It was a big departure for the Federal Reserve—which has historically been run by bankers rather than academics—when Ben Bernanke, a distinguished monetary economist, was appointed as chairman in 2006. But Mervyn King, a former professor at the London School of Economics, was already running the Bank of England. And it was these two professors who guided the English-speaking world’s biggest economies through the recent financial crisis.
.. Now King, like Bernanke, has written a book inspired by his experiences. But it’s not at all the book one might have expected. It’s not a play-by-play of the crisis, or a tell-all, or a personal memoir. In fact, King not-so-subtly mocks the authors of such books, which “share the same invisible subtitle: ‘how I saved the world.’”
.. His assertion that we haven’t done nearly enough to head off the next financial crisis will, I think, receive wide assent; I don’t know anyone who thinks, for example, that the US financial reforms enacted in 2010 were sufficient. But his assertion that the whole intellectual frame we’ve been using is more or less irreparably flawed is a brave position that should produce a lot of soul-searching among both economists and policy officials.
.. The more or less standard account of the 2008 crisis, which King shares, is that the combination of stability-fostered complacency and deregulation led to an accumulation of financial vulnerabilities. Private debt was on a steady upward trend before the crisis, with the ratio of household debt to income rising by about 50 percentage points in both the US and the UK. This debt accumulation arguably made the economy more vulnerable to crisis, because debt-burdened households would find themselves in especially severe distress in the face of a downturn.
.. On the eve of the crisis, however, much of the financial system had enormous leverage—the ratio of debt to equity was 25 to 1 or more—leaving it extremely vulnerable to panic.
.. what almost everyone missed was the rise of “shadow banking”—new financial institutions and arrangements, such as hedge funds and money market funds, that bypassed traditional banking but recreated all the risks of the bad old days.
.. Once everyone noticed the importance of shadow banking, it was straightforward to pull off the shelf an intellectual approach for understanding the crisis. After the fall of Lehman Brothers, economists roamed the streets muttering to themselves “Diamond-Dybvig”—referring to an influential model for analyzing bank runs.
.. His reasoning, however, rests squarely on standard economic analysis—specifically, the concept of an “optimum currency area” defined by the tradeoff between the convenience of a single currency and the flexibility that comes with a country having its own currency.
.. He argues that Europe’s imbalances in production costs and hence in trade are too large to be resolved without either abandoning the euro or moving to full political union, and that given the lack of will for the latter, the former it must eventually be.
.. Still, King calls for what he says is a fundamental rethinking of bank regulation, replacing the lender of last resort with a “pawnbroker for all seasons.” The central bank would be prepared to lend to any financial intermediary, on any occasion, as long as assets were pledged as security—but the required security would depend on the assets. To borrow against low-quality assets, bankers would have to put up extra collateral, known in the trade as a “haircut,” with the size of such haircuts determined in advance.
.. All that talk about the need to ditch conventional economics, to embrace the reality of radical uncertainty—and the punchline is the same as the recommendations of every IMF program for the past sixty years: structural reform and free trade. Really? That’s it?