From Emergency Measures to Permanent Solutions

A specter haunts the global economy, with the lingering prospect of another crisis that might throw the U.S. economy and others back into recession. Central banks and governments have worked to exorcise the specter, but their efforts have not eased anxieties. Nor have they addressed deeper systemic problems that make these economies vulnerable to banking sector risk. Uncertainty, heightened by a turbulent political year in America, casts a long shadow over the prospects for recovery.

Mervyn King, former governor of the Bank of England, who led that institution through the financial crisis of late 2007 to 2009, addresses what went wrong and how problems might be remedied in The End of Alchemy: Money, Banking, and the Global Economy. Ranging beyond present discontents, King discusses the historical and theoretical workings of finance in an engaging style that eschews technical jargon without compromising on substance. In so doing, he follows the injunction of Alfred Marshall, a key figure in the emergence of academic economics from the older idiom of political economy: to translate conclusions drawn mathematically into clear English illustrated with practical examples. Deftly comparing 2007-2009 to earlier crises, and how coping with them shaped policy, King avoids easy and misleading analogies, instead providing context for understanding the larger problem the global economy today faces.

The current problem lies in a combination of radical uncertainty and economic disequilibrium that makes it harder for markets to calculate future demand. Saving requires an interest rate that justifies delaying consumption, while investment demands a sufficiently high return to cover the cost of borrowing. Growth needs a balance of saving and investment that increases productive capital to raise future output. Today’s extraordinarily low interest rates discourage saving. King points out that investment will soon fall as a consequence, which will dampen the future output that produces growth. Low growth makes future planning harder for families and businesses, but it also raises concerns about meeting projected liabilities ranging from pensions to government debts.

King grounds the crisis that hit nearly a decade ago in three reforms that were instituted in the late 1970s, whose results were mixed: 1) central banks received greater independence to cut inflation; 2) exchange controls ended to free the movement of capital, and governments sought to stabilize exchange rates; and 3) deregulation also removed barriers to competition among financial institutions that diversified into new products and regions while expanding in size.  These measures aimed partly to promote stability by protecting banks from risks concentrated in particular regions or lines of business.

Central bank independence, King notes, brought an unprecedented stability of output and prices from 1990 to 2007 that he rightly praises. Ending exchange rate flexibility, however, had the bad consequence of raising debt levels, with growing trade surpluses and deficits. Markets had lost an important mechanism to correct imbalances by their natural process of discovering prices. As for financial deregulation, it turned downright ugly, in King’s words, because it brought into being an extremely fragile system that transmitted risk where it should have been contained.

The result brings to mind the Tacoma Narrows Bridge in Washington state, which earned the nickname “Galloping Gertie.” Its design flaws shifted pressure to its weakest points, and that pressure tore the structure apart during a storm. Leverage among banks rose to levels where even a modest—and predictable—drop in the value of their assets could wipe out shareholder equity and make paying debts impossible. Alchemy had gone too far. Vulnerable financial institutions became dominoes whose fall would start a cascade through the system.

King deftly sketches the story behind the crisis. A massive imbalance grew in the global economy from 1990, while bank balances also expanded. Countries entering the international trading system trebled the labor pool, cutting manufacturing employment and wages in developed economies. Export-driven growth in high savings countries generated a large capital pool that debt-driven consumption in the West did not offset. Balance sheets in Western banks grew as capital flowed into them and rising asset prices, especially for property, increased borrowing. The search for returns with low interest rates encouraged institutions and investors to accept more risk. King describes the savings and banking glut as creating a toxic imbalance that could not be sustained.

The difficulty in pricing derivative bets led banks to suspend lending in late 2007, but panic came the next year, in mid-September, when Lehman Brothers collapsed. Finance, King writes, “froze solid.” The panic lasted less than a month as banks were recapitalized, but global confidence and output plunged. While the banking crisis ended in May 2009 with the announcement that U.S. banks had passed stress tests evaluating risk under various scenarios, the underlying problems in the global economy remained.  By 2015, growth and confidence had still not returned to pre-crisis levels. What King aptly describes as “the great unwinding”—correction of the imbalances that made the crisis so devastating—continues.

A return to global prosperity requires addressing issues beyond finance.  King sees the Great Recession as a consequence of disequilibrium that brought the 2007-2009 crisis. Confusing stability with sustainability had been a key error that prevented steps to restore balance. He emphasizes the difficulty that households and businesses now have in calculating their future needs and planning accordingly. Caution dampens productivity and demand alike, which limits growth. Short-term stimulus cannot solve the deeper problem of long-term growth, which requires fixing politically difficult imbalances. Public debt in the European Union, where Germany insists on holding Greece and other debtors to commitments they cannot meet, is one of several cases King mentions. Solving the larger problem demands a rethinking of how economics works to render the larger system less fragile.

Money and banking, in the larger canvas that King paints, have turned from driving growth since the 18th century (by facilitating investment and exchange) to the economy’s most vulnerable point. Likening the way banks created money to the mythical process of alchemy, which purported to transform base metals into gold, he emphasizes the role of trust. People trust that paper money—or its electronic equivalent—will turn into valuable commodities like gold or silver. The assumption gives money its value. Credit extended by banks similarly rests upon the belief that holdings cover any demand by depositors without calling in loans or liquidating assets. Only when confidence wavers do banks face a crisis that tests whose books balance; but trust usually postpones such a reckoning or eases the challenge of meeting it.

How, then, can the economy dispense with alchemy to operate on a firmer footing?

An important part of King’s answer to a complex question involves changing the way central banks respond to crises. Walter Bagehot framed a standard response after the 1866 financial panic, which was that central banks would step in and act as lenders of last resort. If uncertainty prevented regular banks from lending as usual, then central banks should provide credit at high interest and backed by good collateral. Doing so would spare otherwise sound banks from insolvency while deterring recourse to assistance without need and ensuring loans would be paid. Acting as lender of last resort would calm panic, thereby allowing normal operations to resume.

Recognizing Bagehot’s insight about the psychology that drives bank runs, King notes the difficulty nowadays in determining whether collateral is good. The financial system as it now operates renders it sometimes necessary to lend on inadequate capital at low or zero rates. Then too, Bagehot’s aim of deterring resort to emergency loans with punitive rates and capital requirements poses its own risks. King proposes instead that central banks serve as pawnbrokers for all seasons, supplying liquidity against collateral, with a haircut (loss in value from sale in unfavorable circumstances) priced in beforehand. Calculating the value of collateral beforehand would allow central banks to lend at a moment’s notice; balancing that value against the borrowing institution’s effective liquid liabilities would provide a liquidity insurance that would hedge the risk of expanding balance sheets.

Banks could decide on the composition of their assets and liabilities, giving them flexibility to experiment in their business. Keeping the pawnbroker open for all seasons instead of lending at last resort would, moreover, lower the stigma of resorting to support and thereby put another break on panics. Banks would no longer have any incentive to hold out until they faced no alternative but that of seeking aid. The haircut on bank assets imposes a tax on the alchemy of creating money from the leverage that financial institutions enjoy.

King describes the approach as a natural path from emergency measures to permanent solutions to the dangers of alchemy.

Moving beyond crisis-management to find new ways of effectively managing radical uncertainty presents the great challenge for policymakers and financiers alike. It means seeing familiar things from a new perspective, though with the benefit of historical understanding. Mervyn King’s book takes an important step in the right direction by offering particular solutions to financial problems while raising larger economic questions for reflection. Amidst the sound and fury generated by responses to the Great Recession, he provides a welcome guide to the perplexed.