available on Cato's website (my talk starts at minute mark 7:30).

The PowerPoint slides to accompany the talk are here.

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[Slide 1]. Good morning everyone. Bitcoin is the most radical innovation in the monetary space for a long time: an entirely private system that runs itself and does not depend on trust in any central authority. Instead, it relies on distributed trust – trust in the network – to maintain the integrity of the system. We can well understand the attractions of such a system – a tamper proof money supply, no monetary discretion, no QE, no central bank.

There is only one small problem: despite its success to date, Bitcoin is not sustainable. This means it will collapse. What cannot go on, will stop.

Let’s go back to basics. As a first pass, compare Bitcoin to the stone money in Milton Friedman’s case study. In this story, the people of the island of Yap in Micronesia used large round limestone disks as money. These were too heavy to move, so when ownership was to be transferred, the owner would publicly announce the change in ownership. The stone would remain where it was and the islanders would maintain a collective memory of the ownership history of the stones.

Similarly, in Bitcoin, the record of all transactions, the blockchain, is also public knowledge. Both the stone money and Bitcoin share a critical feature: both operate via a decentralized collective memory.

[Slide 2]. Bitcoin is a type of e-cash system in which there is no central body to authorize transactions; instead, these tasks are carried out collectively by the network. The network verifies transactions through competition between individual bitcoin ‘miners’ seeking rewards in the form of new bitcoins. It is this competition that maintains the integrity of the system. This takes us to Bitcoin’s value proposition.

[Slide 3]. The first point is that the system does not depend on trust on any one body to keep its promises; instead, the only trust required is distributed trust. The second point is that it has no single point of failure: it cannot be brought down by knocking out any particular entity. The third point is a high degree of anonymity. This has enabled some bitcoiners to operate outside of government control. Bitcoin is a dream come true for anarchists, criminals and proponents of private money. The fourth pillar of the value proposition is security against tampering: this comes from the incentive-compatibility built into the system. Underlying that, security comes from the Bitcoin protocol, the Constitution of the system. These features ensure that players play by the rules and that bitcoins are not over-issued.

[Slide 4]. Unfortunately, there is a fundamental contradiction at the heart of the system. The problem is that it requires atomistic competition on the part of the miners who validate transactions blocks. However, the mining industry is characterized by large economies of scale. In fact, these economies of scale are so large that the industry is a natural monopoly. The problem is that atomistic competition and a natural monopoly are inconsistent: the inbuilt centralization tendencies of the natural monopoly mean that mining firms will become bigger and bigger – and eventually produce an actual monopoly.

There are not one but two reasons to see mining as a natural monopoly. The first is based on risk aversion. If two miners merge their operations, they get the same expected return as if they mined on their own, but they obtain a return with a higher probability. If miners are risk averse, they are better off by pooling and sharing their profits. But if it makes sense for any two individual miners to pool, it makes sense for any two groups of miners to pool. The limiting case is then one big mining pool, a monopoly.

The second reason for a natural monopoly is even stronger: the negative externalities of competitive mining. The expected marginal benefit from mining depends on the amount of hash power expected by an individual miner, but the difficulty of mining depends on the hash power expended across the network. Individual miners do not take into account the negative cost externalities that their own activities impose on other miners. We then get an equilibrium in which excessive resources are devoted to mining activities: there is excessive use of bandwidth, excessive use of energy and excessive investment in computing resources. In the early days, a home PC could produce hundreds of bitcoins a day; now, a state of the art mining machine can expect to mine only a fraction of a bitcoin a day. We estimate that the energy power devoted to bitcoin mining has increased by a factor of at least 10 billion. Most of this is pure waste as the system could be maintained on a single server. A single operator could avoid most of this waste.

The implications of these centralizing tendencies are totally destructive of the Bitcoin system. They destroy every single element of its value proposition: one by one, the dominos fall down.

[Slide 5]. The first casualty is decentralized trust. Once the individual miners coalesce into a dominant player, then that entity has control over the system: it decides which transactions are to be deemed valid, and which are not. We then have to trust that entity not to abuse its position and are back to the trust model that Bitcoin had tried to escape from.

Going back to our island of stone money, imagine if everyone woke up one morning unable to remember who owned which stones. However, one individual still claims that he can remember and helpfully offers to remember for everyone else. One wonders how well that would work!

By this point, the dominant player has taken control over the system: it becomes the monarch – albeit, a constitutional monarch still constrained by the Bitcoin protocol. Once that dominant player emerges, it also becomes a point of failure of the whole system: one can bring down the system by taking him out. One could imagine Uncle Sam being very interested: if he wanted, he could now take Bitcoin down and stop all that money flowing to the bad guys he is after.

The next casualty is anonymity. A dominant player cannot possibly operate in a clandestine manner beyond the knowledge of law enforcement. And if it cannot operate anonymously, then it cannot escape government regulation. Anonymity would then disappear. The likelihood is that the government would destroy anonymity at a stroke by requiring that the dominant player insist that users register themselves by providing photo ID, social security numbers and proof of address.

It would also become clear that the system no longer assures incentive compatibility. In fact, it never did: it’s just that the system’s incentive compatibility weaknesses took time to become clear.

The last domino to fall would be the Bitcoin protocol. The protocol no longer provides any discipline on the system, because the dominant player can rewrite it at will. At some point the temptation to tamper with it would be too much to resist. Just a like a modern central bank, it would start throwing out bits of the protocol it didn’t like – like the bits that constrain over-issue of bitcoins. The Bitcoin monarchy would then become an absolute monarchy - assuming that there was anyone else left in the system by then.

The question crying out for an answer is why users of bitcoin would continue to have any confidence in the system when every single element of its value proposition had been kicked down. The obvious answer: they wouldn’t.

Remember also that the willingness of any individual to accept bitcoin is entirely dependent on his or her confidence that other people will continue to accept it. There is nothing in the system to anchor the value of bitcoins because bitcoins have no alternative use-value. They are not like gold or tulips.

Nor is there any rational reason to trust in the dominant player to behave itself. Trust comes from credible assurances – it comes from credible precommitment, a willingness to post performance bonds and to submit to account. There is simply no way that a shadowy dominant mining pool can provide such assurances. I doubt it would be willing to anyway.

The most prominent mining pool is GHash.IO. Here is a snapshot from its homepage [Slide 6].

The page announces that GHash is the number 1 mining pool, is trusted by 300k users, and dates all the way back to late 2013(!). We don’t know for sure who is behind it or where it is based. What we do know is that it has a logo that looks like the hammer and sickle and it has a bad rep. It pointedly refuses to adhere to the principles of high-level Bitcoin idealism that the other players adhere to. It has also been associated with a double-spend attack on a gambling website last year. Very reassuring.

Now this might just be coincidence: GHash also shares its name with a character in the film Ghostbusters. Here is a picture [Slide 7].

Cute critter, eh? In the film, Ghash is a power-obsessed poltergeist who pulls other ghosts into a massive mouth in his torso. Once swallowed up, they are drained of their powers until there is nothing left. Meanwhile, Ghash gets bigger and more powerful. By the time the ghostbusters encounter him, he had become too powerful to control: he was able to shoot beams from his eyes, pull up floorboards, disarm the ghostbusters and throw them around at will. Perhaps GHash is a spectral entity in more ways than one!

John Pierpont Morgan once said that the essence of banking is character. Someone I do not trust would not get any money from me on all the bonds in Christendom, he said. We don’t see much of that character here! If you really trust such an outfit with your wealth, we have a bridge to sell you. In any case, there is no reason to want to trust such an entity when you can use reputable systems such as PayPal instead.

[Slide 8].Anyway, return to the main storyline: The whole Bitcoin system eventually becomes a house of cards: there is nothing within the system to maintain confidence in the system, and anything – a scandal, a government attack, whatever – could trigger a loss of confidence leading to a run that brings down the entire system. The rational decision is to sell before that happens. If enough individuals think the same way – and why shouldn’t they? – their expectations will become self-fulfilling: there will be a stampede for the exit, the price of bitcoin will drop to its intrinsic value – zero – and the system will collapse. Only question is when. With the specter of GHash hovering over the system, our guess is soon.

Now I dare say our message is a disappointment to Bitcoiners. I share that disappointment: it would have been great if Bitcoin could displace government money. However, Bitcoin is an experiment, most experiments fail – and Bitcoin is another failed experiment. I don’t wish it so, but that is the way it is. We make this prediction before the event: if we are wrong, we will eat humble pie afterwards. But we don’t think so.

There is also the Bitcoiner lunatic fringe. Their response to even the mildest criticism is to foam at the mouth and hurl abuse at wicked Disbelievers. To them we say: OH DO GROW UP! And if you won’t listen to us, take Voltaire’s advice: “To succeed in life it is not enough to be stupid. You must also have good manners.”

In the meantime, Bitcoin is a sell. Thank you.


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Let's not ban private money

by Kevin Dowd May 10th, 2014 10:45 pm

[originally posted at the Institute for Economic Affairs on 6 May 2014]

In a recent Financial Times article Martin Wolf announced his conversion to the view that private banks should be stripped of their ability to create money. The proposal to end private money is an old idea that periodically resurfaces in the history of economic thought, typically during crises of confidence in mainstream economic thinking when the conventional wisdom becomes discredited. An early example was the early 19th century Currency School; they succeeded in implementing it in the form of the Bank Chart Act of 1844, which imposed a 100 per cent marginal reserve requirement on the note issue and effectively gave the Bank of England a monopoly of the note supply. Later versions included the Chicago Plan advocated by Irving Fisher and Henry Simons in the 1930s; and it has surfaced repeatedly in the recent financial crisis. These more modern versions boil down to monopolising the issue of bank deposits through a 100 per cent reserve requirement.

Its proponents make extraordinary claims for it: it would slash public debt, stabilise the financial system, make the banking system run-proof and make it much easier for the government to achieve price stability. If these claims seem too good to be true, it is because they are.

In essence, this proposal is just another instance of what Ronald Coase once derided as ‘blackboard economics’ – a scheme that works well on the blackboard, but does not actually work in the real world because the economy never works the way its proponents imagine it to.

The Bank Charter Act is a perfect example. The note issue restrictions of the Act were supposed to ensure banking stability based on the premise that the underlying cause of instability was an unstable private note supply. However, it soon became apparent these restrictions created additional instability of their own, as they suppressed the note issue elasticity that previously worked to calm markets. In subsequent years – 1847, 1857 and 1866 – crises erupted that were only resolved when these note issue restrictions were temporarily suspended. The Bank Charter Act was, thus, a failure.

A second problem with the proposal to prohibit private money is that it would seriously impact the credit system because it would entail a massive switch in bank assets from private lending to government securities. Bank lending to the private sector would go to zero and banks would then exist primarily to finance government. Mr. Wolf acknowledges the issue, but almost casually dismisses it on the grounds that ‘we’ could find new (non-bank) channels to finance investment, as if the problem were easily resolved. These new credit channels would take time to emerge, however, and in the meantime the provision of credit would be to a large extent stopped in its tracks. This amounts to hitting our already fragile credit system with a sledgehammer and would probably be enough to push the economy into a depression.

But perhaps the biggest problem with any proposals to prohibit private money is not practical but intellectual: they are based on a mistaken view of the causes of economic and financial instability. Major fluctuations are not caused by volatile behaviour on the part of the private sector, but by government or central bank interventions that have destabilised the economy again and again. The Currency School is a case in point; it overlooked the point that the main causes of instability were the erratic policies of the Bank of England and the restrictions under which other banks were forced to operate. As a result, they applied the wrong medicine which then didn’t work.

More recent government interventions have created further instability: the botched policies of the Federal Reserve were the key factors behind the length and severity of the Great Depression; deposit insurance and the lender of last resort have created major incentives for banks to take excessive risks; and erratic monetary policies have greatly destabilised the macroeconomy over much of the last century. As Milton Friedman observed back in 1960:

The failure of government to provide a stable monetary framework has…been a major if not the major factor accounting for our really severe inflations and depressions. Perhaps the most remarkable feature of the record is the adaptability and flexibility that the private sector has so frequently shown under such extreme provocation.

So let’s challenge the conventional wisdom by all means, but proposals to prohibit private money are based on a false diagnosis and go in the wrong direction. The problem is not the instability created by private money, but rather the instability created by government intervention into the monetary system. Government money is not the solution; it is the problem.