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Money: The Brave New Uncertainty of Mervyn King

1.

The Bank of England, founded in 1694, isn’t the oldest central bank in the world, an honor that belongs to Sweden’s Riksbank, founded a quarter-century earlier. But the “Old Lady of Threadneedle Street” arguably invented the art of central banking—the visible hand, operating through the money supply, lending policies, and more—that all modern economies, no matter how much they may talk about free markets, rely on to provide monetary and financial stability.

Mervyn King
Mervyn King; drawing by James Ferguson

These days, of course, the pound sterling is much less widely used than the dollar, the euro, or even the yen or the yuan, and the Bank of England is correspondingly overshadowed in many ways by its much younger counterparts abroad. Yet the bank still punches above its weight in troubled times. In part that’s because London remains a great financial center. But it’s also thanks to the Bank of England’s intellectual adventurousness.

It was a big departure for the Federal Reserve—which has historically been run by bankers rather than academics—when Ben Bernanke, a distinguished monetary economist, was appointed as chairman in 2006. But Mervyn King, a former professor at the London School of Economics, was already running the Bank of England. And it was these two professors who guided the English-speaking world’s biggest economies through the recent financial crisis.

Now King, like Bernanke, has written a book inspired by his experiences. But it’s not at all the book one might have expected. It’s not a play-by-play of the crisis, or a tell-all, or a personal memoir. In fact, King not-so-subtly mocks the authors of such books, which “share the same invisible subtitle: ‘how I saved the world.’”

King’s book is, instead, devoted to “economic ideas.” It is rich in wide-ranging historical detail, with many stories I didn’t know—the desperate shortage of banknotes at the outbreak of World War I, the remarkable emergence of the “Swiss dinar” (old Iraqi notes printed from Swiss plates) in Kurdistan. But it is mainly an extended meditation on monetary theory and the methodology of economics.

And a fascinating meditation it is. As I’ll explain shortly, King takes sides in a long-running dispute between mainstream economic analysis and a more or less radical fringe that rejects the mainstream’s methods—and comes down on the side of the radical fringe. The policy implications of his methodological radicalism aren’t as clear or, I’d argue, as persuasive as one might like, but he definitely challenges policy as well as research orthodoxy.

You don’t have to agree with everything King says—and I don’t—to be impressed by his willingness to let his freak flag fly. His assertion that we haven’t done nearly enough to head off the next financial crisis will, I think, receive wide assent; I don’t know anyone who thinks, for example, that the US financial reforms enacted in 2010 were sufficient. But his assertion that the whole intellectual frame we’ve been using is more or less irreparably flawed is a brave position that should produce a lot of soul-searching among both economists and policy officials.

2.

Although The End of Alchemy is more a book of theory inspired by recent economic crises than an account of those crises, it does, inevitably, tell a story about what went wrong. So how does King’s version of our troubles compare with the mainstream view?

The answer, as far as I can tell, is that the crisis according to King isn’t very different from the crisis according to Ben Bernanke, or according to Martin Wolf of the Financial Times (to cite two other well-known authors of recent books on the subject).

First, as many people have noted, the run-up to the global financial crisis that struck in 2007–2008 was a two-decade era of unusual economic calm, at least in wealthy countries, commonly referred to as the Great Moderation—although for some reason King calls it the Great Stability instead. This long era of stability may have encouraged complacency, both in the private sector and among policymakers, so that evidence of an increasingly fragile financial system was ignored.

Indeed, the thrust of policy was toward removal of regulations that limited financial risk. King emphasizes the liberalization of international capital flows, which set the stage for huge cross-border lending—Asian lending that financed the US housing boom, German lending to southern Europe. But he also notes the deregulation of banking—although I was surprised not to see him talk much about what we might call passive deregulation, the failure to extend regulation to cover new forms of finance that in effect did an end run around existing regulations.

The more or less standard account of the 2008 crisis, which King shares, is that the combination of stability-fostered complacency and deregulation led to an accumulation of financial vulnerabilities. Private debt was on a steady upward trend before the crisis, with the ratio of household debt to income rising by about 50 percentage points in both the US and the UK. This debt accumulation arguably made the economy more vulnerable to crisis, because debt-burdened households would find themselves in especially severe distress in the face of a downturn.

Meanwhile, the de- or unregulated financial system became an accident waiting to happen. Traditionally, banks had a substantial “cushion” of equity—that is, while they always made loans mainly with money raised from deposits or short-term borrowing, there was enough difference between their loans and their debts that they could absorb significant losses on loans without going bankrupt. On the eve of the crisis, however, much of the financial system had enormous leverage—the ratio of debt to equity was 25 to 1 or more—leaving it extremely vulnerable to panic. And the panic came.

When it came, the general reaction of economists—certainly my own reaction—wasn’t “How can this be happening?” It was, instead, “Whoops—I should have paid more attention to the details.” Economists know quite a lot about bank runs and financial crises. If they—OK, we—didn’t see this one coming (I thought it would be nasty when the housing bubble popped, but not this nasty), it was because we hadn’t paid enough attention to the nuts and bolts of the financial system. Banks, everyone knew, were no longer subject to old-fashioned runs because deposits are insured; what almost everyone missed was the rise of “shadow banking”—new financial institutions and arrangements, such as hedge funds and money market funds, that bypassed traditional banking but recreated all the risks of the bad old days.

Once everyone noticed the importance of shadow banking, it was straightforward to pull off the shelf an intellectual approach for understanding the crisis. After the fall of Lehman Brothers, economists roamed the streets muttering to themselves “Diamond-Dybvig”—referring to an influential model for analyzing bank runs. OK, not really, but as soon as you realized that banks didn’t have to be marble buildings with rows of tellers, classic analyses of bank runs like the 1983 paper by Douglas Diamond and Philip Dybvig provided an obvious way to make sense of what was happening. And as I’ve said, Mervyn King’s take on the crisis isn’t that different from what many economists are saying.

His view of the somewhat separate crisis within the euro area—the crisis that produced devastating recessions in Ireland, Spain, Portugal, Italy, and, above all, Greece, even as the United States was recovering—is also fairly conventional as an intellectual matter, even if it’s somewhat shocking to hear it from so influential a former policymaker. For King declares the euro a mistake, and he somewhat elliptically calls for its dismantling:

If the alternative is crushing austerity, continuing mass unemployment, and no end in sight to the burden of debt, then leaving the euro area may be the only way to plot a route back to economic growth and full employment.

That’s a big deal—if he’d said it while still in office, it would have provoked a diplomatic crisis.

His reasoning, however, rests squarely on standard economic analysis—specifically, the concept of an “optimum currency area” defined by the tradeoff between the convenience of a single currency and the flexibility that comes with a country having its own currency. He argues that Europe’s imbalances in production costs and hence in trade are too large to be resolved without either abandoning the euro or moving to full political union, and that given the lack of will for the latter, the former it must eventually be. It’s a controversial argument (although it makes a lot of sense), but among economists, at least, a fairly conventional one.

Yet King sees the need for a complete rethinking of how we do economics. Why? To answer that question, we need to look at a dispute that has simmered in economics for eighty years.

3.

Back in the 1970s a great rift opened between “salt water” (i.e., MIT, Harvard, Yale, Princeton) macroeconomists who believed that the government has a valuable part in fighting recessions, and “fresh water” economists (Chicago, Minnesota, Rochester) who denied any such role. On the eve of the global crisis, it was often asserted that this rift had narrowed—but reactions to the crisis and government actions to deal with it showed that any appearance of a new consensus was an illusion, that the two sides were as far apart as ever. And those who advocated forceful action dropped any inhibitions about proudly declaring themselves Keynesians.

What does that mean? For people like Christina Romer, who was President Obama’s first chief economist, or Larry Summers, or yours truly, it doesn’t mean a drastic stylistic departure from ordinary supply-and-demand-type reasoning, which relies heavily on the concept of “equilibrium”—roughly, a situation in which the economy’s participants are each doing what they imagine is in their self-interest, given what everyone else is doing. But it means acknowledging that equilibrium isn’t the same as “good”—that if you take into account more or less realistic frictions, like the reluctance of workers to accept cuts in money wages, it’s entirely possible for an economy to get stuck in an equilibrium that involves sustained high unemployment.

But is that really Keynesianism, as is often claimed? A relatively small but vociferous group of economists say that it isn’t—that true Keynesianism requires rejecting the whole concept of equilibrium, as well as any notion that economic participants bear any resemblance to the rational economic man of the textbooks.

Both positions can find support in Keynes’s own writings, indeed within his 1936 magnum opus, The General Theory of Employment, Interest, and Money. In an essay King cites I described these two factions as “Part 1ers” and “Chapter 12ers.” Chapter 12 of the General Theory is a famously fun read, a discussion of the problems people have making decisions involving the future. In that chapter Keynes argues that the future is inherently unknowable, and that we deal with that fundamental uncertainty essentially by kidding ourselves, telling and acting on stories about the future that are grounded in little more than convention. And these stories, Keynes asserts, are subject to occasional drastic revisions, with huge economic implications. No equilibrium there!

But Keynes opens that very same book with three chapters that are described as presenting his essential argument—and the argument very much involves equilibrium reasoning, with the assumption that spending has a stable relationship with income, and that the economy settles at the level of employment at which desired spending equals income.

So which of these approaches represents real Keynesianism? Who cares? The point is that they do represent choices about how to think. Most self-described Keynesians are Part 1ers. They don’t necessarily believe that workers and consumers are perfectly rational, or deny that sudden shifts in behavior can happen, but irrationality and volatility are at the fringes of their worldview.

King argues, however, that this is all wrong; he is, basically, a Chapter 12er, asserting that economic decisions always take place under conditions of “radical uncertainty”—ignorance about the future that can’t be quantified by probabilities, so that there is no such thing as optimizing behavior. People cope with this uncertainty by settling on “narratives” that are conventionally accepted at any given moment, but can suddenly change. And he urges economists to turn away from supply-and-demand-type analysis, which he calls the economics of “stuff”—as in markets for prosaic physical goods—in favor of the economics of “stuff happens.”

That’s not an unheard-of position, but it’s a remarkable one for an ex–central banker to take, let alone one who, in a former life, was a card-carrying mainstream economist. Why does he go there?

John Maynard Keynes
John Maynard Keynes; drawing by David Levine

It’s not entirely clear, even though King spends a whole chapter explaining why radical uncertainty, not quantifiable risk, is the essence of economic life. Yes, economic forecasts are often grossly wrong; yes, even smart people often have far too much confidence in their ability to assess risks. Every serious economist knows this, yet most don’t consider it sufficient reason to abandon conventional tools of analysis. At most, it’s a reason to use them in the subjunctive—to analyze economic issues as if people were making reasonable choices, while being aware that they might not. What makes King decide that this isn’t enough?

Part of the answer seems to be the sheer scale of the misjudgments leading up to the financial crisis, with nobody in the financial sector even imagining that housing prices could fall so far. What’s odd, though, is that some economists using quite conventional tools—notably Yale’s Robert Shiller, arguably the world’s leading expert on bubbles—warned well in advance that housing prices were unrealistic and would fall to historically normal levels, which was what did in fact happen.

Beyond the crash, King seems to regard the persistent weakness of post-crash economies as a further reproach to any kind of conventional economic reasoning. In fact, I suspect that this is his biggest motivation: he sees the long slump as evidence of “a change in the narrative used by households to judge future incomes,” not to be explained by any objective factors.

But here again you can find plenty of more conventionally minded Keynesians—that is, Part 1ers—who predicted sustained weakness well in advance, based on ordinary analyses of the limits to monetary and fiscal policy. I personally wrote a blog post titled “Deep? Maybe. Long? Probably” in January 2008, predicting a prolonged slow recovery from the recession in prospect. Later that year the economists Kenneth Rogoff and Carmen Reinhart circulated a paper showing that recoveries from financial crises were typically sluggish—and US recovery from the 2008 crisis is no worse than the aftermath of the typical severe financial crisis.

More recently, a number of economists, most famously Larry Summers, have suggested that we may be facing “secular stagnation,” an old term for persistent weakness in spending even with very low interest rates. King dismisses this line of thought on odd grounds, saying that it’s unclear whether it refers to supply or demand (it’s clearly about demand), and that describing the symptoms without definitively identifying the cause is “circular,” which it isn’t.

So I’m not sure why King feels the need to move in such a radical direction. But leave his motivation on one side: What are the implications if he’s right?

4.

Much of King’s book is taken up with monetary analysis—in particular, the role of banks in creating money. The “alchemy” in his title refers to the way banks assure each individual depositor of ready access to his or her funds, while in fact investing most of those funds in loans and assets that cannot be turned into cash on short notice. This process really does seem to create something from nothing—hence the “alchemy.” It works, most of the time, because on any given day only a small fraction of a bank’s depositors are likely to withdraw their funds.

The trouble with such a system, as economists have long recognized, is that many if not all of a bank’s depositors will, in fact, rush to withdraw their funds at the same time if they are afraid that the bank will go bust. Such fears might reflect events that hurt the value of a bank’s assets, but they can also be a self-fulfilling prophecy: if I expect other depositors to demand their money, forcing the bank to liquidate assets at fire-sale prices, the bank may well be forced to go under, so I’d better join the run myself.

All this is standard banking economics, and the traditional answers are well known. First, the central bank stands ready to lend cash to banks in times of turmoil—it acts as the “lender of last resort”—ensuring that those fire-sale liquidations aren’t necessary even if there are bank runs. Second, deposit insurance protects against losses if banks just make bad investments. And third, regulation—restrictions on what banks can do with depositors’ money, requirements that bank equity be sufficiently large, and so on—is supposed to prevent bankers from abusing the privilege the first two policies create.

How does King’s emphasis on radical uncertainty change this story and the accompanying policies? Frankly, I found his exposition and logic hard to follow. But I think his point is that neither the lender of last resort nor the appropriate regulations can be clearly defined, because nobody can know just how badly bank investments might turn out.

Again, I wonder why he is so despairing about the usefulness of conventional approaches. Gary Gorton, perhaps the leading analyst of what exactly happened to create losses in 2008, points out that the introduction of strong bank regulation and deposit insurance during the Great Depression was followed by a “quiet period” in US finance—a period with no major systemic crises—that lasted over seventy years, from 1934 to 2007. Finance is more complex now, but this experience still seems to show that regulation and safety nets can be reasonably effective for long periods.

Still, King calls for what he says is a fundamental rethinking of bank regulation, replacing the lender of last resort with a “pawnbroker for all seasons.” The central bank would be prepared to lend to any financial intermediary, on any occasion, as long as assets were pledged as security—but the required security would depend on the assets. To borrow against low-quality assets, bankers would have to put up extra collateral, known in the trade as a “haircut,” with the size of such haircuts determined in advance.

It’s an interesting proposal. But I have to admit that I’m not sure how it follows from his emphasis on radical uncertainty or how different it is, in a fundamental sense, from the system we have now. If the future is unknowable, how do we determine the size of haircuts? And weren’t the bailouts of 2008–2009, in which the Fed, for example, provided cash to the insurance company AIG in return for 80 percent ownership, quite a lot like demanding that the company pawn its assets? King has been in the thick of finance, and I haven’t, but neither the need for a new system nor how the system would really change things is clear from his book.

In any case, King’s policy proposals don’t stop with banking reform. He also weighs in on macroeconomic policy, on how to fight the economic weakness that has persisted long after the acute phase of the financial crisis ended. He dismisses talk of demographic and other “headwinds”—such as an aging population—that may be holding the economy back. What has happened, he declares, is a change in the narrative that consumers are telling themselves to a story far more pessimistic about what the future might hold, leading them to spend less year after year. And then a funny thing happens: his radical views on economics lead him to what would ordinarily be considered conservative, even boringly orthodox policy recommendations.

The conventional Keynesian view—that is, the Part 1er, “stuff”-oriented Keynesian view—is that what we need in the face of persistent weakness is policies to boost demand. Keep interest rates low, and maybe raise inflation targets to further encourage people to spend rather than hoard. Have government take advantage of incredibly low interest rates by borrowing and spending on much-needed infrastructure. Offer relief to individuals and nations crippled by debt. And so on.

King is, however, having none of it. Under his leadership, the Bank of England was aggressively engaged in monetary easing by keeping interest rates low—the bank was as aggressive in this respect or even more so than the Bernanke Fed. Now, however, King seems to condemn his old policies:

Monetary stimulus via low interest rates works largely by giving incentives to bring forward spending from the future to the present. But this is a short-term effect. After a time, tomorrow becomes today. Then we have to repeat the exercise and bring forward spending from the new tomorrow to the new today. As time passes, we will be digging larger and larger holes in future demand. The result is a self-reinforcing path of weak growth in the economy.

Is this argument right, analytically? I’d like to see King lay out a specific model for his claims, because 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. Also, it’s unclear what this has to do with radical uncertainty. But this is a topic that really should be hashed out in technical working papers.

In any case, however, if monetary stimulus is self-defeating, then what? King also balks at fiscal stimulus, because he’s worried about public debt. So what’s left?

At the very end of the book, King offers a brief three-part plan. First, economic reforms to boost productivity, which he hopes will change that depressing narrative by which consumers determine their behavior. Second, trade liberalization, mainly in services (such as insurance, consulting, data analysis, and so on), since trade in goods is already quite free. Third, restoring exchange rate flexibility, which basically seems to mean ending the euro.

That last part is startling, given the source, but can be justified by conventional economics. But the other two made me blink. All that talk about the need to ditch conventional economics, to embrace the reality of radical uncertainty—and the punchline is the same as the recommendations of every IMF program for the past sixty years: structural reform and free trade. Really? That’s it?

So The End of Alchemy ends with a pretty big letdown. But that doesn’t change the fact that it’s an important, brave book, very much worth reading. Whatever the problems in connecting King’s worldview to specific policy proposals, he does all of us a service by reminding us how fragile our understanding of the world always is, and how dangerous it can be to act as if we know more than we do.