The End of Alchemy - Mervyn King

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High level summary

  • Financial alchemy is the process by which banks convert short-term deposits into long-term investments (maturity transformation) , and by ‘diversifying’ investments, turn risk into stability (risk transformation)
  • Fall of Berlin Wall -> expanded global capital market -> savings glut/disequilibrium -> asset bubbles (as described in Between Debt and the Devil (BDatD))
  • Money, AKA generalized purchasing power exchanged for services rendered today, is a means of dealing with uncertainty, and fiat currencies fundamentally rely on trust/ethics that contracts will be enforced
  • Overdeveloped banking sector created due to implicit public subsidy (the guarantee of a bailout), i.e. a result of moral hazard
    • at least >10% equity financing (BDatD) and other measures such as increased liquidity coverage ratios, stress testing, and ring-fencing suggested 
  • In the presence of radical uncertainty, our ecologically rational strategy is one of coping thanks to heuristics, decision rules that ignore new information 
  • Governments play a crucial role in ensuring trust, controlling the money supply, and possibly nationalizing all money: 
    • instead of acting as a lender of last resorts (LOLR) which subsidizes the risky behavior of banks, the government should become a pawnbroker for all seasons (PFAS), which:
      • keeps a running tab of all commercial bank’s effective liquid assets, which can be loaned against at an instance’s notice 
      • ensures that effective liquid assets > liabilities 
  • “narrative revision downturn”, when people en masse change the heuristics (derived from confidence in the economic climate) that guide their spending leading to a recession… similar to a balance sheet recession/”debt trauma” idea mentioned in Escape From Balance Sheet Recession (EFBSR).


Written in elegant prose and full of keen insight and novel policy suggestions derived from years of hands-on experience, The End of Alchemy, is a book anyone with an interest in understanding the global economy should read. From the start, King frames the discussion by attributing today’s state of affairs to four phenomena: (1) disequilibria, (2) radical uncertainty, (3) the prisoner’s dilemma, and (4) trust. As he touches on topics such as the Great Recession, money, banking, behavioral economics, and Europe, the extent to which these central themes underpin society as we know it is slowly unraveled. 

Sustained disequilibria are at fault for the most recent recession. In the preceding years, excess savings exported from nations running large current account surpluses such as Japan, China, and Germany eroded global bond yields and the resulting lower discount rate for asset valuation fueled asset bubbles around the world, especially in the US housing market.

Too much financialization and securitization based on unfounded principles that radical uncertainty could be ruled out with a large enough probability distribution (i.e. enough economic agents) and the assumption of rational expectations also contributed to 2008, and almost every crisis preceding that. At fault are actions which are individually rational but totally destructive in aggregate – a fallacy of composition effect, also noted by Koo in (EFBSR) – e.g. bank runs. 

Such situations where cooperative collective action, in this case everyone keeping their money in the bank, leads to a better outcome than selfish behavior is an example of a prisoner’s dilemma. Decision-making models which might explain this behavior include: utility optimization, satisficing, and behavioral economics. An evolution-tested coping strategy, the last account is the most convincing explanation: people are unable to predict their ‘lifetime budget’ (how can they predict their future income/expenditure?) and thus use heuristics – decision rules that ignore new information – to make purchasing decisions. These heuristics are derived from confidence in the economic climate, and are only revised when there are significant changes to macro economic conditions. 

Trust is the solution to the prisoners’ dilemmas which persist in the global economy. Without it,  banks would be vulnerable to runs every day (as they were in the heydays of banking, and in 2008 when the interbank lending market shut down), and fiat currencies would hold no value. The belief that your bank will honor your deposits or that the other party in any financial transaction will honor your money serve as the foundation for today’s capitalist economy. It is the government’s and central bank’s role to provide assurances that the economy is safe lest the prospect of a downturn becomes self-fulfilling, or provide caveats if the economy is growing unsustainably quickly. 

Building on this introduction,  King tells us that what banks do is financial alchemy: the conversion of short-term liabilities (deposits) into long-term assets and investments (loans), and of risk into stability. He notes that the invention of paper money is also an alchemist’s trick, a means to deal with uncertainty with regards to what we wish to purchase in the future, and relies on trust and an enforced ethical code to achieve cooperation. 

A sentiment that is shared by many economists today, the belief that banks are too big for today’s world is one that King also holds. Provided with an implicit subsidy that the central bank will be their lender of last resort (LOLR) in times of crises, banks operate with too little liquidity and too much risk. On top of this, huge banker bonuses – rent-seeking behavior – which make it clear that the private returns of the financial sector far outweigh the social return, and sketchy accounting practices that book future revenue as value today are other factors that have led to the dominance of the financial sector to the detriment of society at large. King laments the transformation of financiers from trusted stewards of Main Street to master manipulators of Wall Street, but has a plan that could reverse this trend.

It involves removing the implicit subsidy that a LOLR provides commercial banks. Instead of acting as a LOLR, the central bank could act as a “pawnbroker for all seasons” (PFAS). Inspired by Bagehot’s Rule that: banks should lend freely against good collateral with a penalty, King suggests that the central bank keep running tabs on all commercial bank’s effective liquid assets and ensure that these assets areat all times preponderate to their liabilities – all whilst lending freely regardless of whether it’s a crisis or boom. The added benefit of reduced Byzantine financial compliance regulations is also noted, and the suggestion that banks increase their equity financing is also interspersed in the text.

The implications of this proposal are clear:

  • central banks can provide ‘emergency money’ (liquidity) immediately when necessary, instead of resorting to slow and politicized bailouts 
  • the normalization of central bank funding in both good times and bad reduces the stigma associated with central bank funding that often can act as the Judas kiss for a failing bank
  • commercial banks take out insurance by pre-positioning collateral subject to haircuts with the central bank, and thus no longer have an implicit subsidy; these haircuts should err on the conservative side and not be changed on a ‘mark-to-market’ basis
  • transitions to this system would take advantage of today’s banks’ uniquely expanded balance sheets

Although substantial reform has been passed since the Great Recession that has required banks to maintain higher capital requirements, liquidity coverage ratios, and undergo stress-testing and ring-fencing, the underlying structure of banking is still flawed. The future seems bleak: the continuation of today’s privatized fractional banking system is a foregone conclusion and the privatization of credit creation (covered extensively in BDatD) will continue to be an existential issue as long as debt is favored over equity and banks are provided with a implicit subsidy. But towards these last issues, Mervyn King has proposed a solution that might end financial alchemy as we know it. Let’s hope people have noticed.


Other things:

The recent ‘narrative revision downturn’ AKA balance sheet recession, had its seeds planted in the Great Stability that preceded the Great Recession. This long NICE (no inflation constant expansion) period during which people misperceived their wealth and future income (supported by the stability heuristic of a healthy global economy and rising house prices) and overspent and over-borrowed in aggregate led to a disequilibrium that made a future correction inevitable. 

On the EU, views similar to Koo, in that it was a failed experiment from the start due to a lack of economic convergence and commitment from the richer surplus nations such as France/Germany to transfer/bailout/make select bond purchases of peripheral nations (all of which are considered unconstitutional in Germany). It is ironic and convenient, however, that Germany denies the forgiveness of Greece’s sovereign debt when she herself received very lenient treatment in the aftermath of WWII – a lesson learnt from WWI that oppressive debt repayment restricts and economy’s ability to recover and eventually recontribute to the global economy.