Learning the right lessons from the financial crisis.

• Author: Dowd, Kevin

More than eight years after the onset of the global financial crisis, there is one thing that ought to be clear to everyone: unconventional monetary policies are not working. We have had three rounds of quantitative easing (QE) and the Fed's balance sheet has increased nearly fivefold from $825 million in August 2007 to just over $4 trillion today; the federal funds rate fell from 5.25 percent to almost zero by December 2008 and has remained there until the 25 basis point increase in December 2015; federal debt has more than doubled to just over $18 trillion, rising from 61 percent to 101 percent of GDP; vast amounts of public money have been thrown at the banks to keep them afloat; and there has been a huge expansion in financial regulation. To say that the results have been disappointing would be an understatement: output has been sluggish, unemployment has been persistent, bank lending has flatlined, productivity has risen at an unprecedentedly slow rate since 2011, and poverty and inequality have greatly increased. (1) For their part, the banks are still much weaker than they should be, and major banking problems--especially, "too big to fail"--are still unresolved and continue to pose major threats to future financial stability. Seven years of extreme Keynesian policies have failed to produce their intended results. We see similar results in Europe and in Japan. In the latter, this comes after 25 years of such policies.

It is curious that in every discipline except Keynesian macroeconomics, practitioners first consider what caused a problem and then seek a treatment that addressed the cause. If the cause of a medical condition is excess, then the remedy would be moderation or abstinence. However, in Keynesian economics, if the cause is excess spending, then the standard treatment is even more spending. Keynesians then wonder why their treatments don't work. To give one example, former U.S. Treasury secretary Larry Summers (2014: 67) recently observed: "It is fair to say that critiques of [recent] macroeconomic policy ..., almost without exception, suggest that prudential policy was insufficiently prudent, that fiscal policy was excessively expansive, and that monetary policy was excessively loose." Summers is correct, but he fails to note the irony: that the majority of policymakers still advocate insufficiently prudent prudential policy, excessively expansionary fiscal policy, and excessively loose monetary policy. One can only wonder what these policymakers expect to achieve, other than the same result those policies produced last time, on a grander scale.

It is therefore important that we return to first principles and rethink monetary and banking policy. Instead of mindlessly throwing more money and stimulus around, we should consider what caused our current problems and then address those root causes. We would suggest that the causes of our malaise are activist monetary policies on the one hand, and a plethora of government-created incentives for bank risk taking on the other. Both causes are themselves the product of earlier state interventions.

This diagnosis suggests the following reform program: (1) recommoditize the dollar, (2) recapitalize banks, (3) restore strong governance in banking, and (4) roll back government interventions in banking. The first two reforms directly address the causes just mentioned--monetary meddling and government-subsidized risk taking--and are intended to get the financial system functioning normally again. The two remaining reforms serve to eradicate the root causes and strengthen the system long term by protecting it against future state intervention.

Recommoditizing the Dollar

The key to monetary reform at the most fundamental level is to establish a robust monetary constitution that would have no place for institutions with the power to undermine the currency; thus, there would be no central bank. However, before we can end the Fed, we must first put the U.S. dollar on a firm footing. The natural way to do that is to recommoditize it--that is, anchor the value of the dollar to a commodity or commodity bundle.

The obvious reform is to restore the gold standard. In its purest form, a gold standard involves a legal definition of the currency unit as a specified amount of gold. For example, the Gold Standard Act of 1900 defined the dollar as "twenty-five and eight-tenths grains of gold nine-tenths fine." This definition implies a fixed equilibrium gold price of just over $20.67 per troy ounce.

The gold standard has much to commend it: it imposes a discipline against the overissue of currency, restrains monetary meddlers, and has a fairly good track record. The main problem, however, is that it makes the price level hostage to the gold market. If the demand for gold rises, then the only way in which the gold market can equilibrate is through a rise in the relative price of gold--that is, a rise in the price of gold against goods and services generally--and this requires a fall in the price level (i.e., deflation). Conversely, if the demand for gold falls or the supply rises, the price level must rise (i.e., inflation must occur) to equilibrate the gold market. The stability of the price level under the gold standard, therefore, depends on the stability of the factors that drive demand and supply in the gold market. Historical evidence suggests that the price level under the gold standard was fairly volatile in the short term but much more stable over the longer term.

We might then ask whether we can improve on the gold standard. Over the years there have been many proposals to do so. Perhaps the most promising--and one of the least known--is the "fixed value of bullion" standard proposed by Aneurin Williams in 1892:

In a country having a circulation ... made up of paper, and where the government was always prepared to buy or sell bullion for notes at a price, the standard of value might be kept constant by varying from time to time this price, since this would be in effect to vary the number of grains of gold in the standard unit of money. ... If gold appreciated [relative to the price level], the number of grains given or taken for a unit of paper money would be reduced: the mint-price of gold bullion raised. If gold depreciated, the number of grains given or taken for the note would be increased: the mint-price of gold bullion lowered [Williams 1892: 280].

Thus, the proposal, which admittedly lacks operational details, is that the system respond to shocks in the relative price of gold by changing the gold content of the dollar, instead of letting the whole adjustment fall on the price level, as would occur under a true gold standard. The gold content of the dollar becomes a shock absorber.

We would emphasize, too, that the Williams system is only one example from a broader family of similar systems. (2) We can imagine even better systems that would deliver greater price-level stability.

Having thus restored the convertibility of currency, the next step is to liberalize its issue by removing any Federal Reserve privileges. Any bank would be allowed to issue its own currency, including banknotes. The main restriction would be one designed to guard against counterfeit: any notes should be clearly distinguishable from those issued by other banks. Commercial banks would be free to issue notes denominated in U.S. dollars if they wished but those notes would only be receipts against U.S. dollars as legally defined. In other words, a commercial bank one-dollar note might state, "I promise to pay the bearer the sum of one dollar," as per the conditions governing the redeem-ability of the dollar note, and respecting the legal definition of the U. S. dollar as a given amount of gold at any particular time. There would be no restrictions against the issue of currency denominated in other units of account, nor any restrictions on private currencies. The law would also be changed to allow U.S. courts to enforce contracts made in any currencies freely chosen by those involved.

By this point, the door would be open to private banknotes that would start to circulate at par with Federal Reserve notes. Over time, their market share would rise, as note-issuing banks would be incentivized to promote their own notes over those of rivals, and the Fed's share of the currency market would gradually diminish.

Recapitalize the Banks

Turning now to banking, the first point to appreciate is that the banks are still massively undercapitalized. The root causes of this undercapitalization are the incentives toward excessive risk taking created by various government interventions, including the limited liability statutes, government deposit insurance, the central bank lender of last resort function, and the general expectation that banks can count on being bailed out if they get themselves into trouble. With the exception of limited liability, these interventions are specifically designed to protect the banking system. In fact, however, they are seriously counterproductive: by protecting the banks against the downside consequences of their own decisions, these interventions subsidize risk taking, and the downside is passed on to the taxpayer. Naturally, banks respond to this regime by maximizing the value of the risk-taking subsidy: they increase their leverage and become far too big, with the biggest ones becoming too big to fail.

This trend toward weaker banks can be seen in the history of bank capital ratios. In the late 19di century, it was common for banks to have capital ratios of 40 to 50 percent. By the beginning of the recent financial crisis, however, the capital-to-asset ratios of the 10 biggest banks in the United States had fallen to less than 3 percent. The banks were thus chronically weakened, and the authorities--the Federal Reserve, the Federal Deposit Insurance Corporate (FDIC), and even the federal government--became hostage to them. The authorities dared not let...