The End of Alchemy: Money, Banking and the Future of the Global Economy
By Mervyn King
This book looks at the big questions raised by the depressing regularity of crises in our system of money and banking. Why do they occur? Why are they so costly in terms of lost jobs and production? And what can we do to prevent them?
The crisis was a failure of a system, and the ideas that underpinned it, not of individual policy-makers or bankers, incompetent and greedy though some of them undoubtedly were.
One of the arguments of this book is that economics has encouraged ways of thinking that made crises more probable.
Economics must change, perhaps quite radically, as a result of the searing experience of the crisis.
Why have money and banking, the alchemists of a market economy, turned into its Achilles heel? The purpose of this book is to answer that question.
In the course of this book, I will explain why the fragility of our financial system stems directly from the fact that banks are the main source of money creation, why politics and money go hand in hand and and, most important of all, how we can end the alchemy of our present system of money and banking.
For centuries, alchemy has been the basis of our system of money and banking. We can end the alchemy without losing the enormous benefits that money and banking contribute to a capitalist economy.
Four concepts are used extensively in the book: disequilibrium, radical uncertainty, the prisoner’s dilemma and trust.
Disequilibrium is the absence of a state of balance between the forces acting on a system. The word accurately describes the evolution of the world economy since the fall of the Berlin Wall.
The failure to incorporate radical uncertainty into economic theories was one of the factors responsible for the misjudgements that led to the crisis.
The prisoner’s dilemma may be defined as the difficulty of achieving the best outcome when there are obstacles to cooperation.
Trust is the ingredient that makes a market economy work. Confucius emphasised the crucial role of trust in the authorities: ‘Three things are necessary for government: weapons, food and trust. If a ruler cannot hold on to all three, he should give up weapons first and food next. Trust should be guarded to the end: without trust we cannot stand.’
Fundamental changes are needed in the way we think about macroeconomics, as well as in the way central banks manage their economies.
The cost of lost output and employment from our continuing failure to manage money and banking and prevent crises is too high for us to wait for another crisis to occur before we act to protect future generations.
If we can find a way to end the alchemy of the system of money and banking we have inherited then, at least in the sphere of economics, it will indeed be a far, far better thing than we have ever done.
The financial crisis of 2007–9 was merely the latest manifestation of our collective failure to manage the relationship between finance – the structure of money and banking – and a capitalist system.
The creation of monetary union in 1999 sapped the strength of many of its economies, as they became increasingly uncompetitive.
Almost all accounts of the recent crisis are about the symptoms rather than the underlying causes of the events that overwhelmed the economies of the industrialised world in 2008.
The story of what happened can be explained. So here goes.
We should start at the key turning point – the fall of the Berlin Wall in 1989.
Who would have believed that the fall of the Wall was not just the end of communism but the beginning of the biggest crisis in capitalism since the Great Depression?
China, countries of the former Soviet Union and India embraced the international trading system. The pool of labour supplying the world trading system more than trebled in size.
China and other Asian economies ran large trade surpluses. In other words, they were producing more than they were spending and saving more than they were investing at home.
Asian economies in general also saved more in order to accumulate large holdings of dollars as insurance in case their banking system ran short of foreign currency.
In most of the advanced economies of the West, it was the desire to spend that gained the upper hand, as reflected in falling saving rates.
The consequence was that in the world economy as a whole there was an excess of saving. This glut of saving pushed down long-term interest rates around the world.
Confronted with persistent trade deficits thanks to growth in imports, the United States, the United Kingdom and some other European countries relied on central banks to achieve steady growth and low inflation.
To achieve that, their central banks cut short-term interest rates to boost the growth of money, credit and domestic demand.
Such low interest rates encouraged spending and led it along unsustainable paths in many, if not most, economies.
Because emerging economies were saving more than they were investing at home, they were actually exporting capital to advanced economies.
Much of those capital flows passed through the western banking system, and this led to the second key development before the crisis – the rapid expansion of bank balance sheets, a ‘banking glut’.
Bank balance sheets exploded for two reasons. First, low real interest rates meant that asset prices rose around the world.
Banks financed much of the higher borrowing by the young as housing was transferred down the generations, and the balance sheets of banks expanded rapidly.
There was a second reason behind the expansion of bank balance sheets.
With interest rates so low, financial institutions and investors started to hunt for higher returns, without adequate compensation.
Banks played their part in meeting this search for yield. They created a superstructure of ever more complex financial instruments, such as ‘collateralised debt obligations’. There was no shortage of willing buyers.
Bank leverage rose to astronomical levels – in some cases to more than 50 to 1.
The ‘savings glut’ and the ‘banking glut’ combined to produce a toxic mix of a serious disequilibrium in the world economy, on the one hand, and an explosion of bank balance sheets, on the other.
Sooner or later an adjustment was going to be necessary.
It is always surprising how many bricks can be piled one on top of another without their collapsing.
The ‘small’ event that precipitated the collapse of the pile of bricks occurred on 9 August 2007 when the French bank BNP Paribas announced that it was stopping, temporarily, further redemptions from three of its funds that were invested in so-called asset-backed securities.
From the start of the crisis, central banks provided emergency loans. It didn't solve the underlying problem.
The system staggered on for a year. But on 15 September the long-established investment bank Lehman Brothers failed.
The failure of Lehman Brothers was such a jolt to market sentiment that a run on the US banking system took off at extraordinary speed.
The run soon spread to other advanced economies – and so the Great Panic began. It was the biggest global financial crisis in history.
In early October 2008, two UK banks – Royal Bank of Scotland (RBS) and Halifax Bank of Scotland (HBoS) – found themselves unable to get to the end of the day.
When the western banking system teetered on the verge of collapse, only drastic intervention, including partial nationalisation, saved it from going over the edge.
The problem was that governments ended up guaranteeing all private creditors of the banks, imposing on future taxpayers a burden of unknown magnitude.
World trade fell more rapidly than during the Great Depression of the 1930s. Around ten million jobs were lost in the United States and Europe.
The situation cried out for a Keynesian policy response in the form of monetary and fiscal stimulus. Central banks and governments duly supplied it,
By the summer of 2009, emerging market economies were starting to recover. But although the banking crisis had ended, the problems of the global economy remained.
By 2015 there had still been no return to the growth and confidence.
This account captures, I believe, the essence of what happened in the run-up to and during the crisis of 2007–9, a journey from the Great Stability through the Great Panic to the Great Recession, but not yet to the Great Recovery.
But it leaves some big unanswered questions.
First, why did all the players involved First, take no action to change direction while steaming ahead on a course destined to lead to serious problems and a major adjustment of the world economy?
The economic path on which the world economy was proceeding was clearly unsustainable.
Why were concerns about macroeconomic unsustainability not translated into actions by regulators and policy-makers?
Second, why has so little been done to change the underlying factors that can be seen as the causes of the crisis?
The alchemy of our present system of money and banking continues. They have not changed the fundamental structure of banking.
As the underlying problems are seen to remain, anger is growing.
Why then, in sharp contrast to the 1930s, was there so little enthusiasm for radical reform to our economic system and institutions?
Third, why has weak demand become a deep-seated problem, and one that appears immune to further monetary stimulus?
Since the crisis, there has been a sharp deviation of output from the previous trend path. That gap amounts to around $8500 per person in the US and 拢4000 per person in the UK.
Why have the economic prospects for our grandchildren suddenly deteriorated?
To answer those three questions requires a much closer look at the structure of money and banking that we have inherited from the past and at the nature of the disequilibrium in the world economy today.
The central idea in this book is that money and banking owe a great deal to the technology of earlier times.
Money and banking proved to be not a form of alchemy, but the Achilles heel of capitalism – a point of weakness that threatens havoc on a scale that drains the life out of a capitalist economy.
Since, however, they are man-made institutions, men – and women – can remake them.
Money is misunderstood because it is so familiar. It’s function in a capitalist economy is complex, and economists have struggled to understand it. It is not even easy to define.
So what does money do? Why do we need it? And could it eventually disappear?
The amount of money in the economy is determined less by the need to buy ‘stuff’ and more by the supply of credit created by private sector banks responding to the demand from borrowers.
But the amount of money created by a private banking system may not always correspond to the amount that is socially desirable.
Should money be created privately or publicly? The answer depends on how the choice affects the twin criteria of acceptability and stability.
To leave the production of money solely to the private sector is to create a hostage to fortune. But there must be confidence in the process that generates changes in money. In an era of paper money, that amounts to trust in the central bank or government that controls money creation.
The big question is whether governments can be trusted to maintain the value of money.
Much of the financial history of the past 150 years is the story of unsuccessful attempts to maintain the value of money.
Many industrialised countries, including the United Kingdom, experienced the Great Inflation of the 1970s.
The creation of independent central banks, with a clear mandate to maintain the value of the currency proved successful in stabilising inflation in the 1990s and early 2000s during the Great Stability.
It is still too early to judge whether democratic societies have managed to create sustainable regimes to manage paper money, avoiding the deflationary impact of fixed-supply commodity money on the one hand, and the dangers of excessive inflation from discretionary control of money supply on the other.
Why is modern economics unable to explain why money exists?
Trust obviates the need for money, and money without trust has no value. Perhaps it is trust that makes the world go round.
There needs to be sufficient money to support the steady expansion of economic activity, but not so much as to generate inflation.
Most money today is created by private sector institutions – banks. This is the most serious fault line in the management of money in our societies today.
Why have governments allowed money – a public good – to fall under private control? To answer that, we need to understand the role of banks.anks are the main source of money creation. They create deposits as a by-product of making loans to risky borrowers. Those deposits are used as money.
Banks are part of our daily life. But banks are also dangerous. They are at the heart of the alchemy of our financial system.
Banking crises have been frequent down the years, occurring almost once a decade in Britain and the United States in the nineteenth and twentieth centuries.
With their global reach, their receipt of bailouts from taxpayers, and involvement in seemingly never-ending scandals, it is hardly surprising that banks are unpopular.
In less than fifty years, the share of highly liquid assets held by UK banks declined from around a third of their assets to less than 2 per cent.
What really matters for the economy is the risk inherent in the banking system.
We all want deposits to be safe and yet we also want to finance risky investment projects. How do we square the circle? In other words, we need to look at the financial sector as a whole, and not just the formal banking system.
It is imperative that we find an answer to the question of how to make our banking system safer.
The strength of economics as a social science is the belief that people will attempt to behave rationally. The challenge is to work out how a rational person might cope with radical uncertainty. People aren't dumb. It is just that in a world of radical uncertainty even smart people do not find it easy to know what it means to behave in a smart manner.
If we do not know how the world works, there is no unique right answer, only a problem of coping with the unknown.
The absence of a proper financial sector handicaps development and was well illustrated by the inefficiencies of centrally planned economies.
Much of the impetus for the creation of a wide range of derivative financial instruments, including options, was the belief that by adding more and more markets a gain to society would be achieved.
Finance should support, not overshadow, the real economy. Financial markets can help us to cope with an uncertain future provided we do not succumb to the danger of believing that uncertainty has been turned into calculable risk.
A capitalist economy is inherently a monetary economy. Money has a special role.
The struggle to cope with radical uncertainty affects not just investors, businesses and households but also the institutions set up to deal with collective problems such as money creation.
In the twenty-five years before the Bank of England adopted an inflation target in 1992, prices rose by over 750 per cent, more than over the previous two hundred and fifty years.
In recent years, we have started to take price stability for granted; so much so that some people have become exercised about the possibility of deflation – when prices fall.
Taken together, the verdict of economics, history and common sense is that both inflation and deflation are costly.
Banks create money, but if people lose faith in banks, the ultimate form of money is that created by the central bank – provided it is backed by the tax-raising power of a solvent government.
The phrase ‘lender of last resort’ is widely misused to refer to any action that deals with a financial crisis by dousing the fire with a massive injection of liquidity.
As time passed, it became easier to flood the system with liquidity when problems arose than to design a framework that would counter moral hazard.
The key function of the monetary authorities, whether as government or central bank, is to determine the supply of money in both good times and bad.
A crisis will not be resolved by the provision of liquidity if there is also an underlying solvency problem; in other words, a shortage of capital available to absorb losses and prevent default.
In the end, no central bank can act as a LOLR unless there is confidence in the government that underwrites it.
What has been missing is an integrated single framework within which to analyse the provision of money by central banks in both good and bad times.
It is clear that there is an intimate link between the nation state and the money that circulates within it.
There is a remarkable, almost uncanny, one-to-one relationship between nations and their currencies. Money and nations go hand in hand.
The choice of which money to use is a political act.
European Monetary Union (EMU) is the most ambitious project undertaken in monetary history.
Monetary union in Europe has always been about France and Germany.
Creating a monetary union of separate sovereign states was and remains an enormous gamble, one that required a high degree of mutual trust to be successful.
How long this marriage will last is something known only to the partners themselves; outsiders cannot easily judge the state of the relationship.
The basic problem with a monetary union among differing nation states is strikingly simple.
Policies dictated by Brussels and Frankfurt, and supported by policy-makers in Washington, have imposed enormous costs on citizens throughout Europe.
It was predictable that many voters would seek salvation in parties outside the mainstream. The European elections in 2014 and the Greek elections of 2015 were testimony enough.
The crisis of European Monetary Union will drag on, and it cannot be resolved without confronting either the supranational ambitions of the European Union or the democratic nature of sovereign national governments. One or other will have to give way.
Eventually the choice between a return to national monies and democratic control, or a clear and abrupt transfer of political sovereignty to a European government cannot be avoided.
Voters in a growing number of countries have turned away from centre-left and centre-right parties towards more extreme parties that still respect national sovereignty. There is a limit to the economic pain that can be imposed in the pursuit of a federal Europe without a political counter-reaction.
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.
For centuries, alchemy has been the basis of our system of money and banking.
For a society to base its financial system on alchemy is a poor advertisement for its rationality.
The key to ending the alchemy is to ensure that the risks involved in money and banking are correctly identified and borne by those who enjoy the benefits from our financial system.
Although money is a public good, the bulk of its supply is provided by commercial banks.
The toxic nexus between limited liability, deposit insurance and lender of last resort means that there is a massive implicit subsidy to risk-taking by banks.
The system in place before the crisis provided many incentives for banks to structure themselves in a way that made a crisis more likely – and that is exactly what concern about ‘moral hazard’ means.
The debate about whether banks are ‘too important to fail’ boils down to a simple question. Are banks an extension of the state, as they are in centrally planned economies, or are they part of a market economy?
It is a question of creating a banking and financial system in which governments feel little incentive to step in and bail out failing firms.
There is a natural path from today’s ‘extraordinary’ measures to a permanent solution to alchemy.
Only a fundamental rethink of how we, as a society, organise our system of money and banking will prevent a repetition of the crisis that we experienced in 2008 and from which previous generations suffered in earlier episodes.
Before the crisis, hubris – arrogance that inflicts suffering on the innocent – ran riot, and changed the culture in financial services to one of taking advantage of the opportunity to manage other people’s money rather than acting as a steward on behalf of clients.
What kind of person takes pride in parting a fool from his money?
Keynesian economics formed a sharp intellectual dividing line between the pre-war capitalist economies and the new post-war confidence in state-led economic policy.
Macroeconomics in this era became divided into two schools of thought: Keynesian and neoclassical.
In a world of radical uncertainty there is no way of identifying the probabilities of future events and no set of equations that describes people’s attempt to cope with, rather than optimise against, that uncertainty.
It is not that either people or markets are irrational; it is just that we do not understand how rational businesses and households cope with radical uncertainty, and so we cannot predict sharp movements in the economy.
By the time the crisis hit with full force in 2008, however, the neoclassical way of thinking had come to dominate the less rigorous Keynesian approach.
Inflation is, in the long run, determined not by the amount of money in circulation but by the expectations of the private sector.
It is not surprising, therefore, that the crisis created a serious challenge to conventional economic thinking.
The intellectual framework of the neoclassical model was inadequate to explain the build-up of a disequilibrium that resulted in the crisis.
A key explanation for the success and stability of the immediate post-war decades was a degree of confidence that Keynesian economics could guarantee stability.
So investment continued to rise at a steady rate, producing stable growth.
The oil price shocks of 1973 and 1979 raised inflation and reduced potential output in the industrialised world.
The only way to reduce the growing level of unemployment was by introducing major reforms.
They included legislation to rein in union power, reductions in unemployment benefits relative to average wages, and measures to reduce job protection by introducing temporary labour contracts.
So successful was this approach that inflation fell across the industrialised world, which then experienced an unprecedented period of stable growth and low inflation – the Great Stability.
But the flaw with the Great Stability was that many people confused stability with sustainability.
So households and businesses came to believe that levels of domestic demand were also sustainable.
In the long term, policy in the US and UK needs to bring about a shift away from domestic spending and towards exports.
The irony is that those countries most in need of this long-term adjustment, the US and UK, have been the most active in pursuing the short-term stimulus.
After the crisis, the burden of restoring the world economy to health has been laid fairly and squarely at the door of central banks. They continue to struggle with the responsibility of generating a recovery in the world economy.
Were there other policy instruments, unavailable to central banks, which might have resolved those coordination problems, and would they contribute to the healing process today? Or are we headed for another crisis?
Without reform of the financial system another crisis is certain, and the failure to tackle the disequilibrium in the world economy makes it likely that it will come sooner rather than later.
The most obvious symptom of the current disequilibrium is the extraordinarily low level of interest rates.
If real interest rates remain close to zero, the disequilibrium in spending and saving will continue and the ultimate adjustment to a new equilibrium will be all the more painful.
Lost output and employment of such magnitude has revealed the true cost of the crisis and shaken confidence in our understanding of how economies behave.
Germany faces a terrible choice. Should it support the weaker brethren in the euro area at great and unending cost to its taxpayers, or should it call a halt to the project of monetary union across the whole of Europe? The attempt to find a middle course is not working.
The more likely cause of a break-up of the euro area is that voters in the south will tire of the grinding and relentless burden of mass unemployment and the emigration of talented young people.
Misguided attempts to suppress national sovereignty in the management of an integrated world economy will threaten democracy and the legitimacy of the world order.
The attempt to keep the euro together produced austerity on a scale not seen since the Great Depression, and led to the rise of extreme political parties across Europe.
Whether the next crisis will be another collapse of our economic and financial system, or whether it will take the form of political or even military conflict, is impossible to say. Neither is inevitable.
In October 2015, the US, Japan and ten other Pacific Rim countries signed the Trans-Pacific Partnership (TPP) which lowered trade barriers. It is now up to legislators to implement the agreement. A companion agreement between the United States and Europe – the Transatlantic Trade and Investment Partnership (TTIP) – is being negotiated. Those two agreements are an important part of any attempt to raise real incomes.
Both China and Germany are discovering that being a country in surplus is a mixed blessing in a world that is on an unsustainable trajectory.
Whatever can be said about the world recovery since the crisis, it has been neither strong, nor sustainable, nor balanced.
In a capitalist economy, money and banks play a critical role.
Although they have provided the wherewithal to accumulate capital, they have done so through financial alchemy by turning illiquid real assets into liquid financial assets. Over time, the alchemy has been exposed.
Banks need to finance themselves with more equity so that they can absorb likely losses without the prospect of default and taxpayer support. It is time to end the alchemy.
Only a recognition of the severity of the disequilibrium into which so many of the biggest economies of the world have fallen, and of the nature of the alchemy of our system of money and banking, will provide the courage to undertake bold reforms.
A long-term programme for the reform of money and banking and the institutions of the global economy will be driven only by an intellectual revolution.