It’s hard being Governor of the Bank of England. You get given the top economics job in the UK, inhabiting a fortress in the City with mulberry-jacketed doormen. You set the price of money for 60 million people, forecasting hopes and fears for their collective wealth, controlling the supply of sterling in one of the world’s greatest financial centres. You consort with world leaders and get to jet about in first class.
Then comes a rude awakening. Rather than your august institution having a monopoly on money creation, you find that banks answerable to shareholders have usurped you. Beneath your radar screen they create deposits and new forms of liquidity, with incomprehensible acronyms funding inflated assets, driving their leverage through the roof. When it all goes wrong, the banks’ creditors come running to you, demanding that you fund their collapsing balance sheets. Because of the banks’ role in the economy, you provide all of the funding they need. The banks control you.
Such is the mess they created that you have to print more money (as bank reserves) than the BOE has printed in its 320-year history. The resulting recession shows how bad your models were. The bailouts add to the debt of the UK, and when you support cuts in government spending you are attacked for toadying up to an austerity-loving Chancellor. The criticism hurts, even though you receive a peerage and a handsome pension. After your term ends, superagent Andrew Wylie secures you a book deal.
This is the unspoken backdrop to Mervyn King’s ‘End of Alchemy’, a story of a powerful man unprepared for events that overtook him. To get a feel for how King became damaged goods in UK policy circles, read Alistair Darling’s ‘Back From the Brink’. According to the former Labour Chancellor, King’s ignorance of banking was such a handicap that by mid-2008, he and Gordon Brown seriously considered ending his governorship after a single term, and was only grudgingly reappointed. Later on, Darling blames King for becoming too close to George Osborne, echoing his policy proposals and undermining the Bank of England’s independence.
Although King withstood these attacks and survived to the end of his term (partly by letting his deputies take the brunt of blame for disasters like Northern Rock or Libor rigging), you might think he would address the criticisms in The End of Alchemy.
Far from it. “Blaming individuals is counterproductive”, says King. “Instant memoirs are usually partial and self-serving”. Much better then to write a dispassionate intellectual analysis of the crisis, unless of course it is a self-serving analysis that screens your flaws and positions you above the fray.
Although the End of Alchemy is excellent in many ways, it is the feeling that King is (perhaps subconsciously) not being straight with his audience that makes it a frustrating read. Instead of individuals making decisions, we get big ideas whose absence from mainstream economics are blamed for the crisis.
He is good on ‘disequilibrium’, such as the imbalances between saving and spending before the crisis, characterised by Ben Bernanke as a ‘savings glut’. By driving down real interest rates, this glut boosted asset prices, increasing leverage in the banking system.
In their response to the crisis, central banks’ stimulus policies have maintained these imbalances, King argues. Ultra-low interest rates bring forward consumer spending decisions, but they also create an expectation of lower future demand (because accelerated spending that happens today will no longer happen tomorrow). That helps keep long-term rates low, discouraging investment. In other words, rather than being inflationary, extreme low interest rates can actually generate deflation.
As a useful insight, all is well and good. (As a commentary on the Eurozone it might explain King’s apparent support for Brexit). Then there is ‘radical uncertainty’, a mishmash of Keynes and Frank Knight’s views on unquantifiable probability. Mainstream economics assumes that outcomes, such as job choices, can be categorised and assigned probabilities. Rational agents use probabilities to optimise their decisions, and the rational expectations framework sits at the heart of orthodox monetary policy.
As a former policymaker, King is aware of the shortcomings of this framework: for example, what do central banks do if consumers make a mistake? He makes a useful suggestion by bringing in ideas from Gerd Gigerenzer, thinking about consumers in terms of heuristics or ‘coping strategies’ in response to uncertainty.
But King pushes radical uncertainty too far. It’s true that over longer periods, no-one can enumerate outcomes – there are too many ‘unknown unknowns’. And policymakers habitually underweight extreme, damaging scenarios when making forecasts. However, the temptation to throw numerical probability out of economics must be set against the need for empirical or evidence-based arguments in a democratic society.
So it’s depressing when King approvingly cites an anti-empiricist such as Nassim Taleb. It’s hard to escape the feeling that radical uncertainty is being deployed here in the same way that Alan Greenspan spoke of a ‘once in a hundred year tsunami’: as a kind of smokescreen for incompetence.
Unsurprisingly given his track record, it is the banking system that bothers King the most, particular the ‘alchemy’, or maturity transformation. Was the financial crisis a result of radical uncertainty in the system? The scale of money creation as a result of financial innovation certainly came as a surprise to officials in the Bank of England, who were astonished when non-banks such as Countrywide or Bear Stearns became part of the Fed balance sheet overnight.
I spoke to Paul Tucker in August 2008 who told me: “you should only extend [emergency liquidity] to people whose liabilities are money – to commercial banks, not to investment banks”. Long before the crisis, observers (me included) had warned that shadow bank liabilities such as ABCP (asset backed commercial paper) were connected to the mainstream banking system via liquidity backstops. Like it or not, these liabilities were money and this was not an ‘unknown unknown’.
This feeling that we are being fed an excuse makes it hard to swallow King’s otherwise sensible proposals for reforming banks today. He wants to throw out Basel banking rules, particularly the risk-weighted asset calculations that determine capital ratios, and the requirement to hold a proportion of liquid assets. The prospect of banks calculating risk or liquidity for themselves is too dangerous he says, not without some justification.
Instead King proposes something called a ‘pawnbroker for all seasons’ which entails banks prepositioning (i.e. agreeing in advance) assets as collateral with central banks. In an emergency, such banks could instantly replace depositors with the central bank, avoiding the need for tricky lender of last resort discussions (something King knows a lot about). He thinks, perhaps optimistically, that this system would reduce the ‘deadweight costs’ of today’s complex Basel rules.
These and other good ideas in King’s book deserve attention, if we can overcome our exasperation with his flaws. The book does little to change my view that very few are able to fill the role of governor of the Bank of England.
