The End of Alchemy: Money, Banking, and the Future of the Global Economy - Mervyn King (2017)
Chapter 1. THE GOOD, THE BAD AND THE UGLY
‘I think that Capitalism, wisely managed, can probably be made more efficient for attaining economic ends than any alternative system yet in sight.’
John Maynard Keynes, The End of Laissez-faire (1926)
‘The experience of being disastrously wrong is salutary; no economist should be spared it, and few are.’
John Kenneth Galbraith, A Life in Our Times (1982)
History is what happened before you were born. That is why it is so hard to learn lessons from history: the mistakes were made by the previous generation. As a student in the 1960s, I knew why the 1930s were such a bad time. Outdated economic ideas guided the decisions of governments and central banks, while the key individuals were revealed in contemporary photographs as fuddy-duddies who wore whiskers and hats and were ignorant of modern economics. A younger generation, in academia and government, trained in modern economics, would ensure that the Great Depression of the 1930s would never be repeated.
In the 1960s, everything seemed possible. Old ideas and conventions were jettisoned, and a new world beckoned. In economics, an influx of mathematicians, engineers and physicists brought a new scientific approach to what the nineteenth-century philosopher and writer Thomas Carlyle christened the ‘dismal science’.1 It promised not just a better understanding of our economy, but an improved economic performance.
The subsequent fifty years were a mixed experience. Over that period, national income in the advanced world more than doubled, and in the so-called developing world hundreds of millions of people were lifted out of extreme poverty. And yet runaway inflation in the 1970s was followed in 2007-9 by the biggest financial crisis the world has ever seen. How do we make sense of it all? Was the post-war period a success or a failure?
The origins of economic growth
The history of capitalism is one of growth and rising living standards interrupted by financial crises, most of which have emanated from our mismanagement of money and banking. My Chinese colleague spoke an important, indeed profound, truth. The financial crisis of 2007-9 (hereafter ‘the crisis’) was not the fault of particular individuals or economic policies. Rather, it was merely the latest manifestation of our collective failure to manage the relationship between finance - the structure of money and banking - and a capitalist system. Failure to appreciate this explains why most accounts of the crisis focus on the symptoms and not the underlying causes of what went wrong. The fact that we have not yet got the hang of it does not mean that a capitalist economy is doomed to instability and failure. It means that we need to think harder about how to make it work.
Over many years, a capitalist economy has proved the most successful route to escape poverty and achieve prosperity. Capitalism, as I use the term here, is an economic system in which private owners of capital hire wage-earners to work in their businesses and pay for investment by raising finance from banks and financial markets.2 The West has built the institutions to support a capitalist system - the rule of law to enforce private contracts and protect property rights, intellectual freedom to innovate and publish new ideas, anti-trust regulation to promote competition and break up monopolies, and collectively financed services and networks, such as education, water, electricity and telecommunications, which provide the infrastructure to support a thriving market economy. Those institutions create a balance between freedom and restraint, and between unfettered competition and regulation. It is a subtle balance that has emerged and evolved over time.3 And it has transformed our standard of living. Growth at a rate of 2.5 per cent a year - close to the average experienced in North America and Europe since the Second World War - raises real total national income twelvefold over one century, a truly revolutionary outcome.
Over the past two centuries, we have come to take economic growth for granted. Writing in the middle of that extraordinary period of economic change in the mid-eighteenth century, the Scottish philosopher and political economist, Adam Smith, identified the source of the breakout from relative economic stagnation - an era during which productivity (output per head) was broadly constant and any increase resulted from discoveries of new land or other natural resources - to a prolonged period of continuous growth of productivity: specialisation. It was possible for individuals to specialise in particular tasks - the division of labour - and by working with capital equipment to raise their productivity by many times the level achieved by a jack-of-all-trades. To illustrate his argument, Smith employed his now famous example of a pin factory:
A workman … could scarce, perhaps, with his utmost industry, make one pin in a day, and certainly could not make twenty. But in the way in which this business is now carried on, not only the whole work is a peculiar trade, but it is divided into a number of branches. One man draws out the wire, another straights it, a third cuts it, a fourth points it, a fifth grinds it at the top for receiving the head … The important business of making a pin is, in this manner, divided into about eighteen distinct operations, which, in some manufactories, are all performed by distinct hands.4
The factory Smith was describing employed ten men and made over 48,000 pins in a day.
The application of technical knowhow to more and more tasks increased specialisation and raised productivity. Specialisation went hand in hand with an even greater need for both a means to exchange the fruits of one’s labour for an ever wider variety of goods produced by other specialists - money - and a way to finance the purchase of the capital equipment that made specialisation possible - banks. As each person in the workforce became more specialised, more machinery and capital investment was required to support them and the role of money and banks increased. After a millennium of roughly constant output per person, from the middle of the eighteenth century productivity started, slowly but surely, to rise.5 Capitalism was, quite literally, producing the goods. Historians will continue to debate why the Industrial Revolution occurred in Britain - population growth, plentiful supplies of coal and iron, supportive institutions, religious beliefs and other factors all feature in recent accounts. But the evolution of money and banking was a necessary condition for the Revolution to take off.
Almost a century later, with the experience of industrialisation and a massive shift of labour from the land to urban factories, socialist writers saw things differently. For Karl Marx and Friedrich Engels the future was clear. Capitalism was a temporary staging post along the journey from feudalism to socialism. In their Communist Manifesto of 1848, they put forward their idea of ‘scientific socialism’ with its deterministic view that capitalism would ultimately collapse and be replaced by socialism or communism. Later, in the first volume of Das Kapital (1867), Marx elaborated (at great length) on this thesis and predicted that the owners of capital would become ever richer while excessive capital accumulation would lead to a falling rate of profit, reducing the incentive to invest and leaving the working class immersed in misery. The British industrial working class in the nineteenth century did indeed suffer miserable working conditions, as graphically described by Charles Dickens in his novels. But no sooner had the ink dried on Marx’s famous work than the British economy entered a long period of rising real wages (money wages adjusted for the cost of living). Even the two world wars and the intervening Great Depression in the 1930s could not halt rising productivity and real wages, and broadly stable rates of profit. Economic growth and improving living standards became the norm.
But if capitalism did not collapse under the weight of its own internal contradictions, neither did it provide economic security. During the twentieth century, the extremes of hyperinflations and depressions eroded both living standards and the accumulated wealth of citizens in many capitalist economies, especially during the Great Depression in the 1930s, when mass unemployment sparked renewed interest in the possibilities of communism and central planning, especially in Europe. The British economist John Maynard Keynes promoted the idea that government intervention to bolster total spending in the economy could restore full employment without the need to resort to fully fledged socialism. After the Second World War, there was a widespread belief that government planning had won the war and could be the means to win the peace. In Britain, as late as 1964 the newly elected Labour government announced a ‘National Plan’. Inspired by a rather naive version of Keynesian ideas, it focused on policies to boost the demand for goods and services rather than the ability of the economy to produce them. As the former outstripped the latter, the result was inflation. On the other side of the Atlantic, the growing cost of the Vietnam War in the late 1960s also led to higher inflation.
Rising inflation put pressure on the internationally agreed framework within which countries had traded with each other since the Bretton Woods Agreement of 1944, named after the conference held in the New Hampshire town in July of that year. Designed to allow a war-damaged Europe slowly to rebuild its economy and reintegrate into the world trading system, the agreement created an international monetary system under which countries set their own interest rates but fixed their exchange rates among themselves. For this to be possible, movements of capital between countries had to be severely restricted - otherwise capital would move to where interest rates were highest, making it impossible to maintain either differences in those rates or fixed exchange rates. Exchange controls were ubiquitous, and countries imposed limits on investments in foreign currency. As a student, I remember that no British traveller in the 1960s could take abroad with them more than £50 a year to spend.6
The new international institutions, the International Monetary Fund (IMF) and the World Bank, would use funds provided by its members to finance temporary shortages of foreign currency and the investment needed to replace the factories and infrastructure destroyed during the Second World War. Implicit in this framework was the belief that countries would have similar and low rates of inflation. Any loss of competitiveness in one country, as a result of higher inflation than in its trading partners, was assumed to be temporary and would be met by a deflationary policy to restore competitiveness while borrowing from the IMF to finance a short-term trade deficit. But in the late 1960s differences in inflation across countries, especially between the United States and Germany, appeared to be more than temporary, and led to the breakdown of the Bretton Woods system in 1970-1. By the early 1970s, the major economies had moved to a system of ‘floating’ exchange rates, in which currency values are determined by private sector supply and demand in the markets for foreign exchange.
Inevitably, the early days of floating exchange rates reduced the discipline on countries to pursue low inflation. When the two oil shocks of the 1970s - in 1973, when an embargo by Arab countries led to a quadrupling of prices, and 1979, when prices doubled after disruption to supply following the Iranian Revolution - hit the western world, the result was the Great Inflation, with annual inflation reaching 13 per cent in the United States and 27 per cent in the United Kingdom.7
From the late 1970s onwards, the western world then embarked on what we can now see were three bold experiments to manage money, exchange rates and the banking system better. The first was to give central banks much greater independence in order to bring down and stabilise inflation, subsequently enshrined in the policy of inflation targeting - the goal of national price stability. The second was to allow capital to move freely between countries and encourage a shift to fixed exchange rates both within Europe, culminating in the creation of a monetary union, and in a substantial proportion of the most rapidly growing part of the world economy, particularly China, which fixed its exchange rates against the US dollar - the goal of exchange rate stability. And the third experiment was to remove regulations limiting the activities of the banking and financial system to promote competition and allow banks both to diversify into new products and regions and to expand in size, with the aim of bringing stability to a banking system often threatened in the past by risks that were concentrated either geographically or by line of business - the goal of financial stability.
These three simultaneous experiments might now be best described as having three consequences - the Good, the Bad and the Ugly. The Good was a period between about 1990 and 2007 of unprecedented stability of both output and inflation - the Great Stability. Monetary policy around the world changed radically. Inflation targeting and central bank independence spread to more than thirty countries. And there were significant changes in the dynamics of inflation, which on average became markedly lower, less variable and less persistent.8
The Bad was the rise in debt levels. Eliminating exchange rate flexibility in Europe and the emerging markets led to growing trade surpluses and deficits. Some countries saved a great deal while others had to borrow to finance their external deficit. The willingness of the former to save outweighed the willingness of the latter to spend, and so long-term interest rates in the integrated world capital market began to fall. The price of an asset, whether a house, shares in a company or any other claim on the future, is the value today of future expected returns (rents, the value of housing services from living in your own home, or dividends). To calculate that price one must convert future into current values by discounting them at an interest rate. The immediate effect of a fall in interest rates is to raise the prices of assets across the board. So as long-term interest rates in the world fell, the value of assets - especially of houses - rose. And as the values of assets increased, so did the amounts that had to be borrowed to enable people to buy them. Between 1986 and 2006, household debt rose from just under 70 per cent of total household income to almost 120 per cent in the United States and from 90 per cent to around 140 per cent in the United Kingdom.9
The Ugly was the development of an extremely fragile banking system. In the USA, Federal banking regulators’ increasingly lax interpretation of the provisions to separate commercial and investment banking introduced in the 1933 Banking Act (often known as Glass-Steagall, the two senators who led the passage of the legislation) reached its inevitable conclusion with the Gramm-Leach-Bliley Act of 1999, which swept away any remaining restrictions on the activities of banks. In the UK, the so-called Big Bang of 1986, which started as a measure to introduce competition into the Stock Exchange, led to takeovers of small stockbroking firms and mergers between commercial banks and securities houses.10 Banks diversified and expanded rapidly after deregulation. In continental Europe so-called universal banks had long been the norm. The assets of large international banks doubled in the five years before 2008. Trading of new and highly complex financial products among banks meant that they became so closely interconnected that a problem in one would spread rapidly to others, magnifying rather than spreading risk.11Banks relied less and less on their own resources to finance lending and became more and more dependent on borrowing.12 The equity capital of banks - the funds provided by the shareholders of the bank - accounted for a declining proportion of overall funding. Leverage - the ratio of total assets (or liabilities) to the equity capital of a bank - rose to extraordinary levels. On the eve of the crisis, the leverage ratio for many banks was 30 or more, and for some investment banks it was between 40 and 50.13 A few banks had ratios even higher than that. With a leverage ratio of even 25 it would take a fall of only 4 per cent in the average value of a bank’s assets to wipe out the whole of the shareholders’ equity and leave it unable to service its debts.
By 2008, the Ugly led the Bad to overwhelm the Good. The crisis - one might say catastrophe - of the events that began to unfold under the gaze of a disbelieving world in 2007 was the failure of all three experiments. Greater stability of output and inflation, although desirable in itself, concealed the build-up of a major disequilibrium in the composition of spending. Some countries were saving too little and borrowing too much to be able to sustain their path of spending in the future, while others saved and lent so much that their consumption was pushed below a sustainable path. Total saving in the world was so high that interest rates, after allowing for inflation, fell to levels incompatible in the long run with a profitable growing market economy. Falling interest rates led to rising asset values and increases in the debt taken out against those more valuable assets. Fixed exchange rates exacerbated the burden of the debts, and in Europe the creation of monetary union in 1999 sapped the strength of many of its economies, as they became increasingly uncompetitive. Large, highly leveraged banks proved unstable and were vulnerable to even a modest loss of confidence, resulting in contagion to other banks and the collapse of the system in 2008.
At their outset the ill-fated nature of the three experiments was not yet visible. On the contrary, during the 1990s the elimination of high and variable inflation, which had undermined market economies in the 1970s, led to a welcome period of macroeconomic stability. The Great Stability, or the Great Moderation as it was dubbed in the United States, was seen - as in many ways it was - as a success for monetary policy. But it was unsustainable. Policy-makers were conscious of problems inherent in the first two experiments, but seemed powerless to do anything about them. At international gatherings, such as those of the IMF, policy-makers would wring their hands about the ‘global imbalances’ but no one country had any incentive to do anything about it. If a country had, on its own, tried to swim against the tide of falling interest rates, it would have experienced an economic slowdown and rising unemployment without any material impact on either the global economy or the banking system. Even then the prisoner’s dilemma was beginning to rear its ugly head.
Nor was it obvious how the unsustainable position of the world economy would come to an end. I remember attending a seminar of economists and policy-makers at the IMF as early as 2002 where the consensus was that there would eventually be a sharp fall in the value of the US dollar, which would produce a change in spending patterns. But long before that could happen, the third experiment ended with the banking crisis of September and October 2008. The shock that some of the biggest and most successful commercial banks in North America and Europe either failed, or were seriously crippled, led to a collapse of confidence which produced the largest fall in world trade since the 1930s. Something had gone seriously wrong.
Opinions differ as to the cause of the crisis. Some see it as a financial panic in which fundamentally sound financial institutions were left short of cash as confidence in the credit-worthiness of banks suddenly changed and professional investors stopped lending to them - a liquidity crisis. Others see it as the inevitable outcome of bad lending decisions by banks - a solvency crisis, in which the true value of banks’ assets had fallen by enough to wipe out most of their equity capital, meaning that they might be unable to repay their debts.14 But almost all accounts of the recent crisis are about the symptoms - the rise and fall of housing markets, the explosion of debt and the excesses of the banking system - rather than the underlying causes of the events that overwhelmed the economies of the industrialised world in 2008.15 Some even imagine that the crisis was solely an affair of the US financial sector. But unless the events of 2008 are seen in their global economic context, it is hard to make sense of what happened and of the deeper malaise in the world economy.
The story of what happened can be explained in little more than a few pages - everything you need to know but were afraid to ask about the causes of the recent crisis. So here goes.
The story of the crisis
By the start of the twenty-first century it seemed that economic prosperity and democracy went hand in hand. Modern capitalism spawned growing prosperity based on growing trade, free markets and competition, and global banks. In 2008 the system collapsed. To understand why the crisis was so big, and came as such a surprise, we should start at the key turning point - the fall of the Berlin Wall in 1989. At the time it was thought to represent the end of communism, indeed the end of the appeal of socialism and central planning. For some it was the end of history.16 For most, it represented a victory for free market economics. Contrary to the prediction of Marx, capitalism had displaced communism. Yet who would have believed that the fall of the Wall was not just the end of communism but the beginning of the biggest crisis in capitalism since the Great Depression?
What has happened over the past quarter of a century to bring about this remarkable change of fortune in the position of capitalist economies? After the demise of the socialist model of a planned economy, China, countries of the former Soviet Union and India embraced the international trading system, adding millions of workers each year to the pool of labour around the world producing tradeable, especially manufactured, goods. In China alone, over 70 million manufacturing jobs were created during the twenty-first century, far exceeding the 42 million working in manufacturing in 2012 in the United States and Europe combined.17 The pool of labour supplying the world trading system more than trebled in size. Advanced economies benefited from an influx of cheap consumer goods at the expense of employment in the manufacturing sector.
The aim of the emerging economies was to follow Japan and Korea in pursuing an export-led growth strategy. To stimulate exports, their exchange rates were held down by fixing them at a low level against the US dollar. The strategy worked, especially in the case of China. Its share in world exports rose from 2 per cent to 12 per cent between 1990 and 2013.18 China and other Asian economies ran large trade surpluses. In other words, they were producing more than they were spending and saving more than they were investing at home. The desire to save was very strong. In the absence of a social safety net, households in China chose to save large proportions of their income to provide self-insurance in the event of unemployment or ill-health, and to finance retirement consumption. Such a high level of saving was exacerbated by the policy from 1980 of limiting most families to one child, making it difficult for parents to rely on their children to provide for them in retirement.19 Asian economies in general also saved more in order to accumulate large holdings of dollars as insurance in case their banking system ran short of foreign currency, as happened to Korea and other countries in the Asian financial crisis of the 1990s.
In most of the advanced economies of the West, it was the desire to spend that gained the upper hand, as reflected in falling saving rates. Napoleon may (or may not) have described England as a nation of shopkeepers, but it would be more accurate to say that it is a nation that keeps on shopping. Keen though western consumers were on spending, their appetite was not strong enough to offset the even greater wish of emerging economies to save. The consequence was that in the world economy as a whole there was an excess of saving, or in the vivid phrase of Ben Bernanke, Chairman of the Federal Reserve from 2006 to 2014, a ‘savings glut’ in the new expanded global capital market.20
This glut of saving pushed down long-term interest rates around the world. We think of interest rates as being determined by the Federal Reserve, the Bank of England, the European Central Bank (ECB) and other national central banks. That is certainly true for short-term interest rates, those applying to loans for a period of a month or less. Over slightly longer horizons, market interest rates are largely influenced by expectations about the likely actions of central banks. But over longer horizons still, such as a decade or more, interest rates are determined by the balance between spending and saving in the world as a whole, and central banks react to these developments when setting short-term official interest rates. Governments borrow by selling securities or bonds to the market with different periods of maturity, ranging from one month to thirty years or sometimes more. The interest rate at different maturities for such borrowing is known as the yield curve.
Another important distinction is between ‘money’ and ‘real’ interest rates. Money interest rates are the usual quoted rate - if you lend $100 and after one year receive $105, the money interest rate is 5 per cent. If over the course of that year the price of the things that you like to buy is expected to rise by 5 per cent, then the ‘real’ rate of interest you earn is the money rate less the anticipated rate of inflation (in this example the real rate is zero). In recent years, short-term real interest rates have actually been negative because official interest rates have been less than the rate of inflation. And the savings glut pushed down long-term real interest rates to unprecedentedly low levels.21 In the nineteenth century and most of the twentieth, real rates were positive and moved within a range of 3 to 5 per cent. My estimate is that the average ten-year world real interest rate fell steadily from 4 per cent or so around the fall of the Berlin Wall to 1.5 per cent when the crisis hit, and has since fallen further to around zero.22 As the Asian economies grew and grew, the volume of saving placed in the world capital market by their savers, including the Chinese government, rose and rose. So not only did those countries add millions of people to the pool of labour producing goods to be sold around the world, depressing real wages in other countries, they added billions of dollars to the pool of saving seeking an outlet, depressing real rates of interest in the global capital market.
Lower real interest rates and higher market prices for assets boosted investment. From the early 1990s onwards, as real interest rates were falling, it appeared profitable to invest in projects with increasingly low real rates of return. On my visits to different towns and cities across the United Kingdom I was continually surprised by the investment in new shopping centres, justified by low rates of interest and projections of unsustainable rates of growth of consumer spending.
For a decade or more after the fall of the Berlin Wall, the effects of the trade surpluses and capital movements seemed wholly benign. Emerging markets grew rapidly and their citizens’ income levels started to converge on those of advanced economies. Consumers in advanced economies initially benefited from the lower prices of consumer goods that they imported from emerging economies. Confronted with persistent trade deficits thanks to this growth in imports, the United States, the United Kingdom and some other European countries relied on central banks to achieve steady growth and low inflation.23 To achieve that, their central banks cut short-term interest rates to boost the growth of money, credit and domestic demand in order to offset the drag on total demand from the trade deficit. So interest rates, both short-term and long-term, were at all-time lows. Such low interest rates, across all maturities, encouraged spending and led it along unsustainable paths in many, if not most, economies.24 With high levels of saving in Asia and rising debt in the West, saving and investment in a number of large countries, and in the world economy as a whole, got out of kilter and produced a major macroeconomic imbalance or disequilibrium. What started as an imbalance between countries became a disequilibrium within economies.
When the world economy is functioning well, capital normally flows from mature to developing economies where profitable opportunities abound, as happened in the late nineteenth century when Europe invested in Latin America. A strange feature of the savings glut was that because emerging economies were saving more than they were investing at home, they were actually exporting capital to advanced economies where investment opportunities were more limited. In effect, advanced economies were borrowing large sums from the less developed world. The natural direction of capital flows was reversed - capital was being pushed ‘uphill’.25
Much of those capital flows passed through the western banking system, and this led to the second key development before the crisis - the rapid expansion of bank balance sheets, or in the phrase of Hyun Song Shin, Chief Economist at the Bank for International Settlements, a ‘banking glut’.26 A bank’s balance sheet is a list of all the bank’s assets and all its liabilities. The former are the value of the loans it has made to customers and other investments. The latter is the value of the deposits and other borrowing that the bank has taken in to finance its operations. The difference between the assets and liabilities to others is the bank’s net worth and is the value of the bank to its owners - the shareholders. As western banks extended loans to households and companies, particularly on property, their balance sheets - both assets and liabilities - expanded rapidly.
Bank balance sheets exploded for two reasons. First, low real interest rates meant that asset prices rose around the world. The rise in asset prices induced a corresponding and rational rise in debt levels. Housing provides a good example. The housing stock gradually passes down the generations from old to young. As houses are sold, the older generation invests the proceeds in other financial assets and the younger generation borrows in order to buy the same houses. When house prices rise sharply following a fall in real interest rates, the young have to borrow more than their parents did. The young end up with more debt and the old with more financial assets. The household sector as a whole has a higher ratio of both debt and assets to income. During the Great Stability, banks financed much of the higher borrowing by the young as housing was transferred down the generations, and the balance sheets of banks expanded rapidly. There was nothing irrational in this - provided the belief that real interest rates would stay at that new lower level was itself rational. The market clearly thought it was, and still does. In mid-2015 the ten-year real rate in the industrialised world was close to zero.
There was, however, a second and less benign reason behind the expansion of bank balance sheets. With interest rates so low, financial institutions and investors started to take on more and more risk, in an increasingly desperate hunt for higher returns, without adequate compensation. Investors were slow to adjust and reluctant to accept that, in a world of low interest rates and low inflation, returns on financial assets would also be at historically low levels. Greed and hubris also led them to demand higher returns - such behaviour became known as the ‘search for yield’. Central banks warned about the consequences of low interest rates, but by allowing the amount of money in the economy to expand rapidly did little to prevent the search for yield and increased risk-taking.27 In addition, financial institutions, such as pension funds and insurance companies, were coming under pressure to find ways of making their savings products more attractive and reduce the rising cost of pension provision in the face of falling real interest rates.
Banks played their part in meeting this search for yield. They created a superstructure of ever more complex financial instruments, which were combinations of, and so derived from, more basic contracts such as mortgages and other types of debt - hence their name ‘derivatives’. To increase their yield, banks created instruments that comprised highly risky and often opaque structures with obscure names such as ‘collateralised debt obligations’. The average rate of return on a risky asset is higher than that on a safe asset, such as a US or UK government bond, to compensate the investor for the additional risk - the additional return is called the risk premium. Although some of the deals offered to investors were close to being fraudulent, the desire for higher returns meant there was no shortage of willing buyers. Only an optimist could believe that the risk premium in the market was adequate to compensate for the risk involved. It was all too close to alchemy.
Both the complexity and the size of financial assets increased markedly. The total assets of US banks, which for a long time had been around one-quarter of annual gross domestic product (GDP, the total value of goods and services produced in the economy), amounted to close to 100 per cent of GDP by the time of the crisis. In Britain, as the main financial centre in Europe, bank assets exceeded 500 per cent of GDP, and they were even larger in Ireland, Switzerland and Iceland. Bank leverage rose to astronomical levels - in some cases to more than 50 to 1; that is, the bank borrowed more than $50 for each dollar of capital provided by its shareholders. The banking system had become extremely fragile. Regulators took an unduly benign view of the expansion of the banking sector because while real interest rates continued to fall, asset prices rose and investors, including banks, made substantial profits. The political climate supported the development of large and highly leveraged global banks, and regulators were under pressure not to impede the expansion of the sector.
The ‘savings glut’ and the ‘banking glut’ combined to produce a toxic mix of a serious disequilibrium in the world economy, on the one hand, and an explosion of bank balance sheets, on the other. It was the interaction between the two that made the crisis so severe. Superficially, the position beforehand seemed sustainable. Trade deficits were a fairly stable share of GDP. But the scale of the borrowing meant that the stock of debt - both external and internal - relative to incomes and GDP kept on rising. Domestic spending in countries whose trade balance was in deficit was deliberately boosted to a level that could not be sustained in the long run. Low interest rates were encouraging households to bring forward spending from the future to the present. That, too, could not continue indefinitely - and it didn’t. Sooner or later an adjustment was going to be necessary. And the longer it was delayed, the bigger the adjustment would be.
Which would crack first - the confidence of investors in the soundness of the banks, or the continuation of spending on an unsustainable path? Most policy-makers believed that the unsustainable pattern of spending and saving, and the mirror image pattern of external surpluses and deficits, would end with a collapse of the US dollar, as lenders started to doubt the ability of the United States, the United Kingdom and other borrowers to repay. But the political commitment of emerging economies to their export-led growth strategy was extremely strong. And the US dollar - as the world’s reserve currency - was a currency in which China, and other emerging markets, were happy to invest, not least because its own currency, the renminbi, was not convertible into other currencies. There seemed no limit to China’s willingness to accumulate US dollars. And that has continued unabated - by the end of 2014, China’s foreign exchange reserves exceeded $4 trillion.28 So the dollar remained strong and it was the fragility of bank balance sheets that first revealed the fault lines.
Behind the scenes, the stocks of credits and debits were building in an unsustainable way, like piles of bricks. It is always surprising how many bricks can be piled one on top of another without their collapsing. This truth is embodied in the first law of financial crises: an unsustainable position can continue for far longer than you would believe possible.29 That was true for the duration of the Great Stability. What happened in 2008 illustrated the second law of financial crises: when an unsustainable position ends it happens faster than you could imagine.
The ‘small’ event that precipitated the collapse of the pile of bricks occurred on 9 August 2007 when the French bank BNP Paribas announced that it was stopping, temporarily, further redemptions (that is, investors could no longer ask for their money back) from three of its funds that were invested in so-called asset-backed securities (financial instruments that were claims on underlying obligations, such as mortgage payments), citing ‘the complete evaporation of liquidity in certain segments of the US securitization market’.30 Before long, market liquidity in a much wider range of financial instruments dried up. Attention was focused on risky, irresponsible - and even illegal - mortgage lending in the United States. But the underlying financial problem was the vulnerability of the banking system to US sub-prime mortgages - loans to households on low incomes who were highly likely to default.
At the beginning of September, central bank governors from around the world congregated in Basel at their regular bimonthly meeting. Although young wire service reporters hang around outside waiting for an unwary or publicity-seeking governor to confide his or her thoughts, the meetings themselves are always strictly private. A practice had grown up whereby the heads of the bank regulators from around the world met with central bank governors each September. In 2007 the bank regulators were asked whether the US sub-prime mortgage market was sufficiently large to bring down major banks. The answer was an emphatic no. Although the stock of such mortgages was around $1 trillion, potential losses were not large enough to create a problem for the system as a whole. After all, the loss of wealth in the dotcom crash earlier in the decade had been eight times greater.
This time, however, banks had made large bets on the sub-prime market in the form of derivative contracts. Although these bets cancelled each other out for the banking system as a whole, some banks were in the money and others were under water. The problem was that it was impossible for investors, and in some cases even for the banks themselves, to tell one from the other. So all banks came under suspicion. Banks found it difficult, and at times impossible, to raise money that only weeks earlier had been easily available. They stopped lending to each other. LIBOR (the London Inter-Bank Offer Rate) was supposed to be the quoted interest rate at which banks said they could borrow from each other. It became the interest rate at which banks didn’t lend to each other.
From the start of the crisis, central banks provided emergency loans, but these amounted to little more than holding a sheet in front of the Emperor - in this case the banking system - to conceal his nakedness. It didn’t solve the underlying problem - banks needed not loans but injections of shareholders’ capital in order to be able to reduce their extraordinarily high levels of leverage and to absorb losses from the risky investments they had made. From the beginning of 2008, we at the Bank of England began to argue that banks needed extra capital, a lot of extra capital, possibly a hundred billion pounds or more. It wasn’t a popular message. There was a deep reluctance in the banking community to admit that leverage was unsustainably high and therefore banks needed either to be recapitalised or to drastically reduce their lending. For the economy as a whole, the former was obviously preferable to the latter.
The system staggered on for a year. Market confidence in banks ebbed and flowed. But on 15 September the long-established investment bank Lehman Brothers failed - its large losses on real-estate lending combined with very high leverage prompted a loss of confidence among the financial institutions that provided it with access to cash. Although hardly surprising given the growing appreciation of the system’s underlying fragility over the previous twelve months, the failure of Lehman Brothers was such a jolt to market sentiment that a run on the US banking system took off at extraordinary speed. The runners were not ordinary depositors but wholesale financial institutions, such as money market funds. The run soon spread to other advanced economies - and so the Great Panic began. Already extremely chilly, the financial waters froze solid. Banks around the world found it impossible to finance themselves because no one knew which banks were safe and which weren’t. It was the biggest global financial crisis in history.
Where banks could still borrow, it was only at a very high premium to official rates. Some banks in Europe, which had borrowed large sums at short maturities in US wholesale markets, found that instead of being able to borrow for three months, they could do so only for one month. Then only for a week. And then only for a day. Banks depend on the confidence of their depositors and others who lend to them, and they had lost it. In early October 2008, two UK banks - Royal Bank of Scotland (RBS) and Halifax Bank of Scotland (HBoS) - found themselves unable to get to the end of the day. The Bank of England lent £60 billion to the two banks to avoid a collapse of the banking system.31 I can still hear the disbelief in the voice of Fred Goodwin, the CEO of the Royal Bank of Scotland, as he explained to me in early October 2008 what was happening to his bank. And Goodwin wasn’t the only one to be taken aback. Other central banks took similar action with their own banks.
The Great Panic lasted less than a month from the failure of Lehman Brothers to the announcement of the recapitalisation of the banks - twenty-eight days that shook the world. In October 2008, the finance ministers and governors of the G7 group of seven major industrialised countries (the US, UK, Japan, Canada, France, Germany and Italy) met in Washington DC amid the chaos and fear that followed the failure of Lehman. At that meeting I suggested to Hank Paulson, the US Treasury Secretary at the time, that we tear up the standard (and rather lengthy) communiqué drafted overnight by the G7 deputies and replace it with a short, succinct statement of solidarity and intent to work together.32 To his great credit, Paulson took up the idea and the statement was a turning point in the handling of the crisis. At last, there was an acceptance among governments, and among at least some banks, that the crisis reflected not just a shortage of liquidity but a much deeper problem of insufficient capital.
When the western banking system teetered on the verge of collapse, only drastic intervention, including partial nationalisation, saved it from going over the edge. The potential catastrophe of a collapse finally provoked action to recapitalise the banking system, using public money if necessary; the UK was first to respond, followed by the United States and then continental Europe. That action ended the bank run. The problem was that governments ended up guaranteeing all private creditors of the banks, imposing on future taxpayers a burden of unknown magnitude.
Between the autumn of 2008 and the summer of 2009, there was a collapse of confidence and output around the world. World trade fell more rapidly than during the Great Depression of the 1930s. Around ten million jobs were lost in the United States and Europe, almost as many as were employed in US manufacturing prior to the crisis. The period became known as the Great Recession. The economic consequences were seen well beyond countries that had experienced a banking crisis. My opposite numbers in Brazil and India, for example, talked to me about the puzzle of why demand for cars and steel in their countries had ‘fallen off a cliff’. For almost a year, the collapse in confidence was global. It seemed that, just as in the 1930s, much of what we had to fear was fear itself. Spending had fallen around the world because people feared that others would no longer go on spending. The situation cried out for a Keynesian policy response in the form of monetary and fiscal stimulus. Central banks and governments duly supplied it, and the policy was endorsed by the summit of the Group of Twenty (G20), which included both industrialised and emerging market economies, in London in May 2009.
The banking crisis itself could be said to have ended when the US Treasury and Federal Reserve announced on 7 May 2009 the results of the stress tests carried out on US banks to see if they were capable of withstanding the losses incurred under a range of adverse scenarios and the amount of new capital which those banks would be required to raise in the market or accept from the US government - $75 billion in total. By the summer of 2009, emerging market economies were starting to recover. But although the banking crisis had ended, the problems of the global economy remained. The shock of the events of 2008, and the subsequent sharp downturn, made western households and businesses reluctant to spend and banks unwilling to lend. Uncertainty prevailed. By 2015 there had still been no return to the growth and confidence experienced during the Great Stability.
This account captures, I believe, the essence of what happened in the run-up to and during the crisis of 2007-9, a journey from the Great Stability through the Great Panic to the Great Recession, but not yet to the Great Recovery. Much of my explanation has appeared in one or other previous account, with widely varying degrees of emphasis, and has become conventional wisdom. But it leaves some big unanswered questions.
First, why did all the players involved - governments, central banks, commercial banks, companies, borrowers and lenders - take no action to change direction while steaming ahead on a course destined to lead to serious problems and a major adjustment of the world economy? The three experiments on which the West had embarked were all beginning to fail, and their outcomes - the Good, the Bad and the Ugly - were becoming evident. Of course, big shocks to financial markets, such as a sharp fall in share prices or the failure of a bank, always come as a surprise. Some events are unpredictable, at least in their timing. But the economic path on which the world economy was proceeding was clearly unsustainable. Why was there such inertia before the crisis, and why were concerns about macroeconomic unsustainability not translated into actions by regulators and policy-makers?
Second, why has so little been done to change the underlying factors that can be seen as the causes of the crisis? The alchemy of our present system of money and banking continues. The strange thing is that after arguably the biggest financial crisis in history, nothing much has really changed in terms either of the fundamental structure of banking or the reliance on central banks to restore macroeconomic prosperity. Real interest rates have fallen further. Capital has continued to flow ‘uphill’. Industrialised economies have struggled to recover. Output, even if growing slowly, is well below the pre-crisis path. Real wages have continued to stagnate. The same banks dominate Main Street and the high streets of our towns.
There has certainly been a vast effort to change the regulation of banks - in the United States with the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, in the United Kingdom with the Banking Act of 2009 and Banking Reform Act of 2013, in Europe with a move towards a common regulatory system in the European Union, and internationally through changes in the way banks are required to finance themselves.33 These initiatives have made banks more resilient by reducing their leverage and limiting their ability to put highly risky assets on the same balance sheet as deposits from households. But they have not changed the fundamental structure of banking.
The banking and financial crisis of 1931, and the resulting Great Depression, had a dramatic effect on politics and economics at the time and in many ways shaped the intellectual climate of the post-war period. The response to the recent crisis has so far been much more muted. Of course, the immediate impact on many people was dampened by the response of policy-makers, who threw the monetary kitchen sink at the economy to restore demand and output. But as the impact of such policies peters out, and the underlying problems are seen to remain, anger is growing. To many citizens of advanced economies, the recent financial crisis came out of a clear blue sky. For a generation, they had adapted to the discipline of a market economy by accepting reforms to labour markets and, in Europe, the privatisation of ossified state industries, accompanied by the promise of rising productivity and prosperity. Businesses with products that attracted few customers accepted that they should not be supported by the state, and either adapted or closed. Employees accepted that wages might need to fall if conditions deteriorated in the company for which they worked, and the choice would be either lower wages or less employment. And the market economy delivered, as we seemed to reach the Holy Grail of steady economic growth and low inflation. Then came the collapse and the taxpayer bailouts of the very institutions most prominent in advocating market discipline for others - the banks. Why then, in sharp contrast to the 1930s, was there so little enthusiasm for radical reform to our economic system and institutions?
Third, why has weak demand become a deep-seated problem, and one that appears immune to further monetary stimulus? The crisis was not so much a financial earthquake, releasing pressure that had been building up, as a sudden shift to a lower path for demand and output than had seemed normal only a short time earlier, and one that threatens to persist indefinitely. Between the Second World War and 2008, the path of GDP per person in the US and UK fluctuated around a trend growth rate of about 2 per cent a year, with frequent but temporary deviations from that path. Since the crisis, there has been a sharp deviation of output from the previous trend path, such that output is now around 15 per cent below the level that seemed attainable only a few years ago. That gap amounts to around $8500 per person in the US and £4000 per person in the UK - a huge and continuing loss of output.34 Why have the economic prospects for our grandchildren suddenly deteriorated? When will we see the Great Recovery and what needs to be done to achieve it?
To answer those three questions means going behind and beyond the story of the crisis as told above. It requires a much closer look at the structure of money and banking that we have inherited from the past and at the nature of the disequilibrium in the world economy today. By the end of this book I hope to have suggested some answers.
A capitalist economy is inherently a monetary economy, and, as we shall see, a monetary economy behaves very differently from the textbook description of a market economy, in which households and businesses produce and trade with each other. The reasons for the divergence between the nature of a monetary economy and the textbook model are profound. They derive from the limitations on economic transactions created by radical uncertainty. In practice, buyers and sellers simply cannot write contracts to cover every eventuality, and money and banks evolved as a way of trying to cope with radical uncertainty. Our inability to anticipate all possible eventualities means that we - households, businesses, banks, central banks and governments - will make judgements that turn out to have been ‘mistakes’. Those mistakes lie at the heart of any story about financial crises.
Disequilibrium in the world economy
No country is finding it easy to escape from the devastation that followed the collapse of the banking system in the western world in 2008. From 2000 to 2007 the advanced economies grew at an annual average rate of 2.7 per cent. From 2010 to 2014, when those economies should have been rebounding with rapid growth after the sharp fall in output in late 2008 and 2009, GDP rose at an average rate of only 1.8 per cent a year.35 How can the world economy escape from the comparative stagnation into which it has fallen, despite sharply lower oil prices, since those dramatic days in the autumn of 2008 when central banks stepped in to prevent a complete collapse of the banking system?
After the banking crisis ended in May 2009, confidence in the US banking system was restored. Output started to recover in the emerging economies, and, with the benefit of hindsight, we can see that the falls in output in many of the advanced economies came to an end. A recovery - of sorts - began. Six years later, however, in the middle of 2015, we were still searching for a sustainable recovery despite cuts in interest rates and the printing of electronic money by central banks on an unprecedented scale. Output has started to grow, but only with the support of the prospect of extraordinarily low interest rates for a very long period. Recovery in the United States and United Kingdom has ebbed and flowed, Japan is struggling and the euro area is relying on the stimulus from a lower exchange rate. Growth in China has been slowing for a number of years and its financial system is in trouble. Central banks have thrown everything at their economies, and yet the results have been disappointing. Most sharp economic downturns are followed by sharp recoveries - and the sharper the downturn, the more rapid the recovery. Not this time. So why, after the biggest monetary stimulus the world has ever seen, and six years after the end of the banking crisis, is the world recovery so slow?
Some economists believe that we are experiencing what they call ‘secular stagnation’, a phrase coined by the American economist Alvin Hansen in his 1938 book Full Recovery or Stagnation?36 Today’s American economists, such as Ben Bernanke, Paul Krugman, Kenneth Rogoff and Larry Summers, have been using the more modern literary form of blogging to debate the issue. But it is not exactly clear what they mean by secular stagnation. Does it refer to stagnation of supply or of demand, or indeed both? Growth today seems possible only if interest rates are much lower than normal - at present the long-term real rate of interest is close to zero. The ‘natural’ real rate is the real rate of interest that generates a level of total spending sufficient to ensure full employment. When asked why demand is weak, economists tend to answer that it is because the natural real rate of interest is negative - in other words, people will spend only when faced with negative real interest rates. And when asked why that is, they reply that it is because demand is insufficient to maintain full employment. The reasoning is circular. Simply restating the phenomenon of secular stagnation in different words and pretending to have offered an explanation does not amount to a theory. Secular stagnation is an important description of the problems afflicting the world economy, but we need a new theory, or narrative, to explain why global demand is so weak and real interest rates are so low.
The conventional analysis used by economists and central banks is based on the assumption that the economy grows along a steady path from which it occasionally deviates as a result of temporary shocks to demand or supply. Such shocks are called ‘headwinds’ if negative or ‘tailwinds’ if positive. Output will return to its full-employment level once the temporary shocks have abated. The role of both monetary policy (interest rates and money supply) and fiscal policy (government spending and taxation) is to speed up the return to the underlying path of steady growth. Applied to current circumstances, the conventional view is that the major economies, such as the United States and the United Kingdom, have been held back by ‘headwinds’ to which the kind of stimulus to total spending proposed by Keynesians is the right answer until the headwinds in due course abate of their own accord. The statements of the Federal Reserve in recent years are a good example of this viewpoint.
During the Great Stability, this framework seemed adequate to capture the challenges facing policy-makers. But as it became evident, at least to some, that patterns of spending were unsustainable, the inadequacies of the model were revealed, albeit ignored by many policy-makers. What mattered was not just total spending but how it was divided between different types of demand. The factors holding back demand are not just temporary phenomena that will disappear of their own accord but the result of a gradual build-up of a disequilibrium in spending and saving, both within and between countries, which must be corrected before we can return to a strong and sustainable recovery. From its origins in an imbalance between high- and low-saving countries, the disequilibrium has morphed into an internal imbalance of even greater significance between saving and spending within economies. Desired spending is too low to absorb the capacity of our economies to produce goods and services. The result is weak growth and high unemployment (the euro area), falls in productivity growth (US and UK) and potentially large trade surpluses at full employment (Germany, Japan and China). Policy faces much bigger challenges than responding to temporary shocks to demand; it must move the economy to a new equilibrium.
Since the early 1990s, long-term real interest rates have fallen sharply, and this has had enormous implications for all our economies, as described above. Countries such as the United States, United Kingdom and some others in Europe, were faced with what were in effect structural trade deficits. Those deficits - an excess of imports over exports - amounted to a continuing negative drag on demand. So in order to ensure that total demand - domestic demand minus the trade deficit - matched the capacity of their economies to produce, central banks in the deficit countries cut their official interest rates in order to boost domestic demand. That created an imbalance within those countries with spending too high relative to current and prospective incomes. In countries with trade surpluses, such as China and Germany, spending was too low relative to likely future incomes. And the imbalance between countries - large trade surpluses and deficits - continued.
All this reinforced the determination of central banks to maintain extraordinarily low interest rates. 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. What started as an international savings glut has become a major disequilibrium in the world economy. This creates an enormous challenge for monetary policy. Central banks are, in effect, like cyclists pedalling up an ever steeper hill. They have to inject more and more monetary stimulus in order to maintain the same rate of growth of aggregate spending. This problem was building up well before the crisis, and was evident even in the 1990s. It led to a lopsided growth of demand. Rightly or wrongly, central banks took the view that two-speed growth was better than no growth.
Before the crisis, many thought that the Great Stability could continue indefinitely and failed to comprehend that it could not. Their credulity was understandable. After all, GDP as a whole was evolving on a steady path, with growth around historical average rates, and low and stable inflation. But the imbalance in the pattern of spending and saving was far from sustainable, and was leading to the build-up of large stocks of debts. Bad investments were made, encouraged by low real interest rates. The crisis revealed that much of that misplaced investment - residential housing in the United States, Ireland and Spain; commercial property in Britain - was unprofitable, producing losses for borrowers and lenders alike. The impact of the crisis was to make debtors and creditors - households, companies and governments - uncomfortably aware that their previous spending paths had been based on unrealistic assessments of future long-term incomes. So they reduced spending. And central banks then had to cut interest rates yet again to bring more spending forward from the future to the present, and to create more money by purchasing large quantities of assets from the private sector - the practice known as unconventional monetary policy or quantitative easing (QE). There is in fact nothing unconventional about such a practice - as I will explain in Chapter 5, so-called QE was long regarded as a standard tool of monetary policy - but the scale on which it has been implemented is unprecedented. Even so, it has become more and more difficult to persuade households and businesses to bring spending forward once again from an ever bleaker future. After a point, monetary policy confronts diminishing returns. We have reached that point.
The ‘headwinds’ that the major economies are facing today are not the result of a temporary downward shock to aggregate demand, but of an underlying weakness caused by the earlier bringing forward of spending. Stagnation has resulted from the realisation that domestic spending before the crisis was too high. The focus on short-term stimulus creates a ‘paradox of policy’.37 The policies of Keynesian monetary and fiscal stimulus adopted in the short run in 2008-9 - to encourage consumer spending and borrowing - were necessary then to deal with a dramatic collapse of confidence in the autumn of 2008. The move to inject substantial additional money into the economy was vital to prevent a downward spiral of falling demand and output. It worked. There was no repetition of the Great Depression. The supply of money did not collapse as it had in the United States in the 1930s. But those measures were the absolute opposite of what we needed to do - encourage saving and exports - to correct the underlying disequilibrium. The fact that the recovery is far weaker than we expected, even with the extraordinary monetary stimulus that we have in fact put in place, suggests that something is amiss. We need to tackle the underlying disequilibrium. Easy monetary policy is necessary but it is not sufficient for a sustained recovery. Interest rates today are too high to permit rapid growth of demand in the short run, but too low to be consistent with a proper balance between spending and saving in the long run.
Parallel to these internal imbalances between spending and saving within major economies are the external imbalances between countries. These, too, have not yet been resolved. The sharp fall in demand and output across the world in 2008-9 certainly lowered actual external surpluses and deficits. But surpluses and deficits will re-emerge if countries return to full employment. China’s surplus and America’s deficit are widening again. Most acute, of course, is the position in the euro area. Germany’s trade surplus is now approaching 8 per cent of GDP, and that of the Netherlands is even higher. Those surpluses and the deficits in the periphery countries (the southern members of the euro area with high unemployment) are both consequences of monetary union in Europe.
Correcting the internal and external imbalances will be a long process - the Great Unwinding. It will require many policy changes. The failure to recognise the need for a real adjustment in most major economies, and the continued reliance on monetary policy as the ‘only game in town’, constitute an error as much of theory as of practice, and are the cause of weak growth today. The underlying problem today is that past mistakes - too much consumption in some countries and too little in others; misdirected investment in most - mean that households have lowered their desired level of consumer spending and businesses are not yet confident that a rebalancing of our economies justifies significant new investment. Low interest rates cannot correct the disequilibrium in the pattern of demand. We are seeing a slow recovery not because the economy is battling temporary headwinds, but as the consequence of a more deep-seated problem.
Although we cannot foresee the future, we can study the past. Recent events, vivid though they are in the memories of participants and spectators alike, are only one episode among the many crises in the history of capitalism. The events of previous crises are an invaluable test bed for new ideas, and I shall refer to several of them in subsequent chapters. An unpredictable future means that there will always be ups and downs in a capitalist economy. But are full-blown crises inevitable? Are they the by-product of the processes that generate economic growth? There are no simple answers to these questions. But they are questions worth asking. Although my Chinese friend was absolutely right in saying that the West had worked out how to use a market economy, with free competition and trade, to raise productivity and standards of living, he was also right to point to our failings in managing money and banking. Such was our obsession with money, and the absurdly high pedestal on which we placed money-men, that we failed to see some of the weaknesses of the system. It would be irresponsible if, through intellectual complacency, we failed to analyse thoroughly the lessons of this and earlier crises, to distinguish between symptoms and causes, and to redesign our institutions to prevent a future generation from suffering in the way that so many are today.
The central idea in this book is that money and banking are particular historical institutions that developed before modern capitalism, and owe a great deal to the technology of earlier times. They permitted the development of a market economy and promised financial alchemy. But in the end it was that financial alchemy that led to their downfall. Money and banking proved to be not a form of alchemy, but the Achilles heel of capitalism - a point of weakness that threatens havoc on a scale that drains the life out of a capitalist economy. Since, however, they are man-made institutions, men - and women - can remake them. To do that we must first analyse how money and banking work today.