Sunday 19 March 2017 at 10:11

Book: The End of Alchemy by Mervyn King

By Eric Antoine Scuccimarra

The End of AlchemyMervyn King was the governor of the Bank of England during the 2008 financial crisis. Unlike other books about the crisis, this one does not set out to describe Mr. King as the hero who single-handedly saved the world from economic doom, and does not seek to find someone to blamde for the crisis, but instead points out inherent flaws in the banking system which led to the crisis. While Mr. King goes far beyond what one would expect from someone who held his position, for me, the conclusions he did not reach were far more telling.

Mr. King blames the financial crisis on the banking sector, which he sees as the weakest link in capitalism. Specifically, he lays the blame on what he calls "alchemy" - how banks transform long-term stable assets into short-term risky assets. After the bank runs at the onset of the Great Depression, the US Federal Reserve started the FDIC to guarantee bank deposits. The thinking was that by reassuring people that they could get their money out of the bank, the government could forestall future bank runs. In practice, however, this ended up giving the banks leeway to use the deposits of their customers for high-risk, high-yield investments or loans - as they know that the government will bail out their customers should the investments or loans go bad. What this leads to is the banks making riskier and riskier investments in search of high yields, with the knowledge that they aren't really risking anything. As one bank starts to make higher and higher risk investments, others must do the same to remain competitive. This directly led to the sub-prime mortgage crisis.

Mr. King points out many flaws in the banking system, but doesn't suggest many solutions. One solution he does make is to force banks to have assets to back their liabilities. The Reserve Rate, set by the Federal Reserve, says how much money banks must keep on their books to back their liabilities. Currently it is a very small percentage, between 3% and 10% based on the size of the bank. This means that if I deposit $100 in the bank, the bank only needs to keep between $3 and $10 of that, the rest they can lend out. If I go to the bank and ask for my money, and the bank doesn't have it, the FDIC will guarantee the rest. Lending out deposits is how banks create money - if I put $100 in the bank, theoretically I still have the $100 dollars, but so does the person the bank lent the money to. A 100% reserve rate would mean that the bank would be gambling with its own money, instead of with the tax payers money as the tax payers are currently guaranteeing the bank. Mr. King admits that this is very unlikely to ever happen.

Mr. King says that one of the flaws with economic theory is that it does not account for "radical uncertainty." The Chicago School of economics basically says that a completely free market is completely efficient - meaning that all available information is factored into all prices and the economy will tend towards equilibrium. However this model leaves no room for "radical uncertainty," which refers to how no one can ever know what the future holds. This is the reason we need money at all - to store purchasing power for an unknown future. Mr. King is clearly no fan of this school of economic theory, which advocates that the government should not be involved in the economy at all, and should let the market sort itself out.

When I was in business school we were taught economics as if it was a hard science. Reading this book made me aware of how much what we accept as axioms influence our thinking. While Mr. King goes far beyond what one would expect of a government official as far as the flaws he identifies in the political and economic system, he never questions some basic assumptions of economics which probably should be questioned.

In the United States, in my opinion, one of the government's top priorities is protecting the financial interests of large corporations. This is something that very few elected officials would ever question as doing so would result in them losing millions of dollars in campaign contributions from said corporations. Mr. King does question this, and for that I give him a lot of credit. However, Mr. King is still under the assumption that capitalism as an economic system can and does work, and that the flaws in it can be corrected. While I disagree with this, reading this book almost convinced me otherwise. Not because he argued that point, but because his arguments are based on assumptions which he sees no need to question, and his arguments are well reasoned enough that it almost makes one forget that the bases on which they rest are far from as sure as they are assumed to be. 

While a myriad of other books have been written about the crisis, I have not read one that goes beyond the superficial causes to try to analyze the deeper root causes. It was also very refreshing to read a book written by someone intimately involved in the response to the meltdown who does not set himself as a hero fighting to save the world economy from certain disaster. When I started reading this book I was not expecting Mr. King to offer as deep an evaluation and critique of the world economic and banking system as the book does. While the book was at times rather technical, I still highly recommend it.

Labels: books, economics


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