Book Report – The End of Alchemy by Mervyn King

Alchemy, the medieval practice of attempting to convert base metals into gold in pursuit of a universal elixir, found new purpose during the Industrial Revolution as banks transformed secure short-term deposits into long-term risky investments. Author Mervyn King, the recent governor of the Bank of England, suggests this immensely seductive process led to “the creation of extraordinary financial powers that defy reality and common sense.” In his revelatory 2016 book The End of Alchemy, King calls for change, noting that modern blending of money and banking not only caused last decade’s global recession but is also largely to blame for the painfully slow recovery. “Pretending that deposits are safe when they are invested in long-term risky assets is an illusion,” he writes. Over-leveraged bank balance sheets and insufficient cushions to absorb losses sound problematic, no? While US and European banks may no longer borrow at mind-numbing ratios as high as 50:1 – in other words, $50 leveraged against a single dollar of capital provided by shareholders – King still frets over the inevitable coming crisis during which the demand for liquidity will surely jump.

Central banks are the key and granting them discretion in response to unfolding events is crucial. The Federal Reserve states its objectives as maximum employment and stable prices and it’s the seemingly endless speculation these days over the future of interest rates that captures headlines. Congressmen – many facing volatile midterm reelection campaigns next year – will push to hold the Fed accountable to a formula that neatly demonstrates interest rate adjustments to changes in the economy. Oh, but if it were only that simple. The author goes to painstaking levels to share the history and likely future of inflation targeting, made up of short-term responses to economic shocks coupled with a medium-term goal for inflation, all along selling faith on the Go Tell Crusade in long-term price stability. King considers this practice highly successful “as a way of ensuring the democratic accountability of powerful public institutions.” I’ll take his word for it over some blowhard politician who thinks the definition of ‘quantitative easing’ is shitty approval ratings being graded on a curve.

King further proposes that central banks evolve from the traditional role as lender of last resort into the so-called pawnbroker for all seasons. The difference, dear reader, is liquidity during a crisis and would prevent the ill-begotten habit of lending to private banks against bad collateral. According to the author, “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.” Banks would have to provide true collateral, pay liquidity insurance upfront, and face taxes that would “bear the social costs of alchemy.” This sort of balance sheet scrutiny when it comes to central bank lending seems reasonable and sensible; furthermore, it would promote a climate of accountability and might just help prevent the need for a massive future bailout of financial institutions that are deemed too important and/or too big to fail. If you have the time and appetite for this stuff, read King’s book and make your own judgement on the chances of his proposed solutions taking root. You’ll find it in paperback at your local bookseller, filed prominently in the Fantasy section.