Sunday, June 30, 2019

"Reviewing Mervyn King's The End of Alchemy: Money, Banking, and the Future of the Global Economy"

From Inference Review, Volume 2, Issue 4
The King’s Revolt
There is growing anger towards the central banks. Their seven-year experiment in monetary policy has not worked. The banks are undeterred. Normal economic growth, they argue, is shortly to resume. In the meantime, our economies must deal with negative interest rates. There are even rumors about such as measures as helicopter money—the direct transfer of cash to the private sector from the central bank.

Mervyn King’s The End of Alchemy, which was published in March 2016, is therefore an event. For the ten years between 2003 and 2013, King was the governor of the Bank of England. He was thus in power during the 2007–2008 financial crisis. Given the position that he held, King is remarkable in his forthrightness: “The crisis raised deep questions about the foundations of the economic models used by central banks around the world.”1 Paul Krugman has correctly emphasized the peculiarity of a book in which an insider’s insider sets himself in opposition to economic orthodoxy and its standard forecasting models.2

Minor Key Rebel
King’s criticisms are often astute. Given that economic decisions always take place under conditions of radical uncertainty, King is right to question a purely probability-based definition of risk. This is criticism that can be tracked back to Frank Knight’s work at the beginning of the 1920s.3 “At the heart of modern macroeconomics,” King writes, “is the illusion that uncertainty can be confined to the mathematical manipulation of known probabilities.”4 Perhaps influenced by Friedrich Hayek, one of his predecessors at the London School of Economics, King rejects general equilibrium models based on rational optimization that are reducible to a limited set of mathematical equations.5 In the real world, King notes, human rationality involves rules derived from experience, or tradition. “Heuristics are not deviations from the true optimal solution but essential parts of a toolkit to cope with the unknown.”6

One might think that King, having sloughed off traditional Keynesianism, has undergone pupation as a neoliberal economist. “Our inability to anticipate all possible eventualities,” he writes, “means that we—households, businesses, banks, central banks and government—will make judgements that will turn out to have been ‘mistakes.’”7 That mistakes play a role in any economy is a central tenet of the Austrian approach to business-cycle theory. “The problem,” King remarks, “is not just complexity, but also the pretence of knowledge.”8 It is worth noting that Hayek’s 1974 Nobel Prize acceptance speech was entitled “The Pretence of Knowledge.”9 While King clearly aims at cultivating an image of himself as a heterodox economist, he carefully avoids going too far. Whatever Krugman may say, most of King’s animadversions remain anchored in mainstream economics.

King Completes Bernanke’s Narrative
King’s attachment to conventional orthodoxy is revealed in the parts of the book where he deals with the origins of the 2007–2008 financial crisis. He may not share the stereotypical language of the central bankers, and he does not mince words when criticizing their post-crisis quantitative easing strategies: “Central banks are trapped into [sic] a policy of low interest rates because of the continuing belief that the solution to weak demand is further monetary stimulus.”10 Yet King endorses Ben Bernanke’s explanation for the origins of the Great Recession. In Bernanke’s view, the financial crisis was the product of a global savings glut. This was, in turn, due to the determination of emerging Asian economies to accumulate large trade surpluses as a hedge against a shortfall of foreign currency. These countries produced more than they spent, and saved more than they invested. This excess of savings depressed global interest rates to historically low levels. Combined with the financial deregulation of the 1990s, low interest rates meant that asset prices rose around the world. A massive rise in debt levels followed. Investors began taking risks in an effort to obtain higher returns. Banks responded by creating ever more complex financial instruments. When the inevitable bubble burst, it triggered a banking crisis and a major recession.

After eight years and despite massive injections of base currency, the system has not bounced back to normal economic growth. To Bernanke’s narrative, King now adds its missing conclusion. His explanation relies on Milton Friedman’s concept of permanent income, along with time-preference and malinvestment.11 These are terms that again call to mind the Austrian economic school, circumstances that are never mentioned in King’s book, not even in the notes.

King’s theory focuses on the behavior of spendthrift consumers who have become aware that the pace of their spending is no longer sustainable. The more they draw on their future spending to sustain present demand, the greater the shortfall in future demand. In such a situation, consumers rationally revise downwards their expected future income. They decrease their present spending. “The impact of the crisis,” King writes, “was to make debtors and creditors—households, companies and governments—uncomfortably aware that their previous spending paths had been based on unrealistic assessments of future long-term incomes.” This is an interesting theory, even though, as Krugman points out, it still has not been formally confirmed: “I suspect that this is exactly the kind of situation in which words alone can create an illusion of logical coherence that dissipates when you try to do the math.”12....