[This
book review was published in the Fall 2016 issue of The Journal of Social, Political and Economic Studies, pp. 99-105.]
Book Review
The End of Alchemy: Money, Banking, and
the Future of the Global Economy
Mervyn
King
W. W. Norton & Company, 2016
Mervyn King’s years as governor of the Bank of England
between 2003 and 2013 placed him at the heart of the Great Recession. Those years started with the lead-up to the
crash that began in 2007. He was then involved
as one of the world’s leading central bankers throughout the recession itself
and well into its aftermath. Now
a professor at both New York University and the London School of
Economics, King as a younger man had studied
at Harvard as a Kennedy Scholar and gone on to a career as the Bank of
England’s Chief Economist, Deputy Governor and Governor.
This easily readable book is “aimed at the reader with
no formal training in economics,” and maintains a high level of interest as it
explores a multitude of topics relating to banking and the world economy. It may be surprising that The End of Alchemy is not a memoir.
Unlike the books by such luminaries of the recession as Ben Bernanke, Hank
Paulson, Timothy Geithner and others,[1] it makes no effort to
recount the day-to-day agonies of those who wrestled with the recession. Instead, it is a book of ruminations about a
wide variety of economic issues, while of course not disregarding those raised
by the recession.
An analogy will provide the best way to understand
what King is doing with this book.
Imagine yourself having a comfortable but sleepless night, with your
body relaxed but your mind never quite relinquishing its consciousness. Your mind isn’t racing as though propelled by
some excitation, but instead moves freely from one thought or memory to
another, staying on each long enough to be interesting but not dwelling on it
at length. And so it is with The End of Alchemy. It explores a broad range of subjects that
more or less relate to each other, without their being organized into a coherent
whole. There is, however, coherence in
the parts, and it is in each nugget (some quite extensive) that a reader will
find the book valuable. The bibliography
cites several speeches given by King, and, although the book doesn’t say so,
this reviewer surmises that its eclectic quality is accounted for by much of
their content having been brought together to form the book.
From the title, one would suppose King’s concept of
“alchemy” (which he says is the illusion that demand deposits are safe in a fractional
reserve banking system) would be explored in depth and the illusion resolved
(thus, the “end of alchemy”). Instead,
there is so much digression that we noted as far into the book as page 118 that
King was still giving his lead-in to a discussion of just what the “alchemy” is
and what can be done about it. That long
introduction serves, at least, to explain to readers what fractional reserve
banking is, and how it leads to certain untoward results. King’s explanation isn’t nearly as thorough
as one finds in many other books, but we do find the essentials: that banks use
the money from deposits to make long-term loans, resulting in “illiquid assets
[i.e., the loans] financed by liquid deposits or banknotes” [bank obligations
subject to immediate repayment]. There are two effects: (1) because the banks have
not kept a full reserve fund to back the demand deposits, the banks are
vulnerable to bank runs, in which the depositors want their money back now but
the banks’ assets aren’t in a form that provides ready cash. And (2), the banks become “the main creators
of money.” Probably because the
audiences for his speeches were already well versed in how the system works, King
doesn’t explain the mechanics of the money creation, so a brief explanation
here may be worthwhile: when banks make loans, those become the basis for more
deposits made by the borrowers, which in turn provide the money for still more
loans and then more deposits -- and so
on until the legal requirement of a fractional reserve brings an end to the
escalation. This pyramid isn’t possible
under a “full reserve” system in which each deposit has to be backed by
instantly available liquid assets.
King points out that people’s belief in the efficacy
of the fractional reserve system persists despite the many crises it has
evoked. The illusion that the deposits
are secure is revealed by a bank run, “which exposes the alchemy for what it
is.” The idea that banks are solvent, despite
a world of “radical uncertainty,” is also part of the alchemy; and it, too, is revealed
by a bank run. When governments and
their central banks step in to stop a run by lending “vast sums to commercial
banks,” they are “shifting the risk… to taxpayers.” This amounts, King says, to a “massive
implicit subsidy to risk-taking by banks.”
What, in his opinion, is to be done about this? King discusses the Chicago Plan that was
proposed in the 1930s by a number of prominent economists whose center was at
the University of Chicago. The plan
called for a 100% reserve system. Banks
would then not be subject to bank runs, and banks would no longer be the
creators of money (the money supply would be solely a function of
government). But King sees drawbacks in
this: first, the “transition… could be disruptive”; and, second, the role of
banks in “exploiting economic benefits” would be “constrained” by loan funds’
being limited to money that comes solely from equity.
He proposes what he considers an intermediate plan,
which is to continue to allow fractional reserve banking while making it safe
from bank runs by creating a system of “liquidity insurance” and allowing the
central bank to back the deposits as a modified “lender of last resort” to the
banks. The modification would turn the
central bank into what King calls a “pawnbroker for all seasons.” Whereas central banks have traditionally been
allowed to be “lenders of last resort” only if they are provided with “good
collateral,” the “pawnbroker” idea would allow them to “supply liquidity, or
emergency money, against illiquid and risky assets.” Those assets would be “pre-positioned” with,
and assigned a value by, the central bank in advance of any crisis so that the
central bank’s extension of emergency credit could be done expeditiously.
It would seem that King has come up with a scheme that
would do away with the need for deposit insurance by removing panicked depositors’
reason for bank runs. What is not clear,
at least to this reviewer as he reads the rather disjointed presentation, is
how (or, rather, whether) the pawnbroker idea would put an end to the banking
system’s creation of money through the multiplier effect as deposits are loaned
out. Focusing on bank runs, King seems
to lose track of this important aspect of the “alchemy” of which he
speaks. This oversight is met in part by
his referring favorably to William Jennings Bryan’s position more than a
century ago that the issuance of money “is a function of government,” and by King’s
welcoming the central bank’s creation of money through “quantitative
easing.” We come away with the feeling
that there is inadequate explication of how all of this hangs together in
King’s thinking. If on the face of it there
is merit to the “pawnbroker” idea, economists will want to explore it further.
Much of the book goes into vast other areas that seem
to have nothing to do with fractional reserve banking. There are “sidebars” (if a courtroom term may
be used to convey the idea, since the word “digression” doesn’t seem
appropriate where there is no central theme that is being departed from) about
subjects ranging from Bitcoin, to monetary unions, to the Euro crisis, to the
financial crisis of 1914, to various passages about banking history – and the
like. Readers will find each of these
interesting and valuable.
Despite the book’s title, King’s discussions of the
“alchemy” of fractional reserve banking and of the sidebars are actually
secondary to his ruminations about the state of the world economy. Unfortunately, the threads of his analysis
are scattered, and it is only through a careful collation of our notes that we are
able to arrive at a summary that we think accurately captures his intent. Because he says the usual explanations of the
Great Recession, which center on the many abuses and dysfunctions of the
financial system, focus on surface phenomena and miss the deeper causes, we
have found it best to start by searching for his explanation of what those
deeper causes were.
He finds the deeper causes in the extraordinary trade
imbalances that have resulted from several countries’ with emerging economies
having adopted policies (like those of Japan and South Korea) that pursue “an
export-led growth strategy” by holding their exchange rates down “by fixing
them at a low level against the US dollar.”
“This strategy worked, especially in the case of China.” A result has been “their building up huge
reserves of US dollars” and “the fall of real interest rates across the globe.” He sees “a disequilibrium in spending and
saving, both within and between countries, which must be corrected before we
can return to a strong and sustainable recovery.” When he goes on to say “the desired spending
is too low to absorb the capacity of our economies to produce goods and
services,” he would do well to explain how the trade deficits lead to “a
savings glut,” “low desired spending” and a “negative interest rate.” As we have seen, he intends the book to be
for readers “with no formal training in economics,” but his detailing of the
“basic causes” again subsumes that readers are already familiar with the
interconnections among the various elements he mentions.
One of King’s favorite concepts is “the prisoner’s
dilemma,” where it is unsafe for any member of a group to act without first
knowing what the others are going to do.
The solution to the world disequilibria, King thinks, perhaps naively,
is through “cooperation” whereby nations “seek agreement on an orderly recovery
and rebalancing of the global economy.”
The naiveté would seem to reside in the anticipation that the emerging
economies will somehow come to be persuaded to give up their export-driven
policies, allowing exchange rates to float freely. It would have been well for King to address
that question directly, showing why he considers it a plausible path to
cooperation. He certainly doesn’t favor
protectionism by the United States to stop the trade deficits, since he calls for
“a further liberalization of trade” through such things as the Trans-Pacific
Partnership (TPP). He also believes
national policies can’t solve the problems: “Monetary and fiscal policies are
not the route to a new equilibrium.”
It isn’t totally clear how convinced he is by his
“basic cause” analysis. There is no
reference to trade deficits when he says “the economic failures of a modern
capitalist economy stem from our system of money and banking.” Elsewhere: “Money and banking [have proved to
be] the Achilles heel of capitalism.” More
specifically, “the fragility of our financial system stems directly from the
fact that banks are the main source of money creation.” These things would seem to stand by
themselves, as though he were identifying other “fundamental causes.”
Pointing to yet another “deeper
cause,” he says “the underlying financial problem [in the Great Recession] was
the vulnerability of the banking system to US sub-prime mortgages.” Here, at least, we can see a connection to
his trade deficit emphasis, because he writes that “the excessive risk-taking
and expansion of bank leverage [leading up to the Great Recession] was the
result of low long-term interest rates around the world.” Those low rates led to “rises in asset prices
and a desperate search for yield.” The
wild chase for profits in the housing market – by mortgage brokers, home buyers
refinancing their homes, and investors worldwide buying the bundles of
securitized mortgages – was a major part of that desperate search.
Even though he says that “blaming individuals is
counterproductive” because “the crisis was a failure of the system,” he is acknowledges
that the “search for yield” fed into “greed and hubris [that led to a] demand
for higher returns.” King recounts the
diseased financial scenario that is now so familiar to us all: Central banks
“allowed the amount of money in the economy to expand rapidly,” which fed into
the “increased risk-taking. “Banks
created a superstructure of ever more complex financial instruments, which were
combinations of, and so derived from, more basic contracts such as mortgages
and other types of debt – hence their name ‘derivatives.’” These were “often opaque structures with
obscure names” for which “the desire for higher returns meant there was no
shortage of willing buyers.” “Bank
leverage rose to astronomical levels.”
Through it all, “regulators took an unduly benign view.” He goes on from
there to describe how it all came to smash, resulting in a run on banks that
came not from depositors but from “wholesale financial institutions, such as
money market funds.”
Is it wise to remove blame from individuals? It would seem there were many “but-for causes”
of the debacle that involved abuses by the people involved. “But for” the credit rating agencies’
conflict-of-interest-driven AAA imprimatur stamped on so much that was rotten,
lots of what happened couldn’t have. “But
for” the then-fashionable economic ideology that “markets are perfect,” the
deregulation movement wouldn’t have occurred and the regulators wouldn’t have
persuaded themselves to ignore the warnings that were in fact made to
them. “But for” the “greed and hubris,”
bank CEOs might have been able to count on their boards’ backing them if they
refused to take on obscene risk in order to keep up with the rate of return
other banks were getting. (King says a
bank CEO who failed to keep up with the bank’s competitors “would likely have
lost his job.” He doesn’t reflect about
what this tells us about the boards of directors that would do the firing. It is possible, of course, that the boards
were creatures of the CEOs themselves.
Nobody to be held accountable?)
There were any number of “but-for causes.” If so, their presence suggests that it is
reductionist to look almost entirely to the “deeper causes” and assign only a
supportive role to others. King says a
search for “macro-prudential instruments” such as the “setting of limits on the
size of mortgage loans relative to incomes” is now “all the rage.” When he doesn’t join in the desire for such
correctives, he is being consistent with his analysis, which assigns relatively
little importance to the behavioral excrescences we so recently witnessed. A failure to scrutinize each aspect of how
the financial system is actually working at any given time, and to remove all
“but for causes” of crisis, stems from a limited perspective. We have noticed that many of the writings
about money and banking seem to think the world revolves entirely around
monetary and fiscal policy. King goes
outside that circle, at least, to include the concern we’ve noted about trade
deficits, which he rightly thinks cannot be solved by monetary or fiscal policy. But for the most part he adheres to the
conventional limitations.
It is important to realize that there is much outside
of monetary and fiscal policy that has a bearing on how an economy works. King joins many others in ignoring the scientific/cybernetic/automation/robotic
revolution that is remaking the economic landscape. If he were to take that into account, it is
doubtful he would be able to write that “the economic prospects for our
grandchildren [have] suddenly deteriorated.”
There is no mention of the polarization that is occurring in incomes and
wealth; and he looks forward to a return of “full employment.” He accepts the standard economic statistics
on unemployment as though they reflect reality.
We see from all this that he is encapsulated in the economic world (and
ways of thinking about it) of the past, not making the radical adjustments in
his thinking that the new realities require.[2] It would be a mistake to single King out for
this criticism, since he is by no means alone in adhering to the economic
paradigm we have all known. (Robert
Reich, in Saving Capitalism, reviewed
in our Fall 2016 issue, is an excellent example of someone who has gone from
the customary mindset to the new one.)
The difficulty we mentioned earlier that we have had
to work especially hard to distill an accurate understanding of King’s analysis
suggests that readers will do well to read the book carefully themselves. They may
agree (or not) with our distillation, but in any event will benefit from the
valuable content that abounds in The End
of Alchemy.
Dwight D.
Murphey
Endnotes
1. This Journal’s
reviews of the memoirs of each of seven such men and women have been compiled
into a monograph entitled Memoirs of the
Great Recession available by contacting The Council for Social &
Economic Studies, P. O. Box 34143, Washington, D.C. 20043, USA; socecon@aol.com. The reviews are also available, free of any
charge, on www.dwightmurphey-collectedwritings.info.
2. There are
many places to read about the transforming effects of the technological
revolution. One is Martin Ford’s Rise of the Robots, reviewed in the Journal’s
Fall 2016 issue. Another is this
reviewer’s book A Shared Market Economy,
available at no charge on the website indicated in Endnote 1 here. It is also available on Kindle as an e-book.
[1] This Journal’s reviews of the memoirs of each of seven such men and women have been compiled into a monograph entitled Memoirs of the Great Recession available by contacting us. The reviews are also available, free of any charge, on www.dwightmurphey-collectedwritings.info.
[2] There are many places to read about the transforming effects of the technological revolution. One is Martin Ford’s Rise of the Robots, which will be reviewed in our Fall issue. Another is this reviewer’s book A Shared Market Economy, available at no charge on www.dwightmurphey-collectedwritings.info