NOTES - The End of Alchemy: Money, Banking, and the Future of the Global Economy - Mervyn King

The End of Alchemy: Money, Banking, and the Future of the Global Economy - Mervyn King (2017)

NOTES

INTRODUCTION

1

There was no need for him to add that neither has China.

2

Too many simple-minded critics of economics are scathing about its use of mathematics. But as the great British economist Alfred Marshall once wrote: ‘(1) Use mathematics as a shorthand language, rather than an engine of inquiry. (2) Keep them till you have done. (3) Translate into English. (4) Then illustrate by examples that are important in real life. (5) Burn the mathematics. (6) If you can’t succeed in (4), burn (3)’ (Marshall, 1906).

3

In a commentary on Goethe’s great play Faust, Hans Binswanger wrote, in a conscious reference to Clausewitz, that ‘The modern economy is a continuation of alchemy by other means.’ (Binswanger, 1994, p. 33). Clausewitz’s famous dictum was that ‘war is a continuation of policy by other means’.

4

This is simpler than the classic prisoner’s dilemma in which there are four payoffs: acquittal, light, medium and harsh sentences. In that form of the ‘game’ the strategy of incriminating the other is the dominating one, whereas in my example there is some probability that silence will yield the best outcome.

5

Waley (1938), xii, 7, p. 164.

6

James Carville, reported in the Wall Street Journal (25 February 1993, p. A1).

1 THE GOOD, THE BAD AND THE UGLY

1

The expression was coined by Carlyle in an essay on the slave trade written in 1849.

2

Temin (2014) describes capitalism as a subset of the full range of market economies as they evolved over the centuries.

3

See Neal and Williamson (2014).

4

Smith (1776), pp. 4-5. British £20 banknotes issued after 2007 have on one side a picture of the pin factory.

5

Maddison (2004).

6

A history of UK exchange controls can be found in the Bank of England archives on http://www.bankofengland.co.uk/archive/Documents/historicpubs/qb/1967/qb67q3245260.pdf

7

In October 1973, in response to western help to Israel during the Yom Kippur War, the Arab members of the Organisation of Petroleum Exporting Countries (OPEC) plus Egypt, Syria and Tunisia proclaimed an oil embargo. By the end of the embargo in March 1974, the price of oil had risen from $3 per barrel to nearly $12. In 1979 decreased oil output in the wake of the Iranian Revolution caused oil prices to rise from around $16 to almost $40.

8

King (2007).

9

Federal Reserve Bank of St Louis and Bank of England, http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2013/qb130406.pdf.

10

The Big Bang on 27 October had started as an anti-trust case by the Office of Fair Trading against the London Stock Exchange under the Restrictive Practices Act of 1956. The aim was to end the separation between brokers acting as agents for their clients and jobbers who made the markets, and to allow both foreign and domestic firms combining the two roles to become members of the Stock Exchange.

11

Those new financial products, such as derivatives, are explained in Chapter 4.

12

In the pre-crisis period banks also funded themselves in the short term by putting some of their assets in off-balance-sheet vehicles to which they offered a guarantee. Such contingent liabilities are a form of funding.

13

D’Hulster (2009), Table 2; Kalemli-Ozcan, Sorensen and Yesiltas (2012).

14

In the former camp is Gorton (2012), and in the latter are Admati and Hellwig (2013) and Taylor (2015). The latter states that ‘The Global Financial Crisis of 2008 was fundamentally a credit crisis on a massive, international scale.’

15

Notable exceptions are Dumas (2010) and Wolf (2014).

16

In 1989 Francis Fukuyama published a famous essay ‘The End of History?’ in the international affairs journal The National Interest. He later wrote, ‘What we may be witnessing is not just the end of the Cold War, or the passing of a particular period of post-war history, but the end of history as such: that is, the end point of mankind’s ideological evolution and the universalisation of Western liberal democracy as the final form of human government.’ (Fukuyama, 1992).

17

US Bureau of Labor Statistics website: Workforce Statistics on manufacturing employment; Eurostat website: employment and unemployment database, tables on employment by sex, age and economic activity.

18

World Trade Organisation website: Statistics Database.

19

The policy was relaxed at the end of 2013, and became a two-child policy in October 2015.

20

Bernanke (2005).

21

The fundamental drivers of high saving and weak investment that led to falling real interest rates are a matter for continuing research - see Rachel and Smith (2015).

22

Since the 1980s, it has been possible to measure real interest rates quite accurately by looking at how much governments have to pay to borrow in the form of securities (bonds) on which the returns are indexed to inflation. Such bonds have been issued by a number of industrialised countries over the past thirty years (King and Low, 2014).

23

Germany, with its own objective of promoting its export sector, was a notable exception.

24

Charles Dumas (2004, 2006 (with Chovleva)) provided an early analysis of this problem.

25

Its reversal was a striking feature of what came to be known as the Bretton Woods II international monetary system. Although some foreign direct investment did move from advanced to emerging economies, it was more than offset by financial flows in the opposite direction. This analysis of the Bretton Woods II system was first put forward by Dooley, Folkerts-Landau and Garber (2003). Those authors refined and extended the analysis in a series of papers over the following decade. A key part of their argument is that China wanted to lend large sums to advanced economies so that, in the event of a major economic or political disturbance, these claims would act as ‘collateral’ against the foreign direct investment made by the same economies in China. This made it possible for China to obtain the direct investment it needed to support development, and required China to run a large and continuing trade surplus. In any event, export-led growth meant that China had to invest overseas the proceeds of its trade surplus.

Some economists have placed more emphasis on the gross flows of capital among countries, and especially within the advanced world, than on the net flows from emerging to advanced economies. The most compelling arguments were set out by Borio and Disyatat (2011) and Shin (2012). It is true that European banks invested more money in the United States than did China. But they also borrowed far more from American money market and hedge funds. Those gross flows of capital were recycling money that could have been channelled through the US banking system but were instead intermediated through European banks, which were eager to grow by granting new loans and acquiring assets, so expanding the size of their balance sheets. When the crisis hit, banks belatedly reduced their leverage and, as a result, gross capital flows between Europe and the United States fell sharply - by almost 75 per cent. But the driver of the fall in real interest rates, and hence in the rise of the prices of bonds, shares and houses, was the additional net saving injected into the world capital market by economies with high propensities to save and large trade surpluses, and the decision by central banks in the West to keep official interest rates low in order to maintain steady growth and an inflation rate close to target.

26

Shin (2012).

27

King (2006).

28

Other Asian countries had experienced the ‘Asian crisis’ in the late 1990s when borrowing by their banks in US dollars at low interest rates to lend at higher rates in domestic currency led to a currency mismatch in their banking system and so the need to turn to the West to borrow dollars, often with harsh conditions attached. They wanted to build up large dollar reserves as an insurance policy against the need to lend to their own banking system in a crisis.

29

I learned this from the late Rudiger Dornbusch of MIT.

30

BNP press release, 9 August 2007.

31

Lender of last resort support was extended to HBoS on 1 October 2008 and to RBS on 7 October 2008. The former facility was fully repaid by 16 January 2009 and the latter by 16 December 2008. The peak intraday lending by the Bank of England to the two institutions was £61.5 billion on 17 October 2008 (Review of the Bank of England’s provision of emergency liquidity assistance in 2008-9, Report by Ian Plenderleith, Bank of England, October 2012).

32

Paulson (2010), p. 349.

33

The so-called Basel capital and liquidity requirements for banks are determined by a group of central banks and regulators drawn from the G20 countries. Much of this work is discussed in the international body encompassing the same group of countries and known as the Financial Stability Board.

34

World Bank Tables and author’s own calculations.

35

IMF World Economic Outlook Database, April 2015.

36

The discussion of secular stagnation was revived in an important contribution by Summers (2014).

37

King (2009).

2 GOOD AND EVIL: IN MONEY WE TRUST

1

Created as one element of Britain’s national memorial to President John F. Kennedy, the scholarships enable young British graduates to study at either Harvard or MIT. The other element was the gift of an acre of land at Runnymede, which is now US territory.

2

Maddison (2004).

3

One of the best descriptions of the corrosive effects on civil society of hyperinflation in Central Europe in the 1920s is the autobiography of the Austrian writer Stefan Zweig, The World of Yesterday.

4

Keynes (1930). Goodhart (2015) provides an excellent discussion of the process of money creation.

5

Domesday was the Old English term for the day of judgement. Its contents are available on the National Archives website, www.nationalarchives.gov.uk

6

Smith (1766).

7

Smith (1776), p. 20.

8

Ibid., pp. 20-1.

9

Rae (1895), p. 49.

10

Ricardo (1816), p. 24.

11

MacGregor (2010), Ch. 72. There is a wonderful example of a later Ming dynasty banknote from the fourteenth century in the remarkable Citi Money Gallery of the British Museum in London.

12

Chinese banknotes of the early Ming dynasty carried the warning: ‘Whosoever forges notes or circulates counterfeit notes shall be beheaded’ (Kranister, 1989).

13

Following the application of the 1720 Bubble Act to the colonies in 1741, joint-stock corporations (which permitted many people to share in the ownership of a company operating on a much larger scale than any of the owners could individually afford) became illegal, which made banking operations virtually impossible. So no money was created by banks.

14

Johnson (1997), p.75.

15

In 1764 the British Parliament passed the Currency Act, which outlawed the use of all such paper money in the colonies as legal tender. But, as noted in the text, legal tender is far less important than the general acceptability of a currency, and the new bills circulated successfully in the colonies for a number of years. On that episode see Grubb (2015), Celia and Grubb (2014) and Priest (2001).

16

Franklin (1767) in Labaree, Vol. 14, pp. 34-5.

17

Massachusetts was, perhaps, an exception (Priest, 2001).

18

Harris (2008).

19

The proportion had been reversed by the end of the free banking era.

20

There were two episodes, in 1839 and 1859, in which convertibility into gold was suspended. But there were still discounts of the value of banknotes at a distance from head office from the par value that would be offered at head office.

21

Gorton (1989).

22

Data for 2014 from the respective central banks.

23

Goodhart is persuasive on this point (2015). There are also too many examples of the irresponsible encouragement of people on low incomes to borrow for one to be sanguine about the behaviour of the financial services industry.

24

Gibbon (1776), Vol. 1, p. 282.

25

Although when the British bank Northern Rock started to fail in September 2007, a surprising proportion of depositors who withdrew their money were prepared to leave a branch of the bank clutching a cheque drawn on Northern Rock itself.

26

Between the spring of 2007 and the spring of 2009 the demand for £50 notes rose by 28 per cent, double the increase for other denominations. See Bank of England statistics: http://www.bankofengland.co.uk/banknotes/Pages/about/stats.aspx#1

27

Bernanke and James (1991).

28

In 2013 the Freedom From Religion Foundation, a group of atheists, took legal action against the United States Treasury Department claiming that the inclusion of this traditional motto was unconstitutional on the grounds that whenever they used money they were being ‘forced to proselytise’ for a god in whom they didn’t believe. The suit was rejected by US District Judge Harold Bauer Jr because the motto had a long-standing secular purpose, and didn’t constitute a ‘substantial burden’ on atheists.

29

In 2009 the North Korean People’s won collapsed in external value and its citizens were given a week to exchange old won for new notes that had two zeroes knocked off their value.

30

Roberts (2014), p. 771.

31

For a detailed study of the impact of the hyperinflation on the society and politics of Germany see Feldman (1993).

32

Using the modern definition of one trillion as 1,000,000,000,000.

33

For a magisterial history of inflation over many centuries see Fischer (1996).

34

For example, Holzer (1981) and Cato Institute (2014).

35

There were periods, especially in the nineteenth century, when some countries, including the United States, used a bimetallic standard linked to gold and silver. Fluctuations in the market price of one metal against the other made the system unstable, as the metal with the higher price tended to disappear from circulation. In the US, bimetallism ended during the Civil War.

36

Data on the gold price may be found on the Bank of England website and on www.kitco.com

37

Data supplied by Diggers and Dealers, Kalgoorlie, Western Australia.

38

Some of the gold in New York is held on behalf of overseas owners; other official US holdings are stored in Fort Knox.

39

In a delicious irony, it was exactly 200 years later, to the month, that the then Chancellor, Gordon Brown, restored the monetary independence of the Bank that had been taken away by Pitt.

40

Speech to the Democratic National Convention in Chicago, 9 July 1896.

41

Keynes (1923a), p. 172.

42

See, for example, Greenspan (1966).

43

Figures on gold reserves can be found on the World Gold Council website.

44

Friedman and Schwartz (1963), Friedman (1960).

45

Sims (2013).

46

Hahn (1982), p. 1.

47

Arrow (1951), Arrow and Debreu (1954), Debreu (1951).

48

If people are expected to renege on their contracts then the auction process will disallow bids that cannot be enforced. That will greatly reduce the benefits from trade. Ultimately it may mean that there is no possibility of trade between individuals. An efficient outcome requires that contracts are enforced.

49

O’Neill (2002), Reith Lectures, No. 1.

50

The idea of an economy comprising ‘overlapping generations’ was analysed by the great economist Paul Samuelson (1958).

51

The view that money can help to overcome the constraint of the double coincidence of wants and the implied restriction to exchange by barter was set out in detail by Carl Menger (1892), and was modelled explicitly by Nobuhiro Kiyotaki and Randall Wright (1989).

52

Kiyotaki and Moore (2002). Which came first - money or evil? To judge by the book of Genesis, evil appeared in the Garden of Eden before money. But it was not long, in the book of Deuteronomy, before the Lord commanded Moses, ‘Ye shall buy meat of them for money, that ye may eat; and ye shall also buy water of them for money, that ye may drink’ (Deuteronomy 2:6, King James Bible).

53

Hammond (1975) pointed out that the best outcome in such an overlapping generations model was a cooperative equilibrium of the intergenerational game. For the cognoscenti, in modern game-theoretic terminology, where each generation is represented by a single player, the equilibrium is sub-game perfect and renegotiation proof.

54

Willetts (2010).

55

Binswanger (1994).

56

In the debate over the Re-charter of the Bank Bill (1809).

3 INNOCENCE LOST: ALCHEMY AND BANKING

1

Hastings (2013), p. xvi.

2

New York Times, 10 July 2007.

3

When I became Governor of the Bank of England I decided to formalise a long-standing interest in such matters, and so, in conjunction with Charles Aldington (then of Deutsche Bank), I started a dining group to meet regularly and discuss key episodes in financial history. A short account of the Financial History Dining Club was published in 2015 (Aldington et al., 2015).

4

The bank holiday was announced on 6 March. On 9 March Congress passed the Emergency Banking Act. On 13 March, only four days after the emergency legislation came into effect, member banks in Federal Reserve cities received permission to reopen. By 15 March, banks controlling 90 per cent of the country’s banking resources had resumed operations. But around 4000 insolvent banks never reopened.

5

Source:https://www.fdic.gov/about/history/3-12-33transcript.html

6

Figures are from the Banker Database: www.thebankerdatabase.com. Data are for end 2014.

7

Worldwide bank assets are the total assets of the largest 1000 banks in the world, as listed in the Banker Database.

8

The Banker Database, www.thebankerdatabase.com

9

The description ‘socially useless’ was used by Adair Turner, chairman of the Financial Services Authority in the UK from 2008 to 2013, in his Turner Report on the financial crisis in United Kingdom; The phrase ‘doing God’s work’ was used by the CEO of Goldman Sachs, Lloyd Blankfein, in an interview published in the Sunday Times, 8 November 2009.

10

Figures from the Banker Database, www.thebankerdatabase.com, as of end 2014.

11

Because for any bank total assets must equal total liabilities, leverage can be measured by the ratio of either assets or liabilities to equity capital.

12

Brennan, Haldane and Madouros (2010).

13

I prefer ‘too important to fail’ (TITF) to ‘too big to fail’ (TBTF) as a description of the problem, because a small bank can be significant if it is highly interconnected with other banks or if its failure would be a signal leading to contagion to other banks.

14

Wolf (2010).

15

Bank of England (2009).

16

Bank for International Settlements (BIS), Derivative Statistics 2015.

17

Abbey National demutualised in 1989 and has survived as part of Santander UK.

18

That attitude was brilliantly captured in the book Liar’s Poker by Michael Lewis (1989).

19

CCP Research Foundation estimates of conduct costs 2010-14, http://conductcosts.ccpresearchfoundation.com/conduct-costs-results. The estimate includes provisions made by banks of around $70 billion for future settlements of conduct cases relating to past behaviour.

20

Moggridge (1992), p. 95.

21

Keynes in a 1934 letter quoted by Chambers et al. (2014).

22

Bernie Madoff, former chairman of the NASDAQ stock exchange, for many years managed funds for private investors in which the money paid out was financed by new money coming in - what is known as a Ponzi scheme. He is estimated to have defrauded his investors of around $18 billion and in 2009 was sentenced to the maximum term in prison of 150 years.

23

Quoted in Alan Harrington, ‘The Tyranny of Forms’, Life in the Crystal Palace (Knopf, 1959).

24

This is not to say that accounting standards guarantee a fair and accurate description of the health of a bank (Dowd, 2015, Kerr, 2011).

25

The success of an investment in Berkshire Hathaway is in part the judgement of Warren Buffett and in part the fact that he does not operate his company as a hedge fund, which would typically charge an annual fee of 2 per cent of capital and 20 per cent of profits. Charges of that size drastically reduce the returns to the ultimate investors.

26

Bank of America Annual Report 2014, Table 6. Financial and other assets comprise holdings of equity, debt, securities purchased through agreements to resell (collateralised repos - where one party contracts to sell and then buy back an asset at an agreed price on a specified date) and other assets. Other borrowing includes short-and long-term borrowing as well as borrowing through collateralised repo transactions.

27

The standard analysis of a bank run when banks engage in maturity transformation was explained in a famous article by Douglas Diamond and Philip Dybvig (1983).

28

Macey, Jonathan R. and Miller, Geoffrey P. (1992).

29

An excellent account of the failure of the City of Glasgow Bank, and the subsequent legislation to remove unlimited liability, is contained in the Masters thesis of Thomas Ward at the University of Edinburgh: ‘The Regulatory Response to the Collapse of the City of Glasgow Bank, 1878 to 79’, Masters thesis, 21 August 2009.

30

The Economist, 25 October 1879.

31

This point was first made forcefully by Hellwig (1995).

32

The fate of money market funds and the response by the Federal Reserve is vividly described in Bernanke (2015).

33

The vehicles were also known as conduits or structured investment vehicles (SIVs). Their liabilities were known as asset-backed commercial paper (ABCP).

34

Bagehot (1873), p. 49.

35

Calomiris and Haber (2014).

36

The five banks are Royal Bank of Canada, Toronto Dominion Bank, Bank of Nova Scotia, Bank of Montreal, and the Canadian Imperial Bank of Commerce.

37

Although deposit insurance schemes are nominally supported by the banking system as a whole, in times of crisis, as in 2008, the government provides the finance to ensure that depositors can be paid.

38

See the account of the rise and fall of Enron in McLean and Elkind (2004).

4 RADICAL UNCERTAINTY: THE PURPOSE OF FINANCIAL MARKETS

1

Paul Lambert lost his job in February 2015, an event which, despite his own advice, took him by surprise.

2

Gigerenzer (2002, 2015), Gigerenzer and Gray (2011).

3

Financial Times, 13 August 2007; in other words, the moves in prices that he observed were twenty-five times larger than the standard deviation, a measure of dispersion, of the past experience of changes in prices.

4

Syed (2011).

5

Smith (2012).

6

This example as discussed in Gigerenzer (2014).

7

This is an example of the ‘turkey illusion’, originated by Bertrand Russell (1912) and popularised by Taleb and Blyth (2011), in which the turkey mistakes the pattern of being fed each day for a process that will continue for ever, and is caught unawares when, the day before Thanksgiving, the farmer kills rather than feeds the turkey. The failure to understand the context, or the model, of the process leads to a big surprise for the turkey, similar to the surprise many homeowners got when house prices stopped rising.

8

Letter to Frederick William, Prince of Prussia, 28 November 1770, in Tallentyre, S.G., (1919), p. 232.

9

Knight (1921).

10

Malthus (1798), Chapter IX. 7.

11

The Actuarial Profession, a body of life assurance companies and annuity providers, forecast in 1980 that a man who was 60 in that year could expect to live another 20 years. At that time, it was thought that someone who reached 60 in 1999 would live a further 21 years. But by 1999 the forecast was that a man of 60 would live another 26 years. Over a twenty-year period, expected length of life was revised up by 5 years.

12

Other sources of inefficiencies in a market economy arise from monopoly, ‘externalities’ (unpriced outputs, such as pollution) or public goods, which create a prisoner’s dilemma in terms of how to fund them.

13

Samuelson (1937) and Houthakker (1950) showed that the assumption that rational agents would maximise expected utility could be derived from one basic axiom - the Generalised Axiom of Revealed Preference - that agents who choose among alternative outcomes A, B and C, and prefer B to C and A to B, would never choose C over A.

14

A good example is the bestseller by Levitt and Dubner, Freakonomics (2005).

15

Friedman (1953).

16

Gigerenzer (2002).

17

In the literature, this is known as the ‘gaze heuristic’ (Gigerenzer, 2014).

18

Keynes (1937a).

19

Although there is also no need to retain them in a world of radical uncertainty where coping strategies are about adapting to new environments, which may naturally result in decisions that appear inconsistent over time.

20

Kahneman (2011), Kahneman and Tversky (1979), Tversky and Kahneman (1974), Thaler (1991), Thaler and Sunstein (2008).

21

An early alternative to optimising theories was the idea of ‘satisficing’. It is the rule of thumb of searching through a set of alternatives until one of them meets some threshold of acceptability rather than searching for the optimum among the entire set (a sensible approach to dealing with an extensive menu in a restaurant when one would prefer to speak to a companion), and was proposed by Herbert Simon (1956). Satisficing is one possible rule of thumb for a class of problems where it is relatively easy from past experience to define an acceptability threshold. An interesting application of the concept of satisficing to monetary policy, using the rigorous tool of viability theory, is Krawczyk and Kim (2009). For other problems, where past experience offers little guide, it is of less use.

22

Kahneman (2011).

23

Gigerenzer and Brighton (2009).

24

Tuckett (2011), p.13.

25

For an example of the latest research into heuristics applied to inter-temporal decisions - that is, decisions that have consequences at different points in time - see Ericson, White, Laibson and Cohen (2015).

26

Knight (1921), p. 227.

27

Gigerenzer and Brighton (2009); Gigerenzer (2014).

28

In his remarkably original (and long) book Antifragile, Nassim Taleb proposes a general approach to embracing the unexpected. The opposite of fragile, he argues, is not robust but antifragile, a system that learns from shocks. As Taleb puts it, ‘A complex system, contrary to what people believe, does not require complicated systems and regulations and intricate policies. On the contrary, the simpler, the better. Complications lead to multiplicative chains of unanticipated effects.’

29

The standards are set by the so-called Basel Committee, comprising central bank governors and regulators of the group of G20 countries.

30

Aikman et al. (2014). ‘Failure’ is defined to include cases where it is judged that a bank would have defaulted without substantial government intervention of a kind not given to the generality of banks.

31

Shin (2009).

32

Tuckman (2015).

33

I am indebted, in a straightforward way, to Michael Pescod for this example.

34

Warren Buffett in his annual letter to Berkshire Hathaway shareholders of 2002.

35

For example, my own speech at the Mansion House, 20 June 2007: http://www.bankofengland.co.uk/archive/Documents/historicpubs/speeches/2007/speech313.pdf

36

See Tuckman (2013).

37

Knight (1921), p. 232. Arrow and Debreu themselves were well aware that, beautiful though their theoretical construction was, their achievement was to show that the conditions under which a competitive market economy was efficient were so restrictive as to be wholly implausible.

38

Grossman and Miller (1988).

39

The panel comprises between eight and sixteen banks, depending on the maturity and currency of the interest rate, and LIBOR is the average of the quoted rates after discarding extreme observations on either side.

40

Wheatley (2012), p. 30.

41

Similar improper and illegal behaviour was discovered in the foreign exchange market, and in 2015 a number of global banks were fined billions of dollars for their manipulation of the market.

42

The only sensible solution is to abandon LIBOR as a continuous benchmark rate and replace it with a rate on an instrument, such as an overnight official interest rate, not likely to suffer from the occasional disappearance of liquidity. Since such a large proportion of the existing stock of financial instruments uses LIBOR as the reference rate, a switch to an alternative would raise yet another prisoner’s dilemma: no one firm on its own could change the benchmark for derivative contracts. A much-needed change will take coordinated action among market participants, prodded by regulators and central banks.

43

The three were Eugene Fama, Robert Merton and Robert Shiller.

44

Schumpeter (1942).

45

Keynes (1936), p. 156.

46

See Tuckett (2012), who argues, ‘given that the prices of financial assets cannot be set by fundamentals - which are unknowable - they are set by stories about fundamentals - specifically the stories which market consensus at any one moment judges true. And because which stories are most popular and judged true can change very much quicker than fundamentals, asset valuations can change very rapidly indeed.’

47

A microsecond is one millionth of a second. The story of high frequency trading is told by Lewis (2014).

48

At present, high-frequency traders can learn about the order flow for a stock by placing a bid, receiving a quotation for the price, and then almost immediately (in microseconds) reversing or withdrawing the bid. With an auction system, they would receive no feedback on the bid until the auction had taken place.

49

This dimension of the structure of trading on stock markets was analysed long ago by Admati and Pfleiderer (1988).

5 HEROES AND VILLAINS: THE ROLE OF CENTRAL BANKS

1

Jarvie (1934).

2

Keynes (1931).

3

Goodhart (1988), pp. 122-3.

4

The Federal Reserve Act was passed by Congress and signed into law by President Woodrow Wilson on 23 December 1913.

5

The former was the description of Sir Joseph Banks, the English botanist who was President of the Royal Society for over forty years; the latter is from the magazine The Black Dwarf of 31 March 1819.

6

Veto Message Regarding the Bank of the United States, 10 July 1832 (emphasis added).

7

Goodhart (1988), chapter 5.

8

The slogan is also the title of a 2009 book by Congressman Ron Paul.

9

In his opinion (Ruling 11-779C, 15 June 2015), Judge Wheeler found that the Fed’s action ‘constituted an illegal exaction under the Fifth Amendment’ and that it ‘did not have the legal right to become the owner of AIG’. But, he also ruled, ‘the inescapable conclusion is that AIG would have filed for bankruptcy’ without the bailout and ‘the value of the shareholders’ common stock would have been zero.’ He declined to award any damages. The ruling could be appealed.

10

The concerns relate to Outright Monetary Transactions designed to bring down interest rates on periphery countries’ sovereign debt. In 2015 the European Court of Justice (ECJ) ruled them legal, but the German Federal Constitutional Court (FCC) has yet to respond. Whatever the outcome, the respective powers of the FCC and the ECJ are far from clear, creating some uncertainty about the legal powers of the ECB.

11

Hume (1752). See also Smith (1776).

12

In 1992 the UK adopted an inflation target for the Treasury and Bank of England together to achieve; independence in respect of monetary policy was granted to the Bank only in 1997.

13

Greenspan (2002).

14

Blinder (1995).

15

Gibbon (1776) Vol. 1, p. 346.

16

For a broader investigation of the independence movement among central banks see Crowe and Meade (2007).

17

‘Just do it’ is the phrase from the well-known Nike advertisement.

18

In a deep sense, only a complete understanding of the nature of the frictions makes it possible to decide on the objectives of monetary policy. Woodford (2003) and others discuss the link between that fundamental analysis and the proposition that monetary policy should aim to stabilise inflation and output.

19

The dual mandate was set out in the Federal Reserve Reform Act of 1977.

20

An excellent example is Interest and Prices by Michael Woodford (2003), which builds on the ideas of the Swedish economist Knut Wicksell one hundred years ago that the key to price stability lies in thinking about the appropriate path for future nominal interest rates.

21

The bill was introduced into the House on 8 July 2014.

22

For a discussion of the achievements of inflation targeting in reducing the level and volatility of inflation see King (2012).

23

The general confession in the Book of Common Prayer is ‘We have left undone those things which we ought to have done; and we have done those things which we ought not to have done; and there is no health in us.’

24

Paul Volcker was Chairman of the Federal Reserve from 1979 to 1987, and was the architect of the reduction in inflation in the United States during that period.

25

Albeit that the appointments of Mark Carney and Janet Yellen in 2013 added a certain glamour that was missing from their predecessors.

26

In October 1993 Chairman Greenspan disclosed in evidence before Congress that transcripts of committee meetings were kept. Publication of transcripts began in 1994 with a delay of five years.

27

Friedman (1956). Some of the most important and imaginative analysis of a monetary economy is contained in Patinkin (1956).

28

By ‘private sector’ I mean any private sector person or institution other than a bank. If a bank sells bonds to the central bank, there is no increase in the deposits of the non-bank private sector that corresponds to something that one can call money.

29

The nomenclature reflected the fact that creating money to purchase government bonds effectively meant that the government did not have to sell as much debt to the private sector and so was ‘underfunding itself’, whereas the opposite was the case when extra bonds were sold to limit the growth of money.

30

An injection of money into the economy will lead those people who sold bonds to the central bank to spend some of the money they received on other financial instruments, pushing up their price and lowering their yields relative to yields on government bonds. The difference between the yields on government bonds and yields on other financial instruments is called the risk premium or credit spread. Some economists, as a result, call QE credit easing.

31

Bernanke (2014).

32

Woodford (2013).

33

In tribute to the successful French Montignac diet, I like to call inflation targeting the monetary equivalent - Montignac monetarism.

34

Evidence by Sir Ernest Harvey to the Macmillan Committee in 1930.

35

Bernanke (2014).

36

Thornton (1802), p. 145 in the 1807 US edition published in Philadelphia by James Humphreys.

37

Cowen, Sylla and Wright (2009).

38

Evidence by Jeremiah Harman to the Committee of Secrecy on the Bank of England Charter in 1832, Minutes of Evidence, p. 154, response to Question 2217. Harman was Governor from 1816 to 1818 but gave evidence on behalf of the Bank.

39

The Bankers’ Magazine, June 1866, p. 646.

40

Bagehot (1873), p. 51.

41

See also Mehrling (2011).

42

Hankey (1867), p. 24 of 1887 edn.

43

Ibid, p. 29.

44

Friedman and Schwartz (1963).

45

I expressed my concerns about the parallels with 1914 in a breakfast meeting with Niall Ferguson on 15 December 2006. As he later wrote in a circular for Drobny Associates in 2007, ‘In his [the Governor’s] view, it was perfectly possible to imagine a liquidity crisis too big for the monetary authorities to handle alone. As in 1914, governments would need to step in.’ The two best accounts of the financial crisis of 1914 are Roberts (2013) for the story in London and Silber (2007) for events in New York.

46

Clark (1974).

47

Keynes (1914a), p.4.

48

Quoted in Fildes (2013).

49

Keynes (1914b), p. 473.

50

Grant (2014) and Silber (2007) differ as to the role of McAdoo in the closing of the exchange.

51

Quoted in Roberts (2013), p. 109.

52

Lloyd George (1933), p. 62.

53

Ibid, p. 62.

54

Keynes (1914a), p. 484.

55

A bottle of champagne is offered to the first reader who can identify the source of this quotation.

56

Lloyd George (1933), p. 66.

57

The need to recapitalise the banks was at the heart of the policy discussions between the Bank of England and the British government throughout 2008. It culminated in the announcement on Wednesday 8 October 2008 of a major recapitalisation of UK banks (and a coordinated interest rate cut by the principal central banks). And the turning point of the crisis was when the Americans followed the UK’s example and announced that they would use the money reluctantly appropriated by Congress for the so-called Troubled Asset Relief Program (TARP) to recapitalise their banks instead. When that duly happened in the spring of 2009, following the stress tests of US banks, the banking crisis effectively ended.

58

MacGregor (2014).

59

Roberts (2013), p. 165.

60

Comptroller of the Currency, Annual Report 1907, p. 74, quoted in Silber (2007), p. 77.

61

Silber (2007), p. 81.

62

Daily Gazetteer, 7 April 1737.

6 MARRIAGE AND DIVORCE: MONEY AND NATIONS

1

Mundell (1961).

2

There is much more to an optimum currency area than considerations of trade and changes in competitiveness. Agreement on the objectives of monetary policy, and in particular on the importance of price stability, is essential to a happy union. Chari et al. (2013) have extended the economic calculus of monetary unions to include the benefits of associating with like-minded countries to insure each other against idiosyncratic shocks to market ‘credibility’.

3

Colley (2014), pp. 9-10.

4

Mill, John Stuart (1848), p. 153.

5

http://www.nytimes.com/2014/11/15/world/middleeast/islamic-state-says-it-plans-to-issue-its-own-currency-.html

6

The International Organisation for Standardisation (ISO) lists 152 currency codes for official currencies; the IMF membership, adjusting for monetary unions, accounts for (with the addition of Cuba) 146 currencies - Table 2 of the 2014 IMF Annual Report on Exchange Arrangements and Exchange Restrictions.

7

Wales was formally annexed to England in 1542. The Acts of Union of 1707 created the Kingdom of Great Britain. The Acts of Union of 1800 incorporated Ireland into the United Kingdom of Great Britain and Ireland. Following the creation of the Irish Free State in 1921, and the resulting partition of Ireland, the United Kingdom of Great Britain and Northern Ireland came into being in 1927.

8

In the many discussions I had with colleagues in Europe, I was struck that more than one of them saw in European Monetary Union the opportunity to recreate the Holy Roman Empire.

9

The seven were Bosnia, Croatia, Kosovo, Macedonia, Montenegro, Serbia and Slovenia.

10

In practice the LMU ended in 1914, although some elements of its formal structure limped on until 1927; see Flandreau (2000).

11

Only after its nationalisation in 1946 was the Bank of England able to print notes depicting the sovereign. The first such banknote containing the Queen’s head appeared in 1960. Coins were produced not by the Bank of England but by the Royal Mint, under the UK Treasury, and had depicted the sovereign for many centuries.

12

Mohr (2014).

13

Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal and Spain were founder members in 1999. Subsequent joiners were Greece in 2001, Slovenia in 2007, Cyprus and Malta in 2008, Slovakia in 2009, Estonia in 2011, Latvia in 2014 and Lithuania in 2015.

14

Bagehot (1869), p. 9.

15

Jackson (2001).

16

This view was especially associated with Tommaso Padoa-Schioppa, a key adviser to Jacques Delors, President of the European Commission, and later a leading Italian central bank and government official. He was briefly finance minister of Italy.

17

Quoted in Alexander Woollcott, ‘The First Mrs. Tanqueray’, While Rome Burns (1934).

18

An excellent account of the birth of the euro is Issing (2008).

19

World Bank database.

20

Translation of letter from Archbishop Hieronymos to Prime Minister Papademos by staff at the Bank of England; the letter was posted on the website of the Archdiocese of Athens on 2 February 2012.

21

https://www.ecb.europa.eu/press/key/date/2012/html/sp120726.en.html

22

In January 2015, the Advocate General of the European Court of Justice stated that the programme was in principle compatible with the Treaty on the Functioning of the European Union, provided that it was for the purpose of monetary policy. It is not easy to see how purchases of the debt of some countries but not others can be construed as solely an act of monetary policy. The Advocate General also raised questions about the potential conflict between the ECB’s roles in setting conditions for the eligibility of a country to join the programme and in deciding to buy sovereign debt.

23

Figures from Eurostat.

24

http://www.theguardian.com/news/datablog/2014/oct/02/crowdsourcing-youth-migration-from-southern-europe-to-the-uk. See also data from the respective national statistical organisations.

25

http://www.bbc.co.uk/news/world-europe-33535205

26

IMF Country Report No. 15/186, International Monetary Fund, Washington DC, 14 July 2015.

27

Connolly (1997).

28

If full-employment current account deficits (the trade deficit plus the net costs of servicing external debt) as a share of GDP returned to their 2007 levels then the external financing requirements of Greece, Portugal and Spain alone (ignoring Italy and France) would amount to 4.2 per cent of the GDP of Germany and the Netherlands (IMF WEO database, April 2015).

29

John Maynard Keynes, New Statesman and Nation, 10 July 1937.

30

Bergsten (2014).

31

Issing (2015).

32

‘The German export success of German business also helps others in Europe … The eurozone as a whole has a level external balance. Without our contribution, we would, in relation to the rest of the world, have a rather serious situation.’ Wolfgang Schäuble, German Finance Minister, Financial Times, 30 June 2014.

33

The essay by Brendan Simms (http://www.newstatesman.com/politics/2015/07/why-we-need-british-europe-not-european-britain), which argues that political unions are events, not gradual processes, is persuasive in that, having moved to monetary union, the option of a gradual convergence and eventual political union in the euro area has been removed.

34

At no stage did the Kurdish groups lay claim to the Swiss dinar as their currency. They had no control over it, as shown by the interview given to Gulf News on 30 January 2003 by the Kurdistan Regional Government Prime Minister Barzani, who said, ‘We don’t have our own currency.’

35

Sources for this data include the United Nations (from the oil-for-food programme) and the Central Bank of Iraq.

36

Compiled by the Central Bank of Iraq, based on data collected by the United Nations World Food Program.

37

See Bank of England Museum (2010).

38

Although banknotes issued by Scottish banks are already in existence, by law they have to be fully backed by English banknotes - special million-pound notes printed by the Bank of England for this very purpose.

39

The experience of dollarisation is discussed extensively by Bogetic (2000). In the absence of its own currency, a dollarised country cannot print money to finance government expenditure. A spendthrift government may be tempted to abandon dollarisation and print its own money. In 2014, President Correa of Ecuador announced that it would start to issue its own digital currency. Panama minted its own coins - the balboa - in 2011 - and it is unclear whether these are fully backed by a combination of US dollars and the metallic value of the coins themselves. Several countries have adopted the euro, including Montenegro, which is not a member of the European Union.

40

There would also be no loss of tax revenues to a Scottish government. At present Scotland does not receive tax revenues on the profits of the large banks resident there, because as part of the United Kingdom it has no separate corporation tax.

7 INNOCENCE REGAINED: REFORMING MONEY AND BANKING

1

Bagehot (1873), p. 158-9.

2

Blakey (1839), p. 4.

3

The book is attributed variously to Robert Blakey (by the British Library and the Bodleian), Thomas Doubleday (by Goldsmiths Catalogue, and Ashton, Fryson & Roberts, 1999) and Thomas Ainge Devyr (in a handwritten entry in the first edition in my possession). Robert Blakey was a radical politician in the North-East of England in the nineteenth century. He was the owner of the Northern Liberator, a radical Newcastle paper. Thomas Doubleday was a close friend of Blakey and was one of the main contributors to the paper. Devyr, an Irishman, was the paper’s sub-editor. He later emigrated to New York to escape prosecution for conspiring to promote violent Chartist activities. Devyr’s career was described by an American friend: ‘he was a Nationalist in Ireland, a Chartist in England, a kind of revolutionist even in America. Anyway, he had only scorn and contempt for the politicians of America’ (Adams, 1903). Blakey was prosecuted for seditious libel, eventually pleading guilty, and was bound over to keep the peace for three years. He closed the Northern Liberator in 1840.

4

Blakey (1839), pp. 58-9.

5

In today’s money roughly equivalent to £5000.

6

In the UK, ring-fencing followed the recommendations of the Independent Commission on Banking chaired by Sir John Vickers, which reported in 2011, and in the US the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 included the so-called Volcker rule, which outlawed proprietary trading for their own account by banks.

7

Basel Committee on Banking Supervision, Regulatory Consistency Assessment Program Analysis of Risk-weighted Assets for Credit Risk in the Banking Book, July 2013.

8

Bingham (2010) relates the story of a case in Britain in which neither the lawyers nor the judges realised that the relevant regulations applying to the case at hand had changed between the date of the alleged offence and the date of the hearing because there was no easy way of finding out.

9

Mansfield (1761).

10

Haldane (2013).

11

Information supplied by the Bank of England.

12

A comprehensive survey of proposals to end fractional reserve banking is Lainà (2015).

13

A six-page memorandum describing the plan was circulated confidentially by Henry Simons to about forty individuals in 1933.

14

Fisher (1936a, 1936b), Friedman (1960), Minsky (1994), Tobin (1985).

15

Keynes was nevertheless scathing about bankers. In his memoir of Keynes published by King’s College, Cambridge, in 1949, G. Wansborough wrote: ‘many of us will remember with what unholy joy we used to read in the Nation his annual review of the speeches of the Bank Chairmen, which he greeted, if I remember his words, as “the twittering of swallows to presage the end of winter”.’ He went on, ‘his very brilliance of exposition probably frustrated to some extent the contribution he had to make to the formation of policy; and if he had been more tender of the susceptibilities of those in high places, his wisdom would probably have brought practical advantage to this country many years earlier than it did.’

16

Cochrane (2014), Benes and Kumhof (2012), Jackson and Dyson (2013), Kay (2009, 2015), Kotlikoff (2010), Wolf (2014).

17

As proposed by Kareken (1986) and Litan (1987).

18

Although the Chicago Plan did not envisage the separation of a bank into two parts, the implication of 100 per cent reserves is that banks could not create deposits by extending loans. In economic terms, therefore, a bank would be in effect a combination of a narrow bank and a wide bank, with no ability to mix the financing of safe and risky assets.

19

The advantage claimed by Benes and Kumhof (2012) that government debt and interest would be sharply reduced relies heavily on the assumption that seigniorage income (the profit derived from printing money) would rise because the central bank would not pay interest on reserves. That is unlikely to be sustainable if public money is to survive on the same scale as private money at present, and paying interest on reserves is a feature of a growing number of central banks for purposes of monetary management.

20

Fisher (1936b), p. 15.

21

See the discussion in Holmstrom (2015).

22

Geithner (2014), p. 508.

23

Sedgwick (1840), pp. 104-5.

24

Bulow and Klemperer (2013, 2015) have been thinking about the use of collateral in the context of reforming the capital regulation of banks and the allocation of losses when banks fail.

25

Such assets could not also be used as collateral with other creditors.

26

A more sophisticated, albeit more complicated, measure of effective liquid liabilities would be to weight liabilities by their remaining duration. Short-term secured borrowing, such as in the repo markets, is excluded because if the lender doesn’t roll over the loan the bank receives back the collateral which can be either sold to provide liquid funds, used to borrow from another lender, or taken to the central bank.

27

Institutions that appear to offer to redeem holdings of illiquid assets at fixed prices, money market funds and certain other fund managers, for example, should either make clear that redemptions will be at actual transaction prices or subject to the regulation of the PFAS - see Cochrane (2014).

28

Federal Reserve Board, Banking Statistics Table 5, return H.4.1.

29

Reserve Bank of Australia, Domestic Market Operations August 2015, http://www.rba.gov.au/mkt-operations/dom-mkt-oper.html#tiotb3ls

30

See the persuasive arguments in Admati and Hellwig (2013). In recent years, there has been much interest in the idea of creating new forms of debt that are ‘bail-inable’ - that is, convertible into equity - in the event that the bank crosses a threshold determined either by a regulator or a particular level of its capital ratio. The most interesting of these new instruments is the proposal for equity recourse notes by Jeremy Bulow and Paul Klemperer (2015), which is designed to provide incentives for banks to issue equity. Once markets understand that such forms of debt really are bail-inable, and that the authorities will not hesitate to enforce that option, then it is hard to see, other than its potential to reduce a bank’s tax liability, why the market would price such debt differently from equity. The decision in November 2015 by the Financial Stability Board to count bail-inable debt issued by other banks as part of the effective loss-absorbing capacity of banks is a backward step and weakens the system. Equity has the attraction that it absorbs losses without the intervention of a regulator to trigger the bail-in. Bank resolution would naturally go hand-in-hand with a greater reliance on instruments such as bail-inable debt or contingent capital. Problems will arise if such debt is held by other leveraged firms, because a bail-in to protect firm A could lead to problems in firm B and so on. Equity held by final investors is the only safe buffer to absorb losses. Moreover, all resolution regimes, being legal instruments, are inherently national in character. Banks are global in life and national in death. There would be enormous challenges in resolving global banks that spanned countries with different legal jurisdictions. The prospective failure of a large cross-border bank would, I fear, prompt telephone calls between political leaders to override regulators and prevent the closure of a well-known institution. The only satisfactory defence against failure is to finance with equity.

31

Admati and Hellwig (2013) recommend a ratio of 20 per cent or more. That could be a long-term objective.

32

Bank of England, http://www.bankofengland.co.uk/markets/Documents/smf/annualreport15.pdf

33

Rogoff (2014).

34

In the US bank robberies fell from 7556 in 2004 to 3961 in 2014 (Federal Bureau of Investigation Bank Crime Statistics, 2004 and 2014). The increase of cybercrime is analysed in the 2014 US State of Cybercrime Survey, www.pwc.com/cybersecurity

35

This system, effectively a public ledger of all current and past transactions, is known as the block chain technology.

36

Similar huge swings in prices can be seen in related digital currencies, for example Scotcoins in Scotland.

37

http://auroracoin.org

38

Although, unlike cash, transactions with bitcoins leave a permanent record in the software accounting system, leading commentators such as Brito and Castillo (2013) to describe them not as anonymous but pseudonymous. Money stored as bitcoins can also be stolen by hackers or lost through carelessness, just as cash is vulnerable to theft or loss.

39

Yermack (2013) provides data on the relative volatilities of the prices of bitcoins, gold and the major currencies. The volatility of bitcoins is an order of magnitude higher than the other currencies.

40

Economies of this kind have been discussed by Fama (1980), Hall (1983) and Issing (1999).

41

On money as a unit of account see Doepke and Schneider (2013).

42

Magna Carta, chapter 35, translation of the original Latin of 1215.

43

Hayek (1976). A theoretical discussion can be found in King (1983) and the response by Summers (1983).

44

The second possible problem with a free market in paper money is that, even with a common unit of account, new entrants can undermine confidence in existing monies. Suppose that we start with one paper money, which is called a dollar. The cost of printing a dollar banknote is at most a few cents. So the right to print money is very profitable, provided the issue does not have to be backed by real assets of equivalent value. Now suppose that other issuers are allowed to enter. If they can print currency with a face value of a dollar, they might be tempted to issue new notes backed by fewer real assets (whether gold or loans). If the market can correctly value these new notes they will sell at a discount, as in the world of free banking discussed in Chapter 2. But if consumers have difficulty in valuing the notes of different banks, or if by law they must exchange at par, then the new notes will be used to make payments and the older ones hoarded. The new entrants will earn large profits. In the limit, the supply of currency might expand until its value was equal to the cost of printing the notes. Bad money would have driven out good. This phenomenon is known as Gresham’s Law, after Sir Thomas Gresham, a sixteenth-century British crown agent, who explained why debased coins issued by Henry VIII were circulating widely and the older coins had disappeared from circulation. That, of course, is exactly the aim of counterfeiters of official banknotes today, and it is why Mr Van Court’s Banknote Reporter included information to aid the detection of counterfeits.

45

See the excellent recent book by Kay (2015).

46

A sermon preached to the annual service of Barclays Bank in May 1955 by the Reverend J. d’E. Firth who, as a pupil in 1918, took all ten wickets for Winchester against Eton (reprinted in The Trusty Servant, Winchester College, May 2010).

47

Financial Times, 19 December 2014.

48

Blakey (1839), p. 6.

49

Keynes (1936), p. 383.

50

Ibid, p. 383: ‘Practical men who believe themselves to be quite exempt from any intellectual influence are usually the slaves of some defunct economist.’

8 HEALING AND HUBRIS: THE WORLD ECONOMY TODAY

1

IMF World Economic Outlook Database, Spring 2015.

2

Reinhart and Rogoff (2009).

3

Central banks have been referring to ‘headwinds’ regularly since 2008; for a number of years the Bank for International Settlements promoted the idea that the risks from rising levels of debt were a threat to stability and that the resulting crisis was a ‘balance sheet recession’ (see various of their annual reports). Lawrence Summers, the Harvard economist and former Treasury Secretary, argued at an International Monetary Fund conference on 16 November 2013 that an age of secular stagnation, in which the equilibrium interest rate was negative, might explain the lack of inflationary pressure before the crisis of 2008 and the lack of growth after it.

4

Keynes himself described his work as a contrast to the ‘classical’ theory of economics. The counter-revolution is described as ‘neoclassical’ economics, but is in the same tradition as the ‘classical’ approach of Walras, Ricardo, Marshall and Pigou. More recently, there has been an attempt to integrate the two in a so-called New Keynesian model, which I discuss later in Chapter 8.

5

Keynes (1936), chapter 12, p. 161.

6

US Energy Information Administration.

7

There are many grades of crude oil, but two benchmarks have emerged, Brent and West Texas Intermediate, traded on ICE Futures Europe (formerly the International Petroleum Exchange) in London and the New York Mercantile Exchange (NYMEX) respectively. In addition, there is an active over-the-counter market in bilateral transactions.

8

Several theoretical papers have tried to express coordination failures in terms of an abstract game-theoretic description of an economy; for example, Cooper and John (1988) and, more recently, Angeletos et al. (2014). Such abstraction is not necessary to understand the coordination problem, even if its consequences are fundamental.

9

Krugman (2011).

10

Other path-breaking contributions were made by, among others, the American economists Tom Sargent and Neil Wallace.

11

Random shifts in the distributions generating shocks in a neoclassical model, termed ‘extrinsic uncertainty’ by Hendry and Mizon (2014), are similar to radical uncertainty.

12

Such models were described as ‘New Keynesian’ despite the fact that Keynes’s view of recessions did not depend on the slow adjustment of wages and prices to external shocks and that the essence of Keynes, namely radical uncertainty and the resulting prisoner’s dilemma, was absent from them.

13

They are sometimes described as ‘dynamic stochastic general equilibrium’ (DSGE) models, and have become the basis for much modern macroeconomics. In particular, the forecasting models used by central banks around the world to analyse monetary policy are New Keynesian DSGE models.

14

In practice, central banks also look carefully at survey estimates of inflation expectations and the behaviour of yields on index-linked government securities when making forecasts, but those forecasts revert to target for the reasons explained in the text.

15

There is room for debate over how many of the political events mentioned here could have been foreseen, and incorporated into model forecasts, and how many represented radical uncertainty. But the general point stands.

16

One view that most economists do not find compelling is that there are times in which people want to spend less and take more leisure, and periods in which they want to do the opposite. The former are periods in which employment is low and the latter in which it is high. Business cycles are rational phenomena. Such models are called ‘real business cycle’ models.

17

Minsky (1975, 1986). He died in 1996, some twelve years or so before there was a resurgence of interest in his ideas.

18

See Gennaioli, Shleifer and Vishny (2015), and Eggertsson and Krugman (2012).

19

Such features are sometimes described as ‘financial frictions’, which gives the game away because they are seen as tweaks to a basically true model rather than posing a challenge to the model itself.

20

Keynes (1936), p. 96.

21

Keynes (1923a), p. 80.

22

Hicks (1974), p. 1.

23

The phrase the ‘NICE decade’ was used first in King (2003).

24

Inaugural Address of President Franklin D. Roosevelt, Saturday 4 March 1933. More modern discussions of the effect of lack of confidence on aggregate economic activity can be found in the work of George-Marios Angeletos (Angeletos et al., 2014) and Roger Farmer (Farmer, 2012).

25

Greenspan (2014), p. 44.

26

A perceptive discussion of why the post-war period experienced more stable investment growth than in earlier periods is Matthews (1960).

27

Davidsson (2011). In the UK reforms were instituted in the 1980s, and elsewhere in Europe introduced much later. For example, the so-called Hartz plan to make new job creation easier was implemented in Germany by Chancellor Schröder in 2003.

28

After re-unification of Germany in 1990, for a period Germany ran a trade deficit but over time this became a substantial trade surplus.

29

Borrowing against the increase in the value of your home, and using the proceeds to finance consumption, is described as ‘equity withdrawal’.

30

One explanation of the Federal Reserve’s statistical evidence was that it was drawn from a period in which many of the movements in house prices coincided with upswings and downswings in the economy. Those swings would be likely to have generated corresponding changes in consumer spending, which would be correlated with, but not caused by, changes in house prices.

31

IMF World Economic Outlook Database, April 2015.

32

Caruana (2014).

33

Turner (2014).

34

Taylor (2015).

35

King (2009).

36

Grant (2014).

37

Ibid.

38

Ibid.

39

See the minutes of the Monetary Policy Committee, especially during 2001. All MPC minutes are available at www.bankofengland.co.uk/publications/minutes/Pages/mpc/

40

As anticipated in King (2000).

41

See in particular the minutes of the MPC for January 2002.

42

http://www.bankofengland.co.uk/publications/Documents/speeches/2002/speech156.pdf

43

Consistent with this, those on the MPC most worried about the high level of the exchange rate advocated lower, not higher, interest rates in order to bring about a depreciation, at the risk of making the imbalances more acute.

9 THE AUDACITY OF PESSIMISM: THE PRISONER’S DILEMMA AND THE COMING CRISIS

1

Bagehot (1873), pp. 138-9.

2

Standard and Poor’s and Financial Times, 23 November 2015.

3

IMF World Economic Database, October 2015.

4

Reparations imposed on countries other than Germany were dropped rather quickly, given the state of their economies.

5

Keynes (1919).

6

Schacht (1877-1970) was not a man to hide his light under a bushel. He was President of the Reichsbank from 1923 to 1930 and again from 1933 to 1939, and later Hitler’s Economic Affairs Minister. He was imprisoned for a number of years, and subsequently acquitted by a denazification court in 1950. Schacht was later immortalised by Liaquat Ahamed in his book Lords of Finance, about the four central bank governors (Schacht, Montagu Norman, Benjamin Strong and Emile Moreau) who worked together in the 1920s and dominated international finance during that period.

7

Schacht (1934).

8

Schacht (1955), p. 211. As he wrote, ‘my opponents in this struggle [against foreign indebtedness] were as short-sighted as they were numerous’ (Ibid., p. 217).

9

Benjamin Friedman (2014) has made this point forcefully.

10

John Maynard Keynes (1923b), Collected Writings, Vol. 18, p. 14.

11

Samuel Taylor Coleridge’s poem The Rime of the Ancient Mariner, published in 1798, contained the line ‘Water, water, everywhere, nor any drop to drink’.

12

The Five Presidents’ Report, ‘Completing Europe’s Economic and Monetary Union’, European Commission, 22 June 2015, Brussels.

13

Issing (2015).

14

Keynes (1923b), p. 41.

15

In economists’ language, the equilibrium full-employment exchange rate for a country is, at least temporarily, below its long-term equilibrium level.

16

Rodrik (2011).

17

Macdonald (2015), p. 217.

18

If GDP is measured at purchasing power parity rather than market exchange rates, then China became the largest economy in the world in 2014.

19

A perceptive analysis was outlined by Paul Keating (2014).

20

Macdonald (2015).

21

Taylor (2014).

22

See, for example, Gordon (2016).

23

http://www.bls.gov/news.release/pdf/prod3.pdf

24

Weale (2015) reports similar data for OECD countries as a whole. Experimental data for the UK from the Office for National Statistics (http://www.ons.gov.uk/ons/publications/re-reference-tables.html?edition=tcm%3A77-386314) suggests that over the same period annual multifactor productivity growth fell from around 0.75 per cent to a negative rate. Estimates of negative growth rates suggest measurement error rather than technical progress.

25

http://www.bls.gov/news.release/pdf/prod3.pdf

26

Field (2012).

27

For example, Keynes (1937b) and Reddaway (1939).

28

Whether the pre-crisis path of total output (GDP) will be reached depends on the growth of population and participation in the labour force, both of which are notoriously difficult to predict (Goodhart et al. 2015).

29

Marx and Engels (1848).

30

See, for example, Solow (1956).

31

For example, the communiqué of the G20 finance ministers and central bank governors meeting on 9-10 February 2015 in Istanbul.

32

Winston Churchill, Speech to the Economic Club of New York, 9 February 1932.

33

Lloyd George (1933), Vol. I, p. 74.

34

Acheson (1969).