The End of Alchemy: Money, Banking, and the Future of the Global Economy - Mervyn King (2017)
‘It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity …’
Charles Dickens, A Tale of Two Cities
The past twenty years in the modern world were indeed the best of times and the worst of times. It was a tale of two epochs - in the first growth and stability, followed in the second by the worst banking crisis the industrialised world has ever witnessed. Within the space of little more than a year, between August 2007 and October 2008, what had been viewed as the age of wisdom was now seen as the age of foolishness, and belief turned into incredulity. The largest banks in the biggest financial centres in the advanced world failed, triggering a worldwide collapse of confidence and bringing about the deepest recession since the 1930s.
How did this happen? Was it a failure of individuals, institutions or ideas? The events of 2007-8 have spawned an outpouring of articles and books, as well as plays and films, about the crisis. If the economy had grown after the crisis at the same rate as the number of books written about it, then we would have been back at full employment some while ago. Most such accounts - like the media coverage and the public debate at the time - focus on the symptoms and not the underlying causes. After all, those events, vivid though they remain in the memories of both participants and spectators, comprised only the latest in a long series of financial crises since our present system of money and banking became the cornerstone of modern capitalism after the Industrial Revolution in the eighteenth century. The growth of indebtedness, the failure of banks, the recession that followed, were all signs of much deeper problems in our financial and economic system. Unless we go back to the underlying causes we will never understand what happened and will be unable to prevent a repetition and help our economies truly recover. 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? It also examines new ideas that suggest answers.
In the spring of 2011, I was in Beijing to meet a senior Chinese central banker. Over dinner in the Diaoyutai State Guesthouse, where we had earlier played tennis, we talked about the lessons from history for the challenges we faced, the most important of which was how to resuscitate the world economy after the collapse of the western banking system in 2008. Bearing in mind the apocryphal answer of Premier Chou Enlai to the question of what significance one should attach to the French Revolution (it was ‘too soon to tell’), I asked my Chinese colleague what importance he now attached to the Industrial Revolution in Britain in the second half of the eighteenth century. He thought hard. Then he replied: ‘We in China have learned a great deal from the West about how competition and a market economy support industrialisation and create higher living standards. We want to emulate that.’ Then came the sting in the tail, as he continued: ‘But I don’t think you’ve quite got the hang of money and banking yet.’1 His remark was the inspiration for this book.
Since the crisis, many have been tempted to play the game of deciding who was to blame for such a disastrous outcome. But blaming individuals is counterproductive - it leads you to think that if just a few, or indeed many, of those people were punished then we would never experience a crisis again. If only it were that simple. A generation of the brightest and best were lured into banking, and especially into trading, by the promise of immense financial rewards and by the intellectual challenge of the work that created such rich returns. They were badly misled. 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. There was a general misunderstanding of how the world economy worked. Given the size and political influence of the banking sector, is it too late to put the genie back in the bottle? No - it is never too late to ask the right questions, and in this book I try to do so.
If we don’t blame the actors, then why not the playwright? Economists have been cast by many as the villain. An abstract and increasingly mathematical discipline, economics is seen as having failed to predict the crisis. This is rather like blaming science for the occasional occurrence of a natural disaster. Yet we would blame scientists if incorrect theories made disasters more likely or created a perception that they could never occur, and one of the arguments of this book is that economics has encouraged ways of thinking that made crises more probable. Economists have brought the problem upon themselves by pretending that they can forecast. No one can easily predict an unknowable future, and economists are no exception. Despite the criticism, modern economics provides a distinctive and useful way of thinking about the world. But no subject can stand still, and economics must change, perhaps quite radically, as a result of the searing experience of the crisis. A theory adequate for today requires us to think for ourselves, standing on the shoulders of giants of the past, not kneeling in front of them.
Economies that are capable of sending men to the moon and producing goods and services of extraordinary complexity and innovation seem to struggle with the more mundane challenge of handling money and banking. The frequency, and certainly severity, of crises has, if anything, increased rather than decreased over time. In the heat of the crisis in October 2008, nation states took over responsibility for all the obligations and debts of the global banking system. In terms of its balance sheet, the banking system had been virtually nationalised but without collective control over its operations. That government rescue cannot conveniently be forgotten. When push came to shove, the very sector that had espoused the merits of market discipline was allowed to carry on only by dint of taxpayer support. The creditworthiness of the state was put on the line, and in some cases, such as Iceland and Ireland, lost. God may have created the universe, but we mortals created paper money and risky banks. They are man-made institutions, important sources of innovation, prosperity and material progress, but also of greed, corruption and crises. For better or worse, they materially affect human welfare.
For much of modern history, and for good reason, money and banking have been seen as the magical elements that liberated us from a stagnant feudal system and permitted the emergence of dynamic markets capable of making the long-term investments necessary to support a growing economy. The idea that paper money could replace intrinsically valuable gold and precious metals, and that banks could take secure short-term deposits and transform them into long-term risky investments, came into its own with the Industrial Revolution in the eighteenth century. It was both revolutionary and immensely seductive. It was in fact financial alchemy - the creation of extraordinary financial powers that defy reality and common sense. Pursuit of this monetary elixir has brought a series of economic disasters - from hyperinflations to banking collapses. 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. It sets out to explain why the economic failures of a modern capitalist economy stem from our system of money and banking, the consequences for the economy as a whole, and how we can end the alchemy. Our ideas about money and banking are just as much a product of our age as the way we conduct our politics and imagine our past. The twentieth-century experience of depression, hyperinflation and war changed both the world and the way economists thought about it. Before the Great Depression of the early 1930s, central banks and governments saw their role as stabilising the financial system and balancing the budget. After the Great Depression, attention turned to policies aimed at maintaining full employment. But post-war confidence that Keynesian ideas - the use of public spending to expand total demand in the economy - would prevent us from repeating the errors of the past was to prove touchingly naive. The use of expansionary policies during the 1960s, exacerbated by the Vietnam War, led to the Great Inflation of the 1970s, accompanied by slow growth and rising unemployment - the combination known as ‘stagflation’. The direct consequence was that central banks were reborn as independent institutions committed to price stability. So successful was this that in the 1990s not only did inflation fall to levels unseen for a generation, but central banks and their governors were hailed for inaugurating an era of economic growth with low inflation - the Great Stability or Great Moderation. Politicians worshipped at the altar of finance, bringing gifts in the form of lax regulation and receiving support, and sometimes campaign contributions, in return. Then came the fall: the initial signs that some banks were losing access to markets for short-term borrowing in 2007, the collapse of the industrialised world’s banking system in 2008, the Great Recession that followed, and increasingly desperate attempts by policy-makers to engineer a recovery. Today the world economy remains in a depressed state. Enthusiasm for policy stimulus is back in fashion, and the wheel has turned full circle.
The recession is hurting people who were not responsible for our present predicament, and they are, naturally, angry. There is a need to channel that anger into a careful analysis of what went wrong and a determination to put things right. The economy is behaving in ways that we did not expect, and new ideas will be needed if we are to prevent a repetition of the Great Recession and restore prosperity.
Many accounts and memoirs of the crisis have already been published. Their titles are numerous, but they share the same invisible subtitle: ‘how I saved the world’. So although in the interests of transparency I should make clear that I was an actor in the drama - Governor of the Bank of England for ten years between 2003 and 2013, during both the Great Stability, the banking crisis itself, the Great Recession that followed, and the start of the recovery - this is not a memoir of the crisis with revelations about private conversations and behind-the-scenes clashes. Of course, those happened - as in any walk of life. But who said what to whom and when can safely, and properly, be left to dispassionate and disinterested historians who can sift and weigh the evidence available to them after sufficient time has elapsed and all the relevant official and unofficial papers have been made available. Instant memoirs, whether of politicians or officials, are usually partial and self-serving. I see little purpose in trying to set the record straight when any account that I gave would naturally also seem self-serving. My own record of events and the accompanying Bank papers will be made available to historians when the twenty-year rule permits their release.
This book is about economic ideas. My time at the Bank of England showed that ideas, for good or ill, do influence governments and their policies. The adoption of inflation targeting in the early 1990s and the granting of independence to the Bank of England in 1997 are prime examples. Economists brought intellectual rigour to economic policy and especially to central banking. But my experience at the Bank also revealed the inadequacies of the ‘models’ - whether verbal descriptions or mathematical equations - used by economists to explain swings in total spending and production. In particular, such models say nothing about the importance of money and banks and the panoply of financial markets that feature prominently in newspapers and on our television screens. Is there a fundamental weakness in the intellectual economic framework underpinning contemporary thinking?
An exploration of some of these basic issues does not require a technical exposition, and I have stayed away from one. Of course, economists use mathematical and statistical methods to understand a complex world - they would be remiss if they did not. Economics is an intellectual discipline that requires propositions to be not merely plausible but subject to the rigour of a logical proof. And yet there is no mathematics in this book.2 It is written in (I hope) plain English and draws on examples from real life. Although I would like my fellow economists to read the book in the hope that they will take forward some of the ideas presented here, it is aimed at the reader with no formal training in economics but an interest in the issues.
In the course of this book, I will explain the fundamental causes of the crisis and how the world economy lost its balance; how money emerged in earlier societies and the role it plays today; why the fragility of our financial system stems directly from the fact that banks are the main source of money creation; why central banks need to change the way they respond to crises; why politics and money go hand in hand; why the world will probably face another crisis unless nations pursue different policies; and, most important of all, how we can end the alchemy of our present system of money and banking.
By alchemy I mean the belief that all paper money can be turned into an intrinsically valuable commodity, such as gold, on demand and that money kept in banks can be taken out whenever depositors ask for it. The truth is that money, in all forms, depends on trust in its issuer. Confidence in paper money rests on the ability and willingness of governments not to abuse their power to print money. Bank deposits are backed by long-term risky loans that cannot quickly be converted into money. For centuries, alchemy has been the basis of our system of money and banking.3 As this book shows, 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. These concepts will be familiar to many, although the context in which I use them may not. Their significance will become clear as the argument unfolds, but a brief definition and explanation may be helpful at the outset.
Disequilibrium is the absence of a state of balance between the forces acting on a system. As applied to economics, a disequilibrium is a position that is unsustainable, meaning that at some point a large change in the pattern of spending and production will take place as the economy moves to a new equilibrium. The word accurately describes the evolution of the world economy since the fall of the Berlin Wall, which I discuss in Chapter 1.
Radical uncertainty refers to uncertainty so profound that it is impossible to represent the future in terms of a knowable and exhaustive list of outcomes to which we can attach probabilities. Economists conventionally assume that ‘rational’ people can construct such probabilities. But when businesses invest, they are not rolling dice with known and finite outcomes on the faces; rather they face a future in which the possibilities are both limitless and impossible to imagine. Almost all the things that define modern life, and which we now take for granted, such as cars, aeroplanes, computers and antibiotics, were once unimaginable. The essential challenge facing everyone living in a capitalist economy is the inability to conceive of what the future may hold. 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. Imagine two prisoners who have been arrested and kept apart from each other. Both are offered the same deal: if they agree to incriminate the other they will receive a light sentence, but if they refuse to do so they will receive a severe sentence if the other incriminates them. If neither incriminates the other, then both are acquitted.4Clearly, the best outcome is for both to remain silent. But if they cannot cooperate the choice is more difficult. The only way to guarantee the avoidance of a severe sentence is to incriminate the other. And if both do so, the outcome is that both receive a light sentence. But this non-cooperative outcome is inferior to the cooperative outcome. The difficulty of cooperating with each other creates a prisoner’s dilemma. Such problems are central to understanding how the economy behaves as a whole (the field known as macroeconomics) and to thinking through both how we got into the crisis and how we can now move towards a sustainable recovery. Many examples will appear in the following pages. Finding a resolution to the prisoner’s dilemma problem in a capitalist economy is central to understanding and improving our fortunes.
Trust is the ingredient that makes a market economy work. How could we drive, eat, or even buy and sell, unless we trusted other people? Everyday life would be impossible without trust: we give our credit card details to strangers and eat in restaurants that we have never visited before. Of course, trust is supplemented with regulation - fraud is a crime and there are controls of the conditions in restaurant kitchens - but an economy works more efficiently with trust than without. Trust is part of the answer to the prisoner’s dilemma. It is central to the role of money and banks, and to the institutions that manage our economy. Long ago, 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.’5
Those four ideas run through the book and help us to understand the origin of the alchemy of money and banking and how we can reduce or even eliminate that alchemy.
When I left the Bank of England in 2013, I decided to explore the flaws in both the theory and practice of money and banking, and how they relate to the economy as a whole. I was led deeper and deeper into basic questions about economics. I came to believe that fundamental changes are needed in the way we think about macroeconomics, as well as in the way central banks manage their economies. A key role of a market economy is to link the present and the future, and to coordinate decisions about spending and production not only today but tomorrow and in the years thereafter. Families will save if the interest rate is high enough to overcome their natural impatience to spend today rather than tomorrow. Companies will invest in productive capital if the prospective rate of return exceeds the cost of attracting finance. And economic growth requires saving and investment to add to the stock of productive capital and so increase the potential output of the economy in the future. In a healthy growing economy all three rates - the interest rate on saving, the rate of return on investment, and the rate of growth - are well above zero. Today, however, we are stuck with extraordinarily low interest rates, which discourage saving - the source of future demand - and, if maintained indefinitely, will pull down rates of return on investment, diverting resources into unprofitable projects. Both effects will drag down future growth rates. We are already some way down that road. It seems that our market economy today is not providing an effective link between the present and the future.
I believe there are two reasons for this failure. First, there is an inherent problem in linking a known present with an unknowable future. Radical uncertainty presents a market economy with an impossible challenge - how are we to create markets in goods and services that we cannot at present imagine? Money and banking are part of the response of a market economy to that challenge. Second, the conventional wisdom of economists about how governments and central banks should stabilise the economy gives insufficient weight to the importance of radical uncertainty in generating an occasional large disequilibrium. Crises do not come out of thin air but are the result of the unavoidable mistakes made by people struggling to cope with an unknowable future. Both issues have profound implications and will be explored at greater length in subsequent chapters.
Inevitably, my views reflect the two halves of my career. The first was as an academic, a student in Cambridge, England, and a Kennedy scholar at Harvard in the other Cambridge, followed by teaching positions on both sides of the Atlantic. I experienced at first hand the evolution of macroeconomics from literary exposition - where propositions seemed plausible but never completely convincing - into a mathematical discipline - where propositions were logically convincing but never completely plausible. Only during the crisis of 2007-9 did I look back and understand the nature of the tensions between the surviving disciples of John Maynard Keynes who taught me in the 1960s, primarily Richard Kahn and Joan Robinson, and the influx of mathematicians and scientists into the subject that fuelled the rapid expansion of university economics departments in the same period. The old school ‘Keynesians’ were mistaken in their view that all wisdom was to be found in the work of one great man, and as a result their influence waned. The new arrivals brought mathematical discipline to a subject that prided itself on its rigour. But the informal analysis of disequilibrium of economies, radical uncertainty, and trust as a solution to the prisoner’s dilemma was lost in the enthusiasm for the idea that rational individuals would lead the economy to an efficient equilibrium. It is time to take those concepts more seriously.
The second half of my career comprised twenty-two years at the Bank of England, the oldest continuously functioning central bank in the world, from 1991 to 2013, as Chief Economist, Deputy Governor and then Governor. That certainly gave me a chance to see how money could be managed. I learned, and argued publicly, that this is done best not by relying on gifted individuals to weave their magic, but by designing and building institutions that can be run by people who are merely professionally competent. Of course individuals matter and can make a difference, especially in a crisis. But the power of markets - the expression of hundreds of thousands of investors around the world - is a match for any individual, central banker or politician, who fancies his ability to resist economic arithmetic. As one of President Clinton’s advisers remarked, ‘I used to think if there was reincarnation, I wanted to come back as the president or the Pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody.’6 Nothing has diminished the force of that remark since it was made over twenty years ago.
In 2012, I gave the first radio broadcast in peacetime by a Governor of the Bank of England since Montagu Norman delivered a talk on the BBC in March 1939, only months before the outbreak of the Second World War. As Norman left Broadcasting House, he was mobbed by British Social Credits Party demonstrators carrying flags and slogan-boards bearing the words: CONSCRIPT THE BANKERS FIRST! Feelings also ran high in 2012. The consequences of the events of 2007-9 are still unfolding, and anger about their effects on ordinary citizens is not diminishing. That disaster was a long time in the making, and will be just as long in the resolving. But 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.
Charles Dickens’ novel A Tale of Two Cities has not only a very famous opening sentence but an equally famous closing sentence. As Sydney Carton sacrifices himself to the guillotine in the place of another, he reflects: ‘It is a far, far better thing that I do, than I have ever done …’ 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.