Review of The End of Alchemy by Mervyn King

Mervyn King, the Governor of the Bank of England from 2003 to 2013, has written an interesting book, The End of Alchemy: Money, Banking, and the Future of the Global Economy. As he states at the outset, this book is not a memoir of the financial crisis and its aftermath. Rather it is his reflections on the problems he sees in the world economy and its financial sector informed by his long career in public service.

These reflections are always interesting, and the book, written for a general audience and consequently not burdened by graphs and math, is well written. This does not mean that the book is unsophisticated; a discussion of Keynesian economics is perhaps the clearest presentation of a difficult subject that I have run across, though King has criticisms of modern economic theory, including those derived from Keynes’ significant contributions.

King is particularly critical of the euro. His argument about the folly of creating the euro is essentially the same as the one Yanis Varoufakis makes in his book, And the Weak Suffer What They Must? (reviewed in my previous post). King believes the lack of a political union, a common fiscal policy, and democratic political legitimacy of Eurozone decision makers dooms the monetary union to failure. While he does not propose a path forward, he does write:

“The tragedy of monetary union in Europe is not that it might collapse but that, given the degree of political commitment among the leaders of Europe, it might continue, bringing economic stagnation to the largest currency bloc in the world and holding back recovery of the wider world economy. It is at the heart of the disequilibrium in the world today.”

While the reflections are interesting, the book is not always clear about how the various discussions fit together or, as one proceeds through the book, what the central thesis is. The main proposal in the book, which concerns banking and is aimed at removing the “alchemy’ referred to in the title is made two-thirds of the way through the book, with interesting discussions preceding that, not all of which relate all that much to his proposal.

By “alchemy,” King is referring to our fractional reserve banking system, in which demand deposits are for the most part invested in longer-term and riskier assets, while the owners of the deposits believe that they can withdraw their deposits either to spend the proceeds or transfer them to another financial institution whenever they want. Of course, if all, or many, of the depositors of a bank want to do this at the same time, the bank cannot pay and will have to go to the central bank for a loan backed by the bank’s assets. As banks have gotten into riskier activities, King believes that this is not a satisfactory situation. He wants to transform the central bank from a lender of last resort to a “pawnbroker for all seasons.”

Unlike others who have proposed breaking up banks and limiting what deposit-taking institutions can do and letting other financial intermediaries without access to the central bank take on the riskier activities, King proposes that banks that take deposits pledge up front assets to the central bank in sufficient amount, after haircuts, to back the deposits. He would also impose an overall leverage ratio on the bank, but would eliminate complex regulations after a transition period to this new regime. Within these restraints, the bank could do what it wants with the rest of its balance sheet. If the bank got into trouble, depositors would know that the banks could borrow from the central bank up to the amount of the collateral minus haircuts which it has pledged to the central bank.

This idea is not totally fleshed out. While the haircuts on the pledged assets, which are presumably higher the riskier assets are in terms of market and credit risk, are determined at the outset, King does not explain what would happen during a financial crisis during which the market valuation of some assets may plummet and may not be sufficient after haircuts to back the deposits. This is not an insurmountable issue, perhaps there could be a daily mark-to-market regime, but it would have been better if he had addressed it.

The proposal is quite radical, but worthy of consideration and debate. Banks will of course strenuously oppose this, and it may not be politically possible. King is though correct that financial crises are inevitable and that current arrangements probably make them more likely and lead to ad hoc approaches to dealing with them. For example, while current government officials express confidence that the resolution procedures established by Dodd-Frank will work, many outside observers have doubts that they will work in the case of a failure of a large, international bank. Differences in legal requirements, procedures, and concepts in different countries exacerbated by government officials primarily concerned about protecting their own citizens and companies which are creditors of the failing bank would make international coordination difficult. The untangling of a web of transactions among financial institutions and the necessity for government officials of various countries to understand these transactions and what unwinding them may imply compounds the difficulty. Whatever current laws and expectations are in calm times, one can easily see that officials will conclude in a crisis that creative, ad hoc measures are necessary.

Among other issues, King stresses the importance of political developments affecting economic conditions and economic conditions affecting political developments. He is of course correct in this, and we can see it in the increased popularity of fringe parties and unconventional politicians in the West. Taking this further, King makes a distinction between what he calls the “economy of stuff” and the “economy of stuff happens.” What stuff happens is unpredictable, and consumers deal with “radical uncertainty” by effectively using short-cut rules which may change given experience over time. This criticism of economic theory is well-taken, but King is less clear about how government official should shape policy in a situation of radical uncertainty. At points he seems modest about what an institution such as the Bank of England can realistically know, and at other points, he seems to want the Bank of England to take actions, which may be painful in the short run, in order to change the expectations and heuristic rules of consumers. He thinks this is necessary in order to change the economy from an unsustainable course. Unfortunately, King is not clear about how policymakers determine that an economy is on an unsustainable course, or what he means by that.

As for King’s general prescriptions of the world economy, he outlines them in a chapter entitled “The Audacity of Pessimism: The Prisoner’s Dilemma and the Coming Crisis.” It is hard to take much comfort from this chapter. King’s recommendations are either thin or not politically realistic.

First, he thinks that countries should “boost productivity,” by changing their tax systems and regulations. He writes that “the specific microeconomic policies required will differ from country to country,” but he does not acknowledge that this could make for a robust debate among economists and others. For example, consider the debate in the U.S. about raising the minimum wage, which each side proffering its own economists and studies about whether this decreases employment or reduces income inequality.

Second, King argues for the promotion of trade. Among most economists, though not among the general public, there is general agreement that freer trade (reduced tariffs and many, though not all, other non-tariff barriers to trade) benefit all the countries involved. However, the devil is in the details. Criticisms of trade deals, such as the Trans-Pacific Partnership, include more meritorious arguments than those about employment. The dispute resolution procedures and other issues, such as those involving patent protection for drugs, have been raised, and economic theory has less to say about these political issues. Increased trade is usually good, but King should realize the complexity of some of the issues involved. Trade deals need to be examined, not just supported automatically because of tariff reductions.

His third proposal is that the world move back to a floating exchange rate regime. He does not say it explicitly, but King seems to be recommending here that the euro in its current form needs to be ended. Rather, than kicking many of the weaker countries out, King floats the proposal that Germany should exit. Of course, that is not going to happen, because, as King argues elsewhere in the book, the euro is a political project. The key relationship in Europe is between Germany and France. This is true, even though France has become less powerful than it once was both politically and economically. The political reason for the euro would disappear with a German exit, but at the same time, Germany’s use of the euro causes both economic and political problems, which have been compounded by the current German government’s economic and diplomatic policies in the Eurozone, which are personified by German Finance Minister Wolfgang Schäuble.

In spite of these criticisms, I recommend the book to those interested in the subject matter. While some ideas need more development, King is an original and provocative thinker and he writes well and in an engaging manner. Because the book does not develop clearly one central argument but covers quite a bit of the waterfront, the book is best approached as a series of interesting articles. Though written for a general audience, the book’s arguments are sophisticated, and one hopes that what he has to say will be considered and debated by academics and economic policymakers.