The Alchemists: Three Central Bankers and a World on Fire

by Neil Irwin

  His love of competition extended to his work at the bank, and his adversaries there and in the government found clashing with him a very unpleasant business. To his friends in the international economics club or on the London social scene, King was a charmer, with a sharp wit and lively eyes. To his colleagues at the bank, he could be an intellectual bully, sure of his correctness and willing to use every method available to get his way, including isolating and undermining those who disagreed with him. Chancellor of the Exchequer Alistair Darling described him as “incredibly stubborn” and “exasperating” and wrote that the core problem of the Bank of England was that King ran it “as an autocratic fiefdom of the Governor”—this from a man who had twice given King that position.

  King had become the bank’s chief economist in 1991, a low point for the Old Lady of Threadneedle Street. Inflation had been high for decades, and George Soros was just about to “break” the bank by forcing the pound out of the currency bond.

  As the bank’s top economist, King set about rebuilding the institution’s credibility as a maker of monetary policy. He hired some of the brightest young PhDs in Britain and shoved out many from the bank’s old guard, who had become better at backslapping than economic analysis. His success at that job helped convince Tony Blair’s Labour government, in 1997, to grant the bank the independence from political influence it had long sought. Thanks in no small part to King’s work, no more would interest rate policy be driven by what elected officials wanted. “He made independence credible by raising the bar on the intellectual caliber of economics at the bank,” said Rachel Lomax, who served on the Monetary Policy Committee from 2003 to 2008. King was rewarded with the newly created job of deputy governor for monetary policy in 1998, and then with the governorship in 2003.

  Although his days as a professor were long behind him, he hadn’t abandoned his academic mind-set. As governor, he focused on theories of how the British economy works, debating, developing, and refining economic models. When dealing with some of the more mundane decisions the bank needed to make, he sought to return to “first principles”: What’s the purpose of central banks? How does monetary policy work? And King often urged colleagues to seek advice from academic theorists rather than from those with more practical experience. One recalled when there was a discussion over how the bank should handle the logistics of auctions for newly issued British government bonds. King recommended calling several top researchers in “auction theory,” as opposed to people with actual experience in the market for UK government bonds.

  According to colleagues, the governor was privately disdainful of the economic views of commercial bankers and businesspeople without training in academic economics. He was a warm and ebullient presence and a clever wit to the groups of artists, intellectuals, and government leaders for whom he threw intimate dinner parties, but when he was to speak at some big event for financial grandees, he tended to skip the cocktail hour and show up just in time to fulfill his obligation.

  In contrast to monetary policy, with its elegant theoretical underpinnings, the regulation of banks is a messy business—one the BOE had largely ceded to the new Financial Services Authority as part of the 1997 deal to gain political independence. “Financial stability became a downplayed part of the institution,” said Kate Barker, a member of the Monetary Policy Committee from 2001 to 2010. Former Bank of England economist Richard Barwell told the Financial Times, “Before the crisis, working in financial stability was an absolute career graveyard.”

  Those who prospered were the economists whose interest in creating theoretical models of how the economy works mirrored King’s own. Employees with other approaches saw their careers stall out and frequently left. “His grip on the intellectual approach of the bank had become very tight,” said Barker. King’s attention to detail and desire for total control extended to the smallest things: At an annual summer gathering for staffers and their families to enjoy barbecue and sports, one former employee told the Financial Times, King “fusse[d] . . . about who has turned up, who will win the toss, all the little stuff.”

  King, judged tone deaf as a child, was viewed as insufficiently musical to join his school orchestra. But as an adult he discovered classical music and took to it with great passion, even serving on the advisory council of the London Symphony Orchestra. He viewed his stewardship of the Bank of England and the British economy as something like directing a great musical performance. “I think the role of conductor combines the ability to be a free spirit, to use imagination, as well as to be an intellectual study, which is what I did for most of my life,” King told radio host Gilbert Kaplan in a 2004 interview about his love of music. “The ability to do that and also to lead a team, just to get a team of people playing for you. That’s what I’ve tried to do at the Bank of England and what I think I would have much enjoyed doing as a conductor.”

  King’s players tuned up in the lengthy Friday afternoon gatherings leading up to a Monetary Policy Committee meeting the following Thursday—although some were clearly more favored by their conductor than others. With many of the hundred or so bank staffers in attendance presenting their latest economic data and analyses, the “bank agents,” who are scattered around Britain and charged with staying in contact with commercial banks and businesses, were consigned to a minor role. “The meeting would go on for three hours,” according to David “Danny” Blanchflower, a member of the Monetary Policy Committee whose private disagreements with King eventually turned into a very public feud. “And it would all be theory, and in the last ten minutes, the agents would report—and they said something that was completely different than what the theory said.”

  At the much smaller meetings of the MPC itself, the discussion was focused on applying the bank’s various models—models that assumed a functioning financial system—to current economic circumstances. Even when King was dealing with deepening problems in the banking system in the summer of 2008, he kept the conversation theoretical, sharing little of what he knew with his fellow committee members. “The Monetary Policy Committee was kept out of the loop,” said one person who was on the committee in that era. “Mervyn was holed up in his office reading and thinking. There wasn’t a sense of urgency or a lot of meetings. The rest of us were like, ‘My God, what are we doing?’”

  As the crisis expanded, financial markets were enveloped by uncertainty. But there could be certainty of one thing, at least: At the Bank of England, the King of Threadneedle Street reigned supreme.

  • • •

  At the end of August 2007, the three men were in different places, figuratively and literally. Bernanke was at the Jackson Lake Lodge, plotting crisis response from the secret crisis center set up one floor up from the ballroom. Trichet canceled his voyage there at the last minute, citing personal reasons. King, who usually dispatched deputy Charles Bean to the gathering, did so once again.

  On the evening of Friday, August 31, 2007, buses lined up at the lodge to take conference attendees and their spouses to the evening’s entertainment. Economists and bankers don’t necessarily wear jeans and cowboy hats well, but on this occasion they wore them nonetheless. While they nursed light beers, a local rancher tried to demonstrate the techniques of horse whispering. The bucking mare ignored the rancher’s reassuring body language and quiet words and refused, no matter how delicate the rancher’s approach, to submit to a saddle. The parallels with the financial crisis then just starting to unfold were so obvious that a murmur went through the crowd: Central bankers were whispering to the financial markets, trying to calm them. But just as in the show, soothing words might not be enough.

  The rancher suggested that his guests might want to go ahead and get their buffet dinner of beef brisket and baked beans while he kept working on the horse. Sure enough, by the time dinner was done, the animal had calmed down enough to allow the rancher to ride her. The financial markets would be harder to tame.

  TEN

 
Over by Christmas

  The morning of Friday, September 14, 2007, Mervyn King and Alistair Darling flew to Porto, Portugal, for a scheduled meeting of European Union central bankers and finance ministers. The timing of their trip to the riverside city best known for its sweet fortified wine was terrible.

  For the past several weeks, Northern Rock PLC, a bank based in the North East of England with £100 billion in assets, had been in crisis. Its business was to issue mortgages, which would then be packaged and sold on financial markets—and since August, mortgage securities had been toxic to global investors. Northern Rock faced a cash crunch, as depositors discovered just how bad its situation was, a classic bank run. Television news programs showed ominously long lines of Northern Rock customers waiting to pull their deposits. “You don’t want to be the ones in the end of the queue that the money’s run out,” an uncertain customer said to the cameras outside a branch in Reading.

  In a palatial Moorish hall, the governor of the Bank of England and the chancellor of the exchequer watched from afar—on TV, just like many of those Northern Rock customers determined not to be in the end of the queue when the money ran out. “They’re behaving perfectly rationally, you know,” King told Darling, the chancellor later recalled.

  It was an accurate statement—but hardly what Darling wanted to hear. Britain had seen a number of bank failures over the years. But the two men had overseen the first run on a British bank since Overend & Gurney’s in 1866.

  Known before 1997 as the Northern Rock Building Society, Northern Rock had established itself as a very modern variety of bank. Much of its deposit base came from the Internet, with people all over the country parking their savings there electronically to take advantage of high interest rates. Its home mortgage loans—many made to buyers in the gritty shipbuilding and coal-mining towns of the North East—weren’t held on its own books the way lending banks had done for centuries. Instead, Northern Rock sold them as securities—as quickly as it could, to investors around the world. It had expanded at a breakneck pace, growing around 20 percent a year for seventeen years straight. By 2007, it was a large bank, with shopping-center branches around the UK, but hardly enormous—it was about one twentieth the size of Barclays, for example.

  When the financial system started to shudder in August 2007, what had previously seemed like Northern Rock’s strengths turned out to be terrible weaknesses. Investors, newly fearful that mortgage securities could turn out to be worthless, had little interest in buying more of them. They also didn’t want to lend money to a bank that was built almost entirely on home lending.

  In continental Europe or the United States, this wouldn’t have been much of an issue, because the European Central Bank and the Federal Reserve had relaxed their emergency lending programs so banks like Northern Rock could get money on favorable terms. But King’s concerns about moral hazard meant that the Bank of England would offer no such accommodation until it was too late. When Northern Rock needed cash, it explored using its one branch in Ireland—part of the eurozone—to access money through the ECB. It concluded that getting the legal details in order would have taken two or three months—far too long to wait.

  As the weeks passed, Northern Rock’s cash crunch became increasingly self-perpetuating. With its future in doubt, the bank was less likely to get any money from lenders on private markets; their reluctance made its cash shortage all the more acute.

  The weekend of September 9, King was meeting with the other central bankers in Basel when Darling and chief British bank regulator Callum McCarthy reached him by phone. They argued that the Bank of England needed to follow the lead of the ECB and the Fed by supporting the banking system more actively. King was typically stubborn.

  “During the conference call, I became increasingly frustrated at Mervyn’s insistence that normal judgments could still apply in what were obviously deeply abnormal circumstances,” Darling wrote later.

  King may have been insistent on making banks pay for their previous mistakes, but the Bank of England’s job for three hundred years had been to prevent a bank collapse and the broader public panic that might ensue if British subjects no longer believed their deposits were safe. His strategy was to step in as lender of last resort to Northern Rock, if necessary—but he insisted on ensuring that the Bank of England truly was the bank’s last resort, and on charging a “penalty” interest rate for emergency loans, making them an undesirable option for any other banks that might wish to go to Threadneedle Street for help.

  King argued that an emergency loan to Northern Rock would be most effective if it was covert. After all, if the public knew that Northern Rock had had to turn to the Bank of England for funds, it could increase the sense of panic. But lawyers for both banks fretted that a failure to disclose the loan immediately might be illegal, giving Northern Rock shareholders an inaccurate impression of the bank’s health. A subsequent investigation questioned that interpretation of the law but acknowledged that it would have been hard to keep any large-scale loan to Northern Rock secret for long in the “febrile and fevered atmosphere of that period.”

  Indeed. On Thursday, September 13, the Bank of England was pulling together a funding deal for Northern Rock that was to be announced the following Monday, in a carefully plotted rollout meant to reassure depositors and investors that their money was safe. At 8:30 that evening, however, BBC business editor Robert Peston went live on the air to break the news that a bailout was imminent. There’d been a leak, and the careful rollout wouldn’t be an option.

  Depositors suddenly knew not only that Northern Rock was desperate enough to go to the Bank of England for funds, but also that there was no guarantee from the government that their deposits were safe. The bank’s tiny storefront branches filled up with even two or three people lined up inside; new arrivals had to wait outside. Once queues started forming and TV news cameras started broadcasting them, the “Run on the Rock” was well under way. People who had made deposits online began withdrawing at such a pace that the bank’s servers couldn’t handle the load. When word got around that Web customers were unable to withdraw, the panic worsened still.

  The run ended Monday, September 17, when Darling announced that the government would stand behind all deposits to Northern Rock—despite the fact that there was no clear-cut legal authority allowing it to do so. “It was pretty shambolic,” said one British official involved. But it was enough. The lines abated; the run stopped. The government had bought time to nationalize the bank and shut it down in an orderly way, with depositors’ money protected.

  That same day, Darling had a previously scheduled meeting with Hank Paulson, the U.S. treasury secretary. “Your guy Mervyn has a high pain threshold,” Paulson told him. “I hope you have, too.”

  During the summer and fall of 2007, the major central banks all had different interpretations of the emerging crisis. King and the Bank of England saw a necessary and even healthy market correction after years of excessive risk-taking by the banks. They were disinclined to step in and rescue the banks from their bad decisions, lest they reward dangerous behavior. Jean-Claude Trichet and the ECB saw a banking panic. Their banks were more exposed to shaky U.S. mortgage securities than anybody had realized, but the ECB and bank regulators across Europe pumped euros into the system to keep their banks awash in liquidity. It would be enough, they hoped, to prevent the European economy from facing any real peril.

  Ben Bernanke and the Fed saw a dual threat of a banking panic and recession: The crisis endangered both the financial system and the U.S. economy as a whole. They would use their tools to keep banks afloat, just as the ECB had. But Bernanke’s study of how the financial system interacts with the rest of the economy made him fearful that lending would dry up and slow the U.S. economy to a crawl—or worse. To combat that risk, in mid-September the Fed started cutting the federal funds rate, and by extension lowering the cost of money across the economy, to try to encourage overa
ll economic growth.

  Meanwhile, many of the other leading central banks, including the Bank of Japan and those in the emerging nations of Asia and Latin America, took an isolationist stance: The difficulties in the American and European financial markets are someone else’s problems. They probably won’t affect us here, and we have our own domestic issues to worry about. King was the first to discover how severe those domestic issues could be—and just how connected to the rest of the world’s problems they really were.

  After the big interventions by the ECB and the Federal Reserve, and the more halting efforts of the Bank of England, the sense of crisis ebbed in October. The U.S. stock market even reached new highs that month. But that reversed at the end of the year, as the patchwork of measures the world’s central bankers had put in place started to reach the limits of their effectiveness.

  It was time for the bankers to stop working individually, at different speeds and with different tactics, and begin addressing the crisis together. In the run-up to the crisis, what few policymakers or private economists fully understood was just how important European banks had become to the U.S. financial system.

  As economist Hyun Song Shin—he of the prophetic Millennium Bridge metaphor—explained in a 2011 paper, European banks, more than any others, had the ability to buy the allegedly risk-free mortgage and other assets being created by Wall Street with little or no capital to protect against losses. That helps explain why, by early 2008, non-U.S. banks—most of them European—had more than $10 trillion in exposure to the United States, equivalent to about 70 percent of U.S. economic output. They had roughly that much in both assets (bonds that they owned) and liabilities (money they owed someone else), particularly money market funds. It seemed like a system in balance: A German bank might have lots of dollar assets and lots of dollar liabilities, but they were more or less equal.