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The End of Alchemy: Money, Banking, and the Future of the Global Economy Paperback – March 7, 2017
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- John Plender, Financial Times
“I have read umpteen books about the financial crisis of 2007–2008 and its lessons. This is the cleverest one, brimming over with new ideas. While other ‘lords of finance’ publish memoirs, King has produced a brilliant analysis not only of what went wrong in the global financial system but also of what went wrong in economics itself.”
- Niall Ferguson
“A sophisticated and highly approachable study of how modern finance has lost its way. Few individuals are more qualified than Lord Mervyn King to imagine the banking of the future. His book should be required reading.”
- Henry Kissinger
“Mervyn King asks, ‘Why has almost every industrialized country found it difficult to overcome the stagnation that followed the financial crisis in 2007–2008, and why did money and banking, the alchemists of a market economy, turn into its Achilles heel?’ He addresses these questions, and much more. For those endeavoring to understand the greatest financial crisis of our time and the future of finance, this highly provocative book is a must-read.”
- Alan Greenspan
“Drawing on years of scholarly study of banking history and his real world experience in fighting financial panic, Mervyn King has set out a new framework for monetary and financial reform. Seemingly simple in concept, it challenges prevailing banking and market practice. The End of Alchemy demands debate and a well-reasoned response.”
- Paul A. Volcker
About the Author
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Much of the End of Alchemy gives the reader a background in some of the economic theory that goes into the central bank's role in the economy. The author discusses the money supply, fractional reserve banking and the only recent progression to independent central banking that has taken place. The author also discusses the nature of uncertainty that we actually face in our daily lives. This boils down to considering the concept of Knightian uncertainty where the distribution of outcomes is not known and so there is no objective way to optimize decisions. The author builds out this idea and discusses how modern market clearing mechanisms cant coordinate investment activity under this kind of uncertainty and uses long dated oil demand as an example. The author also spends time discussing the role of banks in maturity transformation of lending to long run risky projects by borrowing short term deposits. This process the author describes as the alchemy of finance. The author discusses how the risks in banking have grown as our risk weighting system has gone towards taking on increasing leverage. In addition the long term low rates has exacerbated the lending binge that seems to be occurring. The author discusses how modern banks and their immense size are subsidized by the lender of last resort policies by central banks that support them as the central banks are too worried about financial fallout to let the system face a systemic institutions default. The author also discusses how the haircutting mechanism that occurs can be counterproductive as pledged assets at the central bank leave less residual value for unsecured creditors.
After discussing where we are and the challenges the system faces the author gives some policy prescriptions. In particular the author discusses how the central bank should ex-ante prescribe haircuts for the range of collateral that would be pledged in extreme circumstances. So in effect the banks would need to pre-clear what risks they would need to pledge and in doing so would better be able to manage their capital structure and the proportion of equity held. The author also discusses how current weak investment and consumption are potentially the result of previous imbalances that cannot be cyclically charged by monetary or fiscal policy. The author discusses how the precautionary savings might be due to greater existential concerns as previous engines of wealth accumulation (housing appreciation) were fictitious. The author discusses how rates at 0 have a risk of not leading to investment as we face greater economic uncertainty that monetary policy is the wrong tool for.
The End of Alchemy achieves several things. It gives a background to the unfamiliar about central banking and monetary policy. It gives a history of some of the intellectual currents that drive policy actions and it describes the current economic environment and institutional arrangement in developed markets. The author also discusses what he believes is solvable in central banking, in particular, some aspects of moral hazard and implicit subsidy, and what is not- clearing up Knightian uncertainty. Definitely a good overview of a subject that is increasingly under scrutiny given the unprecedented low level of rates for all durations.
Although he discusses a host of topics relating to how people make decisions in practice compared to how economic theory suggests they behave, the problems of the fixed exchange rate regime within the European Union, and the difficulties of making policy within a framework of competing nations; I will focus on two issues that he raised.
The first is his suggested reform for the banking system. His reform is a modified “Chicago Plan” of the 1930s which called for 100% reserves. Under that regime bank deposits would be matched with cash and short term government securities. Hence no risk and no potential for bank runs. In contrast the current system is based on fractional reserves where banks hold a small portion of their deposits in reserves and lend out the balance. This process is King’s alchemy where short maturity deposits are transformed into long term assets. In the jargon of economists this process is called “maturity transformation.”
This system is inherently unstable because the cash is not there to pay off depositors if they want all of their money at once. To deal with this contradiction the central bank acts as a lender of last resort to meet the demands of anxious depositors. This gives rise to the issue of “too big to fail.” King’s compromise is to turn the central bank into a “pawnbroker for all seasons.” Under his proposed system banks must hold sufficient reserves, liquid assets and discounted long term assets to meet all deposit and short term borrowing liabilities. The discounted assets would be valued at a “normal times” value with an appropriate “hair-cut” to allow for risk and those asset could be pawned at the central bank should the need arise. Any lending above this threshold would have to be funded by additional equity and long term liabilities. Thus depositors would feel secure that their money be there when they needed it.
All this is fine and good, except there would be very little incentive for banks to make risky loans. Why is that bad? It is bad because new businesses, new ideas and new construction have to be funded if the economy is going to achieve the growth that most of us desire. To undertake King’s reforms we would need new institutions to undertake those risks. King is silent on this question.
The other issue that King raises that I would like to discuss is that the universal answer to all financial crises is to throw central bank money at it. We have been doing this for nine years. The problem that King rightly raises is that if the problem is structural rather than liquidity, throwing money at the crisis will delay solving the structural imbalances. To King’s mind central bankers in this environment may set interest rates too high to permit growth, but too low to allow for a structural adjustment.
The issue in the West is that savings are too low, while in the East consumption is too low. For example in order for the U.S. to cure its chronic trade deficit the savings rate has to rise and consumption has to fall, while China’s huge trade surplus has to be cured by higher consumption and lower savings. Politically asking people to reduce consumption is a hard sell so the easy way out is to keep interest rates low that works to keep consumption up.
All told Mervyn King has written an important book that will play a significant role in the ongoing debates over banking reform and monetary policy. He also offers a well done primer on current thinking on monetary policy that is accessible to the lay reader.
Top international reviews
King suggests that Central Banks, rather than being Lender of Last Resort, should instead be Pawn Broker for All Seasons, and in the last chapter, Lord King outlines the need for essentially a new Bretton Woods, as the current direction is unsustainable in King's eyes, and indeed, the eyes of many.
The book itself is surprisingly readable, and is not as tiring or engrossing as this reader had previously imagined.
If one has already read many books since the Crash of 2008, and wonders if they should read this one, the answer is simply, YES!
Thank you Mervyn King.
Why is this a great book?
* eloquent and well written
* readable by a non economist
* lucid explanations
* interesting and sometimes scary historical perspectives and parallels
* plenty of examples
* enough repetition that they key ideas stick
* concrete ideas for the way forward
* courageous in its challenge to all of us
I will have second read to see how much more I can get to stick.
Logically coherent while reading has enough new stuff that it was not easy for me to internalise... but that is my issue rather than the books!
My off the top of my head insights in no particular order are
* The financial and banking system has relied on alchemy
* governments can print more paper money than they have gold or underlying assets
* banks take low risk deposits (cash and short term debt) and use this to fund long term risky projects. Because they pay little to depositors and expect high returns for the long term investments they make money
* Crises of liquidity can develop due to a lack of confidence in the ability of a bank to pay depositors.
* Crises of solvency occur when the assets underpinning the bank are insufficient to cover their debts
* As banks sought to compete with one another and chase superior returns and performance they ended up participating in ever riskier debts and as interest rates fell to all time lows they ended up highly leveraged, often with just a few % points of equity or less vs banks which might have had 20 to 40% equity in the past.
* Governments had sought to stabilise inflation by controlling interest rates
* There was a failure to recognise a growing disequilibrium in the world between those countries which were spending from the future today using cheap debt and building up trade deficits, and those (China and Germany) which were saving rather than spending, exporting to the others and building up huge surpluses which were used to service the debt of the others.
* Monetary Union in Europe has not been a success. Ultimately it requires political integration to succeed. Germany has a currency which is undervalued and a huge trade surplus. Many others have currencies which are stronger than they deserve to be and are carrying huge debts.
* The situation of Greece today, where it can never repay its debts within the EU by borrowing more and more within the EU (circular argument) or from outside the EU (just increases the debt burden) is a “pretend and extend” policy.
* Radical Uncertainty, Disequilibrium, Prisoners Dilemma, Trust
* Failure of classical economics which consider the economics of “stuff” rather than the economics of “stuff happens”
* Current low demand a response to the changed heuristic concerning the perceived life time income and inability to spend - will not be put right without a rebalancing of the current state of disequilibrium in the global economy
* Net exporters need to focus on demand led growth and give up their surpluses. Net importers need to learn how to export again. If we do not find a peaceful way to rebalance things it will get nasty. The Prisoners Dilemma means we need to trust each other enough to act in a reasonably coordinated way to escape to the right place.
It seems to have had a surprisingly low-key reception, considering the author and the prescience of the subject matter, but that in no way detracts from the humility, importance and humour with which it addresses economic issues. I think any economics student who happens to get their hands on this would get a great springboard with which to build on in the direction that economics and banking are heading.
Clear and well written, with a minimum of technical language, it is most interesting that, unusually for a specialist in his field and unlike many of his colleagues who have gone into print regarding the same issues, Baron King identifies the root causes of the crisis instead of focussing on the all too evident consequences. Therein lies at least the the possibility of a beneficial solution, though, with many of the same, or similar experts involved, that may be asking too much.
More seriously, he shows no real appreciation of the disastrous state of the Greek and some other European economies - a state for which the EU and the European Central Bank bear a lot of responsibility. He keeps talking about "internal devaluation", without either saying what it means, or describing its human consequences.
Naturally he assumes without saying it that GDP is the only thing that matters to the human race.
I have got about a third of the way through but it's left unfinished for the moment.
If an ex governor of the Bank of England can acknowledge this how come these people haven’t stood trial.