Hello, Central

We have already heard from Ben Bernanke, the man in charge of America’s central bank when things began unraveling in September 2008. Released last year, The Courage to Act was Bernanke’s paean to his herculean efforts to salvage a crumbling global economy brought down by financial implosion. As King notes, the postcrisis memoirs of high-ranking monetary and finance officials “share the same invisible subtitle: ‘how I saved the world.’ ” King’s more self-effacing endeavor is to question the prevailing intellectual framework that has guided the thinking of the world’s most powerful central bankers. He does not actually blame them for past mistakes. But he gently urges his colleagues to admit the possibility that, perhaps, they haven’t quite figured out how to perfectly calibrate the availability of money and credit to the needs of the real economy.

How daring. No wonder former Treasury secretary Lawrence Summers describes The End of Alchemy as “the most important book to come out of the crisis” and deems its “visionary ideas” worthy of the attention of “everyone from economics students to heads of state.” But, really: What is so visionary about saying that people don’t always behave rationally when confronted with uncertainty? Because that’s the essential message the reader derives after slogging through this long-winded treatise that, early on, promises so much more. Does the fate of the global economy depend on tweaking the assumptions of an econometric model to account for normal human edginess in the face of the unknown?

Let’s back up. When economists refer to rational behavior, they mean in the sense of “optimizing” among an array of decisions representing expected outcomes to maximize utility for the individual. Believe it or not, we actually construct mathematical formulas and charts to quantify such behavior. What King brings to the seminar is the notion that, in the face of “radical uncertainty” about the future (which he considers a perpetual state in a capitalist economy), people don’t attempt to “optimize” so much as merely struggle to cope with potential disaster. In other words, according to King, economists have been paying too much attention to how people attempt to accumulate “stuff” when we should have been concentrating on what people do when “stuff happens.” And maybe that qualifies as a clever quip from a staid central banker, but should it be heralded as a profoundly original insight with consequential policy implications?

If so, we’re all in trouble. Because it means that the world’s top monetary mavens—the ones who anguish over interest rates and wrestle with liquidity ratios, the ones who risk being blamed for the next meltdown (though it’s uncanny how they manage to avoid responsibility)—have no idea how to fix what broke. They don’t know how to escape the boom-and-bust syndrome. They cannot ensure that credit markets won’t seize up again, even as the devastation wrought by the last financial crisis still dogs the global economy. Not exactly a comforting thought.

There must be something more reassuring to be gained by ploughing through King’s treatise. Why else would it elicit high praise from such observers as the historian Niall Ferguson (“King has produced a brilliant analysis”) and the influential Financial Times columnist Clive Crook (“a deeply examined critique of economics as usual”)? But that’s when it hits you: The Alchemy of Finance threatens to disturb those who inhabit the wood-paneled world of central bankers and finance ministers—not to mention a few Nobel laureates in economics—because King’s analysis implies that the reigning theory of economic mechanisms they have bought into for decades is pretty much bunk. This somber realization begins to sink in long before King gets around to laying out his less-than-bold recommendations for reforming money and banking.

By pulling back the curtain on the presumed wizardry of central planning through central bankers, King has performed an intellectual public service—one that the practitioners of monetary policy might find strangely liberating. They are now free to acknowledge that, despite all pretenses and the obsessions of Wall Street tea-leaf readers, they are not omniscient, and one of their own has admitted as much. But there is grave danger, too. If equity and bond markets got wind of the fact that those entrusted with creating money out of thin air secretly harbor doubts about their own ability to gauge what economic indicators should be heeded, let alone acted upon, it might very well precipitate a crash. The central paradox of central banking is that it’s the ultimate confidence game: It is precisely the misplaced faith of investors—those who deposit modest savings in bank accounts as well as wealthy portfolio holders—in the wisdom and discretion of fallible central bankers that keeps the whole financial edifice from crumbling.

While it remains unspoken, anyone reading between the lines here ought to derive that conclusion. In a remembrance from his early days as chief economist at the Bank of England, King tells the revealing story of cornering Paul Volcker, who headed the Federal Reserve from 1979 to 1987, and meekly asking the legendary central banker for one word of advice: “He looked down at me from his great height (a foot taller than I) and said, ‘Mystique.’ ” We begin to understand why the word “credit” comes from the Latin root credere—”to believe, to trust.”

So what are those recommended measures that King offers as a way to more solidly justify the social confidence that underpins the stability of the world’s money and banking arrangements? How can the future of the global economy be better protected? Here’s the shorthand version:

• Commercial banks should back deposits with cash or guaranteed claims on reserve accounts held at central banks so that financial crises don’t induce widespread panic.
• Central banks should be willing to tackle solvency issues, not just meet liquidity needs, by being prepared to lend to almost anyone who pledges sufficient collateral.
• We should try to raise productivity. We should try to reduce global economic disequilibrium.
• We need to set a timetable for rebalancing the major economies of the world and let’s designate the International Monetary Fund as custodian of the process. (Ugh.)
• Oh, and get ready to forgive huge chunks of sovereign debt.

All this sounds faintly reminiscent of the closing advice from Monty Python’s The Meaning of Life: “Try and be nice to people, avoid eating fat, read a good book every now and then, get some walking in, and try and live together in peace and harmony with people of all creeds and nations.” And the parallel makes perfect sense if you consider that economics was probably never well-suited to being taken seriously as a hard science based on methodological rigor, exactitude, and objectivity. It’s a social science, after all.

Just consult the writings of John Maynard Keynes, who would undoubtedly be considered the world’s greatest economist by those readers willing to shell out real money to buy The End of Alchemy. Conservatives use “Keynesian” as a damning adjective for economic policy initiatives that amount to redistribution under the guide of stimulus. But Keynes had his moments of genuine clarity: He recognized an important factor that applies to both the meaning of economics—with its emphasis on short-term versus long-term effects—and the meaning of life. Writing in 1937, Keynes observed:

So let us thank Mervyn King not only for piercing the veil on monetary policy decisions based on sterile economic theories but also for exposing the fragility of global finance. The End of Alchemy is a well-mannered attempt to jerk policymakers back to the reality of temporal fixes versus enduring solutions. Central bankers, it turns out, only know enough to put a thumb in the dike after the crack has appeared. It won’t ensure that economies won’t be brought low by financial excess or guarantee any kind of future stability. But it’s enough to be awarded a peerage.

Judy Shelton, author of Money Meltdown: Restoring Order to the Global Currency System, is co-director of the Sound Money Project for the Atlas Network.