There is growing anger towards the central banks. Their seven-year experiment in monetary policy has not worked. The banks are undeterred. Normal economic growth, they argue, is shortly to resume. In the meantime, our economies must deal with negative interest rates. There are even rumors about such measures as helicopter money—the direct transfer of cash to the private sector from the central bank.
Mervyn King’s The End of Alchemy, which was published in March 2016, is therefore an event. For the ten years between 2003 and 2013, King was the governor of the Bank of England. He was thus in power during the 2007–2008 financial crisis. Given the position that he held, King is remarkable in his forthrightness: “The crisis raised deep questions about the foundations of the economic models used by central banks around the world.”1 Paul Krugman has correctly emphasized the peculiarity of a book in which an insider’s insider sets himself in opposition to economic orthodoxy and its standard forecasting models.2
Minor Key Rebel
King’s criticisms are often astute. Given that economic decisions always take place under conditions of radical uncertainty, King is right to question a purely probability-based definition of risk. This is criticism that can be tracked back to Frank Knight’s work at the beginning of the 1920s.3 “At the heart of modern macroeconomics,” King writes, “is the illusion that uncertainty can be confined to the mathematical manipulation of known probabilities.”4 Perhaps influenced by Friedrich Hayek, one of his predecessors at the London School of Economics, King rejects general equilibrium models based on rational optimization that are reducible to a limited set of mathematical equations.5 In the real world, King notes, human rationality involves rules derived from experience, or tradition. “Heuristics are not deviations from the true optimal solution but essential parts of a toolkit to cope with the unknown.”6
One might think that King, having sloughed off traditional Keynesianism, has undergone pupation as a neoliberal economist. “Our inability to anticipate all possible eventualities,” he writes, “means that we—households, businesses, banks, central banks and government—will make judgements that will turn out to have been ‘mistakes.’”7 That mistakes play a role in any economy is a central tenet of the Austrian approach to business-cycle theory. “The problem,” King remarks, “is not just complexity, but also the pretence of knowledge.”8 It is worth noting that Hayek’s 1974 Nobel Prize acceptance speech was entitled “The Pretence of Knowledge.”9 While King clearly aims at cultivating an image of himself as a heterodox economist, he carefully avoids going too far. Whatever Krugman may say, most of King’s animadversions remain anchored in mainstream economics.
King Completes Bernanke’s Narrative
King’s attachment to conventional orthodoxy is revealed in the parts of the book where he deals with the origins of the 2007–2008 financial crisis. He may not share the stereotypical language of the central bankers, and he does not mince words when criticizing their post-crisis quantitative easing strategies: “Central banks are trapped into [sic] a policy of low interest rates because of the continuing belief that the solution to weak demand is further monetary stimulus.”10 Yet King endorses Ben Bernanke’s explanation for the origins of the Great Recession. In Bernanke’s view, the financial crisis was the product of a global savings glut. This was, in turn, due to the determination of emerging Asian economies to accumulate large trade surpluses as a hedge against a shortfall of foreign currency. These countries produced more than they spent, and saved more than they invested. This excess of savings depressed global interest rates to historically low levels. Combined with the financial deregulation of the 1990s, low interest rates meant that asset prices rose around the world. A massive rise in debt levels followed. Investors began taking risks in an effort to obtain higher returns. Banks responded by creating ever more complex financial instruments. When the inevitable bubble burst, it triggered a banking crisis and a major recession.
After eight years and despite massive injections of base currency, the system has not bounced back to normal economic growth. To Bernanke’s narrative, King now adds its missing conclusion. His explanation relies on Milton Friedman’s concept of permanent income, along with time-preference and malinvestment.11 These are terms that again call to mind the Austrian economic school, circumstances that are never mentioned in King’s book, not even in the notes.
King’s theory focuses on the behavior of spendthrift consumers who have become aware that the pace of their spending is no longer sustainable. The more they draw on their future spending to sustain present demand, the greater the shortfall in future demand. In such a situation, consumers rationally revise downwards their expected future income. They decrease their present spending. “The impact of the crisis,” King writes, “was to make debtors and creditors—households, companies and governments—uncomfortably aware that their previous spending paths had been based on unrealistic assessments of future long-term incomes.” This is an interesting theory, even though, as Krugman points out, it still has not been formally confirmed: “I suspect that this is exactly the kind of situation in which words alone can create an illusion of logical coherence that dissipates when you try to do the math.”12
Ignoring Alternatives
King’s book hardly mentions other lines of research.13 Some of the most promising research is being carried out by a team of economists working at the Bank of International Settlements (BIS) in Geneva. King was one of its administrators, and in a paragraph about the rise of global financial disequilibrium, he refers to one of its researchers, Hyun Song Shin.14
What he does not say about this team is far more important than what he does.
The BIS economists are developing new theoretical and empirical models of the global economy. Their models depart from orthodox Keynesian theory in three respects:15
- They do not assume the medium- or long-term neutrality of money.
- They do include medium- or long-term monetary variables never included in the usual forecasting models: level of debt, ratios of indebtedness, and financial leverage.
- They question the focus of central banks on deflationary risk.16
Their approach to international finance reveals the inadequacy of current models of a global economy.17 BIS simulations have provided more reliable forecasts than the models still used by central banks.18
According to the standard view, economic growth moves in irregular waves, with apparent cycles on the order of seven years, around a long-term trend represented by a straight line. The role of the central bank is to make sure, by manipulating interest rates, that growth does not vary too much from its linear trajectory. BIS economists have argued for the simultaneous existence of a sixteen- to twenty-year financial cycle. Its motor is the structural asymmetry of monetary policy. For political reasons, central banks typically lower rates further and faster than they raise them.19 In the long-term, this policy asymmetry translates into an endogenous process of accumulating financial disequilibria, which must one day burst apart.20 This is what happened in 2007–2008.
Something similar must inevitably happen again in the near future, as quantitative easing policies and negative interest rates unleash a new cycle.
BIS experts are not the only ones to call into question the narrative to which King adheres. There is also the work of those who identify themselves as market monetarists. Academic disciples of Friedman, they have developed a somewhat modified version of monetarism.21 Observing that the velocity of money is less stable than Friedman’s equations suggest, market monetarists consider that money aggregates are not fully reliable markers of an economy’s monetary situation. They also challenge the conventional role played by interest rates in Keynesian models as a mechanism for targeting and calibrating monetary interventions.
Central banks today are rather in the position of a man who is deaf being guided by a man who is blind.
Counter visions of the 2007–2008 crisis are based on a detailed analysis of events.22 Market monetarists view the great recession as a series of errors by the American Federal Reserve; these, in turn, were caused by reliance on a set of mistaken tools that led to a defective understanding of the economic situation before the fall of Lehman Brothers.23 “The view of the leading Market Monetarists,” Lars Christensen has noted, “is that the Great Recession was not caused by a banking crisis but rather excessively tight monetary policy.”24
New monetary policies are drowning the world in liquidity. Such is the standard view. Just the reverse is true. Such is the view of the new monetarists. They believe that Basel III and the Dodd–Frank Act25 have exerted a strong deflationary pressure on the global money supply.26 Central banks relying on non conventional monetary policies failed to produce enough base currency in compensation. The result is the tepid recovery everywhere in evidence.
Changing Central Banks
Mervyn King is nothing if not a big thinker. “A long-term programme for reform of money and banking,” he writes, “and the institutions of the global economy will be driven only by an intellectual revolution.”27 King has a precise idea of the type of revolution he would like to see. “The transmutation of bank deposits—money—with safe value into illiquid risky assets is the alchemy of money and banking.”28 King therefore proposes to kill off all the alchemists by preventing banks from creating money by leveraging their fiduciary assets. This reform would transform those legendary lenders of last resort into “pawnbroker[s] for all seasons”—no lending without security. Banks would be required to maintain reserves to the top of the till.29 Under this new regime, liquidity support would be provided to banks experiencing temporary cash shortfalls, but only under the umbrella of contracts fixing the collateral they hold at the central bank and the conditions under which they would be forced to accept a haircut.30 Having thus secured their reserves over the short term, the banks would no longer be able to turn those reserves into long term and risky investments. In the face of a run on deposits, banks would no longer have to fear finding themselves unable to respond to withdrawal requests. Depositors would have no reason to dash to the banks either.
According to King, this plan would correct the inherent instability of any banking system founded on fiat currency with fractional reserves.31 It would put an end to the mechanism that has been the cause of all major economic fluctuations.
It would soothe capitalism’s aching Achilles heel.
The program that King advocates has resurrected a two-century-old debate among economists: should banks be forced to hold one hundred percent of their reserves or only some fraction?32 King seems to consider this problem definitively resolved. He is, after all, a professor at the London School of Economics and Yale University. He has imbibed his milk at the source. Science and historical experience have shown, he believes, that a system of fiat currency with fractional reserves is intrinsically unstable and prone to crisis. Under these conditions, recourse to a central bank becomes indispensable. This is why, King adds, governments progressively granted central banks their responsibilities.
Such is the King’s narrative. But the debate has never been conclusively settled. New research has focused on free banking systems, in which the central bank no longer holds a monopoly on currency.33 This work has expressed a narrative at odds with the one found in textbooks.
The economist Joseph Salerno has defined fiduciary media as “that portion of bank-issued notes and demand deposits that is unbacked by the standard money or ‘cash.’”34 King is opposed to any fiat money system, such as that defined by Salerno, and to support his opposition he invokes the American free banking era, which lasted for the twenty seven years between 1837 and 1864. The period was marked by numerous bank failures and frequent financial crises. There was nothing really free about the banking system of that era, although the system was somewhat freer than the one that preceded it. In 1836, President Andrew Jackson released bankers from their obligation to obtain a charter from their local state legislatures. But banks remained subject to highly restrictive regulations prohibiting them from developing branch networks. One bank, one branch. Banks were also forced to place their reserves exclusively in state bonds. The system was far from a competitive scheme in which private banks freely issued fiat money without supervision. This is what economists today call free banking. This example does not support King’s argument.
The same can be said of the 1907 banking crash. The textbooks and King agree: this is what happens when there is no central bank. The American Federal Reserve System was created in 1913. Renewed interest among economic historians has established that the primary cause of the crash was banking legislation preventing American banks from developing branch networks.
New research has revealed that the usual justification for the existence of central banks rests on an accumulation of anecdotes.35 Episodes of significant systemic contagion were, in fact, extremely rare.36 The amount of bank money created through fractional reserves is all the greater when politics, state regulations, and central bank binding rules allow colluding private entrepreneurs to restrain market competition in the banking industry.37 This is not to deny that fiduciary media may have disruptive economic consequences. Far from it. It is when banks are most free that one has the least to worry about the destabilizing consequences of King’s alchemy.38 No one has demonstrated that a system of banks regulated by a central bank leads to economic and financial stability.
The economists certainly have not.
King’s plan to transform the banks into “pawnbroker[s] for all seasons” commits the central bank to haircut management, a far from trivial task.39 Haircuts determine the amount of financial assistance a stricken bank can expect to receive as a percentage of the market value of its pledged portfolio. If the portfolio is discounted by sixty percent, the bank has leeway to finance only forty percent of the nominal value of the portfolio. If the bank wishes to grant more loans to its clients, it will have to finance them through long-term borrowing or by a further capital increase. Long-term borrowing is more expensive than short-term borrowing. Central banks will then be in a position to determine haircuts according to the type of assets involved (bonds, bullion, real estate, stocks), the nature of the bank’s clients (corporate, government, individual), and the characteristics of the banks (location, risk profile, size). Such a system gives the central banks a lot of power. Even home mortgage rates will come to depend on which haircut was applied to which bank.
Under the current system, central banks set only their own short-term rate. They leave it to the market to determine the rest of the rates. Under the new system, central banks would set the entire rate schedule; and they would be able to manipulate prices in order to favor a particular sector, or to subsidize the development of specific activities. Hello Soviet-style planning. In his review of The End of Alchemy, Jonathan McMillan writes that “King’s proposal is designed to preserve private money creation. … [But] in the new framework that King proposes, central banks would make decisions that determine the fate of the entire economy.”40
Such a conclusion is shocking.
A Misunderstood Paradox
Both King and Hayek placed radical uncertainty at the heart of their analysis. For Hayek, it was the world’s radical uncertainty that made market institutions a superior method of social organization. The market sets prices. Well and good. The market is not only a coordination system through price mechanism (the neo-classical version) but also, and above all, a discovery process which, through competition, serves to elicit knowledge to which economic agents do not otherwise have access. King does not see any of this. A neoclassical economist, he understands radical uncertainty as a kind of imperfection, one that, because it prevents competition from working properly, justifies the need for a regulatory body.
King criticizes mainstream economics for its reliance on mathematical models of perfect competititon. Yet he defines radical uncertainty as a kind of imperfection—the most radical imperfection: “absence of many crucial markets for future goods and services”41 This is not an imperfection that could be corrected, since one cannot devise markets for things that do not exist yet. By doing so, he anchors his own concept of radical uncertainty in the paradigm of conventional pure and perfect competition.
As a consequence, though reasonably objecting to perfect competition, King finds himself endorsing all of its theoretical attributes. He assumes that to perform their job, agents of the central banks may have access to costs and prices information independently of any competitive process; such information is not available outside of the process of competitive disclosure. Like so many other economists, King thinks of the State as an entity both omniscient and benevolent, to use James Buchanan's famous turn of phrase.42 This is neoclassical orthodoxy. Better to move closer to the market; best to get rid of central banks. Most people are not prepared for this.
King might consider the work of George Selgin, the author of the most comprehensive work on the theory and history of free banking experiments. Selgin suggests that central banks should hold credit auctions of the sort pioneered by the Bank of England. Of all places! Selgin’s reform would merge the extraordinary management of liquidity support represented by a credit auction with the ordinary management of bank reserves.43 Such an approach, while still far from perfect, would allow competitive forces to replace more broadly political and bureaucratic allocations, even in emergency situations such as 2007–2008.
The destabilizing influence of public interventions would thus be reduced.
The End of Alchemy reflects a slowly rising awareness among central bankers that mainstream economics may be an obstacle to returning to economic normality. Having been made aware of the plain facts, King remains unable to devote himself to a commitment that does not favor the omnipotence of an institution.
He cannot imagine a world without it.
Global Money
King’s book contains very little about the future of international monetary institutions, and what it does contain is misleading. He mentions global money, but only tangentially. His approach to international economics remains narrowly territorial and national. This allows him to highlight all the major geographical imbalances that added to the 2007–2008 crisis, and contributed to its prolongation. The work of BIS experts makes clear that this is a vision preventing us from properly perceiving reality.44
Nothing is more revealing in this respect than the way King deals with shadow banking. Bernanke defines shadow banking as “a diverse set of institutions and markets that, collectively, carry out traditional banking functions—but do so outside, or in ways only loosely linked to, the traditional system of regulated depository institutions.”45 Shadow banks played an essential role in the course of the crisis. They relayed and amplified the shock coming from the American subprime collapse. But the vision King offers remains very conventional. He sees shadow banking as a set of practices that exacerbated the fragility of an unstable banking system. This is a little shortsighted. At the onset of the crisis, the very concept of shadow banking was virtually unknown. Today, this is no longer the case. The financial crisis intensified efforts to understand shadow banking. What has emerged is very different from the image offered by King.
According to Perry Mehrling and Zoltan Pozsar, there is nothing in the least parasitic about shadow banking.46 Economists concerned that the present global financial system would lead to a multi-polar regime of competing currencies have nothing to worry about. Mehrling defines shadow banking as “the natural form of banking in the globalized world.”47 What may be forthcoming is a radically new international monetary order.48 This new kingdom would see the merger of national and global financial systems.49 It would be a kingdom upholding the key role of price market mechanisms, while being backed up by a permanent network of central bank swap agreements.50
A rebooting of the world monetary order is already in prospect.
Translated from the French and revised in English by the editors.
