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The end of alchemy: money, banking, and the future of the global economy: Mervyn King.

In his fascinating and thought-provoking book, The End of Alchemy, Mervyn King recounts a post-dinner conversation with a Chinese central banker during a visit to Beijing in 2011. The central banker told King that China wanted to emulate the Western idea that competition and a market economy are key factors in boosting living standards. However, the banker told King that China was not so enamored with the West's money and banking institutions. King writes that this conversation was the motivation for his book.

There is no follow-up conversation--in the book, anyway--as to whether the central banker believed that the Chinese system of state-dominated, directed finance was the better way. No matter, this book is not about comparative economics. Rather, it crystalizes King's view that the economic and financial superstructures of the United Kingdom and the United States are in dire need of reform--and pretty serious reform at that.

Mervyn King spent more than 20 years at the Bank of England, from March 1991 to July 2013: during the last decade, he was serving as its Governor. He is no small figure in the world of central banking, and there is much to be gleaned from his experience, including his assessment of the shortcomings of modern policymaking. King stipulates up-front that his book is about ideas--four big ideas, in fact: disequilibrium, radical uncertainty, prisoner's dilemma, and trust. Using these ideas, he proposes a bold set of new policies designed to boost economic growth.

In the aftermath of the crisis, the Queen of England asked the most trenchant of questions: Why did nobody see it coming? King admits that central bankers like himself failed miserably in their role of economic sentinels. This is undoubtedly true in hindsight. After all, as even King argues, central bankers are constantly learning about the economy. Revealingly, King claims that during the financial crisis, he learned more from studying history than from reading academic papers. Armed with this knowledge, King believes that central bankers must have the foresight--or is it intuition or courage?--to deviate from both well-prescribed rules and finely honed forecasts. This is a tall order for two reasons. First, central bankers tend to place a great deal of confidence in their economic models (more on this later). Second, the inputs for these imperfect models are imperfect data (because of revisions, mismeasurement, etc.). And all of these decisions must be done in real time in the midst of a boatload of economic uncertainties.

"Radical uncertainty" is one of the big ideas, which shows up repeatedly in the book. By uncertainty, King is referring to the Knightian kind--that is, outcomes with unknown probability distributions. In other words, he says, "stuff happens." Uncertainty must be distinguished from risks which are potentially unknown events but which have computable probability distributions. Central bankers and economists, argues King, tend to focus on risk. In this vein, they are most familiar with risks of higher inflation, slower growth, or financial market stability. However, King argues that policymakers are not as adept when confronting radical uncertainty. If the policymaker is staring in the face of radical uncertainty, then the best that a central banker can do is to develop a "coping strategy." Such a strategy, he argues, would rely heavily on rules of thumb (not models). This strategy would then form the basis for a narrative with which to communicate to markets. Sounds all good in theory, but markets, as King undoubtedly knows, like their central bankers to be clear and highly certain about almost everything!

Instead of a well-defined coping strategy to confront radical uncertainty, King writes that central bankers--and by extension, modern macroeconomists--have instead relied too heavily on elegant, mathematical models. In his view, the New Keynesian (NK) general equilibrium models, which are the gold standard of modern macroeconomics, failed miserably when they were needed the most. They were a "source of embarrassment" for several reasons. (1) First, they have no role for money in determining inflation. Second, they cannot adequately account for asset price inflation and their effects. Third, they do not incorporate political economy factors. This last shortcoming is crucial, he believes, but extraordinarily difficult to model. An obvious example from the crisis era in the United States was the political pressure to raise homeownership rates by dramatically lowering mortgage underwriting standards. (2) In sum, the best forecasters know when to apply a healthy dose of judgement to augment their model-based forecasts. This job is tough--perhaps tougher than King is willing to admit.

A second shortcoming of the economic superstructure is the modern financial system. King's condemnation is blunt: The modern financial system (money and banking) has become the Achilles heel of the market economy. Absent much-needed change, the United Kingdom and the United States are destined to have another financial crisis at some point in the future. At this point, a historian is apt to recall the warnings of Kindleberger and Aliber (2005) and Reinhart and Rogoff (2009). King's book touches on many types of economic reforms. I'll highlight two financial reforms he proposes.

The first necessity is to eliminate financial alchemy. This term sounds sketchy, but it is simply the well-known asset transformation process by which banks turn insured deposits into risky loans. In King's view, risks created by alchemy must be identified and borne by those institutions that enjoy their benefits. To eliminate this alchemy, King would create two types of banks: Narrow banks and wide banks. Narrow banks, modeled after the University of Chicago plan from the early 1930s, would be forced to hold 100 percent reserves against deposits. These reserves would be highly liquid, safe assets such as government securities and reserves held at the central bank. In effect, narrow banks would make money by performing payment services. King points to earlier support for narrow banking principles from Milton Friedman, James Tobin, and Hyman Minksy. Today, prominent academics and economic commentators who favor this approach include John Cochrane, John Kay, Larry Kotlikoff, and Martin Wolf. There does not appear to be wide support for narrow banking among most other notable financial economists.

Traditionally, the powerful linkages between economic development and financial intermediation mostly flowed through commercial banks that matched savers with spenders. That is no longer the case, as the traditional banking system accounts for a smaller share of lending. Thus, King's reform proposal would establish a second type of bank called a "wide bank." We can think of these as financial companies, or shadow banks. Wide banks would finance all other activities--importantly, risky loans to the private sector. Importantly, wide banks could not issue demand or short-term deposits. Instead, they would finance these risky loans by issuing equity or long-term debt. Such a system, says King, would eliminate alchemy by severing the link between the creation of money and credit. But he also admits that it faces long odds of ever becoming enshrined in law because of its opposition by the largest banks.

A second aspect of his reform is a do-over of the central bank's traditional lender of last resort (LOLR) function. In a financial crisis, the central bank is charged with adding liquidity. Optimally, this is accomplished by lending against good collateral and at a high rate (Bagehot). But even King's two-tiered system would face an inevitable financial crisis. So how would the LOLR operate in his two-tiered system? Here, King proposes a novel solution: The government would transform the central bank into a pawn broker for all seasons (PFAS). Under the PFAS, each bank and financial intermediary would be required to pre-position--in advance--some portion of its assets that it could subsequently use as collateral (with appropriate haircuts, if necessary) to borrow from the central bank. To this requirement, the bank or financial intermediary's liquid assets must exceed its liquid liabilities. King claims that the PFAS would be welfare-improving for several reasons, including removing the moral hazard problem associated with the LOLR and greatly simplifying financial regulations.

We read a lot about disequilibrium and the prisoner's dilemma in the final two chapters of the book. Here, King continues to gore a lot of oxen. Disequilibrium refers to the low interest rate environment that continues to incentivize leverage and risk-taking and erode savings. Some countries, such as the United States, need to save more and spend less. Other countries, such as Germany and China, need to do the opposite. Central bankers, for their part, need to understand that their policy of keeping the proverbial pedal to the metal (hyper-accommodative monetary policy) is making things worse. Accordingly, central banks are trapped in a prisoner's dilemma: Do nothing and postpone the inevitable, or act alone and punish their economy with higher rates (short-term pain but long-term gain). Thus, the most important challenge confronting central bankers is whether they should try to correct mistaken beliefs about their post-financial crisis policies that are long past the point of diminishing return.

Finally, King argues that fiscal policymakers need to do their part. Governments can best do this by putting in place a three-pronged reform program to boost the rate of economic growth. The first part of the program would be to enact policies to boost labor productivity growth. King is not a productivity pessimist who believes that all the low-hanging fruit has been harvested. Instead, King argues that if all the low-hanging fruit has been picked, then countries should build taller ladders via tax reform, eliminating monopolies, reducing inefficient regulations, and boosting infrastructure expenditures. Second, as a globalist and an economist, Lord King sees much growth-enhancing potential from boosting international trade. Sadly, though, mercantilist policies have done much to diminish the benefits of trade in the eyes of many politicians and the electorate they serve. The third arrow in the reform quiver is to restore floating exchange rates to help eliminate the perpetual current account surpluses and deficits of some countries. In this vein, he believes that Germany's export-intensive economy is benefiting from an undervalued euro (relative to Germany's economic strength). In short, says King:
   We can roll back the black cloud of uncertainty and
   allow the rays of supply-side sunshine to peer through
   in order to return to a more balanced and sustainable
   path of economic growth, (p. 366)

DOI 10.1057/s11369-017-0036-2


Gurkaynak, Refet, and Cedric Tille. 2017. DSGE Models in the Conduct of Policy: Use as Intended. Centre for Economic Policy Research.

Kindleberger, Charles P., and Robert Aliber. 2005. Manias, Panics, and Crashes: A History of Financial Crises, 5th ed. Hoboken: Wiley.

Reinhart, Carmen M., and Kenneth S. Rogoff. 2009. This Time is Different: Eight Centuries of Financial Folly. Princeton: Princeton University Press.

(1) For other views about DSGE models and the research efforts to improve their usefulness for policymaking and forecasting, see the recent VoxEU electronic book edited by Gurkaynak and Tille (2017).

(2) See Bill Poole's review of Sebastian Mallaby's biography of Alan Greenspan in the January 2017 issue of Business Economics.

Kevin L. Kliesen [1](iD)

[1] Business Economist and Research Officer, Federal Reserve Bank of St. Louis, St. Louis, MO, USA

[mail] Kevin L. Kliesen
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Comment:The end of alchemy: money, banking, and the future of the global economy: Mervyn King.
Author:Kliesen, Kevin L.
Publication:Business Economics
Geographic Code:9CHIN
Date:Jul 1, 2017
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