Mervyn King makes many of the same observations in his book “The End of Alchemy” as I do in my own, “Upside Down World”, not least: the focus on the difference between uncertainty and risk (he calls it “radical uncertainty”); the importance of different world views (he calls them “narratives”) and how shifts in them create crises; and the origins of the 2008 global financial collapse. Whereas my book is also a critique of finance theory and asset allocation, Lord King goes into more detail on policy choices in the developed world. I find myself agreeing with almost everything he says.
My only significant disappointment is that, in my opinion, Lord King, like many others, suffers from Core/Periphery Disease in not seeing the crucial role of emerging markets in the solution to current global economic problems. Emerging market sovereign debts are seen as a problem briefly on page 338 before the real culprit – the Eurozone – is discussed in detail. Although the importance of emerging market savings in pushing down developed world yield curves is mentioned, there is neither much focus on emerging market policy choices, nor on the crucial related arena of the international monetary system, nor on how a re-focus on emerging markets could assist in developed world recovery.
Nevertheless, Lord King’s book may have a profound influence in waking people up to the realities facing the Eurozone, indeed the whole European project. The stark economic and political realities involved are well spelled out. The book also includes a call for global adjustments including more UK exports, and, being my normal hedgehog self here, this in my view is probably best achieved with free trade agreements with emerging market countries (and without the encumbrance of the Common Agricultural Policy).
The most obvious strength of Lord King’s book, however, lies in its clear proposal of how to fix moral hazard in the banking sector. Banks are currently incentivized to lend and invest recklessly in the knowledge they will be bailed out in a crisis. Lord King’s proposal is both simple and profound: the idea is for central banks to cease being ‘lenders of last resort’ and instead become ‘pawnbrokers for all seasons’ (PFAS). The essence is to take the alchemy out of finance and stop bank money creation. This is to be achieved by moving, bit by bit over maybe a 20-year period, to a situation where private bank deposits at the central bank and their borrowings from the central bank backed by collateral are found together at least as much as short-term bank liabilities (deposits). In such an environment bank runs should not occur unless this rule is perceived to have been breached, and should not spread from one bank to another. Individual banks can still collapse, but taxpayer bailouts via the central bank should no longer be needed.
The proposal is an improvement on the earlier idea, much discussed in the first half of the 20th century, to end fractional reserve banking by requiring banks to hold liquid assets to cover 100% of deposits. PFAS is similar – but with the added feature that banks can borrow from the central bank against a variety of good and less good quality assets as collateral. PFAS is not as difficult to achieve and has the additional advantage that it would also reduce systemic risks associated with the maturity mismatches of banks, which putting an end to fractional reserve banking would not necessarily do. As a central bank does not need to sell collateral in a crisis but can hold it for the long term, PFAS not only reduces money creation by banks, but also underwrites the maturity transformations carried out by banks. All this is achieved whilst nevertheless ensuring the banking system remains in the private sector, able to set its own budgets and lending criteria.
Lord King argues that implementation is, for the most part, unproblematic. Central banks have already moved a long way from Walter Bagehot’s formulation of lending to solvent but illiquid banks in crisis at punitive rates only against the best quality collateral (the lender of last resort function). Central banks are already lending against, and applying haircuts to, less than top quality collateral, and lending at non-punitive rates. Quantitative easing has also resulted in large bank deposits at the central bank. These two recent developments set the scene for a move to PFAS. What needs to change is not what central banks are doing but their rationale for doing it.
The only difficultly is applying the correct haircuts to assets, erring on the prudent, offered to the central bank as collateral. It is important that haircuts do not jump up in a crisis. Lord King suggests a three-year time-scale for collateral value assessment, and 100% haircuts for anything too complex to understand.
PFAS is a radical proposal, and a challenge to the dominant and powerful position of banks in money creation. The book makes clear that, without such reforms, another banking crisis is inevitable. Coming as it does from a former governor of the Bank of England, PFAS deserves to be taken as a serious policy proposal. Unfortunately, the chances are that it won’t be – given its challenge to the status quo, and the transformation costs that would be imposed on banks by the removal of their access to taxpayer bailouts.
“The End of Alchemy: Money, Banking, and the Future of the Global Economy”, by Mervyn King is published by W.W. Norton & Company (2016)
New Sparta is the private office of Dr Jerome Booth – economist, entrepreneur, investor, commentator and leading expert on emerging markets. New Sparta is majority owner of bne IntelliNews. Follow him on @Jerome_Booth