The End of Alchemy by Mervyn King

‘For centuries alchemy has been the basis of our system of money and banking. Governments pretended that paper money could be turned into gold even when there was more of the former than the latter. Banks pretended that short term riskless deposits could be used to finance long term risky  investments.  In both, cases the alchemy is the apparent transformation of risk into safety. … For a society to base its financial system on alchemy is a poor advertisement for its rationality.  The key to ending the alchemy is to ensure that the risks involved in money and banking are correctly identified and borne by those who enjoy the benefits from our financial system.’  [pp250,251]

‘Four concepts have run through this book in order to explain the nature of financial alchemy and the reasons for the present disequilibrium of the world economy: disequilibrium, radical uncertainty, the prisoner’s dilemma and trust. It is hard to think about money and banking and their role in the economy, except in these terms.’ [p367]

Mervyn King seems to enjoy quoting Horace Walpole saying ‘the world is a comedy to those who think, a tragedy to those who feel.’ [p369]  Once we appreciate that King belongs to the former category, we can appreciate his thoughtful book for the valuable insights it does contain and tolerate – though with  difficulty in my case -  the lack of feeling which makes him so relaxed about the unfolding tragedy it describes so clinically.

He was Governor of the Bank of England in the dreadful years of the financial crisis and as such can offer a privileged insight into matters of banking and economic management at the very highest level but there is a danger in feeling excessive deference.  When the book slows down to provide readers with a basic introduction to the theory of money, banking and global economics, the fear is not that we are being patronised (it is always helpful to go over the fundamentals) but that we are being nudged towards a particular way of thinking.  While one can hardly challenge King on his areas of expertise, one does have to be aware of the topics he does not focus on and does not expose to scrutiny. He is not only explaining the financial crisis but also framing it, inviting us to see it as a technocratic challenge for which the solutions lie in the expertise of our central bankers, beyond the grasp of ordinary mortals.  His is a world of economic mistakes, not economic crimes. It is a world millions of light years apart from (say) Ship of Fools: How Stupidity and Corruption Sank the Celtic Tiger by Fintan O'Toole or perhaps Treasure Islands: Uncovering the Damage of Offshore Banking and Tax Havens by Nicholas Shaxson.

We have to respect King’s position among the key decision makers of the global economy and he gives the sense that, from practical experience, he is impatient with classical economists and so, it seems, are his colleagues. He writes for example:  ‘Bob Bernanke, then Chairman of the Federal Reserve, said in January 2014, that ‘the problem with QE is that it works in practice, but it doesn’t work in theory’. Perhaps there was a problem with the theory.’ [p183]  He mocks winners of the Nobel Prize for Economic Science in a way that suggests he is not expecting to win in the near future. For instance: ‘In 1998, the hedge fund Long Term Capital Management (LTCM) failed, although its senior management team comprised two Nobel Laureates in Economic Science, Myron Scholes and Robert Merton, and an experienced practitioner in financial markets, John Meriwether. ...The choice of assets was based on sophisticated statistical analysis of high frequency date over a decade or more.  But ...when a rare but significant event occurred – the Russian default and devaluation of 1998 – past correlations proved a poor guide to asset returns….At the heart of modern macroeconomics is the same illusion that uncertainty can be confined to the mathematical manipulation of known probabilities. To understand and weather booms and slumps requires a different approach to thinking about uncertainty.’ [p121]

Another example was the alleged resolution of the search for Adam Smith’s “Invisible Hand” which to my own mind recalls Douglas Adams’  Restaurant at the End of the Universe:  ‘Then, in the early 1950s,  two economists , Lenneth Arrow and Gerard Debreu, both working in America, finally produced a rigorous explanation for the invisible hand (for which they were subsequently awarded the Nobel Prize). They imagined a hypothetical grand auction held at the beginning of time in which bids are made for every possible good and service that people might want to buy at all future dates. … Because the auction at the beginning of time has done its job, no market needs to reopen in the future. ... Central to the Arrow-Debreu view of the world is a special way of dealing with uncertainty about the future. ... In other words, radical uncertainty is ruled out by assumption.  Obviously there are many ways in which the world is very far removed from this abstract description, apart from the obvious impracticability of organising the grand auction. Two are of particular importance – the need for institutions to police a market economy and the nature of uncertainty.’ [pp79/80]

As a banker, King seems especially annoyed at the failure of classical economics to appreciate the importance of money and the sterling labours of a central banker like himself.  In discussing the Arrow-Debreu grand auction he writes ‘… There is no need for money to act either as a medium of exchange (the ‘double coincidence of wants’ problem is circumvented by the auction), a store of value (there is no requirement for a reserve of savings), or indeed an absolute standard of value (consumers bidding in the auction need only know the relative prices of different goods and services, including labour).  Money has no place in an economy with a grand auction. ...’ [p79]   Elsewhere he moans: ‘It is ironic... that economists who believe that money matters (for example, Milton Friedman) argue that ‘the demand for money is highly stable’, whereas Keynesian economists argue that money does not matter because demand is unstable. Both groups are wrong – money really matters when there are large and unpredictable jumps in the demand for it.’ [p182]  This of course is where our caped crusader comes in.

What King complains about in classical economics is – or includes – the delusion that there can be a well defined, rational explanation for economic behaviour which, once properly understood, permits prediction and hence effective economic management. He contrasts this unduly rationalist model with an irrational one:  ‘The main challenge to the economists’ assumption of optimising behaviour comes from ‘behavioural economics, a relatively new field associated with Daniel Kahneman, Richard Thaler and Amos Tversky.  It studies the emotional and psychological dimensions of economic choices. … Daniel Kahneman suggested that decisions are made by two different systems in the mind: one fast and intuitive, the other slower, deliberate and closer to optimising behaviour. In this way he was able to explain aspects of behaviour that appear anomalous in the traditional approach.’ [p132]  But King is not impressed by this perspective and writes  ‘But simply patching up the optimising model by making the decision process more complicated – adding an intuitive to a rational self – in order to explain particular observed anomalies does not mean that it is likely to perform better in explaining future behaviour. … A complicated explanation of the past makes it no more likely that we can predict the stock market over the coming year than simply tossing a coin.’[p132-133]  He is clearly right to say that one cannot deploy Kahneman as a technical fix to repair the classical model of the rational market, but he is wrong to equate “irrational’ with ‘stupid’ as he does.  Indeed, he cites evidence that, in practice, many financial decisions are based on emotion and not pure reason.  Kahneman did not say we are stupid but that in practice it is not possible to make decisions in a deliberative, rational manner and we need other strategies.  These may lead us to make characteristic types of mistake for which we may find some protection when we understand them better, but those mistakes are often a fair trade off in order to enable us to make decisions at all and not be paralysed.

This matters because King continues to argue: ‘…  we need an alternative to both optimising behaviour and behavioural economics.    What does it mean to be rational in a world of radical uncertainty? Once we are liberated from the view that there is a single optimising solution, rules of thumb – technically known as heuristics – are better seen as rational ways to cope with an unknowable future.  … Ignoring information is rational when it is likely to be of little help in solving the problems we confront – sometimes less is more. Heuristics are not deviations from the true optimal solution but essential parts of a toolkit to cope with the unknown.’ [p134]  He is certainly right but this is more or less what Kahneman was saying in his classic book, Thinking Fast and Slow.  Actually, it is also a variant of what is argued in another book that is not mentioned: Fuzzy Logic: The Revolutionary Computer Technology That Is Changing Our World by Daniel McNeill, Paul Freiberger.  King really does  need to join up with Goodreads. The essence of fuzzy logic is that instead of a rational plan dealing with all eventualities, which will almost always turn out to be problematic, decision making is a process that continues across time, continually adjusting to meet changing conditions.

‘A coping strategy comprises three elements - a categorization of problems into those that are amenable to optimising behaviour and those that are not; a set of rules of thumb, or heuristics, to deal with the latter class of problems; and a narrative. … [135] .. The narrative is a story that integrates the most important pieces of information in order to provide a basis for  choosing the heuristic and the motive for a decision.’  [136]   For example, Dennis Wetherstone, CEO of JP Morgan, made it a rule that if he could not understand a new financial product after three, 15 minute presentations, then the firm refused to sell it.

‘Delegating monetary policy to an independent central bank with an inflation target is a coping strategy. Its clarity and simplicity mean that the target provides a natural heuristic for central banks and the private sector. … The great attraction of an inflation target is that it is a framework that does not have to be changed each time we learn something new about how the economy behaves.[p170]

King provides a positive account of the achievements of banking in general, and central banks in particular, with the implication that, of course, we need to continue learning from experience and improving over time.  He offers possible modifications to the way Central Banks regulate money and finance which will certainly have a keen audience and may even save the world – who knows? However, mistakes are unavoidable and King explores a range of different financial crises over several centuries from which he observes:  ‘Each crisis has its own distinctive pattern.  No two are the same.’ [p307]  He also remarks that it is a general rule that each country learns only from its own crises – which leads to the wrong solutions offered for the wrong crises.  He makes an especially important distinction between financial crises arising from lack of liquidity – a type of problem for which central banks have excellent solutions – and those arising from structural problems that are unsustainable  - which require political and economic solutions that may be at odds with the first.  The latter danger arises when a financial crisis which requires economic adjustment is held at bay by throwing more money into the ring, not only deferring the necessary adjustment but also allowing the structural problems to escalate.

On this basis, King looks at the financial crisis of 2007/8 and suggests that the immediate crisis, in  which central banks supplied the liquidity necessary to prevent economic catastrophe, masked a major, structural defect in the global economy which is not yet getting the attention it requires and for which different solutions are essential.   This can be simplistically stated – China and Germany have economies which export too much and consume too little, leading to massive savings that are invested in other countries which save too little and consume too much. This structural disequilibrium is not sustainable and a correction will have to take place one way or another.  For example, he writes:  ‘ Unless it finds a way to allow its real exchange rate to appreciate – by leaving the euro area or somehow engineering a much higher rate of wage inflation than in other parts of the euro area – Germany will find that continuing trade surpluses mean that it is accumulating more and more claims on other countries, with the risk that those claims turn out to be little more than worthless paper. That is already true of some of the claims of the euro area as a whole on Greece. Both China and Germany are discovering that being a country in surplus is a mixed blessing in a world that is on an unsustainable trajectory.’  [p364]

King is thus able to point a very striking finger at governments that argue to their own electorate that their responsible management of the local / national economy is being put at risk by  the crazy policies of Johnny Foreigner. ‘The weakness of demand across the world means that many, if not most countries can credibly say that if only the rest of the world were growing normally then they would be in reasonable shape. But since it isn’t, they aren’t.’ [p347,8]  This is one reason why King puts a lot of weight on the Prisoners Dilemma in his book.  He argues that there are no national solutions and only international ones, which governments are sadly unwilling to entertain.  Instead, they are pursuing economic policies that put off the day of reckoning to beyond the next election but which will inevitably alienate and enrage their electorates, who are turning – he feels as a direct consequence – to fringe political parties out of disillusion with the mainstream political elites.

If governments are unwilling to make the key economic choices, one possible remedy might be to delegate economic management to central banks and rely on their technocratic expertise to sail the ship.  In fact, King seems to believe this is entirely wrong and politically irresponsible and dangerous.  Central banks have a valuable role to play but so does democracy and accountable government.  For example, writing of the European Central Bank [ECB] and the euro, he says this:

‘...The ECB has had to choose between allowing the euro to fail and becoming a politicised institution.  Naturally it chose the latter. In years to come that may return to haunt the bank if there are attacks on its independence for straying into political territory.’ [p231]

‘… in the euro the fight for survival has become a battle between politicians and arithmetic.  Although the future outcome is unknowable, history is on the side of arithmetic. The tragedy of monetary union in Europe is not that it might collapse but that, given the degree of political commitment among the leaders of Europe, it might continue, bringing economic stagnation to the largest currency bloc in the world and holding back recovery of the wider world economy. It is at the heart of the disequilibrium in the world today.’  [p248]

On the broader economy, if King’s recommended policy measures are the correct ones and the only available ones, then there is no good news for the political Left, although there is not a lot of comfort either for the political Right. That makes it all the more helpful that he is so clear about the importance of the political process and democratic accountability in the decisions that need to be taken.  If we adopt his concept of a coping strategy, which I feel is excellent and non ideological, then we could potentially agree with his strategic goals – to resolve the unsustainable disequilibrium in the global economy and to ensure that the risks involved in money and banking are correctly identified and borne by those who enjoy the benefits from our financial system– while offering alternative ways of arriving at a more sustainable vision for the future, something less like a plutocracy and less environmentally destructive.  It is always best to be wary of writers who claim to think more than they feel.