Money and the market In this volume of essays Kevin Dowd presents a strong case that state inter­ vention into financial and monetary systems has manifestly failed, and that we would be better off if governments stopped interfering with financial markets and central banks were abolished. Instead, he argues that financial markets should be left to regulate themselves; market forces would then deliver an efficient and stable financial system, safe and strong banks and sound money. Money and the Market fall into three parts: • Part 1 deals with the theory of free banking and begins with a presentation of the case in its favour. This is followed by essays examining the arguments advanced for government deposit insurance, capital adequacy regulation, banking clubs, the role of the invisible hand in the evolution of the monetary system, and asks whether we can blame laissez-faire for the instability we observe in contemporary financial markets. • Part 2 explores the monetary regime under laissez-faire and examines how fully automatic monetary systems might operate to stabilize the price level. Further essays look at Irving Fisher's 'compensated dollar' and at currency boards to replace central banks. • Part 3 examines a variety of diverse policy issues from a free market standpoint - international capital controls, monetary policy in the twenty­ first century, the future of gold, the bailout of Long-Term Capital Management in 1998 and the Financial Services Act in the UK. This collection will be of considerable interest to students, researchers and policy-makers in the monetary and financial area. Kevin Dowd is Professor of Financial Risk Management at the University of Nottingham Business School and adjunct scholar at the CATO Institute in Washington. Foundations of the market economy Edited by Mario J. Rizzo, New York University and Lawrence H. White, University of Georgia A central theme in this series is the importance of understanding and assessing the market economy from a perspective broader than the static economics of per­ fect competition and Pareto optimality. Such a perspective sees markets as causal processes generated by the preferences, expectations and beliefs of economic agents. The creative acts of entrepreneurship that uncover new information about preferences, prices and technology are central to these processes with respect to their ability to promote the discovery and use of knowledge in society. The market economy consists of a set of institutions that facilitate voluntary co-operation and exchange among individuals. These institutions include the legal and ethical framework as well as more narrowly 'economic' patterns of social interaction. Thus the law, legal institutions and cultural and ethical norms, as well as ordinary business practices and monetary phenomena, fall within the analytical domain of the economist. Other titles in the series The Meaning of Market Process Essays in the development of modem Austrian economics Israel M. Kirzner Prices and Knowledge A market-process perspective Estaban F. Thomas Keynes' General Theory of Interest A reconsideration Fiona C. Maclachlan Laissez-Faire Banking Kevin Dowd Expectations and the Meaning of Institutions Essays in economics by Ludwig Lachmann Edited by Don Lavoie Perfect Competition and the Transformation of Economics Frank M. Machovec Entrepreneurship and the Market Process An enquiry into the growth of knowledge David Harper Economics of Time and Ignorance Gerald o 'Driscoll and Mario 1. Rizzo Dynamics of the Mixed Economy Towards a theory of intervention Sanford Ikeda Neoclassical Microeconomic Theory The founding of Austrian vision A. M. Endres The Cultural Foundations of Economic Development Urban female entrepreneurship in Ghana Emily Chamlee-Wright Risk and Business Cycle New and old Austrian perspectives Tyler Cowen Capital in Disequilibrium The role of capital in a changing world Peter Lewin The Driving Force of the Market Essays in Austrian economics Israel Kirzner An Entrepreneurial Theory of the Firm Frederic Sautet Time and Money The macroeconomics of capital structure Roger Garrison Microfoundations and Macroeconomics An Austrian perspective Steven Horwitz Money and the Market Essays on free banking Kevin Dowd This page intentionally left blank Money and the Market Essays on free banking Kevin Dowd ~ 1 Routledge ~ ~ Taylor & Francis Group LONDON AND NEW YORK First published 2001 by Routledge Published 2013 by Routledge 2 Park Square, Milton Park, Abingdon, Oxon OXI4 4RN Simultaneously published in the USA and Canada by Routledge 711 Third Avenue, New York, NY, 10017, USA Routled~e is an imprint of the Taylor & Francis Group, an informa business © 2001 Kevin Dowd Typeset in Times by Curran Publishing Services Ltd, Norwich All rights reserved. No part of this book may be reprinted or reproduced or utilised in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying and recording, or in any information storage or retrieval system, without permission in writing from the publishers. British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library. Library o/Congress Cataloging ill Publication Data Dowd, Kevin Money and the market: essays on free banking/Kevin Dowd p. cm. - (Foundations of the market economy series) A collection of 16 essays written between 1986 and 2000, with 14 previously published, they are a sequel to his LaissezJaire banking (1963). Includes bibliographical references and index. 1. Free banking. 2. Money. 3. Free enterprise. l. Dowd, Kevin. Laissez­ faire banking. II. Title. III. Series. HGI811.D6822000 332.1--dc21 00-032180 This book has been sponsored in part by the Austrian Economics Program at New York University. TSBN 13: 978-0-415-24212-7 (hbk) Contents List of tables ix Preface Xl Permissions acknowledgements Xlll 1 Introduction 1 PART! The theory of tinanciallaissez-Jaire 15 2 The case for financial laissez-faire 17 3 Bank capital adequacy versus deposit insurance 26 4 Does asymmetric information justify bank capital adequacy regulation? 34 5 Competitive banking, bankers' clubs, and bank regulation 40 6 The invisible hand and the evolution of the monetary system 57 7 Are free markets the cause of financial instability? 75 PART 2 The monetary regime 83 8 A proposal to end inflation 85 9 Reply to Hillier 98 lOUsing futures prices to control inflation: reply to Garrison and White 100 Vlll Contents 11 The 'compensated dollar' revisited 104 12 Money and the market: what role for government? 114 PART 3 Policy issues 129 13 Two arguments for the restriction of international capital flows 131 WITH K. ALEC CHRYSTAL 14 Monetary policy in the twenty-first century: an impossible task? 141 15 Reflections on the future of gold 145 16 Too big to fail? Long-Term Capital Management and the Federal Reserve 153 17 Paternalism fails again: the sorry story of the Financial Services Act 167 WITH JIMMY M. HINCHLIFFE Notes 183 References 213 Index 221 Tables 6.1 The stages of development of the monetary system under laissezjaire 71 8.1 Equilibration under the QFC rule 88 13.1 UK balance of payments 1975-85 (£ million) 132 13.2 UK capital flows by category (£ million) 133 This page intentionally left blank Preface This book is a collection of essays on financial laissez-faire (or free banking) and its opposite, state intervention in the financial services sector and the monetary system. These essays were written between 1986 and 2000, and are a sequel to my earlier book, Laissez-Faire Banking (1993). Of the sixteen essays included here, fourteen have been published before in various places and two are published here for the first time. Those that appeared before have been lightly edited, but are substantially the same as they were before - with dubious judgements, falsified predictions, and so on, mostly intact. I would like to thank the various publishers and copyright holders for permission to reprint my articles here: Blackwell publishers and the Royal Economic Society (chapters 2, 9 and 10), the Journal of Financial Services Research (chapter 3), the Cato Institute (chapters 4, 12, 14 and 16), the Ohio State University Press and the Journal of Money, Credit, and Banking (chapters 5 and 10), John Smithin and Routledge (chapter 6), Critical Review (chapter 7), Natwest Bank (chapter 13), and Sheffield Hallam University's Review of Policy Issues (chapter 15). It is a great pleasure to thank many friends and co-workers for all manner of contributions, both direct and indirect. To begin with, I thank Alan Jarvis, Heidi Baytazo, Robert Langham, and the rest of the team at Routledge for various inputs to the book, Susan Curran for editing, and Maureen Jackson for help with the typing. I thank Alec Chrystal and Jimmy Hinchliffe, who co-authored one chapter each, and contributed to the book in many other ways besides. Thanks also to Charles Goodhart and Mervyn Lewis for encouragement and good advice which often went over my head, and to Chris Tame, Jim Dorn and the Cato Insitute for their steadfast moral as well as other support over many years. I also thank many co-workers in the field: Jeff Friedman, George Selgin, John Smith, Larry White and the many other people acknowledged in indi­ vidual chapters throughout the book, as well as friends in the UK and Eire: Dave Cronin, Tony Courakis, David Goacher, Chris Humphrey, Ian Gow, Dave Owen, Denis Smith, and John Whittaker. I particularly thank Mark Billings, xu Preface Dave Campbell, Dave and Pat Chappell, David and Yabing Fisher, Barbara Hollman, Duncan Kitchin, Anneliese Osterspey, Alan and Ruth Rawling, Sheila Richardson, Stan and Dorothy Szynkaruk, and Basil and Maggie Zafiriou for their encouragement and friendship over many years. As ever, however, my biggest debts are to my family - to my parents, to my brothers Brian and Victor; and, most of all, to my wife Mahjabeen and my daughters, Raadhiyah and Safiah, for their love and support, and for all that they have had to put up with over the years.