11 March 2016

What we can learn from the economic theories of a former Bank of England governer

Mervyn King's The End of Alchemy is rigorous - but his “audacity of pessimism” may be more pessimistic than audacious.

There are two Mervyn Kings. One is the brilliant academic economist: in the view of many of his peers, one of the finest of his generation. The other is the practical man of affairs who was governor of the Bank of England for a decade and, arguably, through the most turbulent period in its history. As King’s introduction makes clear, this book is entirely about the former. But the role segregation is extreme and, to me, unsatisfactory. There is not even passing reference to the three chancellors he served. Issues such as the “tripartite system of regulation”, which, however mistakenly, the current Chancellor saw as fundamental to the financial crisis in the UK, are not even dignified with a dismissive sentence.

In lucid prose, King addresses what he regards as the underlying economic causes of the financial crisis rather than its symptoms. He debunks populist theories that it can be explained by greedy bankers or misguided policymakers. “Fred the Shred” appears as a hapless victim of events. King is no less impatient with more sophisticated explanations based on rising debt levels: a consequence, not a cause.

Rather, we should be looking at a structural, global problem of disequilibrium; too much planned saving relative to investment: what Ben Bernanke, the former chairman of the US Federal Reserve, has called a “savings glut”. In the years leading up to the crisis, this imbalance drove down long-term interest rates, bond yields, and the cost of risk-free capital. This in turn led to a search for yields mainly through the “alchemy” of the banking system, with extreme leverage and trading in enormous volumes of complex derivatives of questionable underlying value. The “savings glut” and chronic imbalances have continued, and explain the present pessimism about growth.

King’s analysis is rigorous, but when the book moves to prescription we encounter what he calls “the audacity of pessimism”. Should we try firmer monetary policy, beyond negative interest rates and quantitative easing, such as monetisation of deficits and “helicopter drops” of money to boost spending? Not much point, he writes, because such policies offer diminishing returns and do not address the underlying weakness: the US and the UK should be investing and exporting more. What about another round of Keynesian fiscal stimulus, based on public investment? Possibly a good thing but, again, stimulus is pointless because it does not change the uncertainty and pessimism, or rectify international imbalances.

So, what is to be done? Not much, pending an outbreak of global economic co-ordination. King suggests working at policies to raise productivity and improve investors’ expectations about returns, as well as trade-liberalising measures such as the Transatlantic Trade and Investment Partnership between the EU and the US. Having spent five years in government trying to develop productivity through industrial strategy, competition policy, skill training and trade liberalisation, I am pleased to see endorsement of these low-key, long-term initiatives. But in this narrative there are too many echoes of what I used to hear in Whitehall from the Treasury: “Yes, minister, it’s all a mess but, sadly, nothing much can be done about it” – pessimism without the audacity.

The End of Alchemy earns endorsements from Larry Summers, Niall Ferguson, Alan Greenspan, Henry Kissinger and others. It is difficult to quarrel with their conclusions: that it is important, erudite and readable. I worry, however, about the conservatism of the author’s conclusions. His discussion of the role of central banks leads to the conclusion that the established structure through which he worked (inflation targeting) must be the best. He damns with faint praise innovations such as macro-prudential policies to address speculative “bubbles” (as in property markets), on the basis that this comes too close to interfering in the choices of individuals. He pointedly disagrees with Hyman Minsky and others who have written about “irrational exuberance” and panic in markets. He is brutally contemptuous of attempts to create monetary union in Europe, though he could be more supportive of Mario Draghi, the president of the European Central Bank, who is making a good fist of improvising some surprisingly effective policy in tough circumstances.

I am left feeling much as I used to do after reading a brilliant brief from a civil servant explaining that all options apart from the status quo were deeply problematic. My reaction echoes Thatcher’s: “I know there are problems. Bring me some solutions.”