What’s Mervyn King on about?

Meryn King, former governor of the Bank of England, has just published a book, entitled “The End of Alchemy….”. And one of the central objectives of the book, as the title implies, is to end alchemy. So what does he mean by “alchemy”? Well this is his (rather long complicated) definition:

“By alchemy I mean the belief that all paper money can be turned into an intrinsically valuable commodity, such as gold, on demand and that money kept in banks can be taken out whenever depositors ask for it. The truth is that money, in all forms, depends on trust in its issuer. Confidence in paper money rests on the ability and willingness of governments not to abuse their power to print money. Bank deposits are backed by long-term risky loans that cannot quickly be converted into money. For centuries, alchemy has been the basis of our system of money and banking. As this book shows, we can end the alchemy without losing the enormous benefits that money and banking contribute to a capitalist economy.”

Notice that phrase “As this book shows, we can end the alchemy…”. It certainly seems that one of the central objectives of the book is to end alchemy. Indeed that point is repeated elsewhere in the book.

Well now, I’d imagine that the more astute half of the population are already aware that if everyone with money in their bank tried to withdraw it all at once, the first problem is that banks just wouldn’t be able to supply that money: banks would immediately go insolvent. And the more astute half of the population is also aware that that’s not too much of a problem because the chance of everyone or even a largish proportion of depositors trying to withdraw all their savings at once is so remote that we can forget about it. Plus that half of the population will also be aware that it would be impossible to turn “all paper money” into gold or anything else of real value at the drop of a hat.

So as far as that half of the population goes, alchemy doesn’t exist. That is, there just isn't a “belief” to use King’s phraseology, that all paper money can be turned into gold at the drop of a hat or that everyone can withdraw all their savings at once from every bank in the country.

As for the less astute half or so of the population, if they think everyone really can withdraw all or most of the money they’ve deposited at banks without there being a problem, what of it? Unless there’s some sort of major loss in confidence in ALL BANKS, that mass withdrawal just won’t happen. So as far as that less astute half of the population goes, what’s the big problem with alchemy? The truth is that there just isn't a problem.

And the above material all appears in the opening pages of the book. Well that’s not a good start to the book!

But that’s not to say the bank system is totally without problems – to suggest that would be obviously absurd. Moreover, there certainly is a problem which is roughly speaking related to King’s non-existent alchemy problem. That is, banks are in the business of “borrow short and lend long” and with a view to maximising profits, they tend to borrow as short as possible and lend as long as possible. When that process is taken too far, some banks can’t meet their liabilities as they fall due. They are then insolvent.

So the problem is not, as King suggests, that banks are unable to turn ALL THEIR liabilities into gold or something of real value at the drop of a hat. The problem is that some banks get into the position where they can’t turn QUITE ENOUGH of their liabilities into something of real value, or something that their creditors regard as being of real value.

Lehmans was a classic example. As I understand it, Lehman’s liabilities did not exceed its assets when it went under. It’s problem was that it couldn’t turn the assets into cash fast enough to satisfy its creditors.