The End of Alchemy by Mervyn King
I read Lord King’s new book with curiosity and puzzlement. Since I’m not a professional economist (and it’s as much about economics as it is about banking – and it becomes clear just how different those disciplines are), I’m not going to “review” it, particularly since you have seen or will soon see plenty of column inches devoted to it. Most will take the usual tack of summarising it, which I shan’t. Because what’s most interesting is what’s not there.
Before I go further let me state that I think the book is admirable in many ways. As a summary of the problems in banking, finance and economics, it is accurate, readable and informative. Unlike so many books about these subjects it doesn’t patronize, and although it avoids mathematics the ideas are explained with far more nuance and sophistication than in most popular accounts: so it can be read with profit (although in view of its message perhaps not with pleasure) by everyone. And there is added a wealth of cultured references which I certainly enjoyed – going beyond sport, the usual pool from which financial writers draw, to T S Eliot, Brecht, Swift and Hegel. An 1839 volume entitled The Political Pilgrim’s Progress proved particularly rich in parallels with the mess we are now in.
As I’ve said I’m not going to take you through the author’s argument. Alchemy is the transformation of maturities (where a bank lends long but borrows short) which he sees as the root of the instability that causes crashes of increasing frequency and amplitude. And he identifies the factors that exacerbate this, including “radical uncertainty” (which he refrains from calling unknown unknowns), and several other such concepts that will be familiar to anyone who follows this area: disequilibrium, the prisoners’ dilemma, and trust. He questions whether there is a fundamental weakness in economic thinking (and comes up with many), and whether we can preserve the benefits of capitalism but abolish alchemy.
It is what he says along the way that will be of most value to readers, offering intelligent and incisive discussions of many of today’s most important debates, such as what people mean by secular stagnation and whether lowering interest rates can create demand. He’s very good on the cognitive errors that persist around finance, and the deficiencies of economics as an intellectual discipline. But it is all the more surprising that when he comes up with suggestions they seem almost naïve.
Thus his prescription for ending alchemy consists in replacing the central bank’s role as lender of last resort (for which he introduces the acronym LOLR, making me wonder if my social media skills are current) with that of “pawnbroker for all seasons”. The key feature of PFAS is essentially that each bank pre-agrees its assets with the central bank, as well as the level of “haircut” to be applied to each class of asset, so that there is a committed but normally undrawn facility from the central bank which is able to cover liabilities maturing within the next 12 months. He sees this as the panacea (rather than additional equity, which is merely desirable). But there is no discussion of whether in practice the central bank would be able to deal with a market panic where all commercial banks needed to draw these lines at the same time; nor what happens at the end of 12 months (an odd omission given that the last crash took far longer than that to unwind); nor what happens to the astronomical derivatives positions that are not reflected on the balance sheet; nor whether the collateral would actually be delivered (he does not discuss the widespread concern about the bankruptcy analysis of rehypothecation as it is increasingly practised in the City).
And the concept seems to remain focused within the central bank’s perspective: a mere tweak of the Bagehotian formula of lending on collateral. Even though King is sound on the arithmetic of collateralised lending (in the one example in the book that comes close to numbers), he fails to draw the obvious inference that any secured borrowing destabilises a bank’s position by making it impossible to borrow unsecured except from stupid or uninformed depositors.
King also fails to grasp the nettle of uninsured depositors and the rate of interest they should require: while seemingly acknowledging politically that such depositors would have to be bailed out, not in, next time, and while being fully conscious of the moral hazard and other implications of saying so, he does not seem to feel strongly (or at least not explicitly) that the current ambiguity is outrageous.
That in essence is my puzzle with this book. It is too civilised; too well written; too elegant. He describes a mess far deeper than most commentators or politicians have acknowledged, and is realistic about the chances of rectifying the situation before the next crash, but where is the anger?
Perhaps the answer is at the back of the book. Lord King is now a knight of the Garter, whose motto, you will recall, is Honi soit qui mal y pense. He has lifted up the skirts and found the indescribable. The true alchemy here is the distillation of the sæva indignatio into a courtier’s polish. One which will allow politicians to do with this book what they would anyway – ignore it.