The End Of Alchemy (Mervyn King)
Around 2012 I decided that I wanted to understand what had happened during the 2007-8 financial crisis, and so spent around 6 months reading all of the newly-published assessments, condemnations, accusations and blame-filled books I could find. My own conclusion was that if one were to point to a single action that created the crisis to the magnitude it eventually occurred, it was in the Federal Reserve's allowing Lehman Brothers to fail in September 2008. The authorities were going to have to restore trust and confidence in the financial system and wider economy for a recovery to happen, and allowing Lehman to fail set back this process immeasurably. In addition, even if the point was to accept some short term pain in order to send the message that big banks would have to suffer their failures without taxpayer help, this too failed. The damage was so severe and systemic that it reinforced the doctrine of Too Big To Fail, whilst senior management lost their jobs but remained extremely wealthy individuals. This assessment was of course a narrow one.
Mervyn King, former governor of the Bank Of England's book The End Of Alchemy is neither a justification of his own role in the financial crisis nor a mea culpa - rather it is an honest-to-God attempt at explaining the root causes of the crisis, and a meditation on how we can avert the next one. Reading this book (written in 2015), during a global pandemic was an exhilarating experience, giving a great understanding of the policy decisions currently facing governments the world over.
There are essentially two parts to King's exposition in The End Of Alchemy; how the central banks can handle or possibly avert future crises, and how the world economy can avoid the causes of the previous crisis (as he sees them) from creating the next one. Understandably, the former comes closer to an outright solution than the latter. Underpinning it all are four concepts King sees as being overlooked by both Keynesian and neo-classical economists; these are Disequilibrium, Radical Uncertainty, Trust and the Prisoner's Dilemma.
The essential problem of finance & banking is that it is predicated on a mutually beneficial lie. For an economy to be able to invest in new plant & machinery, firms need to borrow over long periods, with potentially risky loans from banks. Banks use money from depositors that they guarantee will be available at a moments notice and are 100% safe. The obvious contradiction is never born out unless all depositors test the true safety and immediate availability of their money at the same time - which they will only do if there is a feeling that the bank is lying when it claims to have everyone's money available on demand. Which it is.
A crisis comes when all actors cease to play the game. So when trust is lost, a prisoner's dilemma ensues - it is better for everyone to leave the money in the bank, but it is still rational to withdraw your money during a crisis, lest you be too late and suffer from the bank's insolvency. A similar form of self-fulfilling prophecy happens (and happened in 2007) when banks and financial institutions stop lending to each other because they doubt the value of the assets held by the counter party. This forces banks & institutions to sell assets in order to meet immediate liquidity requirements - and of course asset prices fall, exasperating the problem, leading to lower asset prices, reduced lending, more selling...and so on.
The first of King's major proposals is to change the role of central banks from Lender Of Last Resort (as is presently the case) to what he calls Pawnbroker For All Seasons (PFAS). Traditionally central banks will come to the rescue of commercial banks when liquidity threatens a run on the bank - but the decision is made ad hoc, based on dubious judgements as to whether it is a liquidity or solvency problem facing the bank, and supposedly secured by safe assets such as government bonds. Amidst the chaos of 2007/8 central banks were making loans based on other more risky assets, but valuing such assets in time of crisis is a difficult and potentially chaotic process. King's recommendation of PFAS works as follows. Any bank that wishes to be bailed out in time of crisis holds assets with the central bank, against which it can borrow when needed. A 'haircut' is placed on each asset class based on the central bank's perception of riskiness. So $100 billion of equity shares might be given a 30% haircut, meaning the bank can borrow $70 billion against it, whereas $100 billion in U.S. treasury bands might have 1% haircut so the bank could borrow $99 billion against it. Under PFAS, banks would be required to have the total amount they can borrow from a central bank match their total liabilities - eliminating what I referred to as a mutually beneficial lie, and what King calls Alchemy in banking.
The reason this is such a good idea is that the major banks know that they will be bailed out in a crisis, so why not chase high returns by taking crazy risks during the good times? Again this is the prisoner's dilemma, where even if Goldman Sachs knew in 2005 that securitised mortgages were riskier than people thought (they did), they still had to participate in the market or fall behind competitors. An imminent blow up years in the future was no disincentive, since they get free implicit insurance from the government (and of course, bonuses are annualised). By making banks hold assets that are safe enough to cover losses, it reduces the potential profits from banks, acting as a form of tax on risky activities. Crucially, banks don't need to sell assets in this crisis, and so the spiral of falling asset prices is avoided.
King's proposal is sensible, as to be expected from someone who actually did the job. A brilliant aspect of his thinking is his approach to radical uncertainty; what Donald Rumsfeld called unknown unknowns - unknowable events as opposed to calculable risks. Since we don't know, simple heuristics (rules of thumb) are more effective than complex models - for example banks own 'sophisticated' risk models rated U.S. residential mortgages and Greek sovereign debt as extremely safe before the crisis.
The second, arguably more interesting question King tackles stems from his assessment of the root cause of the financial crisis - a disequilibrium in the world economy - with some countries such as Germany & China saving and exporting too much, and the U.S. and UK importing and consuming too much. This trend led to perennial low interest rates in UK & USA, inflating asset prices, whilst any reduction in consumption in those countries hurt the exporter country. As investors chased higher returns, bad investments were made by both taking on excess risk, and low interest rates allowing unproductive 'zombie' firms to survive.
The problem identified by King is that the standard policy response to a financial crisis is to boost demand by slashing interest rates, and (during 2007/8) increasing the money supply with quantitive easing (QE). This exasperates the underlying issue, since it attempts to boost consumption in the UK and US - maintaining the disequilibrium. Whilst he makes some suggestions, King's assessment of the problem largely calls for new ideas and is less prescriptive than his PFAS proposal. My own opinion is that King underrates two potential solutions he identifies. If all currencies were free floating, both Chinese and German currencies would appreciate, making their exports more expensive relative to UK & US goods, redressing the imbalance. This is what should happen. China artificially holds its currency down, and the German 'natural' exchange rate is obscured by membership of the Euro (which as King points out, is devastating for countries like Greece, who cannot devalue). The currency imbalance is critical and must be addressed.
Secondly, King's explanation of the slow recovery from the crisis is that people's spending decisions are based on their own narrative of lifetime income. The great moderation in the 90s and 00s gave people a distinct expectation of the future - and the crisis shattered these expectations. So when interest rates are cut to almost zero, people are reluctant to go and spend - because they have reassessed lifetime spending and are saving any excess income (from say, lower mortgage repayments) in light of new information. King dismisses 'helicopter money' (essentially giving private citizens cash) as a solution to the problem because, he says, it is technically no different to the QE response in 2008. Purchasing government bonds from financial institutions, who then use the money to buy equities or make loans increases the money supply and increases asset prices. To King this is the same as giving money to individuals. The difference is that if you give money annually to individuals (and call this policy permanent), immediately households would reassess the lifetime expenditures and change their behaviour. The proportion of this fixed income guarantee that is 'printed' can change with economic circumstances.
Further, as King states, real economic growth comes from increased productivity, which comes from new ideas, inventions, technology. Just keeping interest rates low in a pessimistic environment will maintain the status quo, as unproductive businesses eek out a living without going bust, but also without major investment in labour-saving technology. Since things will likely go wrong again they reason, better to just employ people that can be laid off during the next crisis, rather than borrowing and making major investments to qualitatively improve the company (and therefore, the economy). The mistake here is to conflate saving firms with saving as economy. If we raised interest rates and killed off weak firms, but paid individuals a lump sum annually, aggregate demand would still be strong, and the economy would be ripe for innovation. This is creative destruction without destroying people's lives. But this is just my opinion.
Overall The End Of Alchemy is a brilliant book by a heavyweight economist with real-world experience; it offers an original and big-picture assessment of not just the economic crisis, but the workings of the world economy as a whole. The practical recommendations relative to central banking have the rare quality of being both commonsensical and visionary, and the identification of the disequilibrium of the world economy as a cause of the crisis is credible. Most of all, King's practical attitude to uncertainty and risk is an example to policy makers everywhere.