King for a day
In his new book, “The End of Alchemy”, Mervyn King argues that financial crises arise because people hold mistaken beliefs about an uncertain future. “Crises don’t come out of thin air,” he writes, “but are the result of unavoidable mistakes made by people struggling to cope with unknowable futures.” Uncertainty is always present. It can’t explain why the financial system occasionally blows up. Something more must be at play.
The former governor of the Bank of England seeks to understand why mainstream economists, himself included, failed to anticipate the financial crisis. He wants to “explore the flaws in the theory and practice of money.” Like many others, King points to the inadequacy of the economic models used by central banks, which pay little attention to the role of money and banking. Such models assume that economic actors are rational and well-informed and that economies are in equilibrium.
The crisis prompted King to return to the work of Frank Knight, an influential early 20th-century Chicago economist, who argued against assessing most economic activities using mathematical probabilities. Uncertainty rules. This means that quantitative measures of risk, favoured by economists and bankers in the pre-crisis era, are fundamentally unsound. King believes that under conditions of radical uncertainty, people naturally make mistakes about the future which result in the economy becoming unbalanced. According to this view, the crisis was a “collective failure” of the imagination. No individual was to blame.
The destabilizing “alchemy” of capitalism, alluded to in the title, derives from banks transforming their short-dated liabilities (deposits) into long-term assets (loans). The crisis arrives when the demand for liquidity picks up sharply. King suggests a fix: banks should be required to post collateral with the central bank in good times to cover their liquidity needs during the crisis.
Neither Knight’s uncertainty principle, nor the flaws inherent in modern banking, provides a good explanation for our recent financial history. Why did so many people around the world make similar mistakes in the years leading up to the Lehman Brothers bust? The most likely answer is to be found scattered in odd observations throughout King’s book. Namely, low interest rates in the early years of the century encouraged people to borrow excessively and take on too much risk.
King follows the line of Ben Bernanke, his counterpart at the Federal Reserve, in seeing low interest rates as originating from surplus savings in Asia – an explanation which frees the Fed from responsibility for the decline in long-term rates and any consequent ill effects. The “savings glut” hypothesis, however, has been questioned by researchers at the Bank for International Settlements, who argue that the origin of the crisis cannot be explained by “excess savings” since banks can create deposits (“savings”) by new lending.
According to the BIS, low interest rates in the United States at the turn of the century fed capital flows into emerging markets. Central banks in those countries turned this inflow of dollars into foreign-exchange reserves by printing their own currencies. The result: an explosion of global liquidity both before and after the Lehman collapse.
Regardless of the origins of low interest rates, King agrees they’ve done much damage over the past decade and a half. Prior to 2008, low rates encouraged households to bring forward future spending, inflated asset prices, incentivized leverage, resulted in risk taking (the “search for yield”) and led to bad investments. In the periphery of Europe, low real interest rates fuelled property booms and debt binges.
The crisis revealed that the UK economy, among others, had moved far away from equilibrium – too much money had been borrowed from the future. That explains why even lower rates, combined with an explosion of central-bank lending in recent years, have done little to restore health. King worries that the continuation of near-zero rates will eventually “pull down rates of return on investment, diverting resources into unprofitable projects.” He sees negative interest rates as a wealth tax that is unlikely to promote more spending.
“The End of Alchemy” is a wide-ranging book which draws upon King’s broad knowledge of financial history and experience at the heart of modern central banking. However, King doesn’t achieve his ambition to spark an “intellectual revolution” in economics. The notion of radical uncertainty is a welcome antidote to the unrealistic assumptions of modern economics, but it does little to explain the crisis and its aftermath.
King is aware that monetary policy has been used to provide short-term gains at the cost of long-term pain – what he calls the “paradox of policy”. Despite extremely low rates, the global economy remains out of kilter. It’s a pity that King never considers Friedrich Hayek’s early work which suggests that economies become unbalanced when central bankers impose an inappropriate interest rate. But as King buys into the “savings glut” story, he doesn’t believe that monetary policymakers are to blame. For the man in charge of the Bank of England when UK bank Northern Rock went down, this is a convenient if not quite satisfactory conclusion.