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Newsmaker: Lord Mervyn King, former governor of the Bank of England

Chris Gaetano
Published Date:
Aug 8, 2016

Mervyn King

The former Bank of England governor on banking system reform, accounting standards’ role in the financial crisis and why restoring Glass-Steagall won’t prevent another one.

Lord Mervyn King served as the governor of the Bank of England from 2003 to 2013. In his recent book, The End of Alchemy: Money, Banking, and the Future of the Global Economy, he reflects on the roots of the 2008 financial crisis and warns about financial policies that defy reality and common sense, particularly the degree to which the future can be extrapolated from the present. He took the time to talk to The Trusted Professional from his office in London.

You’re very critical of the banking system in your book. Did this view develop during the financial crisis, or was this something you’ve been worried about for a while?

I think these are things that I have been concerned about, but I don’t think the full scale of them came to me until the crisis—the problems [were not created] only just before the crisis. They were inherent in the structure of banking that we’ve got, and so rather than blame individuals and ask questions of who is at fault, it would seem to me they we’re all collectively at fault for not recognizing the system we put in place had these inherent risks at heart. While there have always been economic crises, [in] the last 200 to 300 years they have become frequent, and we never got to the bottom of dealing with it.

Which of these inherent risks do you think is the most prominent, and what must be done?

I think in the banking area, there are two.

One is the fact that, because banks are central to the operation of the economy, they’re rather like electricity suppliers—they have enormous significance and we’d be hard pressed to see a functioning economy without such a system. … So, you do need banks with enough equity finance as part of its total liability structure to enable banks to absorb losses that are bound to occur from time to time. Unexpected things happen. Radical uncertainty is pervasive.  Banks need a cushion of equity finance so these losses can be absorbed without banks having to go through a special bankruptcy process, often called a resolution process, which disrupts the payment system.

The second is why … I call the system one of alchemy. It’s because when we put our money in the bank, we are told we can take it out whenever we want and it’s safe, and we get it back. And yet, this money is issued to finance long-term loans, which are highly risky. It has some benefit to the economy, but it cannot be sensible, in the long run, to finance all long-term loans by short-term borrowing. That’s the alchemy in the system. What shows up in practice is from time to time, when people lose confidence in banks, they can’t get their money out. Bank runs are a feature of banking systems around the world and have been for several hundred years. We’ve never found a way to absorb them other than guarantee by the taxpayer.

I think, inevitably, central banks will need to support banks when there’s a run on the system, but what I want to do—I call this the “Pawnbroker for All Seasons”—is to ensure banks have to take out insurance with a central bank before anything goes wrong, rather than pay nothing up front and demand to be bailed out when the crisis hits.

We do need a banking system…but the question is how to make the system safe. And since stuff happens, I want people to recognize this will involve support from a central bank. But the most important thing is to make sure banks are charged an appropriate insurance premium up front.

You talk about fundamental problems in the banking system that were not properly addressed in the wave of reforms after the crisis. How much of this fundamental problem can be addressed via fiscal policy, how much can be addressed via monetary policy, and how much can’t be addressed by either?

There are two issues resulting from the crisis. One, you had the biggest banking crisis the world has ever seen, and despite massive and complex legislation, the basic structure of the problem hasn’t really been addressed. The second thing is, you have the biggest monetary policy stimulus the world has ever seen, and yet, [it] has not generated a sustainable recovery. People think maybe monetary policy is not the answer, and they would be right. We can’t rely on monetary policy exclusively. But even fiscal policy is not necessarily the answer either, because just increasing spending might be a short-term palliative, but it doesn’t get to the roof of the problem.

So, a completely different set of policies is needed, based on structural changes to improve productivity, based partially on promoting greater trade, partially based on recognizing that floating exchange rates are probably the only way to go. The last point I’d add is that we will need a degree of cooperation among countries where they try to rebalance their economies over the same timetable, because it’s hard for any one country to rebalance its economy if the rest of the world isn’t doing the same.

Beyond specific policies, there has also been the criticism of Wall Street culture that people who work in finance have values that do not mesh with the public good. How much of a role does culture play in regard to these fundamental problems, and can industry culture be changed?

I don’t think it was the main cause of the crisis. I do think that there were some serious failings in this area, which grew out of a period in which we’ve become rather complacent about our economic stability, and [in] which it became acceptable for people who are very smart to say, ‘I’m really smart and I can make money off people who are less smart.’ I think a culture we want to encourage instead is, ‘I’m very smart, so I’m paid well for looking after other people’s money, and my role is to be a custodian of this money and not try to find ways to transfer it to my own pocket.’

Now, that’s as old as the hills, but I think it did increase in scope in that period running up to the crisis. So, instead of sitting back and saying how can we reform the banking structure, people wanted action against individual bankers. That’s quite understandable, but I’m afraid this won’t resolve problems in the long term. I used to go to schools to talk about the role of the Bank of England, and I was struck by how many sixth formers [12th graders, in the U.S. who were asked what they wanted to do, said they wanted to go work in the city and make a lot of money. Then I’d ask why they want to make lots of money, and there were hardly any answers. Many weren’t entirely sure why.

What are we not taking seriously enough, as far as threats to financial stability? Conversely, what’s something that we’re all taking far too seriously?

I think one thing we’re taking too seriously is the need to pass detailed regulations to constrain what banks do. I don’t think that makes sense. The market is already having quite an effect on banks. Look at the extent to which banks combine investment and retail banking into the same institutions. Investment banks have shrunk in size, and the apparent profitability of investment banking has been reduced as people change their views on the value of some of that. I also worry that there are certain aspects of compensation that were deeply faulty precrisis, but I hope now people who run these institutions know this.

We’re not worrying enough about the underlying structure of banking itself, and we don’t have a solution to bank runs. In principle, the same problems could occur again, and the banks don’t have enough equity finance to absorb losses if there were another crisis.

The Bank of Japan announced negative interest rates a few months back. They join other countries such as Sweden, Denmark and Switzerland. What are your thoughts on these developments? While clearly not a long-term solution, is it feasible as a short-term one?

Well, of course, at some point, the short term needs to turn into the long term. Cutting interest rates can buy time—what it does is try to encourage people to spend today rather than tomorrow. That works a bit, and you see these spending figures and economic data improving. But then it peters out. Why? When you transfer spending from the future to the present, you dig a hole—time passes, and the future becomes today. So, now you cut interest rates again to bring even more spending forward, and that digs an even deeper hole. As time passes, that too becomes the present, and if you haven’t tackled the underlying problem, you create more and more of an incentive for central banks to cut rates further.

But there’s a limit to how much people want to bring spending forward from the future to the present. You have to do more and more monetary policy measures to maintain current levels of spending, and at the cost of reducing spending in the future. … So, it may buy time, but that time runs out. Monetary policy exhibits diminishing returns the longer you do it, if you don’t take action to deal with the underlying problems. And that is the mistake being made now. There is an assumption by many policy makers that there aren’t underlying problems and the cause of the weakness in demand is only temporary—some kind of headwind that will abate over time. And if we just wait long enough, the problem will go away. I don’t think that’s true. Until this problem is tackled, monetary policy has reached the limit of what it can do.

The role of central banks has expanded since the crisis. Do you see this as a good thing or a bad thing? Should central banks play an even larger role?

I think this certainly poses challenges. Independent central banks were very important in response to the experience of the 1970s and ’80s with very high inflation. They played a key role in putting price stability on the top of the agenda. Inflation was 13.5 percent in the U.S., 27 percent in the U.K. This was a very unhappy period that led to significant ups and downs in the economy. So, the period of stability was a great achievement. I think it was probably sensible to recognize that central banks would have to be at the heart of dealing with the problems of the banking sector, so where they acquired responsibilities for bank supervision, that was appropriate.

But I think it’s very important for them to not go down the road of doing anything that can be construed as fiscal policy or quasi-fiscal policy, where they take risks with taxpayer money. That’s a role for an elected government. The risk is, people will look back and ask what was your authority for taking those measures. If it becomes an issue, people start challenging the role of a central bank, and if that undermines the ability to construct monetary policy independently, we have thrown out the baby with the bath water. So, it’s important for central banks not to go too far in acquiring responsibilities so they can retain their independent role in monetary policy.

What role can accounting standards play, either in addressing a crisis or exacerbating it?

I think accounting is very important. We didn’t pay enough attention to it before the crisis. I’ll give you two examples, without commenting on whether these particular changes are bad: The difference in treatment in derivative transactions between European banks and American banks turned out to be very significant in trying to assess the extent of their leverage and if they had enough equity finance. So, coming to some sort of agreement on that is important. Second, I think the ability of banks to convert an anticipated future stream of earnings into present income and then pay themselves bonuses out of that current income is highly dangerous. On one level, it’s not too far removed from what Enron did in its accounting problems. It’s very important for accountants to put down tough rules when making transactions in, for example, derivatives or future earnings streams.

Another example, during the crisis, was that marking to market sounds extremely sensible in normal times, as it prevents people from concealing what is going on. But in the middle of a crisis, it’s very unclear what prices are—if you’re not careful, if you’ve only got one or two observations on a price in a very thin market, and by insisting everyone mark their assets down to that value, you can create incentives for people to sell assets, which leads to a self-fulfilling fire sale of assets. I think the question of the extent of marking to market when markets are very thin is a difficult one. I don’t pretend there’s a simple answer, but one thing we found in the crisis was how few transactions there were in a number of markets where we just assumed they were fairly liquid. It turns out they weren’t. Liquidity is here one day and gone the next. This causes a potential problem for marking to market.

We’ve been seeing valuations of tech companies growing higher and higher in a short number of years. There’s been more talk that we’re in another tech bubble, that the companies cannot live up to their valuations and, eventually, there will be a correction. How does this bubble compare with the other we had in the early 21st century?

I am not an expert in the tech market. But I would say, in general, the cause of most of the high valuations we saw was very low interest rates. However, that wasn’t true in the tech sector, because there was a specific element of people framing assumptions of future earnings from tech companies. Now, whether this is happening again, only people in tech can comment. But one thing, in general, is that when people get nervous about asset prices, do not blame the market but ask why the interest rates used to discount future earnings have fallen to such low levels.

Well, the Fed has recently raised rates, and is pondering whether to raise them again. Is now the time to raise rates around the world?

I don’t think the solution is simply to raise interest rates. What we need are other policies to rebalance our economies so central banks can then make the judgment of when it is safe and sensible to raise interest rates. We want to get back to a world where interest rates are higher, but we don’t do it just by raising rates. You put in other policies and then central banks would naturally raise interest.

Before you were the governor of the Bank of England, you were an academic economist. In what way did your practical experience there lead you to question your academic beliefs?

I don’t think it was being a central bank governor, as such, that did that. It was the other way around. Being an academic led me to think of central banking in a different way, but the crisis did stress what I talk about in my book: radical uncertainty. It doesn’t make sense to assume we can construct probability distributions to price everything that could hit the economy. Most risks that generate booms and slumps are unexpected, and we either can’t imagine them at all or can’t attach probabilities to them. And so, they’re not priced in the market. That is another important factor in trying to understand how vulnerable the banking system is and to recognize many of the models academic economists and central banks use to discuss monetary policy have tended to miss some of the key factors driving the economy today.

Where are we most likely to see another financial crisis emerge?

I think, almost by definition, it’s very hard to predict that. If we could pinpoint it, it wouldn’t be a crisis. … The overall area of risk I’d point to, though, is the extent to which we see defaults of debt in different parts of the world. We see sovereign debt problems in the Euro area already, and China has been experiencing problems, too. There could be a series of debt defaults, which could lead to another crisis in terms of people being deeply concerned about continuing to lend, and the fact that many of the creditors might realize assets in their balance sheets are worth less—a lot less—than they thought.

There's some push to restore the Glass-Steagall Act in the United States. But since you trace the origins of the crisis to the end of the Cold War in your book, would restoring that actually help?

No, I think it’s too simple for the current state of play, and I think the market is doing some of it. No doubt, having investment banking on the same balance sheet as accounts of households and small businesses is a real risk. …If people can put lots of risky things on that balance sheet, you have a problem. But rather than a separation, the better thing is to have tough limits on leverage ratios on banks and, second, to introduce the Pawnbroker for All Seasons.

How much of the headwinds the global economy is currently experiencing the result of the crisis, and how much are due to new circumstances unconnected to it?

I don’t think our big problems are what we call “headwinds,” because that phrase refers to impediments to growth that gradually disappear, and enough monetary policy stimulus will see us through. I think we have a serious disequilibrium in the economy, which will be corrected only by rebalancing spending and savings in different economies, where China and Germany and other countries are spending less and exporting more, and countries like the U.K. and U.S. are doing the opposite. That’s not a headwind. That is a move to a new equilibrium. Until we do that, we’ll always have difficulty generating growth. There will always be occasional headwinds that come up, but we’ve been seeing those since the end of World War II. It’s the disequilibrium that’s the bigger problem.

Prior to the crisis, you said central bankers were most worried about a collapse of the U.S. dollar. Today, the dollar is very strong relative, to its competitors. In a postcrash world, is this still a risk?

It is. The problem we face today is with the passage of time, people have come to see that monetary— and, to a large extent, fiscal—policy are hitting diminishing returns. So, what can we do? Temporarily push down exchange rates to get a bigger share of world demand? That is self-defeating, but you can see around the world, many countries have adopted that policy, like Japan and the Eurozone, and the U.S. is the only economy that is approaching things from the other end. So, we have a strong dollar. That’s unlikely to continue. At some point, there will be an adjustment, but I think the use of exchange rates as an alternative to monetary policy poses significant risks.

A big enough risk to cause a financial crisis?

It would hinge, I think, on how countries as a whole manage a transition to a new equilibrium. If we have some kind of agreement among major economies to make this transition over, say, five years or eight years, and all take the appropriate steps to do that, and as a result exchange rates move, it will not be a crisis. The risk is if one country or one financial market moves significantly and the other countries try to block the movement to the new equilibrium, you could see another crisis build up.

What, to you, is the biggest unanswered mystery of the financial crisis?

One of the practical policy challenges that all central banks faced was in trying to provide liquidity to the banking system. In many cases, banks were reluctant to acknowledge they needed liquidity support. There were historical examples when banks didn’t want to signal that they might be in difficulty and require liquidity. So, they deliberately did not ask for the liquidity they needed for fear of damaging their reputation—the “stigma” problem.

I don’t think we were conscious of this before the crisis started and it became a bit of a surprise to us all, and I don’t think central banks have a convincing answer to it. … Central banks started auctions of liquidity, where banks could bid anonymously, and while that was a help, sometimes, banks need money between auctions. You can refuse to disclose the name of banks that receive central bank liquidity support, but the Dodd-Frank Act limited the ability of the Fed to do that.

This is, I think, still a challenge in how to manage the process of central bank provision of liquidity support. This is one of the big intellectual issues that hasn’t been fully resolved.

Another that occurs to me is that, in the 1930s, after the Great Depression, there was a tremendous period of intellectual and political foment, with people exploring new ideas in economics and politics, when very left-wing parties grew, when there was a crisis of capitalism, not just in practice but in theory. After this one, there didn’t seem to be the same degree of intellectual and political turmoil. The action of central banks to avoid a repeat of the Great Depression meant the political consequences were not as immediate or violent. But as time goes on, the impact of the crisis and the fact that the banks were bailed out was a big challenge to the market economy and is leading people to be concerned about the functioning of a market economy. Do we still believe in it? Can it meet our aspirations? This is not being discussed as openly as [it] could, and you can see the creeping concern, the anger, has not dissipated. It has transmuted to votes for extreme political parties in the U.S. and the rest of the world.

What was the last really good book you read?

One of the outstanding books of the past year was Niall Ferguson’s first volume of his biography of Henry Kissinger [Henry Kissinger: 1923–1968: The Idealist], which describes his life until 1968, when Kissinger left academic life to work as Nixon’s national security advisor. I had wondered whether it was possible for the life of an academic to be that exciting, but, in fact, this life from the 1920s to 1968 is a story of the world during that period from Kissinger leaving Germany, through the Second World War, and on to the Cold War. Kissinger’s life mirrored quite well what was going on in the world at the time, and I was fascinated to read what Kissinger wrote about developments around him from postwar Germany to Russia and the start of the U.S. involvement in Vietnam. 

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