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Giving the Baron King of Lothbury his Due

June 7, 2016

The Bank of England is not only the central bank of the United Kingdom, in continuous operation since 1694; it is the model upon which central banking worldwide has been created. The Mother Central Bank is what it is. Mervyn King, the chief economist of the Bank of England through most of the 1990s, then its deputy governor, finally for 10 years beginning in 2003 served as its Governor.

King hasn’t spent the period since 2013 in quiet retirement. He has reflected on his tumultuous tenure, especially upon the years 2007-09, has studied the already vast literature on the subject, and has given us this book of reflections and advice, The End of Alchemy: Money, Banking, and the Future of the Global Economy.

That titular use of the word “alchemy” references the efforts to create a proto-chemistry in late medieval Europe, before the distinction between elements and compounds was well understood, efforts associated with Geber and Flamel.  Such endeavors come to King’s mind because one of the quests of the alchemists was for the “philosopher’s stone,” a stone that could turn base metals into gold.

Central Banking: The Alchemy That Failed

Likewise, in King’s view, learned people today believe that mere paper can be turned into a store of value by a philosopher’s stone composed of governmental fiat.  “Confidence in paper money rests on the ability and willingness of governments not to abuse their power to print money,” he writes in his introduction, though in context it is clear that this has to be coupled with the general publics’ belief that “money kept in banks can be taken out whenever depositors ask for it.” That belief is necessary even though everyone at some level understands that banks have to hold assets that cannot quickly be converted into cash.

Of course these ‘alchemical’ elements are critical to the sort of banking that King practiced in his career with the Bank of England, and the sort of economics he taught in his academic career before that.  There’s an element of self-criticism in the book. He mentions that in 2011 he dined with a senior banker in Beijing. He asked that banker a broad question about westernization in China, and got this response. “We in China have learned a great deal from the West about how competition and a market economy support industrialization and create higher living standards. We want to emulate that. But I don’t think you’ve quite got the hang of money and banking yet.” That remark, he says, was “the inspiration for this book.”

Banking or central banking without what King calls “alchemy” will not consist of the institutions with which we are familiar. It will be something quite different, whether or not it retains the old names. For it was precisely that alchemy that failed in the global financial crisis.

Ah, you may respond, “but there has already been a wave of banking reforms in the world’s developed country – banking is not the industry it was during the crisis – has King perhaps not come too late to the Fair?”

King (formally, Baron King of Lothbury), doesn’t think so. He wastes no admiration on the many new banking laws, regulations, and international accords that have come about since the crisis. This regulation is “extraordinarily complex,” he writes, “and in ways that do not go to the heart of the problem of alchemy.” Indeed, he quotes Lord Mansfield, who back in 1761 cautioned that complexity is part of the problem, not of the solution. “The daily negotiations and property of merchants ought not to depend upon subtleties and niceties; but upon rules easily learned and easily retained, because they are the dictates of common sense, drawn from the truth of the case.” Recent efforts would not have pleased Lord Mansfield.

A Greater Crisis Ahead

King is convinced that without a more fundamental sort of reform than anything yet seen, the next banking crisis will be worse than the last, in both economic and human costs. So … what is to be done to limit the recurrence of crises as great as or greater than that of 2007-09? King suggests as a start that we stop thinking of central banks as lenders of last resort. That we start thinking of them, instead, as pawnbrokers for all seasons (PFAS).

Pawnbrokers in general are “prepared to lend to almost anyone who pledges collateral sufficient to cover the value of a loan,” such as by borrowing $25 against a gold watch.  The assets of private banks should be seen as collateral available to the central bank, and the central bank should make itself available as a lender to its members only to the extent that the pledged assets justify.

How does this make the alchemy disappear? The PFAS as King sees it will serve as an insurance company, receiving mandated premiums, and this will reduce the significance of the implicit taxpayer guarantee to the creditors of “too big to fail” financial intermediaries.  This system won’t itself constitute an end to alchemy. Once this system is in place, the alchemical element in the system can be reduced gradually over time.

How does this matter to the hunters of alpha? If King represents a powerful body of opinion, then we may see continued efforts, not to realize his ambitious PFAS program exactly, but in the general direction: rendering banking ever safer and ever more boring as an occupation. The more banks becoming boring, the more the exciting and risky stuff in the financial world moves elsewhere, into the “shadow” of banking, making life more intriguing for those who are already there.