28 June 2016

The End of Alchemy

Money, Banking, and the Future of the Global Economy

Mervyn King
2016, Brown, 488 pages,
ISBN 9780393247022

Reviewer: Andrew Sentance, Senior Economic Adviser, PwC

Former Governors of the Bank of England do not normally write books. So Mervyn King’s recent book The End of Alchemy gives us an insight into the thinking of the UK central bank that we have not had from his predecessors. His period at the Bank spanned 22 years, from 1991 – when he joined as Chief Economist – to 2013 when he retired after a decade as Governor. He made a major contribution to the Bank’s involvement in inflation targeting in the 1990s and steered the launch of the Bank’s Inflation Report. He was a founder member of the Bank of England’s Monetary Policy Committee (MPC) and became its most longstanding member (16 years). And, of course, he was at the helm at the Bank during the global financial crisis.

The book is neither a memoir of the crisis nor a blow-by-blow guide to who said and did what behind the scenes. Rather, it is his attempt to explain what went wrong structurally in the financial system and how these faults might be corrected. To those of us who served with him at the Bank of England during the financial crisis – as I did as a member of the MPC from 2006 to 2011 – much of the analysis in the book will come as no surprise.

Mervyn adheres to the ‘global savings glut’ hypothesis promoted by Ben Bernanke and other Central Bankers to explain the build-up of financial imbalances before the 2008/9 crisis. According to this view, the integration of China and other emerging market countries into the global economy depressed real interest rates and stimulated risk-taking by banks and other investors in a search for yield. The problem with this analysis is that it only makes sense if you ignore the contribution of the United States to the world economy; this does not make sense as it is the world’s biggest national economy and was the largest global borrower over this period.

An alternative perspective is that of Ragurham Rajan, currently the Governor of India’s Central Bank, in his book Fault Lines, which points the finger of blame more clearly at the US, for its housing market policies from the mid-1990s onwards and the Fed’s willingness to accommodate the build-up of an unsustainable level of housing debt. This view of the world is much more consistent with the analysis I published jointly with Michael Hume when I was at the Bank of England back in 2009.[1]  It would imply that Central Bankers, and in particular US monetary policy in the mid-2000s, should bear a bigger share of the blame for the global credit boom which turned to bust in 2008/9.

As a key player in the introduction and operation of inflation targeting within the UK, it is not surprising that Mervyn King defends this too. “Inflation targeting has been highly successful,” he writes, “Both in its primary aim and as a way of ensuring the democratic accountability of powerful public institutions.” He muses later in his book about the potential problems of very low or negative interest rates, although he offered no support to those on the MPC (including me) who tried to shift away from this policy as the economy recovered from the financial crisis.

In terms of macroeconomics and monetary policy, therefore, Mervyn backs the conventional wisdom and the US-led policy consensus. His more critical analysis lies in his view of the operation of the financial sector. He does not go in for banker-bashing, but seeks to explain where the weaknesses in the financial system arose – and then sets out his proposals for how they might be put right.

This line of argument takes him into a long historical exploration of the role of money, the development of the financial system, and the various ways it has been regulated. Money and financial markets more generally, he argues, are important in the economy because of ‘radical uncertainty’ about the future. This radical uncertainty is akin to the ‘unknown unknowns’ famously highlighted by Donald Rumsfeld. It cannot be expressed in terms of neat probabilities or an objective risk assessment. Mervyn links this idea to Keynes’ insights into the importance of expectations, and hence the potential for expectations to be destabilised by events which do not fit into the prevailing narrative. Here, the former Governor is revealing his academic roots. As a Cambridge student in the late 1960s, he studied at Kings College, which was Keynes’ college too.

Mervyn explains that money is both a blessing and a curse. It helps us deal with future uncertainties but is also a source of instability. And he believes that the way the banking system is regulated is the key to dealing with this potential instability. He points out that the financial crisis has spawned a vast array of new banking regulations (though he broadly supported this approach as Bank Governor). However, he is now concerned about the effectiveness of this approach and the burden it will impose on the financial sector and the economy more broadly.

His own proposal is for Central Banks to act more like pawnbrokers than regulators, and he sets out an approach to bank regulation that he describes as being a Pawnbroker for all Seasons (PFAS).  Central Banks would continue to act as Lenders of Last Resort, but there would be limits. The balance sheets of banks would be assessed for the quality of their assets, with a haircut or discount being imposed on more risky loans and other assets. Banks would be required to operate within the limits imposed by the Central Bank. Mervyn believes this would avoid the vast array of detailed regulation that has grown up since the financial crisis, while safeguarding the integrity of the financial system.

If this idea is so good, why has it not been implemented so far? The answer is set out in pages 272-273 of the book, though the implications are not fully spelt out. To get from where we are now to the new system will require a further contraction of bank balance sheets – and hence further limits on their ability to lend. In other words, there will be a hit to the real economy.

This interaction between financial regulation and monetary policy is the basic problem which central bankers failed to resolve properly in the mid-2000s, and which contributed to the build-up to the financial crisis. Then, the problem was that an excessively deregulated financial system contributed to excessive credit growth, creating boom time conditions in the global economy which were not reined in by tighter monetary policy. Now, the difficulty would be that most Central Banks do not have the monetary tools to offset the impact of a further tightening of lending conditions implied by Mervyn’s proposal – with interest rates at zero or near-zero levels across the OECD economies.

Looking back at my experience as a member of the MPC during the financial crisis, I draw different conclusions. The financial crisis was not just a failure of bank regulation – it was a composite of monetary policy and regulatory failures, at the global level. The solution is not to apply a fix to financial regulation, but to work out a better structure for linking together the various responsibilities of central banks and to co-ordinate policy better internationally.

The Bank of England does not yet seem to have done this. The Financial Policy Committee and the MPC are distinct bodies with different remits. We need a more joined up approach within central banks, and better international policy co-ordination outside periods of extreme crisis. That is probably the only way we can break out of the current impasse of persistent low or negative interest rates, which risk creating long-term economic damage in many economies.

Mervyn King’s book is a very good read with a vast array of insightful analysis and historical perspective. It is accessible to non-economists but also of interest to economists like myself, who will read more closely between the lines. It is greatly to his credit that he has chosen to share his views with the rest of the world, a break from the tradition of his predecessors at the Bank. But I do not believe he has yet found the key to success for 21st Century Central Bankers. There are more profound lessons from the global financial crisis still to be learned.


[1] See Hume, M and Sentance, A “The global credit boom: Challenges for macroeconomics and policy” Bank of England MPC Unit Discussion Paper No.27 http://www.bankofengland.co.uk/monetarypolicy/Documents/externalmpc/extmpcpaper0027.pdf