1. The Good, the Bad and the Ugly
Chapter 1 of “The End of Alchemy” by Mervyn King, titled “The Good, the Bad and the Ugly,” provides an overview of the history of money, banking, and the financial system. King sets the stage by highlighting the importance of the financial system in facilitating economic activity and the risks associated with it.
He discusses the “alchemy” of banking, referring to the traditional approach where banks transform short-term liabilities (deposits) into long-term assets (loans). King explains that this process inherently involves risk-taking, as banks are susceptible to liquidity and solvency issues due to maturity transformation.
The chapter explores the historical evolution of banking and the role of central banks in maintaining financial stability. King emphasizes the importance of trust in the banking system and how it can be shattered during periods of financial distress, as witnessed during the 2008 financial crisis.
King also introduces the concept of the “three pillars of alchemy”: the belief in money as a store of value, the trust in banks to safeguard deposits, and the confidence in central banks to maintain stability. He argues that these pillars are interconnected and vulnerable to disruption, as seen in the aftermath of the crisis.
Furthermore, King addresses the shortcomings of the regulatory framework that failed to anticipate and prevent the crisis. He criticizes the prevailing belief in the Great Moderation, an era characterized by low inflation and stable economic growth, which led to complacency and inadequate risk assessment.
In summary, Chapter 1 serves as an introduction to the book, setting the stage for a critical examination of the flaws within the financial system. It discusses the risks inherent in banking, the importance of trust, and the need for regulatory reform to address the vulnerabilities that were exposed by the 2008 financial crisis.
2. Good and Evil: In Money We Trust
Why has money been so difficult to manage?
Part of the answer is the failure of political institutions to avoid the temptation to create money either as a source of revenue or a way to court popularity by engineering a short-term boost to the economy before the resulting rise in inflation becomes apparent. But there have also been significant advances in our understanding of how to manage money. The creation of independent central banks, with a clear mandate to maintain the value of the currency in terms of a representative basket of goods and services (inflation targeting), proved successful in stabilising inflation in the 1990s and early 2000s during the Great Stability. The conquering of inflation across the industrialised world over the past twenty-five years was a major achievement in the management of money, and one, despite the financial crisis, not to be underrated. It was the result of successful institutional design (see Chapter 5).
Nevertheless, designing a system of monetary management that is capable of achieving price stability – providing the right amount of money in good times – and coping with crises – providing the right amount and quality of emergency money in bad times – is by no means straightforward. Neither the private nor the public sector has an unblemished record in striking a balance. That is why over the years, and right up until today, there are those who continue to search for a deus ex machina to provide monetary stability.
Gold versus Paper
Gold has held a special position as money down the centuries and across the globe. The Egyptians used gold bars as a medium of exchange as far back as the fourth millennium BC. Even when paper money came into existence, its acceptance usually depended on its convertibility into gold. Major currencies were readily convertible into gold at a fixed exchange rate – the ‘gold standard’, as it was called. A country on the gold standard promised to exchange its notes and coin for gold at a fixed price. When a country joined the gold standard its exchange rate against other member countries became fixed.
The persistent attraction of gold as an acceptable medium of exchange in any set of circumstances stems from the fact that, apart from new mining, its supply is fixed, independent of human decision, and its weight and value can easily be checked. New mining adds only a small amount to the total stock of gold each year.
For centuries gold has been the most widely accepted form of payment. It is independent of government, and, ironically, governments themselves want to hold reserves in gold because they do not trust other countries to maintain the real value of claims denominated in their own paper currency. But despite its attractions, gold suffers from two major drawbacks as money:
• First, it is extremely heavy and inconvenient to use, and even when gold coins were used widely by travellers (in the way that we might use travellers’ cheques or credit cards today), coins of smaller denominations were usually made out of metals such as bronze or copper.
• The second drawback is more fundamental. The attraction of gold to many – namely that its supply cannot easily be expanded by governments – is in fact a serious weakness. In times of financial crisis, paper money can be created quickly and easily when the demand for liquidity is high; not so the supply of gold. Almost invariably, the gold standard was suspended during a financial panic.
Gold has the advantage that its supply is not dependent on unpredictable human institutions. Its disadvantage is precisely the same – namely that when a discretionary increase in the supply of money would be advantageous to overcome a sudden panic, gold cannot play that role. The evolution of a framework for the issue of paper money, culminating in the 1990s inflation-targeting regime, showed signs of success. But it is still too early to judge whether democratic societies have managed to create sustainable regimes to manage paper money, avoiding the deflationary impact of fixed-supply commodity money on the one hand, and the dangers of excessive inflation from discretionary control of money supply on the other.
3. Innocence Lost: Alchemy and Banking
What is a bank?
Banks are a particular type of financial intermediary which provide loan finance to businesses and households. They are particularly well placed to monitor their borrowers’ cash flows because they can observe the movements into and out of the bank accounts of the people to whom they lend. In most jurisdictions, the legal definition of a bank is an institution that takes deposits from households and businesses. A bank can raise finance by taking in or creating deposits, issuing other debt instruments and increasing equity invested in the bank. In the days of Walter Bagehot, banks’ assets mainly comprised loans and holdings of government debt and their liabilities consisted of deposits and shareholders’ equity. Banks today have more complex balance sheets, although the similarities remain.
What is it that makes banks special?
The distinguishing feature of a bank is that its assets are mostly long-term, illiquid and risky, whereas its liabilities are short-term, liquid and perceived as safe. Returns on risky long-term assets are normally much higher than the returns which the bank has to offer on its safe short-term liabilities. So banking is highly profitable. Unfortunately, the notion that a bank can offer safe returns on deposits that can be withdrawn at a moment’s notice by using them to finance long-term illiquid risky investments is, as common sense would suggest, generally false. The transformation of short-term liabilities into long-term assets – borrowing short to lend long – is known as maturity transformation. And the creation of deposits, which are regarded by the depositors as safe, into loans which, by their nature, are inherently risky constitutes risk transformation. Banks combine maturity and risk transformation. This is what makes them special.
The transmutation of bank deposits – money – with a safe value into illiquid risky investments is the alchemy of money and banking. Despite innumerable banking crises, belief in the alchemy persists. Economists have shown great ingenuity in coming up with explanations of how the alchemy of money and banking works, and in suggesting some special synergy between bank assets and liabilities.
People believed in alchemy because, so it was argued, depositors would never all choose to withdraw their money at the same time. If depositors’ requirements to make payments or obtain liquidity were, when averaged over a large number of depositors, a predictable flow, then deposits could provide a reliable source of long-term funding. But if a sizeable group of depositors were to withdraw funds at the same time, the bank would be forced either to demand immediate repayment of the loans it had made, resulting in a fire sale of the borrowers’ assets that might realize less then the amount owned to the bank – or to default on the claims of depositors.
The basic problem with the alchemy of the banking system is that it is irrational for one person to place trust in a bank if others do not. And it is rational to be concerned about whether a bank can make good its promise to return a deposit on demand when radical uncertainty means that it is impossible to know how big might be the losses on loans. Four ways have been suggested to deal with this problem:
• First, banks might suspend withdrawal of deposits in the face of a potential bank run. Banks could just shut their doors for a few days until the crisis has subsided. Of course, for a bank to close its doors, even if only because of a temporary shortage of liquidity, would send a signal that might lead to a loss of confidence on the part of depositors. It might only encourage a run to start sooner than would otherwise be the case, and if suspensions were regarded as potentially likely, then bank deposits would no longer function effectively as money.”
• Second, governments could guarantee bank deposits to remove the incentive to join a bank run. Deposit insurance is now a common feature of most advanced economies’ banking systems. Nevertheless, the insurance provided is not fully comprehensive, and on occasions that has created difficulties. In 2007, when the UK bank Northern Rock failed, individual depositors joined a bank run because their deposits were insured only up to a limit and not for their full value. The run stopped only when the UK government belatedly announced a taxpayer guarantee of the deposits. In 2008, financial institutions withdrew their funds from US banks or their new equivalents, known as ‘shadow’ banks, because those deposits were not insured. The Federal Reserve stepped in to provide a degree of guarantee to stop the run. The provision of deposit insurance is a subsidy and an incentive to risk-taking by banks.
• Third, the benefits of limited liability could be revoked for the shareholders of banks. In modern times, limited liability originated in the nineteenth century as companies sought to find capital on a scale adequate to finance the expansion of railways and new industrial plants. In the case of banks, unlimited liability would mean that shareholders were responsible for all losses, providing assurance to depositors and making a bank run less likely. In the United States, between 1865 and 1934 (when deposit insurance was introduced), bank shareholders were subject to ‘double liability’ – in the event of failure they were liable to lose not merely their equity stake but also an additional amount corresponding to the initial value subscribed for the shares they held, which could be used to repay depositors and other creditors. During this period, claims on shareholders in failed banks were quite successful in producing resources to pay out depositors.
In Britain, the death knell of unlimited liability came somewhat sooner with the failure of the City of Glasgow Bank, the third largest bank in the UK, in October 1878. The bank had been badly managed and its accounts falsified. Following a report that revealed serious problems with the accounts, other banks withdrew their support for City of Glasgow and it closed its doors. Later that month, the directors were arrested and charged with fraud. With a promptness that seems remarkable by today’s standards, the directors went on trial the following January, were convicted and sent to prison. It was left to the shareholders to meet the costs of supporting the depositors. Not only individual shareholders but also the trustees of private trusts which owned shares in the bank were personally liable for the losses, and 80 per cent of them went bankrupt. The plight of the shareholders aroused widespread public concern and the government introduced legislation to permit banks to convert to limited liability status.
• Fourth, central banks could replace lost deposits by providing official loans to a bank experiencing a run. It would, in the phrase that has become only too well known, act as a ‘lender of last resort’. If banks experienced a run then the central bank could supply liquidity to enable each individual bank to meet its depositors’ demands until the panic subsided and confidence returned. And if the crisis were a purely temporary one and the bank were solvent – in the sense that its assets could be sold once the crisis was over for an amount greater than the value of its liabilities – this ‘lender of last resort’ policy would achieve the objective of stabilising the banking system.
Flooding the system with liquidity has been seen by many economists, officials and politicians as the answer to almost any financial crisis. But it is never easy to distinguish between a liquidity and a solvency problem. In only a matter of days, a shortage of liquidity can turn into a solvency question. Banks will always claim that their problems result solely from illiquidity rather than a fall in the value of their assets.
The failure before the crisis was a lapse into hubris – we came to believe that crises created by maturity and risk transformation on a massive scale were problems that no longer applied to modern banking, that they belonged to an era in which people wore top hats. There was an inability to see through the veil of modern finance to the fact that the balance sheets of too many banks were an accident waiting to happen, with levels of leverage on a scale that could not resist even the slightest tremor to confidence about the uncertain value of bank assets. For all the clever innovation in the world of finance, its vulnerability was, and remains, the extraordinary levels of leverage. Pretending that deposits are safe when they are invested in long-term risky assets is an illusion. Without a sufficiently large cushion of equity capital available to absorb losses, or the implicit support of the taxpayer, deposits are inherently risky. The attempt to transform risky assets into riskless liabilities is indeed a form of alchemy.
‘Shadow banking’ system
In the run-up to the crisis, new institutions grew up to form a so-called ‘shadow banking’ system. In the US it became larger in terms of gross assets than the traditional banking sector, especially between 2002 and 2007, largely because it was free of much of the regulation that applied to banks. There is no clear definition of what constitutes ‘shadow banking’, but it clearly includes money market funds – mutual funds that issued liabilities equivalent to demand deposits and invested in short-term debt securities such as US Treasury bills and commercial paper.
Money market funds were created in the United States as a way of getting around so-called Regulation Q, which until 2011 limited the interest rates that banks could offer on their accounts. They were an attractive alternative to bank accounts. Such funds – and hence the owners of their liabilities – were exposed to risk because the value of the securities in which they invested was liable to fluctuate.
At one time or another, almost all non-bank financial institutions have been described as shadow banks. In some cases, such as special purpose vehicles set up by banks themselves, the description is merited. Those vehicles were legal entities, such as limited liability companies, set up for the sole purpose of issuing short-term commercial paper, not dissimilar to bank deposits, and purchasing longer-term securities, such as bundles of mortgages, created by the banks themselves. In essence, they were off-balance-sheet extensions of banks, and during the crisis many were taken back on to the balance sheet of their parent bank. Entities such as hedge funds and other bodies carrying out fund management are also sometimes described as examples of shadow banking. But since they do not issue demand deposits, the comparison with banks is much less convincing. The challenge posed by shadow banks is to ensure that institutions engaging in the alchemy of banking are regulated appropriately.
Financial engineering allows banks and shadow banks to manufacture additional assets almost without limit. This has had two consequences:
• First, the new instruments created are traded largely among big financial institutions and so the financial system has become enormously more interconnected. The failure of one firm causes trouble for the others. This means that promoting the stability of the system as a whole by regulating individual institutions is much less likely to be successful than hitherto. As in the stylised example described above, maturity and risk mismatch can grow through chains of transactions among banks and shadow banks without any significant amount being located in any one institution. Shadow banks posed as big a risk to the stability of the financial sector as conventional banks. Second, although many of these positions even out when the financial system is seen as a whole, gross balance sheets are not restricted by the scale of the real economy, and so banks and shadow banks were able to expand at a remarkable pace. When the crisis began in 2007, no one knew which banks were most exposed to risk.
4. Radical Uncertainty: The Purpose of Fiancial Markets
The illusion of certainty
The difficulty we have in confronting uncertainty, and our strong desire to control our own lives, lead to seemingly irrational decisions. After the terrorist attacks on New York on 11 September 2001, many Americans stopped flying for a period and drove instead. Traffic on interstate highways rose 5 per cent in the three months after the attack, and it took a year before normal patterns of travel were resumed. In that period, around 1600 Americans lost their lives in road accidents because of the switch from flying to driving, some 50 per cent of the death toll incurred on 9/11 itself.6 Such behaviour might appear irrational. After the attacks, airline security was drastically tightened. But how were people to assess the risk of flying in a world of new uncertainties? They opted for a form of transport more directly under their own control, even if it turned out to be more dangerous.
The two types of uncertainty
In coming to terms with an unknowable future, it is helpful to use the distinction between risk and uncertainty introduced in 1921 by the American economist Frank Knight. Risk concerns events, like your house catching fire, where it is possible to define precisely the nature of the future outcome and to assign a probability to the occurrence of that event based on past experience. With risk it is then possible to write contracts that can be defined in terms of observable outcomes and to make judgements about how much we would pay to take out insurance against that event. Many random events take the form of risk, and that is why there is a large industry supplying insurance against fire, theft, accidents and death. Uncertainty, by contrast, concerns events where it is not possible to define, or even imagine, all possible future outcomes, and to which probabilities cannot therefore be assigned. Such eventualities are uninsurable, and many unpredictable events take this form.
The distinction between risk and uncertainty can be illustrated by human mortality. ‘In this world nothing can be said to be certain, except death and taxes,’ wrote Benjamin Franklin in 1789.
Economists typically think about risk rather than radical uncertainty. They see the future as a game of chance in which we know all the outcomes that might emerge and the odds of each of them, even though we cannot predict the roll of the dice. In that world, because all future outcomes can be defined, it is theoretically possible to hold the grand economic auction described in Chapter 2, leading to efficient decisions about what to produce and consume.12 Although such an auction would, of course, be impossible to organise in practice, the real failure of the auction model is more profound. If we cannot imagine the goods and services that may exist in the future, nor conceive of all the eventualities that may befall us, then it is impossible to define the markets that are required by the auction model. Radical uncertainty drives a gaping hole through the idea of complete and competitive markets. Even if the markets that do exist are competitive, many crucial markets for future goods and services are absent. When IBM launched its personal computer (the ‘PC’) in 1981, there were no markets in the products that subsequently displaced it in the consumer marketplace, such as laptop and tablet devices. Neither producers nor consumers can know what options will be available to them in the future, and so they cannot express preferences in markets that might provide a guide to investment decisions. The markets are simply missing. And how tedious it would be if we could imagine what the future holds. Uncertainty – radical uncertainty – is the spice of life.
Coping strategies as rational behaviour under uncertainty
The main challenge to the economists’ assumption of optimising behaviour comes from ‘behavioural economics’, a relatively new field often associated with Daniel Kahneman, Richard Thaler and Amos Tversky. It studies the emotional and psychological dimensions of economic choices. Behavioural economics has identified an impressive array of cognitive biases in the way people behave in practice. For example, people are observed both to display overconfidence in their ability to judge probabilities and to underestimate the likelihood of rare events. But behavioural economics assumes that deviations from traditional optimising behaviour result from the fact that humans are hardwired to behave in a way that is ‘irrational’. Daniel Kahneman suggested that decisions are made by two different systems in the mind: one fast and intuitive, the other slower, deliberate, and closer to optimising behaviour. In this way he was able to explain aspects of behaviour that appear anomalous in the traditional approach.
The problem with behavioural economics is that it does not confront the deep question of what it means to be rational when the assumptions of the traditional optimising model fail to hold. Individuals are not compelled to be driven by impulses, but nor are they living in a world for which there is a single optimising solution to each problem. If we do not know how the world works, there is no unique right answer, only a problem of coping with the unknown. A different way of thinking about behaviour as neither irrational nor the product of a constrained optimisation problem is, I believe, helpful in understanding what happened both before and after the crisis. In other words, we need an alternative to both optimising behavior and behavioral economics.
Financial markets and derivatives
Over the past twenty years, a wide range of new and complex financial instruments has emerged, expanding dramatically the scale of financial markets. These new instruments are elaborate combinations of the more traditional debt, equity and insurance contracts, and as such they are known as ‘derivative’ instruments. They package streams of future returns on a wide variety of investments, ranging from housing to foreign exchange. They are claims on returns generated by the underlying basic financial contracts and play a valuable role of filling in gaps in markets, offering new ways both to hedge risks and speculate on future price movements of the underlying contracts, such as stock prices. Derivatives typically involve little up-front payment and are a contract between two parties to exchange a flow of returns or commodities in the future. The principle of derivative instruments is simple, but if you want to make it complicated there are many lawyers, and investment bankers who will help you – at a (significant) price.
Examples of derivative instruments include forward and futures contracts (the purchase of a commodity to be delivered at a future date), options (the right to buy, or sell, a basic contract such as a stock at a given price on or before a given date), and swaps (where two parties exchange a stream of cash flows in different currencies or for different profiles of interest payments to hedge their other exposures). Many of these instruments have real practical value.
Why, then, did derivatives grow so quickly? One answer is that betting is more addictive than chess, and the trading mentality fed on itself. Derivatives also allowed a stream of expected future profits, which might or might not be realised, to be capitalised into current values and show up in trading profits, so permitting large bonuses to be paid today out of a highly uncertain future prospect. But another answer is that derivatives do have real value when used in the right way – to reduce, not create risk. Many companies and institutions want to hedge (that is, insure against) risk associated with future shifts in the prices of commodities, changes in interest and exchange rates, and other economic variables. Derivatives also create financing options that may not exist in conventional debt markets.
Used carefully, derivatives can reduce risk. But the very complexity and obscurity of derivatives can mislead the unwary into thinking that they are hedging risks while in fact they remain exposed to great uncertainty and huge potential losses in the event of even a small change in underlying asset prices.
The illusion of liquidity
Liquidity is the quality of ‘immediacy’. For liquidity to be valuable it must be reliable. One aspect of the alchemy of financial markets is the belief that markets are always liquid. It is an illusion because the underlying assets (the physical assets and goodwill of a company, for example) are themselves usually illiquid, and liquidity depends on a continuing supply of buyers and sellers on opposite sides of the market. Radical uncertainty can disrupt that supply. Markets can be liquid one day and illiquid the next, as happened on 19 October 1987 (‘Black Monday’) when the Dow Jones Industrial Average fell 23 per cent in a day and the market-makers temporarily disappeared because they were worried about the risk of buying at one price and being able to sell only at a much lower price a short time later.
5. Heroes and Villians: The Role of Central Banks
After the experience of banking crises in the late nineteenth and early twentieth centuries, Congress was persuaded that a central bank was both constitutional and a good idea. What led to the change in view? During the era of free banking, described in Chapter 2, the US had no central bank. Banknotes issued by commercial banks often traded at a discount to their face value. That made them less useful as money that could be used to buy stuff or as a store of value. There were concerns that banks might issue too many notes in order to exploit the lack of information among depositors about the solvency of the bank. And when there was a crisis in the banking system there was no central authority to restore confidence – in 1907 the task of putting together a consortium of banks to support their weaker brethren fell to John Pierpont Morgan, founder of the eponymous bank. In a similar fashion, the German Reichsbank was set up in 1876, not to coincide with unification of the country in 1871 but in response to a financial crisis in 1873. Central banks acquired their modern role as the result of experiences of earlier monetary and banking crises. The position of central banks that started life as commercial banks developed into that of first among equals, organising occasional rescues and acting in effect as the secretary of the club of banks, above the competitive fray in which other banks were engaged.
Experience has demonstrated the importance of a public body – normally the central bank – responsible for two key aspects of the management of money in a capitalist economy:
• The first is to ensure that in good times the amount of money grows at a rate sufficient to maintain broad stability of the value of money, and
• The second is to ensure that in bad times the amount of money grows at a rate sufficient to provide the liquidity – a reserve of future purchasing power – required to meet unpredictable swings in the demand for it by the private sector (see Chapters 2 and 3 respectively). Those two functions are rather simple to state, if hard to carry out. They correspond to the twin objectives of price stability and the provision of liquidity by a ‘lender of last resort’.
Price stability – inflation targeting as a coping strategy
Over the years, governments have been unable to resist the temptation to debase the currency, and, with the advent of paper money, to print as much of it as possible to finance their expenditures.
In more modern times, governments, even if they profess a belief in price stability, have found themselves tempted to depart from the path of righteousness in order to obtain a short-term benefit by stimulating the economy prior to an election in the hope that the inflationary cost will become apparent to the electorate only after the vote. Once having given in to temptation, they are faced with an unpalatable choice between a recession to bring inflation back down again, or high and possibly accelerating inflation. Taken together, the verdict of economics, history and common sense is that both inflation and deflation are costly. Giving a central bank the exclusive right to issue paper money raises the question of how we can prevent the abuse of the power to issue money. We cannot commit future generations – or even ourselves – to a particular policy. So how can we design an institution to create the reasonable expectation that money will retain its value?
Prices and wages do not adjust instantaneously to clear markets whenever demand and supply are out of balance. Firms change prices only irregularly in response to changes in demand; wages adjust only slowly as labour market conditions alter; and expectations are updated only slowly as new information is received. Such ‘frictions’ or ‘rigidities’ introduce time lags into the process by which changes in money lead to changes in prices. These lags in the adjustment of prices and wages to changes in demand – so-called ‘nominal rigidities’ – and lags in the adjustment of expectations to changes in inflation – ‘expectational rigidities’ – generate short-run relationships between money, activity and inflation.18 Monetary policy affects output and employment in the short run and prices in the long run. Central banks care about both.
An inflation-targeting monetary policy is a combination of two elements: (a) a target for inflation in the medium term and (b) a response to economic shocks in the short term. From time to time shocks – to oil prices or the exchange rate, for example – will move inflation away from its desired long-term level, and the policy question is how quickly it should be brought back. The answer depends on the relative costs of deviations of inflation from the target and of unemployment from its long-term equilibrium level, and central banks have discretion in making that judgement. From this perspective there is no essential difference between the actions of a central bank with a Fed-style dual mandate and a central bank with a single mandate to meet an inflation target.
Inflation targeting has been highly successful, both in its primary aim and as a way of ensuring the democratic accountability of powerful public institutions. Some economists have argued that central banks should be compelled to set policy according to a ‘policy rule’ set by legislators, or at a minimum to explain why their chosen policy deviates from that implied by the rule. Monetary policy rules have become a major area of research. Perhaps the most famous is the so-called Taylor rule, named after John Taylor of Stanford University. The Taylor rule implies that interest rates should rise if inflation is above its target and output is above its trend level, and fall when the converse is true.
Inflation targeting is about making and communicating decisions. It is not a new theory of how money and interest rates affect the economy. But, by anchoring inflation expectations on the target, it can in theory reduce the variability and persistence of inflationary shocks – and has done so in practice. And it has done so without pretending to commit to a rule that is incredible because it is not expected to last.
Old problems and new instruments
There are, deeper reasons to ask why central banks should worry only about consumer price inflation rather than the state of the real economy. The practical significance of this question has been highlighted by the current disequilibrium in the world economy. Should central banks take responsibility for trying to correct such mistakes before households and businesses come to a true appreciation of the situation, or should they stay focused solely on targeting inflation a year or two ahead? Did central banks contribute significantly to the crisis by not trying to correct the big mistakes made by the private sector? To suggest that monetary policy has the purpose of preventing the economy from getting into an unsustainable position is tantamount to arguing that central banks should, on occasions, target the real equilibrium of the economy and not just price stability – a much deeper and more difficult question than that of whether a central bank should have a dual or a single mandate. The fundamental question is whether central banks should take responsibility for preventing substantial deviations of real variables, such as spending and output, from their normal levels, because the cost of permitting the continuation of a large and growing disequilibrium is a crash at some point in the future, followed by economic stagnation and persistently low inflation.
The proper role of a central bank un guiding the economy is, therefore, a thorny and controversial issue.
New probelms and old instruments
Until recently, central banks thought of monetary policy in terms of setting interest rates rather than fixing the supply of money. The two are, of course, closely related. Reducing interest rates stimulates the demand for borrowing and if banks increase their lending, the supply of bank deposits rises. That pushes up the money supply. But frequent and volatile shifts in the demand for money have led central banks to choose interest rates as their principal policy instrument.
To prevent a repetition of the Great Depression, central banks during 2008 and 2009 cut interest rates virtually to zero, at which point influencing the supply of money directly was the only remaining monetary instrument. The new problem they faced was what to do when interest rates are zero and cannot be lowered any further. When official interest rates have reached zero, modern Keynesians draw the conclusion that monetary policy is impotent and only fiscal policy can return the economy to full employment. Central banks did not accept this proposition, and took steps to expand the money supply. For most of the post-war period, governors of the Bank of England had been trying to prevent the amount of money in the economy from growing too quickly. If it were to expand at a rate much faster than the ability of the economy to grow, then the result would be inflation. But the problem facing the Bank in 2009 was that the amount of money in the economy available to finance spending was actually falling. The reason was that banks had begun to contract their balance sheets by refusing to roll over loans and no longer making new ones, thus reducing their total assets. The automatic counterpart on the liabilities side was a corresponding reduction in deposits as loans were repaid. Since most money comprises bank deposits, the fall in deposits meant that the amount of money available to finance spending actually fell. If left unchecked, that threatened a depression. So the task of the Bank was to ensure that the amount of money in the economy grew neither too quickly nor too slowly.
In the particular circumstances of 2009, that meant creating more money. It did not create inflation for two reasons.
• First, the increase in the supply of money was matched by a sharp increase in the demand for highly liquid reserves on the part of the banking system and the economy more generally.
• Second, the total supply of broad money, including bank deposits, rose only moderately. The ‘emergency money’ created by the Bank was necessary to prevent a fall in the total money supply.
It was precisely because the demand for money and liquidity changed so sharply that monetary developments mattered. It is ironic, therefore, that economists who believe that money matters (for example, Milton Friedman) argue that ‘the demand for money is highly stable’, whereas Keynesian economists argue that money does not matter because its demand is unstable. Both groups are wrong – money really matters when there are large and unpredictable jumps in the demand for it.
The method used to create money was to buy government bonds from the private sector in return for money. Those bond purchases were described by many commentators as ‘unconventional’ monetary policies and became known as ‘quantitative easing’, or QE.
Monetary policy in bad times – emergency money
Of particular significance to Bagehot was the failure of Overend, Gurney & Co., an erstwhile competitor of the Bank of England. On Thursday 10 May 1866 the bank announced that it would immediately suspend its activities following a severe run. As The Bankers’ Magazine put it at the time, the announcement generated ‘the greatest possible excitement in the City’. The Bank of England lent unprecedented sums to other banking houses, but it did not step in to prevent the failure of Overend, Gurney itself. For several years, there had been concerns about the health of Overend, Gurney and the reaction when it became a public company in 1865 had been decidedly mixed. But it was more than three years after its collapse when it emerged that the directors of the company, who stood trial on charges of fraud, had published a false prospectus concealing the fact that the firm had been, in essence, bankrupt before it went public. From his vantage point as editor of The Economist, Bagehot observed the 1866 crisis and drew the conclusion that when faced with a sudden and large increase in the demand for liquidity by the public, in other words a bank run – a ‘panic’ – the responsibility of the central bank was to meet it. In Germany in October 1923, as the hyperinflation was nearing its peak, the government was close to insolvent with only 1 per cent of its expenditure financed by taxation. Commercial banks have accounts at the central bank, and in a crisis, the central bank can lend to them against the collateral of their assets. Bagehot’s doctrine was that in a crisis central banks should lend freely against the security of good collateral, at an interest rate above normal levels to ensure that the central bank was the lender of last resort not the lender of first resort. What Overend, Gurney revealed to Bagehot was that, although in a crisis it might be difficult to know whether a bank was solvent, it was nevertheless safe for the central bank to lend against good collateral.
His view has since become the conventional wisdom. So much so, that the phrase ‘lender of last resort’ is widely misused to refer to any action that deals with a financial crisis by dousing the fire with a massive injection of liquidity. It is used to urge the European Central Bank to lend to sovereign governments within the euro area, and to imply that the IMF should lend to any country in difficulty; The expressions ‘lender of last resort’ and ‘bailout’ have become synonymous. It is only a matter of time before there is a demand for a LOLR for the Bank of Mum and Dad. Bagehot’s argument was very different. In essence, the problem was that the banking system was an intermediary financing illiquid assets by promising instant liquidity to depositors. For the economy as a whole, the promise cannot be met. When enough depositors want their money back, the banking system cannot provide it. If this additional demand for liquidity is temporary, then the provision of emergency money by the central bank can tide the system over until the panic subsides. But if the assets have genuinely lost value, then the central bank must be careful not to subsidise insolvent undertakings. The problem is that in a world of radical uncertainty it is never clear whether a bank is solvent or insolvent, and in a crisis there is rarely time to find out. Actions by a LOLR can prevent a liquidity problem turning into a solvency problem, although not all solvency problems can be converted into liquidity problems by LOLR lending, as governments have painfully discovered in recent times.
The centenary of the First World War witnessed a veritable blizzard of new books on that dreadful conflict – almost as many as on the recent financial crisis. Few people have drawn comparisons between the two episodes. But the outbreak of the First World War saw the biggest financial crisis in Europe, at least until the events of 2008, and an equally severe crisis in New York, albeit that the Great Depression was a bigger economic crisis in terms of its impact on output and unemployment.
So what happened in 1914? Historians have long documented the prevailing disbelief in the likelihood of a European war. Among other things, the economic cost would simply be too high. Just two days before Britain declared war in August 1914, the Governor of the Bank of England, Lord Cunliffe, was lunching on the yacht of the wealthy and well-connected Clark family, moored off the west coast of Scotland.
The next two weeks saw panic in markets and among banks. European stock markets fell sharply, and several were closed. There was a flight to safety, especially to cash, and liquidity dried up in all major markets, including those for foreign exchange, stocks and shares. Three-month interest rates more than doubled. At 10.15 a.m. on Friday 31 July the London Stock Exchange was closed in order to postpone settlement of transactions and thereby prevent a wave of failures among its members as prices plummeted.
That same day, lines formed in Threadneedle Street outside the Bank of England as depositors queued, as was their right, to convert deposits or notes into gold sovereigns, which commercial banks would not provide to them. As Keynes later put it, ‘the banks revived for a few days the old state, of which hardly a living Englishman had a memory, in which the man who had £50 in a stocking was better off than the man who had £50 in a bank’.
Meanwhile, on the other side of the Atlantic, the position was no less precarious. Europeans had begun to sell their investments on Wall Street and convert the dollars they received into gold to bring back to Europe. The dollar fell sharply. What happened over the next few weeks, however, was to result in New York displacing London as the money centre of the world. Although the Federal Reserve System had been created by Congress in December 1913, nominations to the Federal Reserve Board stalled in the Senate Banking Committee, and it met for the first time only in August 1914. So although William McAdoo, as Treasury Secretary (and, coincidentally, the son-in-law of President Woodrow Wilson), was also the first Chairman of the Board, the Fed did not enter the playing field until after the financial crisis had come and gone. As a result, in 1914 the major decisions in dealing with the crisis were taken not by central banks but by the respective finance ministers – Treasury Secretary McAdoo and Chancellor of the Exchequer Lloyd George.
Despite falls in stock prices of around 10 per cent earlier in the week, a meeting of bankers on the evening of Thursday 30 July had seen no reason for closing the New York Stock Exchange. But McAdoo intervened and, worried that if New York remained the only open exchange European investors would take the opportunity to sell and repatriate gold, ordered the exchange to close on Friday 31 July, a matter of hours after the closure of the London Stock Exchange.
Out of the 1907 crisis came another solution to the problems of 1914. The Aldrich-Vreeland Act of 1908 permitted banks to deposit government bonds or short-term paper issued by American companies with the US Treasury and receive ‘emergency notes’ in return. Emergency banknotes, embossed with each bank’s own name and logo, worth $500 million were printed in advance and stored with the Treasury in a new underground vault. Here was a source of emergency money that could be distributed to banks in exchange for collateral without the need for a central bank. There was a limit on the value of the notes that could be obtained of 90 per cent of the value of the bonds and 75 per cent of the value of commercial paper deposited by the banks with the US Treasury. And there was a tax on the value of the emergency notes drawn.
The first measure – on the Tuesday – was emergency legislation to impose a moratorium on all London bills of exchange for one month. Three days later this became a general moratorium. Debts, except for wages, and taxes and debts owed by foreigners, could not be enforced. The legislation provided that, if necessary, the moratorium extended to bank deposits. This provided temporary relief but did not tackle the underlying solvency problem.
Unfortunately, unlike in 1825, the Bank did not have sufficient stores in its vaults to meet the sudden increased demand for low denomination notes as gold coin was conserved to rebuild the nation’s gold reserves. So the second measure to be taken – on the Thursday – was the passage in one day of the Currency and Bank Notes Act, allowing the Treasury to print special £1 notes, to a much lower standard – in the interests of speed – than the Bank of England would have accepted. This amounted to temporary removal of the limits on the fiduciary note issue of the Bank of England, and required the suspension of the Bank Charter Act of 1844, as had previously happened in 1847, 1857 and 1866. Britain had not learned from the US experience in 1907 and had printed no store of emergency money to distribute in a crisis.
Third, on Friday 7 August the government decided that the bank holiday should end and the banks reopened. The crisis had been contained, if not solved.
Two broad lessons emerge from the experience of 1914.
• The first is that the key function of the monetary authorities, whether as government or central bank, is to determine the supply of money in both good times and bad.
• The second is that a crisis will not be resolved by the provision of liquidity if there is also an underlying solvency problem; in other words, a shortage of capital available to absorb losses and prevent default.
“The concept of ‘emergency money’ is important. It captures the need for a sudden increase in money when there is a sharp rise in the demand for liquidity. A jump in the demand for liquidity can arise for many reasons, including a loss of confidence in the public sector itself.”
The future of central banks
Central banks have a role to play in changing the heuristic used by households and businesses when they see a serious disequilibrium building up. In such circumstances, what is required is a clear and convincing explanation of why it may be desirable to allow inflation to run above or below target for a period in order to restore a sustainable path for the economy. It would be a big mistake to jettison inflation targeting altogether. It is a valuable heuristic for central banks, provided there is room to deviate when circumstances demand.
6. Marriage and Divorce: Money and Nations
What is the relationship between money and nations? From the role that money plays both in normal periods and, even more, in times of crisis, it is clear that there is an intimate link between the nation state and the money that circulates within it. That link runs very deep. There is a remarkable, almost uncanny, one-to-one relationship between nations and their currencies. Money and nations go hand in hand.
Three examples illustrate the complex relationship between money and nations. The first is monetary union in Europe – an example of many countries with a single currency. It is the obvious counter to the post-war trend of fragmentation and its fate will affect the whole world economy. As a marriage of currencies accompanied by no tying of the political knot, it is developing into a battle between political will and economic reality. The second is very different in scale and scope, but no less interesting. It concerns the currency arrangements in Iraq before and after the invasion in 2003, an example of one country with two currencies. And the third relates to the new currency arrangements that might have emerged from the referendum on Scottish independence held in 2014 had the result been ‘yes’ rather than the actual ‘no’.
European Monetary Union
The European experience over the past fifteen years or so suggests three main lessons for the relationship between nations and monetary unions:
• First, it is sensible to ensure that all partners in a monetary union have fully converged on the same underlying rates of wage and price inflation before they are permitted to join. Although this was the intention of the monetary union in Europe, political pressures led to the admission of countries where inflation rates had not fully converged.
• Second, once a union has been created, it is important to monitor and prevent the emergence of divergences in wage and price inflation before they lead to losses of competitiveness, which can be reversed only by long periods of mass unemployment. To its credit, the European Central Bank issued many warnings about this, but they were ignored.
• Third, future economic shocks are inherently unpredictable and monetary union will come under great strain unless there is a high degree of mutual trust and willingness to make transfers to countries that have suffered major shocks. That requires a degree of political integration that is absent in Europe today.
Iraq between the Gulf Wars
The second example illustrating the complex relationship between money and nations is the remarkable story of currency arrangements in Iraq between the First and Second Gulf Wars. It is the unusual story of one country with two currencies, or, perhaps more accurately, a country divided into two halves, one of which had a government and a badly run currency and the other, which had no government but a stable currency.
At the time of the First Gulf War in 1991, the Iraqi currency was the dinar. Following the war, Iraq was divided into two parts that were politically, militarily and economically separate from each other: southern Iraq was under the control of Saddam Hussein, and northern Iraq, protected by a no-fly zone north of the 36th Parallel, became a de facto Kurdish protectorate. In the south, Saddam’s regime struggled to cope with UN sanctions, and resorted to printing money to finance growing budget deficits. Unable to import notes printed abroad because of sanctions, the official Iraqi government started to print new notes that bore Saddam’s image. These were known as ‘Saddam’ dinars. Citizens had three weeks to exchange old notes for new. So many notes were eventually printed that the face value of cash in circulation jumped from 22 billion dinars at the end of 1991 to 584 billion only four years later. Inflation soared to an average of about 250 per cent a year over the same period.
For ten years, therefore, until the invasion in 2003 by the United States and its coalition partners, Iraq had two currencies. In the south the Saddam dinar was issued by the official government of Iraq. In the north the Swiss dinar circulated, even though backed by no formal government or central bank, nor any law of legal tender. For a fiat currency this was an unusual situation. Whatever gave the Swiss dinar its value did not derive from the official Iraqi government, nor indeed from any other government.
An independent Scotland
Sterlingisation is a perfectly reasonable policy for a country that is happy to accept the economic consequences of a fixed exchange rate with sterling, but does not have the option of joining a formal monetary union with the UK. The attraction to Scotland of such a solution is that nothing significant would need to change. Many banknotes issued by banks in Scotland already have distinctive national designs, and the same could occur with coins if another symbol of Scottish identity was desired, as in Ireland following independence.
Dollarisation has worked well for countries looking for a safe haven in stormy monetary conditions – including Cambodia, Ecuador and Panama – and sterlingisation would work for Scotland. It would be the right solution because Scotland has successfully lived in a currency union with England and Wales for three hundred years. Current expectations of inflation and wage settlements are consistent with an enduring exchange rate link. Scotland would not be joining, as were the members of European Monetary Union, a new currency arrangement. Scotland has less need than in the past for subsidies from England to offset adverse shocks specific to Scotland because changes in the industrial structure of both Scotland and England, with the decline of heavy manufacturing and mining and the decreasing contribution from North Sea oil, mean that the two economies tend to move together. Nor would Scotland be faced with a substantial burden in the event of another banking failure. It is true that under sterlingisation major banks in an independent Scotland would have to unscrew the brass plates at their legal headquarters in Edinburgh and move them to London. Effectively, Scotland would have only foreign banks. As a consequence, Scotland would need no ability to act as a lender of last resort to those banks. That role would continue to be performed by the Bank of England, just as it does today for UK banks, such as Barclays, with overseas banking operations. But there is no reason to suppose that there would be any significant change in the number or location of jobs in banks in Scotland – the economic incentives to locate jobs in different places would be unchanged.
What do these three examples tell us about the relationship between nations and monies? As we saw in Chapter 2, the key role of governments is to supply the right amount of money in good times in order to avoid the extremes of hyperinflation on the one hand, and depression on the other, and to create emergency money in bad times. In both cases that involves political judgements in the face of radical uncertainty. In good times, monetary policy combines an inflation target, whether implicit or explicit, with a policy for how quickly to react to temporary disturbances to inflation and growth.
7. Innocence Regained: Reforming Money and Banking
Liquidity is an illusion; here one day, gone the next. It reminds me of those attractive soap bubbles that one can blow into the air. From a distance, they look appealing. But if you ever try to hold them in your hand, they disappear in a trice. And whenever at the same time many people try to convert their assets into a liquid form, they often discover that liquidity has disappeared without trace. When there is a sudden jump in the demand for liquidity and investors rush to convert their claims on illiquid assets into money, the result is usually a crisis, exposing the alchemy for what it is. Liquidity is, however, only one aspect of the alchemy of our present system. Risk, and its impact on the solvency of banks, is the other. And in the recent crisis, concern about solvency was the main driver of the liquidity problems facing banks. When creditors started to worry that bank equity was insufficient to absorb potential losses, they decided that it was better to get out while the going was good. Concerns about solvency, especially in a world of radical uncertainty, generate bank runs. To reduce or eliminate alchemy, we need a joint set of measures to deal with both solvency and liquidity problems.
If a market economy is to function efficiently, businesses and households need a secure mechanism by which to pay their bills and receive wages and salaries. Ordinary current accounts are not vehicles for speculative investments and it is important that they have a stable value in terms of money, in which payments are denominated. But if a bank has assets that are highly risky, as many of its loans may be, then it is alchemy to pretend that deposits can be secure. So governments decided to guarantee deposits, first by creating deposit insurance and then in the recent crisis by extending blanket guarantees to all bank creditors. Because of their importance to the economy, and their political power, banks had become too important to fail. And the larger they became, the more likely it was that the government would bail them out in times of difficulty. Central banks lent vast sums to commercial banks. That stopped the rot, in the sense of removing the incentive to run on a bank, but at the cost of shifting the risk of the assets of banks on to taxpayers. In the case of Ireland, it almost bankrupted the country.
Official sector reforms
Since the crisis, the official sector has been hyperactive. Both at the national and international level, regulators have been tightening up on the freedoms given to banks in respect of how they finance themselves, their structure and their conduct. At the international level, a concerted effort has been made by the major countries in the G20, working through the Basel Committee of the Bank for International Settlements, to rectify some of the pre-crisis failures in regulation. The minimum amount of equity a bank must use to finance itself, known as its capital requirement, has been raised, and banks also have to hold a minimum level of liquid assets related to the deposits and other short-term financing that could run from the bank within thirty days, known as the liquidity coverage ratio. Regulators are also conscious of the need to look outside the boundaries of the traditional banking sector to see if elements of alchemy are appearing in the ‘shadow’ banking sector, and to conduct stress tests to see if banks are capable of withstanding the losses incurred due to particular adverse scenarios.
Countries such as the United Kingdom and United States have introduced legislation to separate, or ring-fence, basic banking operations from the more complex trading activities of investment banking. And most countries have either improved or introduced special bankruptcy arrangements – known as resolution mechanisms – to enable a bank in trouble to continue to provide essential services to its depositors while its finances are being sorted out and, if necessary, to faciliate a speedy transfer of depositors from a failinf ro a profitable bank.
Moreover, the market itself has imposed its own discipline on banks and other financial institutions. As a result, the banking system has changed a great deal since 2008. The largest banks have become smaller; the balance sheet of Goldman Sachs in 2015 was around one quarter smaller than in 2007. Investment banking is not as profitable now as it was when asset prices were rising in the wake of falling real interest rates. Many banks have cut back on the size of their investment banking operations and some, such as Citigroup and Bank of America, have sold their proprietary trading desks, which bought and sold investments on their own account, and turned themselves back into more traditional commercial banks.
Let’s ask the following question: how much equity finance does a bank need to issue in order to persuade potential creditors that it is safe for them to lend to the bank? Before the crisis, the answer was hardly any at all. Markets were content to lend large sums to banks at low interest rates, even though banks were highly leveraged. After 2008, the answer was a very large amount. Not even the new higher levels of capital mandated by regulators were sufficient to ensure that markets were happy to restore previous levels and pricing of funding. The innocence that was lost during the crisis was proving very expensive to regain. For investors, the narrative about the wisdom of lending to banks had changed. So it is extremely difficult to know the appropriate level of equity finance a bank should be required to use in a world where alchemy is still a characteristic of the banking system. And the right answer can change from one day to the next. In 2012, the Spanish bank Bankia reported a risk-weighted capital ratio of over 10 per cent, well above the regulatory minimum; three months later it required a capital injection of €25 billion.
More radical reforms
Even though the degree of alchemy of the banking system was much less fifty or more years ago than it is today, it is interesting that many of the most distinguished economists of the first half of the twentieth century believed in forcing banks to hold sufficient liquid assets as reserves to back 100 per cent of their deposits. They recommended ending the system of ‘fractional reserve banking’, under which banks create deposits to finance risky lending and so have insufficient safe cash reserves to back their deposits.12 The elimination of fractional reserve banking was a proposal put forward in 1933 as the ‘Chicago Plan’.
There are two ways of looking at these radical approaches to banking reform, one by focusing on the banks’ assets and the other on their liabilities. The essence of the Chicago Plan was to force banks to hold 100 per cent liquid reserves against deposits. Reserves would include only safe assets, such as government securities or reserves held with the central bank. In this way there would be no reason for anyone to run on a bank, and even if some people did withdraw their deposits there would be no incentive for others to join them, because there would always be sufficient funds to support the remaining deposits. The great advantage of reforms such as the Chicago Plan is that bank runs and the instability they create would disappear as a source of fragility.
So why hasn’t the idea been implemented? One explanation is that it would eliminate the implicit subsidy to banking that results from the ‘too important to fail’ nature of most banks. Banks will lobby hard against such a reform. To protect the system of making payments, as crucial to the daily functioning of the economy as electricity is to our daily lives, governments will always guarantee the value of bank accounts used to make payments, and it is therefore in the interest of banks to find ways of putting risky assets on to the same balance sheet as deposits.
More importantly, however, eliminating alchemy in this particular way has some other disadvantages.
• First, the transition from where we are today to complete separation of narrow and wide banks could be disruptive, forcing a costly reorganisation of the structure and balance sheet of existing institutions.
• Second, the complete separation of banks into two extreme types – narrow and wide – denies the chance to exploit potential economic benefits from allowing financial intermediaries to explore and develop different ways of linking savers, with a preference for safety and liquidity, and borrowers, with a desire to borrow flexibly and over a long period.
• Third, and most important of all, radical uncertainty means that it is impossible for the market to provide insurance against all possible contingencies, and one role of governments is to provide catastrophic insurance when something wholly unexpected happens.
A new approach – the pawnbroker for all seasons
It is time to replace the lender of last resort by the pawnbroker for all seasons (PFAS). A pawnbroker is someone who is prepared to lend to almost anyone who pledges collateral sufficient to cover the value of a loan Since 2008, central banks have become used to lending against a much wider range of collateral than hitherto, and it is difficult to imagine that they will be able to supply liquidity insurance without continuing to do so.
When there is a sudden jump in the demand for liquidity, the pawnbroker for all seasons will supply liquidity, or emergency money, against illiquid and risky assets. Only a central bank on behalf of the government can do this.
The aim of the PFAS is threefold:
• First, to ensure that all depositors are backed by either actual cash or a guaranteed contigent claim on reserves at the central bank.
• Second, to ensure that the provision of liquidity insurance is mandatory and paid for upfornt.
• Third, to design a system which in effect imposes a tax on the degree of alchemy in our financial system – private financial intermediaries should bear the social costs of alchemy.
The basic principle is to ensure that banks will always have sufficient access to cash to meet the demands of depositors and others supplying short-term unsecured debt. The key is to look at both sides of a bank’s balance sheet. (1) Start with its assets. Each bank would decide how much of its assets it would position in advance at the central bank – that is, how much of the relevant assets the central bank would be allowed to examine and which would then be available for use as collateral. For each type of asset the central bank would calculate the haircut it would apply when deciding how much cash it would lend against that asset. Adding up all assets that had been pre-positioned, it would then be clear how much central bank money the bank would be entitled to borrow at any instant. (2) The second step is to look at the liabilities side of a bank’s balance sheet – its total demand deposits and short-term unsecured debt (up to, say, one year) – which could run at short notice. That total is a measure of the bank’s ‘effective liquid liabilities’. The regulatory requirement on banks and other financial intermediaries would be that their effective liquid assets should exceed their effective liquid liabilities.
The PFAS rule is not a pipe dream. Some central banks have already moved in that direction. For example, the Bank of England has for some while encouraged banks to pre-position collateral as way of obtaining liquidity insurance. In the spring of 2015, the value of collateral pre-positioned with the Bank was £469 billion and the average haircut was 33 per cent. Together with reserves at the Bank of £317 billion, the effective liquid liabilities of the banking system were £632 billion, compared with £1820 billion of total deposits.32 There was still a substantial degree of alchemy, but around one-third of deposits were backed by ‘effective’ liquid assets and the idea of gradually eliminating alchemy through a PFAS is realistic. Alchemy can be squeezed out of the system by pressing from the two ends – by raising the required amount of equity and keeping central bank balance sheets, and hence bank reserves, at broadly their present level. That would allow the PFAS rule to complete the job. Far from being a radical and unrealistic objective, the elimination of alchemy could be achieved by building on actions that were taken during the crisis and the adoption of the PFAS rule. The idea is new; the means of implementation isn’t. There is a natural path from today’s ‘extraordinary’ measures to a permanent solution to alchemy.
The future of money
There is clearly a strong demand for anonymity when making payments. Much of that has been eroded in respect of electronic payments with counter-terrorism surveillance and the introduction of regulation to prevent money laundering that requires the disclosure of large amounts of information to governments. So the demand for paper money is unlikely to disappear quickly, and anonymity for illegal transactions is the opposite side of the coin of individual privacy.
Nevertheless, electronic payments are the way of the future. Even old-fashioned bank robberies are diminishing – they almost halved in the US between 2004 and 2014 – to be replaced by an explosion of cybercrime. At present, electronic transfers simply move money from one bank account to another – convenient but not revolutionary – and banks then clear payments with each other through their own accounts at the central bank. In principle, two parties engaged in a transaction could instead settle directly by a transfer of money from one electronic account to another in ‘real time’.
A step in that direction was the creation of bitcoin – a ‘virtual’ currency launched in 2009, allegedly by one or more individuals under the pseudonym of Satoshi Nakamoto. Ownership of bitcoins is transferred through bilateral transactions without the need for verification by a third party (necessary in all other current electronic payment systems). Transactions are verified by the use of a software accounting system accessible to all users.35 The supply of bitcoins is governed by an algorithm embodied in the software that runs the system (with a maximum number of twenty-one million). If you can persuade someone to accept payment in bitcoins, then you can use them to buy ‘stuff’. The price of bitcoins in terms of goods and services, or currencies such as the dollar, is determined in the market. Without any public body setting the standard for bitcoins as a unit of account, their price is highly volatile. With no one standing ready to redeem them in terms of any other commodity or currency, bitcoins are a highly speculative investment. They have no fundamental value: their price simply reflects the value that bitcoins are expected to have in the future.
The integrity of the algorithm determining the supply of bitcoins is vital. An indication of what can go wrong when confidence in that process is lost is the fate of a related venture, the auroracoin, a digital currency in Iceland. As an alternative to government-issued paper money, auroracoins were circulated in Iceland by a private entrepreneur in March 2014 through a ‘helicopter’ drop to every citizen listed on the national ID register. Within a few months they had lost over 96 per cent of their launch value.37 Moreover, as described in Chapter 2, with any private fiat money new entry can undermine the value of existing currencies. What is to stop some new group of programmers from launching a digital currency under the name ‘digidollars’? The aggregate supply of digital currency cannot be controlled by any one issuer, which is why governments have nationalised the production of paper currencies.
8. Healing and Hubris: The World Economy Today
Keynesian and neoclassical macroeconomics
Macroeconomics in this era became divided into two schools of thought: Keynesian and neoclassical. Keynesian school focused on the role of the state in returning an economy from depression to full employment. The neoclassical school studied the conditions in which a market economy returns to full employment under its own steam after a temporary deviation from its normal equilibrium. Neoclassical economists often argue that the Keynesian analysis presents a special case in which employment is temporarily below its attainable level, often as a result of misguided government policies.
Keynes’s basic argument was that capitalism might fail to deliver full employment because it could not coordinate the spending plans of all the different participants in the economy. This idea was contrary to the apparently common-sense view that if every market equates supply and demand for its product, then adding up across all markets means that aggregate demand equals aggregate supply in the economy as a whole. How could one explain this apparent paradox?
The oil market provides a good example. World oil production is around 90 million barrels a day.6 At a price of $50 a barrel, annual turnover is over $1.6 trillion – a lot of money. Higher oil prices should in theory stimulate more investment in production and extraction of oil. But the supply response to higher oil prices is dampened because potential producers cannot be confident of the prices they will receive in future. There is one very good economic reason why a liquid futures market for oil to be delivered at dates many years into the future has not developed. It would be attractive to many potential oil producers, such as those developing the Canadian tar sands, to be able to sell oil today for delivery in the future. That would remove the uncertainty about price and make the investment decision a matter of mere calculation rather than entrepreneurial judgement. Equally, those considering investing in alternative sources of energy would have more confidence about the future because they would know the price they would have to match.
But a futures market cannot develop unless there is demand as well as supply. At first sight, it might seem that heavy users of oil, such as airlines, would wish to buy in a futures market. That would reduce the uncertainty surrounding their future fuel costs. But the problem for any airline contemplating doing this is that they cannot sell forward their own outputs, namely airline tickets. So by buying oil forward at the price in today’s market, they would be leaving themselves open to competitors who could enter the market if the future price of oil turned out to be well below today’s future price. Only by selling forward both their inputs and outputs would airlines and other energy users find it attractive to use a futures market. And the reason there is no futures market in airline tickets is because travellers do not know today where they will want to fly in the distant future, and how much they are willing to pay for the trip. The crucial factor determining the demand for new planes will be the expectations of airline companies about the demand for flights over a particular horizon in the future. Despite the best efforts of airline analysts, those expectations will inevitably be subjective. If they could today sell tickets for the relevant future dates then the market would coordinate supply and demand for flights, and in turn for oil. But in the absence of those futures markets, such coordination is impossible.
An implication of the Keynesian argument is that it is misleading to think of the economy as a whole as if it were simply a single household. If one household saves more today with a view to spending more tomorrow, its income is unaffected. But if many households try to save more today, total spending falls and so do total incomes and actual saving – the so-called ‘paradox of thrift’. Only if households’ intention to save today and spend tomorrow can be communicated to producers might investment rise to offset the fall in consumption. But in the absence of a complete set of markets, no producer will receive a signal that the demand for her production in the future has increased. The coordination problem is an instance of the prisoner’s dilemma. Collective action is needed to stabilise the economy – for example, by expanding government spending in a downturn or reining in private spending in a boom.
The challenge to Keynes came in the form of two questions.
• First, why could unemployment not be cured by cutting wages in order to stimulate the demand for labour? Keynes was vehement that – contrary to the beliefs of most of his predecessors and contemporaries – a cut in wages was not the answer to a slump in demand. It took the rigour of the auction model to show why his intuition was correct. In the grand auction, a cut in the price of a good for which supply exceeds demand can restore balance between the two because that price cut takes place only in the context of a complete resetting of all prices to ensure balance between demand and supply in each and every market. In the world, Keynes argued, a cut in wages might, as incomes fell, lead to a fall in consumer spending, which in turn would change the expectations of businesses and households about future demand. That could lead to a self-reinforcing fall in overall spending – a ‘multiplier’ effect. Wage and price flexibility does help to coordinate plans when all the markets relevant to future spending decisions exist. But in practice they do not, and in those circumstances cuts in wages and prices may lower incomes without stimulating current demand.
• The second, and related, question was why would an increase in money supply not stimulate spending, returning the economy to full employment? Keynes’s reply was that in a slump the demand for liquidity – emergency money – was so high that further injections of money would simply be absorbed in idle cash balances as a claim on generalised future purchasing power without any impact on current spending. The economy would be stuck in a ‘liquidity trap’.
Keynes argued that when short-term and long-term interest rates had reached their respective lower bounds, further increases in the money supply would just be absorbed by the hoarding of money and would not lead to lower interest rates and higher spending. Once caught in this liquidity trap, the economy could persist in a depressed state indefinitely. Since economies were likely to find themselves in such conditions only infrequently, Hicks described Keynes’s theory as special rather than general, and relevant only to depression conditions. And this has remained the textbook interpretation of Keynes ever since. Its main implication is that in a liquidity trap monetary policy is impotent, whereas fiscal policy is powerful because additional government expenditure is quickly translated into higher output.
If wage cuts don’t restore employment, then why should interest rate cuts restore spending? Other things being equal, a fall in real interest rates would be expected to stimulate both consumption and investment spending. But other things are not equal. For example, the imposition of a negative real interest rate – effectively a wealth tax – on all forms of financial wealth expropriates the incomes of savers and might alter expectations of future effective rates of wealth taxes. If you are told, for example, that all your assets held in accounts fixed in money terms will be subject to a 5-percentage-point wealth tax, you might, it is true, decide to spend today, but you might well, fearful of what the government could do next year, batten down the hatches and cut spending. Households and businesses might simply conserve their resources to cope with an unpredictable and unknowable future. The outcome will depend on expectations.
Even if monetary policy could lower the real interest rate into negative territory, there is no guarantee that demand would pick up. In the world of the economics of ‘stuff’ it might work by bringing spending forward. But in a world where ‘stuff happens’, the missing markets for future goods and services provide no price signals to encourage investment to meet future demand. Indeed, digging a hole in expected future demand may actually cause investment to fall. There is a good case to be made for saying that the importance of the zero lower bound on interest rates has been overstated as the source of our macroeconomic problems.
Most of the large-scale econometric models used by governments and central banks to make forecasts are based on sophisticated versions of ‘New Keynesian’ models. They afford little role for money or banks, a property that has been a source of embarrassment, both intellectual and practical. They also have one other unfortunate feature – inflation is, in the long run, determined not by the amount of money in circulation but by the expectations of the private sector. Moreover, the inflation target is assumed to be completely and perfectly credible, meaning that people are assumed to set wages and prices in a way that leads the target to become self-fulfilling. As a result, forecasts of inflation made by central banks always tend to revert to the target in the medium term. Because they assume rather than explain inflation in the long run, the models are reminiscent of the old joke about the physicist, the chemist and the economist stranded on a desert island with a single can of food. How are they to open it? The economist’s answer is, ‘Assume we have a can opener.’
The crisis created a serious challenge to conventional economic thinking. Many of the large shifts in macroeconomic variables, such as productivity and real wages, output and inflation, migration and population size, are determined ultimately by unobservable and unpredictable events: the political changes that led to the oil price shocks of the 1970s; the Vietnam War that led to the political decision to accept high levels of inflation in the United States and elsewhere; the political decision to go ahead with monetary union in Europe in 1999; the political reforms in China that led to its rapid growth and integration in the world economy. None of those would have found a place in the economic forecasting models used by central banks. They are ‘political economy’ variables. Yet these big surprises were in fact the driving force of major developments in the world economy. They represent not the random shocks of the forecasters’ models but the realisation of radical uncertainty.15 The intellectual framework of the neoclassical model, as implemented empirically in New Keynesian models, appeared the best on offer, but it was inadequate to explain the build-up of a disequilibrium that resulted in the crisis.
To sum up, neither Keynesian nor neoclassical theories provide an adequate explanation of booms and depressions. After the recent crisis there was a resurgence of interest in theories that purported to explain the transition from periods of boom to periods of boom to periods of slumps.
Foremost among these was the theory of Hyman Minsky, an American economist who tried to reinterpret Keynes, that market economies inevitably exhibit financial instability. Long periods of stability would, he argued, create excessive confidence in the future, leading to the underpricing of risk and overpricing of assets, a boom in spending and activity, and excessive accumulation of debt, ending in a financial crash which, because of high debt burdens, would lead to a deep recession. Inevitably, in the wake of a crisis such ideas appear common sense and highly plausible; up to a point, they are. But they suffer from two problems.
• The first is that Minsky believed there would always be a boom before the bust. But in the recent crisis there was no boom beforehand – growth in the major economies in the five years leading up to the start of the crisis was close to its long-term average – although there was certainly a post-crisis bust. There was a rapid rise in asset prices, debt and leverage of the banking system, but output growth, unemployment and inflation were all rather stable. Each crisis has its own distinctive pattern. No two are the same. Their causes differ, although most are accompanied by sharp changes in levels of money and debt and entail problems in the banking sector. Sometimes a crisis is a reaction to a dramatic and wholly unexpected event, as in 1914, when the shock was the realisation of the inevitability of the First World War.
• The second problem with Minsky’s theory is that it depends on the irrationality of households and businesses. Periods of stability are characterised by excessive optimism, inevitably followed by excessive pessimism. The idea that people have a psychological propensity to underestimate the probability of events that have not occurred for some time – and so underestimate the chances of a crisis – underlies recent work on the psychology of financial crises.
9. The Audacity of Pessimism: The Prisoner’s Dolemma and The Coming Crisis
The coming crisis: sovereign debt forgiveness – necessary but not sufficient
Maintaining interest rates at extraordinarily low levels for years on end has contributed to the rise in asset prices and the increase in debt. Debt has now reached a level where it is a drag on the willingness to spend and likely to be the trigger for a future crisis. The main risks come from the prospect of a fall in asset prices, as interest rates return to normal levels, and the writing down of the value of investments as banks and companies start to reflect economic reality in their balance sheets. In both cases, a wave of defaults might lead to corporate failures and household bankruptcies. By 2015, corporate debt defaults in the industrial and emerging market economies were rising.2 Disruptive though a wave of defaults would be in the short run, it might enable a ‘reboot’ of the economy so that it could grow in a more sustainable and balanced way. More difficult is external debt – debt owed by residents of one country to residents of another country – especially when that debt is denominated in a foreign currency.
The situation in Greece encapsulates the problems of external indebtedness in a monetary union. GDP in Greece has collapsed by more than in the United States during the Great Depression. Despite an enormous fiscal contraction bringing the budget deficit down from around 12 per cent of GDP in 2010 below to 3 per cent in 2014, the ratio of government debt to GDp has continued to rise, and is now almost 200 per cent. All of this debt is denominated in a currency that is likely to rise in value relative to Greek incomes. Market interest rates are extremely high and Greece has little access to international capital markets. When debt was restructured in 2012, private sector creditors were bailed out. Most Greek debt is now owed to public sector institutions such as the European Central Bank, other member countries of the euro area, and the IMF. Fiscal austerity has proved self-defeating because the exchange rate could not fall to stimulate trade. In their 1980s debt crisis, Latin American countries found a route to economic growth only when they were able to move out from under the shadow of an extraordinary burden of debt owed to foreigners. To put it another way, there is very little chance now that Greece will be able to repay its sovereign debt. And the longer the austerity programme continues, the worse becomes the ability of Greece to repay.
Much of what happened in Greece is reminiscent of an earlier episode in Argentina. In 1991, Argentina fixed the exchange rate of its currency, the peso, to the US dollar. It had implemented a raft of reforms in the 1990s, and was often cited as a model economy. At the end of the 1990s, there was a sharp drop in commodity prices and Argentina went into recession. Locked into a fixed-rate regime, the real exchange rate had become too high, and the only way to improve competitiveness was through a depression that reduced domestic wages and prices. Argentina’s debt position was akin to that of Greece, and it had a similarly high unemployment rate. So in the face of a deep depression, the exchange rate regime was abandoned and capital controls were introduced. Bank accounts were redenominated in new pesos, imposing substantial losses on account holders. Initially, the chaos led to a 10 per cent drop in GDP during 2002. But after the initial turmoil, Argentina was able to return to a period of economic growth. Commodity prices rose steadily for a decade and Argentina was able to enjoy rapid growth of GDP – almost 10 per cent a year for five years.
It is evident, as it has been for a very long while, that the only way forward for Greece is to default on (or be forgiven) a substantial proportion of its debt burden and to devalue its currency so that exports and the substitution of domestic products for imports can compensate for the depressing effects of the fiscal contraction imposed to date. Structural reforms would help ease the transition, but such reforms will be effective only if they are adopted by decisions of the Greek people rather than being imposed as external conditions by the IMF or the European Commission. The lack of trust between Greece and its creditors means that public recognition of the underlying reality is some way off.
The inevitability of restructuring Greek debt means that taxpayers in Germany and elsewhere will have to absorb substantial losses. It was more than a little depressing to see the countries of the euro area haggling over how much to lend to Greece so that it would be able to pay them back some of the earlier loans. Such a circular flow of payments made little difference to the health, or lack of it, of the Greek economy. It is particularly unfortunate that Germany seemed to have forgotten its own history.
Escaping the prisoner’s dilemma: wider international reforms
The Asian financial crisis of the 1990s, when Thailand, South Korea and Indonesia borrowed tens of billions of dollars from western countries through the IMF to support their banks and currencies, showed how difficult it is to cope with sudden capital reversals resulting from a change in sentiment about the degree of currency or maturity mismatch in a nation’s balance sheet, and especially in that of its banking system. The IMF cannot easily act as a lender of last resort because it does not own or manage a currency. In the Asian crisis, therefore, it was almost inevitable that conditionality was set by the US because the need of those countries was for dollars. The result was the adoption by a number of Asian countries of do-it-yourself lender of last resort policies, which involved their building up huge reserves of US dollars out of large trade surpluses. That, together with their export-led growth strategy, led directly to the fall in real interest rates across the globe after the fall of the Berlin Wall. Resentment towards the conditions imposed by the IMF (or the US) in return for financial support has also led to the creation of new institutions in Asia, ranging from the Chiang Mai Initiative, a network of bilateral swap arrangements between China, Japan, Korea and the ASEAN countries to serve as a regional safety-net mechanism now amounting to $240 billion, to the new Chinese-led Asian Infrastructure Investment Bank that was created in 2015. It is likely that Asia will develop its own informal arrangements that will, in essence, create an Asian IMF, an idea that was floated in 1997 at the IMF Annual Meetings in Hong Kong and killed off by the United States. Twenty years on, the power of the United States to prevent a mutual insurance arrangement among Asian countries is limited.
The audacity of perssimism
Is there good cause for pessimism about the rate at which economies can grow in future? There are three reasons for caution about adopting this new-found pessimism. • • First, the proposition that the era of great discoveries has come to an end because the major inventions, such as electricity and aeroplanes, have been made and humankind has plucked the low-hanging fruit is not convincing. In areas such as information technology and biological research on genetics and stem cells we are living in a golden age of scientific discovery. By definition, ideas that provide breakthroughs are impossible to predict, so it is too easy to fall into the trap of thinking that the future will generate fewer innovations than those we saw emerge in the past.
• Second, although the recovery from the downturn of 2008–9 has been unusually slow in most countries, the factors contributing to the growth of labour supply have behaved quite differently across countries. For example, in contrast to the US, the UK has experienced buoyant population growth and rising participation in the labour force. And even some of the periphery countries in the euro area, such as Spain, have recently seen rises in measured average productivity growth. The factors determining long-term growth seem to be more varied across countries than the shared experience of a slow recovery since the crisis, suggesting that the cause of the latter is rooted in macroeconomic behaviour rather than a deterioration in the pace of innovation.
• Third, economists have a poor track record in predicting demographic changes. Books on the theme of the economic consequences of a declining population were common in the 1930s. A decade and a world war later, there was a baby boom.27 Agnosticism about future potential growth is a reasonable position; pessimism is not. History suggests that changes to underlying productivity growth occur only slowly. Many economists in the past have mistakenly called jumps in trend growth on the basis of short-term movements that proved short-lived.
Most discussion of this demand pessimism fall into one of two camps.
• On the one hand, there are those who argue that our economies are facing unusually strong but temporary ‘headwinds’ which will, in due course, die down, allowing central banks to raise interest rates to more normal levels without undermining growth. We simply need to be patient, and a natural recovery will then follow.
• On the other hand, there are those who advocate even more monetary and fiscal stimulus to trigger a recovery. To be sure, it is hard to argue against a well-designed programme of public infrastructure spending, financed by government borrowing, especially when you are travelling through New York’s airports. But the difficulty of organising quickly a coherent plan for expanding public investment, while maintaining confidence in long-term fiscal sustainability, makes this option one for the future rather than today, albeit one worthy of careful preparation.
With the audacity of pessimism, we can do better. A reform programme might comprise three elements.
• First, the development and gradual implementation of measures to boost productivity. Since the crisis, productivity growth has been barely noticeable, and well below pre-crisis rates. A major reason for this disappointing performance is that there has been a sharp fall in the growth rate, and perhaps even in the level, of the effective capital stock in the economy. Part of this reflects the fact that past investment was in some cases a mistake, directed to sectors in which there was little prospect of future growth, and is now much less productive than had been hoped. Some of the capital stock is worth less than is estimated in either company accounts or official statistics, or even in economists’ models. Part reflects pessimism about future demand and uncertainty about its composition which has led to a fall in business investment spending around the world. Current demand is being met by expanding employment. Companies do not wish to repeat the mistake of investing in capital for which there is little future profitable use. If future demand turns out to be weak then it will be cheaper to adjust production by laying off employees. A higher ratio of labour to effective capital explains weaker productivity growth. Reforms to improve the efficiency of the economy, and so the rate of return on new investment, would stimulate investment and allow real interest rates to return to a level consistent with a new equilibrium. Over time, as invetment rebuilt the effective capital stock, productivity growth would return to rates reflecting the underlying innovation in a dynamic capitalist economy.
• Second, the promotion of trade. Throughout the post-war period, the expansion of trade has been one of the most successful routes to faster productivity growth, allowing countries to specialise and exchange ideas about new products and processes.
• Thrid, the restoration of floating exchange rates. The experiment with fixing exchange rates has not been successful and it is important that exchange rates are free to play their stabilising role in order to correct the current disequilibrium.
The principle behind such a programme is to raise expected future incomes, not by recreating the false beliefs held before the crisis, but by boosting productivity.
Four concepts have run through this book in order to explain the nature of financial alchemy and the reasons for the present disequilibrium of the world economy: disequilibrium, radical uncertainty, the prisoner’s dilemma and trust. It is hard to think about money and banking, and their role in the economy, except in those terms.
In a capitalist economy, money and banks play a critical role because they are the link between the present and the future. Nevertheless, they are manmade institutions that reflect the technology of their time. Although they have provided the wherewithal to accumulate capital – vital to economic growth – they have done so through financial alchemy by turning illiquid real assets into liquid financial assets. Over time, the alchemy has been exposed. Unlike aeroplane crashes, financial crises have become more, not less frequent. Precisely because money and banks are manmade institutions, they can be reshaped and redesigned to support a successful and more stable form of capitalism.
Dealing with the immediate symptoms of crises by taking short-term measures to maintain market confidence – usually by throwing large amounts of money at it – will only perpetuate the underlying disequilibrium. Almost every financial crisis starts with the belief that the provision of more liquidity is the answer, only for time to reveal that beneath the surface are genuine problems of solvency. A reluctance to admit that the issue is solvency rather than liquidity – even if the provision of liquidity is part of a bridge to the right solution – lay at the heart of Japan’s slow response to its problems after the asset price bubble burst in the late 1980s, different countries’ responses to the banking collapse in 2008, and the continuing woes of the euro area. Over the past two decades, successive American administrations dealt with the many financial crises around the world by acting on the assumption that the best way to restore market confidence was to provide liquidity – and lots of it.
For many centuries, money and banking were financial alchemy, seen as a source of strength when in fact they were the weak link of a capitalist economy. A long-term programme for the reform of money and banking and the institutions of the global economy will be driven only by an intellectual revolution. Much of that will have to be the task of the next generation. But we must not use that as an excuse to postpone reform. It is the young of today who will suffer from the next crisis – and without reform the economic and human costs of that crisis will be bigger than last time. That is why, more than ever, we need the audacity of pessimism. It is our best hope.
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