JULY 16, 2016
THE END OF ALCHEMY is a book that demands close attention. Its author, Mervyn King, was governor of the Bank of England from 2003 to 2013 (and he had been at the Bank since 1991, signing on to serve as its chief economist). He was, therefore, both close witness to and participant in the global financial crisis, the events and policy decisions that preceded it, and the efforts to contain the crisis and to reform the financial system that followed.
Not only does The End of Alchemy showcase a distinct and essential perspective, its author commands enormous respect. This is not a book that boasts. But in the years leading up to the crisis, King was right, and most others wrong, about two crucial concerns — and the widespread indifference of those others made a crisis virtually inevitable: flaws in our understanding of the macroeconomy, and the emergence of systemic risk in the financial system. In the good intellectual company of figures like former Federal Reserve Board Chairman Paul Volcker (a marginalized Cassandra dismissed as out of touch with the magical genius of modern finance), King put his finger on the fatal blind-spots that self-congratulatory central bankers, complacent directors of international organizations, fantastically well-remunerated mandarins of financial conglomerates, and mainstream economists willfully disregarded — allowing them to behave as if financial crisis were a virtual impossibility.
King was right to be enormously skeptical of “Rational Expectations Theory” — an approach to macroeconomics that was fully embraced by mainstream economics, and which allowed for the nearly universal embrace of models of the economy that simply assumed away the possibility of a financial crisis. “No economist can point to a particular model, and in honesty say ‘that is how the world works,’” King explained in 2005. “Our understanding of the economy is incomplete and constantly evolving,” and as a result, “we can never definitively conclude that one [policy choice] is right and the others wrong.”
This is as eminently sensible as it is correct, and it also means that thoughtful agents who are “rational” by any reasonable definition of the term can walk around with different implicit (and explicit) models of how the economy works. Thus they will often reach different conclusions and expectations when pressed to evaluate the consequences of economic disturbances or policy proposals. But such differences of opinion are explicitly forbidden by “Rational Expectations Theory,” where actors must all share the same (and more or less accurate) model of how the economy works. As one of the founding fathers of Rational Expectations explained, coincidentally also in 2005 (a time when no card carrying member of the economics profession in good standing would dare suggest otherwise), “you simply cannot talk about” the possibility of differences across models. In Rational Expectations, “all agents inside the model, the econometrician, and God share the same model.”
King was also right (and again outside of respectable opinion) with his perspective that financial systems were inherently vulnerable to financial crises, and thus central bankers and regulators needed to be attentive to the danger of systemic risk. (Because even sound and solvent financial institutions are invariably leveraged, with given assets on hand at any moment insufficient to cover all of their liabilities, and because they are also intimately and often opaquely enmeshed with one another, the financial system as a whole is often vulnerable to crisis in ways that cannot be understood simply by looking at the positions of individual players.) In a speech in 2007, King laid out these concerns explicitly, warning, “Exotic instruments are now issued for which the distribution of returns is considerably more complicated than that on the basic loans underlying them”; also noting, ahead of the crowd, that such financial exotica were “highly sensitive to small changes in the correlations of underlying returns which we do not understand with any great precision.” Raising the multi-trillion dollar question, King asked: “Excessive leverage is the common theme of many financial crises of the past. Are we really so much cleverer than the financiers of the past?”
Tragically, the financial community and its public and private cheerleaders answered this question with a resounding, “Yes.” Compare King’s perspective with that of his American counterpart, Alan Greenspan, the then-revered Revenge-of-the-Nerds rock star Chairman of the Federal Reserve Board. “Rising leverage appears to be the result of massive improvements in technology and infrastructure,” Greenspan lectured in 2007. “Increasingly complex financial instruments have contributed to the development of a far more flexible, efficient, and hence resilient financial system than the one that existed just a quarter-century ago.” Greenspan both reflected and crucially buttressed the broadly held conventional wisdom. “Systemic breakdowns occur, of course,” he wrote on the eve of the financial crisis, “but they are surprisingly rare.”
The End of Alchemy thus holds enormous promise. Plainly written for a non-specialist audience, the book is not a blow-by-blow insider account of the crisis — King argues that such accounts would be better recounted by professional historians — but rather, it is a book “about economic ideas.” Despite his being right about the big ideas, this is not an I-told-you-so book, but rather, more modestly (and productively), one that is motivated by the knowledge that “unless we go back to the underlying causes we will never understand what happened and will be unable to prevent a repetition and help our economies truly recover.” King also quickly establishes (but does not linger on) two political touchstones that bear repeating, especially as ideologically expedient revisionist accounts of the crisis proliferate with the passage of time. First, the “government rescue cannot conveniently be forgotten. When push came to shove, the very sector that had espoused the merits of market discipline was allowed to carry on only by dint of taxpayer support.” Second, both state and sector bear considerable culpability for the disaster: “Politicians worshipped at the altar of finance, bringing gifts in the form of lax regulation and receiving support, and sometimes campaign contributions, in return.”
With those accounts acknowledged, The End of Alchemy capably reviews the now familiar causes of the crisis: the massive increases in the “size, concentration and riskiness of banks,” the shift in the business model from lending money to churning securities, the explosion of synthetic, astonishingly complex financial instruments bearing risks and exposures that not even experts (no less ordinary investors) could properly assess, lucrative trading techniques with “no social benefit,” and, above all, “levels of leverage on a scale that could not resist even the slightest tremor to confidence.” The story is distressingly familiar; reading another inquest into this disgraceful mess is like watching an infinite loop of the Hindenburg going up in flames — except that we should have known better than they did. But we didn’t, and so the “western banking system teetered on the verge of collapse,” and “only drastic intervention […] saved it from going over the edge.”
One drawback for the book is that we have seen this movie before, perhaps too often. King’s is an indisputably, even profoundly important voice, and The End of Alchemy is laudable, largely right, invariably reasonable and cogently argued — but it is also a late entrant into a crowded field. There are dozens of books already out there on the crisis, and among the very finest include contributions from leading journalists (Martin Wolf’s The Shifts and the Shocks), academics (Barry Eichengreen’s Hall of Mirrors), and former practitioners (Alan Blinder’s After the Music Stopped), with the result that there is not much fresh ground left to be tilled. Alchemy also has its weaknesses. It is lightly padded with tangential historical excursions, topical shifts, and occasional discontinuities from the main thread of the narrative. (A digression on the manipulation of the Iraqi Dinar in the 1990s is of interest to me personally as a specialist in practice of international monetary power, but others will find this and other detours arriving as uninvited guests.) King also comes across as surprisingly innocent of politics, at one point informing readers that “the relationship between nations and their money reflects politics more than economics,” as if this was news. King, of course, is an economist, but the omission of even a few morsels of the relevant political science literature is both consequential and disappointing (any one of four of Benjamin Cohen’s most recent books, for example, such as The Geography of Money, would have been most welcome).
Despite these ultimately modest limitations, the strengths of The End of Alchemy greatly outweigh its weaknesses. King is especially clear on elucidating the problems of the Euro, which can be situated in both economics and politics. With regard to the former, joining a monetary union is a boon to the international trading prospects of those countries for whom participation amounts to an implicit currency devaluation (like Germany), while undermining those who have signed on to what amounts to a currency appreciation, making their goods less competitive abroad (the Southern Europeans). Monetary union also takes policy levers from the hands of national leaders, leaving only naked austerity — “sustained mass unemployment in order to bring down wages and prices” as the means of adjustment. And, of course, as economic integration galloped far ahead of political integration in Europe, although only one monetary policy is possible — one size must fit all — sharp political divisions over economic remedies along brightly drawn national lines and identities are inevitable, with the weak at the mercy of the strong. The bitter disputes between member states, including conflicts over reputedly profligate fiscal policies “have been largely consequences, not causes of the crisis of the euro area.”
The End of Alchemy also has some indispensable things to say about the road ahead, and the dangers very much still lurking from the endurance of misguided ideologies and from largely unreformed and vulnerable financial systems. King is shy about blaming policymakers and individual bankers, retreating instead to the passive voice to find both groups more or less populated by decent fellows responding understandably to perniciously structured incentives. (He ought to have heeded Blinder’s never-bettered one-sentence summary of the entire catastrophe: “it was shameful business practices, coupled with regulatory neglect, that got us into this mess.”) But while it treads lightly with the bankers (though he does bemoan the decline in the ethical standards of that culture), he is swift, pointed, and compelling in his sweeping condemnation of the economics profession. The original sin here remains the disciplinary embrace of Rational Expectations Theory, and King insists that “economics must change, perhaps quite radically, as a result of the searing experience of the crisis.” (No sign of that yet, by the way, as we approach a full decade’s remove from the upheaval.) Economists “have brought the problem upon themselves by pretending that they can forecast,” which is all well and good — most of the time. But the entire edifice collapses at those moments when it is most needed: “many of the statistical estimates of economic relationships turn out to be unstable, and break down during periods of crisis.” Or as Paul Volcker put it (well before the crisis hit), “The banks want to run a risk management system based upon the idea that we have a normal distribution of outcomes,” an approach that works right up until that crucial moment that it doesn’t, because “there ain’t no normal distribution when it comes to financial crises.”
A fundamental flaw of Rational Expectations Theory (and of allowing the financial world to run untended and unsupervised as if Rational Expectations held), is that the theory assumes the financial sphere is safely characterized by a world of risk (that is, a situation in which the probability distribution of all possible eventualities is fully known), whereas in fact the setting is one of uncertainty (where incalculable unknowables determine outcomes). The distinction between risk and uncertainty (which has a long pedigree but went completely out of fashion in economics with the rise of Rational Expectations), and the consequences of uncertainty for economic theory and public policy, is a central theme of The End of Alchemy. (King prefers the phrase “radical uncertainty” which seems technically redundant.) The problem of contemporary economic theory, King argues, is that “the concept of ‘rational’ expectations has no clear meaning in a world of radical uncertainty.” Mainstream economics can’t find a way to conceptualize uncertainty, which “drives a gaping hole though the idea of complete and competitive markets” — so its models pretend that uncertainty can be reduced to risk, and thus “radical uncertainty is ruled out by assumption.”
This might seem like an obscure academic debate, but King is right to hammer away at the issue, because it speaks directly to the profound public policy failures that contributed to the financial crisis — and the public policy failures that followed in its wake. Two other central themes of The End of Alchemy: That in general, finance is inherently vulnerable to crisis, and that recent efforts to reform the system have been woefully inadequate, flow from King’s simple but ominous and powerful observation that, “If the future is unknowable, then we simply do not know.”
Throughout The End of Alchemy, King aligns himself with those who emphasize the inherent fragility of finance, something that flows naturally from uncertainty, but which is easier to sweep under the rug with risk. But in either conceptual setting, finance is different and distinctly fragile (in ways that, say, manufacturing firms are not), because banks are almost always to some extent exposed, with their liabilities commonly short-term and vulnerable, while their assets, at any given moment, long term and less immediately accessible. Systemic risk also leaves even well-managed institutions vulnerable to the troubles of others, because even if their own position is sound, financial crises are self-perpetuating and can spin out of control — in the heat of the moment actors are incapable of distinguishing between firms that are temporarily illiquid as opposed to those that are irretrievably insolvent; in scrambling to cover their positions they make a bad situation worse. Worse, in the years leading up to the Global Financial Crisis, bankers and their asleep-at-the-switch would-be overseers convinced themselves that they had overcome systemic risk. In any event, with firms facing limited liability and implicitly aware that Central Banks would surely bail them out if somehow lightning did actually strike, there was every incentive to participate in the orgy of reckless speculation that was making everybody they knew fantastically wealthy.
The problem was, and remains, that when a financial crisis strikes, governments will have no choice but to protect the financial system, because if it collapses, it will bring the entire economy down with it. As King explains, in a metaphor that ought to be widely embraced, fire departments have no choice but to respond to fires — even those that are the result of people who do carelessly dangerous things, like smoking in bed. We simply cannot stand by and watch a city block burn to the ground, taking innocent victims with it, because we are unwilling to rescue the irresponsible few who touched off the blaze. But King knows that the metaphor does not, and must not end there. Given the costly public service provided, “as a society we supplement fire service by strict regulations to make it less likely that fires will start. We need to do the same in the financial sector.”
King proposes a number of new measures, including requiring banks to hold more equity, since over-leveraged financial institutions played such a large role in fomenting the crisis, and left others unable to absorb unexpected losses, accelerating the cascade. (He suggests that “a minimum ratio of equity to total assets of 10 per cent would be a good start” — that sound you now hear is Wall Street squealing like a stuck pig.) But the larger point of The End of Alchemy is that the fantastically complex cocktail of new regulations that have been ginned up (and the elaborate efforts to circumnavigate them) are not making us safer: “little [has] been done to change the underlying factors that can be seen as causes of the crisis.” He is not alone in reaching this conclusion. In Eichengreen’s estimation, “little was done to make the world a safer financial place.” Wolf describes the preservation of “a system we already know is extremely fragile, and which is sure to implode once again.” For King, “Without reform of the financial system […] another crisis is certain.”
Ten years ago it was perhaps understandable to have been caught off guard. This time we have been warned.