THE END OF ALCHEMY:
Money, Banking and the Future of the
Global Economy
By Mervyn King
Little Brown. 448 pages. £25.00
ISBN 978 1 408 706 107
Lord Mervyn King served as the Governor of the Bank of England from 2003 to 2013 and is now a Professor at New York University and at the London School of Economics.
His tenure at the Bank of England coincided with the financial crisis of 2008 (the greatest crisis experienced by Western economies since the Great Depression) when the bankruptcy of Lehmann Brothers set off a chain reaction of bank failures and a subsequent severe recession. King is thus superbly qualified to analyse the events leading up to and after the crisis, a job he does brilliantly.
The book provides a highly readable – and alternately entertaining and depressing – survey of the history of modern economics, the development of money and banking, his view of the causes of financial crises, the history of monetary unions and his prognosis for the durability of the Eurozone, and a proposal for reducing what he considers to be the fragile state of banking.
A long series of crises
He points out that the crisis of 2008 was just one in a long series of financial crises that occur with depressing regularity. He suggests that all crises share similar causes. During good times, individuals and governments display a natural tendency to believe that good times will continue, so they spend and invest accordingly. This behaviour creates disequilibrium in the economy, usually in the form of excessive debt and investment, leading to asset price ‘bubbles’ and large trade deficits and surpluses which are unsustainable. Then an unpredictable shock occurs that challenges everyone’s assumptions about the future, which causes a fall in spending and investment, followed by recession and unemployment, until the economy finds a new equilibrium.
Future unknown
King then describes some of the main economic theories and economic modelling, which he says governments hubristically use to try to promote stable economic growth, because of something he calls ‘radical uncertainty’, i.e. that it is impossible for us to know the future, so we can’t develop policies and models that can anticipate people’s behaviours or economic events. As Proverbs 19:21 states: ‘Many are the plans in the mind of a man, but it is the purpose of the LORD that will stand.’ Model predictions fail, not because people don’t act rationally, but rather because they adopt ‘coping’ strategies instead of ‘optimising’ their choices.
The prisoners’ dilemma
Another phenomenon King describes is the so–called ‘prisoners’ dilemma’, a parable that illustrates the fact that, when presented with a problem, we know the best solution is cooperation with others, but find it impossible to do so due to mistrust of them and/or self–interest: ‘All we like sheep have gone astray; we have turned–every one–to his own way..’(Isaiah 53.6). King shows how this principle explains why people and governments don’t do the right thing even when they know better.
The prisoners’ dilemma and radical uncertainty also explain, in King’s view, the reason for bank failures. He explains how banks have evolved into private corporations that actually create money through their lending and deposit activities, the so–called ‘alchemy’ of banking. Banks borrow short-term money from depositors and lend it out long-term, usually in illiquid assets, such as mortgages, which can’t be converted into cash quickly – think of It’s a Wonderful Life, where George Bailey (Jimmy Stewart) tries to prevent a run on his bank.
A new banking proposal
When an unforeseen financial shock occurs, people act rationally to withdraw their money. But when banks can’t get cash quickly, a panic ensues, causing runs on banks and a steep decline in the money supply as banks deleverage, causing a recession. This is why governments feel compelled to ‘bail-out’ banks. This is where King introduces his proposal for reducing the risk of bank failures. He argues that central banks, rather than being ‘lenders of last resort’, should be ‘pawnbrokers for all seasons’. Banks would be required to match their deposits with short-term assets which the central bank could take as collateral to lend against, subject to haircuts, until the crisis has passed. In this way, taxpayers wouldn’t foot the bill, and banks would be less likely to fail.
Euro zone worries
King then ends his book with a view of the future of the Eurozone (which will play into the hands of the ‘outers’, although the writer suspects that King would not argue that separating the UK from the EU would insulate us from the problems of the Eurozone).
I commend this book to anyone wanting a highly readable, layman’s explanation of modern economics, banking and money. I don’t know if Mervyn King is a Christian, but his masterful, commonsense explanations and light–hearted mocking of politicians’ hubris in believing they can create stable economic growth with no bumps along the way lead me to suggest he would agree with Proverbs 3.15: ‘Trust in the Lord with all your heart, and do not lean on your own understanding.’
