Lord Mervyn King served as the governor of the Bank of England from 2003 to 2013, giving him a ringside seat to the financial crisis and, perhaps, some measure of responsibility for it. “The End of Alchemy” is a book about ideas rather than a memoir, with King correctly noting in the introduction that memoirs tend to have “the invisible subtitle: ‘how I saved the world.’” Leaving what happened during the financial crisis to the historians who will have access to the bank’s records in 20 years when they become public, he instead focuses on where he thinks economic theory has gone astray. This is too bad, since hearing his account (which, as he notes, would surely be seen as self-serving) would be a valuable source for historians and policymakers alike. Waiting 20 years for access to those materials is not going to help us understand the origins of the financial crisis now.
Instead, he offers a book about what he thinks are the important ideas. This is illuminating, since it gives us insight into what a key player in the financial crisis thinks is important now, even if it doesn’t tell us much about what he thought was important then. Moreover, King is a clear writer and is able to explain his ideas succinctly and thoughtfully.
King’s story of ideas focuses on four: disequilibrium, radical uncertainty, the prisoner’s dilemma, and trust. His main thesis is that the failure of economics to properly account for the role of these four ideas is what led economists – presumably including those at the bank – to fail to prevent the financial crisis.
King defines disequilibrium as “the absence of a state of balance between the forces acting on a system” and says it defined the world economy “since the fall of the Berlin Wall.” When there is a disequilibrium, he argues that “a large change in the pattern of spending and production will take place as the economy moves to a new equilibrium.” (9)
Here is where King’s project begins to go off the rails. King is right that economists’ models generally look at equilibriums; he’s living in a fantasy land if he thinks that the world economy is ever in an equilibrium. If we look at 1945-2008, consider the various dis-equilibrating forces at work: decolonization, the creation of the European Union’s various forerunners, the end of the gold standard, the rise of floating exchange rates, the Korean War, the Vietnam War, the various Arab-Israeli wars, the oil shocks, the Iranian Revolution, the collapse of the Soviet bloc, the creation of the euro, the rise of Hugo Chavez, the death of Hugo Chavez, the invention of the PC, the invention of the cell phone, and so on. Equilibrium is a useful intellectual tool but it is not a real-world concept.
Frankly, it is astounding that the former leader of an important central bank thinks that the absence of equilibrium conditions is something that everyone, except perhaps central bankers, didn’t know. When King writes that “[o]ur inability to anticipate all possible eventualities means that we – households, businesses, banks, central banks and governments – will make judgments that turn out to have been ‘mistakes’” (42-43), he cannot possibly believe that he has said anything new. Of course people, including important people in important jobs, make mistakes. The question is whether or not we have institutions robust enough to adjust to those mistakes and to minimize their consequences. One clue as to where he went wrong is the index, which has a single entry for Friedrich Hayek, whose analysis of markets as discovery mechanisms would have been helpful for King but 21 for John Maynard Keynes and 41 more for “Keynesian economics.”
For central banks, one means of reducing the number of mistakes is to reduce the number of decisions central bankers make. The “Taylor Rule,” proposed by macroeconomist John Taylor, is one means of doing so: It specifies how central bankers should adjust the nominal interest rate based on unemployment and GDP. Its great virtue is certainty: Individuals and businesses know how the central bank would react to economic data in advance. King rejects solutions like the Taylor Rule, arguing that “there is no timeless rule that is likely to remain optimal for long” and that new research would undermine any announced rule. (169) This misses the central point that a rule-based central bank would become more predictable, reducing uncertainty in the economy. King’s position seems to be that, despite central bankers’ mistakes, they should remain the experts guiding the economy.
Radical uncertainty is “uncertainty so profound that it is impossible to represent the future in terms of a knowable and exhaustive list of outcomes to which we can attach probabilities.” (9) This is a critical concept for King. He says “it presents a market economy with an impossible challenge – how are we to create markets in goods and services that we cannot at present imagine?” (11)
King is right that the world includes much “radical uncertainty.” There are many events which cannot be anticipated and thus future goods and services for which there are no current markets. This is only a problem for an economic model based on the assumption that there is a complete set of such markets or a central banker who is making decisions relying on models that incorporate such assumptions – at least without thinking through the consequences for the predictions of the absence of these markets. However, he is wrong to think that this is a new idea.
Positing a complete set of markets for future goods and services is a nice trick to make the math in general equilibrium models tractable. I am unaware of anyone who has ever thought it was a description of the world. Economists and central bankers may occasionally forget that an elegant model is based on such assumptions but it would be gross negligence for a central bank to act based on the belief that such assumptions describe, rather than simplify, reality.
The prisoner’s dilemma
King defines the prisoner’s dilemma as “the difficulty of achieving the best possible outcome when there are obstacles to cooperation.” (9) This is confusing, at best. First, the scenario on which the prisoner’s dilemma is based is one explicitly created to eliminate the opportunity for cooperation. Two prisoners are kept in separate cells and prevented from communicating. Given the structure of the relative payoffs to confessing and staying silent, they both opt to confess even though they would receive lighter sentences if both stayed silent. The key is that each is better off confessing regardless of what the other does. In the context of the two prisoners, this is a good outcome: We get confessions from both.
King sees a prisoner’s dilemma in the financial crisis: bankers and central bankers “naturally responded to the incentives they faced. As individuals, they tried to behave in what they saw as a rational manner, but the collective outcome was disastrous. Because they could not affect the behavior of others, all the key actors in the drama were understandably acting in their own self-interest – given the actions of everyone else.” (89) This is simply wrong.
Bankers and central bankers before, during, and after the financial crisis were in no way analogous to prisoners unable to communicate with one another. King asserts that even today “[c]entral banks are trapped into a policy of low interest rates because of the continuing belief that the solution to weak demand is further monetary stimulus. They are in a prisoner’s dilemma: If any one of them were to raise interest rates, they would risk a slowing of growth and possibly another downturn.” (335) Well, no. This is wrong. Lord King, or any other central banker and most heads of major banks, could simply phone any of the other participants in the banking system or any other central banker and communicate freely at any time. There were and are no structural impediments to communication in place analogous to being locked in a cell. The world of central bankers is a tiny club – if the heads of the ECB, the Bundesbank, the Bank of England, the Federal Reserve and Bank of China cannot collaborate it is not because they are in a prisoner’s dilemma.
Moreover, simply saying something is a “prisoner’s dilemma” does not make it so. Prisoner’s dilemmas exist only where the payoffs fit a particular structure: The payoff to the actors must be greater if they take one action rather than another, regardless of what actions the other actor takes. Blaming “the inherent difficulty of finding a way to a cooperative solution” is inaccurate. If the governor of the Bank of England could not find a way to communicate a cooperative solution to the banks he regulated, there seems little point in having a central bank governor.
King thinks trust is important but often absent: “Trust is the ingredient that makes a market economy work.” (10) and “More generally, our inability to make credible pre-commitments, or to trust each other, explains why ‘evil is the root of all money’….” (82) Here King is partly right, but, like many economists, ignores the institutions that make trust available in the world.
If I decide to go to Britain to visit King at the London School of Economics, I will need a plane ticket to get there, together with a place to stay and food to eat while I am there. If I purchase a ticket from American Airlines to fly from my home near Dallas/Fort Worth airport to London, I agree to pay Citibank money for the ticket by using my Citibank credit card. Citibank agrees to pay American the money (less a fee), once I’ve flown. American would like its money now, so it may use asset securitization to bundle future revenue from passengers like me into a financial instrument (perhaps using a special purpose vehicle in a tax neutral jurisdiction like the Cayman Islands) that pension funds or university endowments might purchase. All of these transactions happen without any of the usual things that lead us to use the word “trust.” Rather they occur through legal commitments (the creation of the SPV, the contract between American and Citibank, etc.) and through market forces (if I don’t pay my Citibank bill, my card will stop working).
Similarly, when I arrive in London, my credit card serves as a substitute for knowing me for the hotel where I stay or the restaurants where I eat. They don’t know me, and may not even know Citibank. But they do know their banks, which in turn are confident that Mastercard will ensure that Citibank pays their bank, so their bank will pay them. The market thus provides a substitute for trust that enables all sorts of transactions. By underestimating the ability of entrepreneurs to create means of substituting for personal relationships, King misses an important source of a substitute for trust.
The “alchemy” of money is – according to King – the “idea that paper money could replace intrinsically valuable gold and precious metals, and that banks could take secure short-term deposits and transform them into long-term risky investments.” (5)
There are at least three things wrong with King’s use of the term “alchemy” to describe banking.
First, alchemy doesn’t work. It is thus a poor metaphor for banking, which does work (albeit imperfectly). You cannot turn lead into gold through incantations or using the philosopher’s stone. You can turn short-term deposits into long-term loans by amassing enough of deposits and making few enough of the loans. As King notes, that becomes an issue when there is a run on a bank. But to label this process as “alchemy” is false analogy.
Second, over-leveraging of financial institutions, which King points to as a major contributor to the financial crisis, is not “alchemy”; it is a failure of regulatory institutions. Banking is a highly regulated industry. It was a highly regulated industry in 2007. If banks are taking on “too much” leverage, it is at least in part because regulators did not stop them from doing so. King explains this as “an inability to see through the veil of modern finance to the fact that the balance sheets of too many banks were an accident waiting to happen, with levels of leverage on a scale that could not resist even the slightest tremor to confidence about the uncertain value of bank assets.” (110)
This is an astonishing claim – banks were on a knife edge and regulators missed it because of “the veil of modern finance”? Was the math too hard? Did the regulators not actually understand the bank balance sheets? It is hard to see this as anything other than a massive regulatory failure.
Third, the analogy fails once we consider the historical development of alchemy and chemistry. The application of the scientific method to the various experiments of alchemists moved us to chemistry because things like the position of the moon were shown to be irrelevant to the outcome of the experiments. The pre-crisis banking institutions were not operating based on irrelevant factors but on incomplete understandings of the operation of financial markets. It may seem obvious to us now that defaults among U.S. residential subprime mortgages are likely to be correlated but many people ignored this possibility before 2008. Why? Not because they were alchemists or because of radical uncertainty but because of incentives. Mortgage brokers got paid for originating mortgages, rating agencies for providing good credit ratings. Banks assumed they could offload the mortgages once securitized, making them relatively uninterested in the quality of the mortgages in the pools. They proved wrong about that, which is one of the problems that led to the financial crisis. Everyone was chasing financial instruments providing higher returns, in part because Lord King and his central banker friends had depressed interest rates significantly. These were not errors of alchemy but sloppiness among regulators which allowed further sloppiness among bankers.
Wrong but interesting
As I’ve argued, King gets a great deal wrong in his analysis. Perhaps not coincidentally, all of his errors have the effect of reducing central bankers’ culpability in the financial crisis. Nonetheless, this is a book that needs to be widely read for three reasons.
First, if we are to do better in the future, we need to understand the errors of the past. Despite King’s initial disclaimer that he is not writing an account of the crisis as a memoir, his analysis reveals a great deal about the flaws in the central banking system.
Second, because King held such an important position in the financial world, his proposals are likely to get attention from other regulators. Understanding his analysis and his proposed fixes is thus important to understanding where we are headed.
Third, King’s view that he and his fellow central bankers were unable to prevent the financial crisis because their banks could not grasp relatively obvious concepts like the incompleteness of markets for future goods and services should disabuse anyone looking to central bankers for salvation in the future.