The End of Alchemy

1. The financial crisis of 2007-9 exposed fundamental flaws in our economic system

The crisis was a failure of a system, and the ideas that underpinned it, not of individual policy-makers or bankers, incompetent and greedy though some of them undoubtedly were.

Root causes: The crisis stemmed from a global savings glut and a banking glut. Emerging economies, particularly China, saved excessively and invested in advanced economies. This pushed down long-term interest rates, encouraging risk-taking and asset bubbles. Simultaneously, banks expanded their balance sheets dramatically, becoming highly leveraged and interconnected.

Consequences:

• Sharp fall in world trade
• Millions of job losses
• Collapse of confidence and output
• Massive government interventions and bailouts

Lessons learned: The crisis revealed the need for:

• Better regulation of the financial sector
• More robust risk management practices
• A deeper understanding of global economic imbalances
• Rethinking the role of central banks and monetary policy

2. Money and banking are based on alchemy, creating inherent instability

The alchemy of our present system of money and banking continues.

Alchemy in banking: Banks engage in maturity and risk transformation, borrowing short-term (through deposits) and lending long-term (through loans). This creates an illusion of safety and liquidity that can quickly unravel during crises.

Inherent instability:

• Bank runs can occur when depositors lose confidence
• The fractional reserve system amplifies economic shocks
• Financial innovation often outpaces regulatory oversight

Historical perspective: Banking crises have been frequent throughout history, occurring almost once a decade in Britain and the United States in the 19th and 20th centuries. This suggests that instability is a feature, not a bug, of our current system.

3. Radical uncertainty undermines traditional economic models

Radical uncertainty refers to uncertainty so profound that it is impossible to represent the future in terms of a knowable and exhaustive list of outcomes to which we can attach probabilities.

Limitations of traditional models: Most economic models assume that uncertainty can be quantified using probabilities. However, radical uncertainty implies that many future events are simply unimaginable, making such quantification impossible.

Implications:

• Economic forecasts are inherently unreliable
• Risk management tools based on historical data may fail
• Policy decisions must account for unknown unknowns

Coping strategies: Instead of optimizing based on probabilities, economic actors use heuristics and narratives to guide decision-making under uncertainty. This approach better reflects how businesses and households actually behave in the face of an unknowable future.

4. Financial markets struggle to cope with an unknowable future

Keynes's description of the stock market has become famous: '… professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole.'

Market inefficiencies: Financial markets often fail to efficiently allocate capital due to:

• Herding behavior and self-fulfilling prophecies
• Short-termism and excessive speculation
• Difficulty in pricing complex financial instruments

Liquidity illusion: Markets can appear liquid in normal times but become illiquid during crises, leading to sudden price collapses and market freezes.

Policy challenges: Regulators and central banks face difficult decisions in managing market stability:

• When to intervene in asset price bubbles
• How to maintain market confidence without creating moral hazard
• Balancing financial innovation with systemic risk management

5. Central banks play a crucial role in managing money and crises

Central banks were seen as heroes for delivering the decade of the Great Stability and for preventing a relapse into a second Great Depression after 2008.

Key responsibilities:

• Maintaining price stability through monetary policy
• Acting as lender of last resort during crises
• Regulating and supervising the banking system

Evolution of central banking: Central banks have become more independent and transparent over time, adopting frameworks like inflation targeting to guide policy decisions.

Challenges:

• Balancing multiple objectives (e.g., inflation, employment, financial stability)
• Communicating policy effectively to manage expectations
• Navigating the political pressures that come with increased power and responsibility
• Adapting to new financial technologies and global economic shifts

6. The relationship between money and nations is complex and evolving

Money and nations go hand in hand.

National sovereignty: The ability to issue and control a national currency is closely tied to political sovereignty and economic autonomy.

Monetary unions: Attempts to create supranational currencies face significant challenges:

• European Monetary Union struggles with divergent economic conditions
• Historical examples of monetary unions breaking up (e.g., Soviet Union, Yugoslavia)

Future of money: Technological innovations like cryptocurrencies and digital central bank currencies may reshape the relationship between money and nations.

7. Reforming money and banking is essential for long-term economic stability

To leave the production of money solely to the private sector is to create a hostage to fortune.

Key reform areas:

• Increasing bank capital requirements
• Improving resolution mechanisms for failing banks
• Enhancing transparency and risk disclosure
• Rethinking the role of central banks as "pawnbrokers for all seasons"

Challenges to reform:

• Resistance from the financial industry
• Coordination problems in a globalized economy
• Balancing stability with innovation and economic growth

Potential benefits: A more stable financial system could reduce the frequency and severity of crises, leading to more sustainable economic growth and a fairer distribution of risks and rewards.

8. The world economy today faces ongoing challenges from past disequilibrium

The struggle to revive the world economy is the result of the disequilibrium that led to the crisis itself.

Persistent issues:

• High levels of public and private debt
• Weak productivity growth in many advanced economies
• Growing inequality within and between nations
• Ultra-low interest rates and their potential side effects

Policy dilemmas:

• Balancing stimulus with long-term sustainability
• Managing global imbalances in trade and capital flows
• Addressing structural economic changes (e.g., technological disruption, aging populations)

Future outlook: Achieving sustainable global growth requires addressing the underlying disequilibria that contributed to the crisis, rather than simply treating the symptoms through short-term policy measures.

Last updated: January 25, 2025