Mervyn King on credit

John Plender gives a warm review to Mervyn King’s recent book, The End of Alchemy: Money, Banking and the Future of the Global Economy

Uncertainty principles: ‘The End of Alchemy’, by Mervyn King


It is rare to encounter a book on economics quite as intellectually exhilarating as The End of Alchemy

I’m not convinced, at least by the review.

The aim of the book is said to be to “put an end to the alchemy that has made financial crises a permanent feature of the landscape and allowed money — a public good — to become the by product of credit creation by private-sector banks”.

This is odd, because there are numerous public goods which are created to a significant extent as by products of private-sector activities.  A typical pattern is that private sector agents engage in transactions where both parties benefit – which, if you insist, can be expressed as both seeing an increase in their utility – and that by such transactions becoming routine, helped by the emergence of institutions to support them, a public good is created.  Very often a public sector agency is needed to support such goods – so judges to support a system for enforcing and interpreting contracts, paid as indirectly as possible – by general taxation – by the parties to the transactions.

It’s how money and banking systems developed, and while in a sense they are inherently unstable, being based on a degree of trust which may suddenly evaporate, on balance I would expect a Central banker to see private-sector credit creation as a strength of a banking system, to be helped impartially in supporting the public good it creates, but not something to be eliminated.

The starting point for the argument is that we live in what economists now call “radical uncertainty”, where it is not always possible to compute the expected utility of any action, and the probabilities of all future events cannot be identified, so no set of economist’s equations that describe people’s attempts to cope with that uncertainty.

I wonder if it was ever possible to calculate the probabilities of all future events, so raising some doubts about any such set of equations.  So what have bankers and monetary economists being doing all along?  Doing the best they can, and if we accept that banking systems have on balance been beneficial, then the policy focus should be on helping them do better in serving the public. This would suggest greater transparency, more public provision of data which will help bankers and their customers identify individual risk, and the prevention of structure which divorce individual risk from public risk (the problem of too big to fail.)

Instead, the concept of radical, or Knightian uncertainty, asserts that some risks can never be calculated, so is qualitatively different from the sorts of risk which it might be possible to understand better.  I can accept that a theoretical distinction can be made between some risks which is it possible to quantify – the result of tossing a coin, for example – and others, which are not, such as whether a potential client is actually an extraordinarily accomplished conman, or whether a technology which depends on cutting edge science – quantum computing, anyone? – is actually going to deliver. Put like that, I’d suggest bankers have always dealt with radical uncertainty, an impression supported when I google to look for examples of such uncertainty.

Explained: Knightian uncertainty

Mervyn King’s response to accepting the world as it is, with such uncomfortable uncertainty to be found not only in businesses as modelled by central banks, but the financial sector itself, is to give Central banks the authority to perform various calculations

he offers an elegant refinement of the concept of “narrow banking”, which seeks to ensure that all deposits are covered by safe, liquid assets. In his system, banks would decide how much of their asset base to lodge in advance at the central bank to be available for use as collateral. For each asset, the central bank would calculate a haircut to decide how much to lend against it.

What is more, it would not just apply to the current financial system, but to any other business which emerged performing an equivalent role

The system would apply to all financial intermediaries, including those now outside full banking regulation, to avoid the “boundary” problem whereby depositors evacuate in search of higher yielding outlets.

I struggle to see how this is elegant – unless the word carries with it the suggestion of intensely learned or technical discussion, with subtleties beyond the appreciation of those not trained as economists.  It doesn’t look that different, to me, to the system of risk weighting for bank capital.

What is rather clearer, however, is that somehow, in a world just admitted to be characterised by radical uncertainly, the central banks will someone be in a class apart from everyone else in the economy, and able to get their calculations right.

It is fairly clear this is nonsense.

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