Review: ‘The End of Alchemy’ by Mervyn King
Lord King draws on decades of experience to provide a detailed but digestible assessment of the how we got to where we are today and how to get out of the secular stagnation that no amount of fiscal or monetary stimulus seems to have remedied. In a backdrop of discontent against experts, he holds no punches either. Early on, he states that economists “have brought the problem upon themselves by pretending that they can forecast”, expanding later that many of the large shifts in macroeconomic variables are determined ultimately by unobservable and unpredictable events (such as the Vietnam War, the creation of the Euro, or economic reform in China). None of those would have found a place in the economic forecasting models used by central banks. His advice to the economics community is to accept that we live in a world of radical uncertainty, where there are multiple and unquantifiable outcomes. It is not irrational for individuals and households to use coping strategies or heuristics to deal with these uncertainties. Neither should central banks shy away from doing so.
The book addresses two major concerns; the state of the world as it stands, and the role of the banking sector to be able to weather shocks better than it has in the past.
Since the collapse of the Berlin Wall the global economy has been in a widening disequilibrium – something he defines as an unsustainable position that will eventually require a large change in the pattern of spending and production to allow us to move to a new equilibrium. Driven in part by large structural trade deficits in the USA, UK and parts of Europe, financed by China, and latterly Germany after the creation of the single currency, long term real interest rates have been below their equilibrium level for over twenty years. Whilst monetary stimulus was required to prevent a collapse in the money supply in the immediate aftermath of bank failures in 2008, the current low level of central bank rates is compounding this problem.
Productivity and wage growth in the USA and UK have ebbed and flowed, Japan is struggling, and the Eurozone is relying on the ECB to tread water. Growth in China has been slowing for a number of years and its financial system is in trouble. His discussion of solutions is wide ranging. It is China’s intention to transition away from an investment/export-led economy towards domestic consumption. This will mean that artificially strong currencies in the USA and UK can eventually normalise. Real interest rates need to revert to equilibrium levels and supply side reforms will be needed to encourage productivity growth as this happens. Normalising real rates is especially required in the Eurozone, where they are artificially low for Germany and artificially high for France and Southern Europe. Departure from the Euro by countries such as Greece may be the best outcome for this. Perhaps by trying to fight the last major crisis of this scale (the Great Depression) instead of this one, we have tried to borrow growth from the future with an extraordinary level of stimulus which has now been rendered ineffective, and making matters worse, is actually prolonging this disequilibrium.
King posits that capitalism has been central to the significant increases in general prosperity since the Industrial Revolution. Within that money and banking play a key role. Market participants have different requirements for consumption and investment, and different time horizons for when to commit to such spending and when instead they would prefer to save. Banks are intermediaries who accommodate these differences. The issue arises from the fact that deposits are the main source of an economy’s money supply. These deposits can be called on in an instant (often sparked by negative economic or geopolitical newsflow), but they have been transformed into illiquid loans that banks can earn superior interest on. This is what King describes as alchemy within the financial system. Such a liquidity mismatch can lead to a run on banks’ deposit bases further compounding the problem. Walter Bagehot’s Lombard Street, which describes a central bank’s role as a Lender of Last Resort, has been the template to follow when such a bank run happens. The problem today is that banks’ balance sheets have become increasingly complicated and interconnected with the global economy, making it difficult to analyse, especially with time pressure, which bank needs what level of bailout. This gives the system as a whole an implicit bailout guarantee that allows banks to not follow the usual rules of capitalism and slacken their lending procedures in periods of apparent stability.
Rather than breaking up banks’ retail and investment divisions, or calling for an end to fractional reserve banking King suggests ending the implicit bailout guarantee that comes with central banks acting as Lenders of Last Resort. Instead he suggests that because we live in a world of radical uncertainty, they should adopt a coping strategy in the form of Pawnbrokers for all Seasons. Put very simply, banks deposit collateral dependent on the level of risk they are taking which serves as a form of mandatory liquidity insurance that is purchased from the Central Bank. This would address the issue of moral hazard whilst allowing the flexibility that comes with fractional reserve banking to allow long term lending.
The book covers many topics. The prisoner’s dilemma faced by individual countries that prevents them from unilaterally normalising interest rates, leads him to call for greater coordination. He is however aware that any global agreements compromise national sovereignty. Ultimately the entire financial system is based on trust which global policy makers should be weary of violating. It is targeted towards readers interested in economics rather than industry professionals. It is encouraging that someone who was very much a part of the ‘establishment’, is willing to give a robust defence of capitalism, whilst providing a fresh basis of discussion on how to tackle the underlying causes of today’s malaise. If we are to be able to return to trend levels of productivity and prosperity growth that capitalism has made possible in the past, then this book is the perfect place to start.
Amul Pandya (CFA) is the Director of Cape Wrath Capital. He is writing here in a personal capacity.