Monday 7 March 2011 8:27 pm

Risking the City: the economist who sees no future in political meddling

LONDON will be… an excellent market for rottweilers, wire mesh and tattooed thugs. Docklands in particular will revert to its 1970s squalor, albeit with some very expensive buildings scattered around… [G]iven the crippling burdens under which British citizens already live, London’s downturn has a fair chance of tipping the economy over into national bankruptcy.” This apocalyptic warning is sounded towards the end of Kevin Dowd and Martin Hutchinson’s book Alchemists of Loss: how modern finance and government intervention crashed the financial system, published last year. It is a vision of London if the City’s lights go off and, as the book explains, it is the fate that the authors believe the financial services industry is currently on course for, unless it undergoes significant reform. “We can say without hesitation that the flaws in the financial and political systems that caused the crash have not so far been remedied and in many cases have been made far worse.” Yet in person, Kevin Dowd, a recently-retired academic economist, seems an unlikely prophet of doom. No declaimer of jeremiads, he is serious and softly spoken, bringing a forensic interest in the historical and human factors at work in the crisis together with genuine concern for the dangerous future he sees ahead. “We could find ourselves in an awful situation. Very nasty stagflation, reminiscent of the early 70s but worse.” And he is not optimistic about how long Britain has to get its house in order, saying it could happen “faster than most people think”, a long, devastating slide of deterioration year by year. It’s a fear that for Dowd is evidently coloured by his experience of Britain’s economic failures in the 1970s, and his fear of a return to that kind of national catastrophe. “I was appalled by it – watching the country go down the tubes. It’s very depressing: I thought we’d kissed Keynesianism goodbye.” John Maynard Keynes – and his enthusiasm for government intervention in the economy – is one of the main villains of the book. Modern finance is the other, which, Dowd argues, simply lost touch with reality in recent decades. In particular, he tackles a risk measure that shot to fame in the early 1990s: Value-at-Risk (VaR). Loosely speaking, this measures the maximum likely loss. But as Dowd explains, “it gives you a measure of risk in a market that’s not particularly risky,” telling you what is the worst you can lose on 99 out of 100 good days, and nothing about what happens on the other, bad day. This crucial failing of VaR is “tail-blindness” – an inability to say anything about how large losses might be in an extreme situation. When combined with the assumption that losses follow a normal, Gaussian distribution rather than a distribution more weighted to extreme events, the VaR provides a false sense of security to anyone using it. Despite this fatal flaw, VaR became widely adopted. It is still popular and, indeed, provides an excellent example of why Dowd is so concerned that nothing has changed to prevent a new crisis brewing: the international Basel accords on bank regulation set capital requirements using the VaR measure, which, as the authors write in their book, “virtually guarantees that risks will be underestimated”. VaR is just one of the many factors that alarm Dowd and his co-author Hutchinson in their book. And in person, Dowd’s greatest concern is that a system of flawed regulation and political patronage is being mistaken for a free market. He wanted in part to write the book to clarify that opposing the one was coherent with support for the other: “as a defender of capitalism – I don’t want to be in the position of defending all this,” he says, wearily indicating the world of bailouts and too big to fail. A proponent of free banking, Dowd makes a persuasive case in the book that even Milton Friedman was misled on the virtues of federal deposit insurance in the United States and that recent events “should persuade any thinking person that the monetary policy ‘experiment’ – giving government control of our money – has failed.” Perhaps the most frightening aspect of the book, and Dowd’s position, is that the radical changes he calls for are so unlikely. The book states: “Our first choice environment would be one with a commodity standard, free banking (no central bank) and financial laissez-faire, restrictions on the use of the ‘limited liability’ corporate form, and the most limited government.” The authors offer some compromise solutions as well, but it is not clear that these will really tackle the scale of the problems they see. “Tinkering won’t make the slightest difference,” Dowd says. If it takes another collapse to bring about action, the results are unlikely to look pretty, as Dowd suggests. Things may not get that bad, but is it a risk worth taking? CV | KEVIN DOWD Lives: Sheffield Family: Married, with two daughters Title: Emeritus professor, Nottingham University; visiting professor, Pensions Institute, Cass Business School Associate editor/editorial board: Cato Journal; International Journal of Intelligent Systems in Accounting, Finance, and Management; Journal of Accounting and Finance; Journal of International and Global Economic Studies; Journal of Risk Education: BA, University of Sheffield; MA in Economics, University of Western Ontario; PhD in Economics, University of Sheffield Publications include: Alchemists of Loss: how modern finance and government intervention crashed the financial system, with Martin Hutchinson (2010); Measuring Market Risk (2005); An Introduction to Market Risk Measurement (2002); Measuring Market Risk (2002); Money and The Market: Essays on Free Banking (2000); Beyond Value at Risk: The New Science of Risk Management (1998)