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Stark contrast: Mervyn King and Alan Greenspan |
It has only been nine years since Alan Greenspan published his memoirs, The Age of Turbulence. It is a paean to his belief in free markets and their ability, unhampered by government and regulation, to produce growth and prosperity. For the majority of academic economists, the US Federal Reserve under Greenspan made manifest their belief in general equilibrium. He was the maestro, conducting interest rate policy in a way that allowed the self-healing powers of laissez-faire capitalism to work its ineluctable magic.
The contrast between Greenspan’s book and the recently published The End of Alchemy by former Bank of England governor Lord King could not be more stark. Instead of wondering at the miracle of capitalism and its miraculous ability to return to equilibrium, King sees inherent instability. He pointedly chooses the word alchemy, the ultimate pseudo-science, to describe fractional reserve banking, the system that allows banks to transform short-dated liabilities (deposits) into long-term assets (loans).
This system can only operate with the connivance of central banks. When depositors panic, central banks step in as lenders of last resort. In the global financial crisis they did this and so much more. Since the crisis we have seen what King calls “the biggest monetary policy stimulus in the history of the world”. Yet the reassuring equilibrium of the Greenspan era has still to return. Growth is sluggish, inflation nonexistent, animal spirits hors de combat.
Reflections
No one can blame Greenspan for not predicting the crisis. Few did. In its aftermath he has been suitably reflective. Ayn Rand shaped Greenspan’s unshakeable faith in the genius of capitalism. His belief in the ability of economics to model the world was no more than a reflection of current academic thinking. You only have to list the Nobel prize winners in economics since the 1980s to see the triumph of the modellers – Franco Modigliani, Merton Miller, Harry Markowitz, Bill Sharpe, Robert Merton, Myron Scholes et al.
In spite of his establishment credentials, King is more of an iconoclast. He believes that the quantitative measures of risk favoured by his profession are largely worthless. Instead he embraces radical uncertainty – the “things we do not know we do not know” to quote former US defence secretary Donald Rumsfeld. It is a view found in Keynes and echoed in the Austrian school and Friedrich Hayek’s dismissal of economists who pretend that they are practising a hard science.
We’re all radicals now
King’s world view is certainly more in tune with the current pervasive uncertainty that besets markets. Though markets are still in thrall to ultra-low interest rates and addicted to liquidity, the ability of central banks to control events and the efficacy of policy are increasingly questioned. The clearest signal of this was the response to the Bank of Japan’s decision to cut interest rates into negative territory. The Japanese yen rallied 12% against the dollar. It was the last thing policymakers wanted or expected.
Negative interest rates are uncharted waters. The long-term effects are unknowable. The implicit assumption that everybody knows everything, the underpinning of the efficient market hypothesis, has always looked more than a little shaky. Macroeconomics aspires to the precision of microeconomic models that undergraduates find so intuitively appealing. The real world is more complex.
Between 1997 and 2007 the financial system dealt with the Asian crisis, the collapse of Long Term Capital Management, the dot.com boom and bust and it stood tall. It appeared to be well-ordered, self-regulating and self-repairing. In reality, the financial system had become leveraged, inter-connected and complex. Complexity amplifies uncertainty because nobody knows where the buck stops (or, in some cases, what it is worth).
The ascent of financialised capitalism from the turn of the millennium was rapid. In 2001 Citigroup’s assets stood at $1 trillion. It had taken an institution that traced its origins back to the foundation of City Bank of New York 189 years earlier, to reach this landmark. It took just six more years for its assets to double to $2 trillion. Then the crisis hit.
Greenspan has since written: “The role of human nature in economic affairs was never more apparent than on that fateful day in September and in the weeks that followed… I began my post-crisis investigation, culminating in this book [The Map and the Territory], in an effort to understand how we all got it so wrong, and what we can learn from the fact that we did.”
The financial crisis came with real costs. On average, public debt across the G20 has increased from around 70% of GDP to 105%, in large part due to the direct costs of bailing out the banks and indirect costs of the aftermath. The global economy is still to return to the growth rates before the crisis. The Age of Turbulence will be essential reading for future historians. It marks the high watermark of our faith in economists and finance. That faith is unlikely to return.