[This book review was published in the Fall 2016 issue of The Journal of Social, Political and Economic Studies, pp. 99-105.]
The End of Alchemy: Money, Banking, and the Future of the Global Economy
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, 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. 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
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; firstname.lastname@example.org. 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.
 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.
 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