The Alchemists: Three Central Bankers and a World on Fire

by Neil Irwin

  These were harsh judgments to share with a foreign power about the men who would soon rule Britain, even if King meant them to remain in confidence.

  Britons went to the polls on May 6, 2010, the same day ECB officials gathered in Lisbon and discussed how to rescue the eurozone late into the evening, and the same day the U.S. stock market experienced its Flash Crash. Between the perpetually gloomy Gordon Brown and the dismal economy, things weren’t looking good for Labour. All the polls pointed to the party being swept from office. Indeed, the Conservatives picked up ninety-seven additional seats in the 650-seat House of Commons, with Labour losing nearly as many. It wasn’t quite the decisive result that Cameron and company had wanted, however. They fell short of a majority and would need to form a coalition with the Liberal Democrat Party, which held fifty-seven seats, to take control of the government.

  For once, the third party of British politics had some real negotiating power, as both the Conservatives and Labour competed for the affections of the Lib Dems as coalition partners. King wasn’t directly involved in the negotiations, of course—yet he wasn’t entirely absent from them either. The deficit, wrote David Laws, a Liberal negotiator, “was the spectre which loomed over our talks. This was the reason that the Governor of the Bank of England stood ready to brief us on his perspective on the risks to the UK.” The Tories cited King’s support for spending cuts as a lever through which to push the Liberals toward more austerity, faster. Sunday, May 9 (the day Trichet and most of the other central bankers were in Basel hammering out what would be the ECB’s controversial bond purchase program), civil service chief Gus O’Donnell is said to have offered to arrange a briefing by King so negotiators could “understand the seriousness of the economic situation.”

  King was in a curious position, both at the center of momentous events taking place in Basel and London and physically apart from them. He was on a long conference call with the finance ministers and central bankers of the world’s leading powers, which stretched over the entire evening of May 9 and into the early morning hours of May 10. (One American official dialed into the international number from home and ended up with an $800 phone bill.) There was a long stretch of silence, as the European finance ministers in Brussels put their phone on mute in order to hammer out some differences among themselves. King, showing his impish humor, entertained the other leaders on the phone by reading off that day’s soccer scores, the joke being that this was his only way of staying awake.

  When British politicians finally did reach agreement to form a coalition and on immediate austerity, King gave them a sort of reward. “The most important thing now is for the new government to deal with the challenge of the fiscal deficit,” he said in a press conference May 13. “It is the single most pressing problem facing the United Kingdom. . . . And I have been told what is in the agreement between the Conservatives and the Liberal Democrats this morning, and I am very pleased that there is a very clear and binding commitment to accelerate the reduction in the deficit.” As a government came together, so did the forces that would buffet the British economy under Prime Minister Cameron. Prices for food, energy, and other commodities had soared on global markets in the first part of the year, even as the value of the pound had fallen due to the Bank of England’s quantitative easing policies, hiking the cost of imports. Additionally, a stimulus measure that had cut the value-added tax expired, meaning the purchase price of a wide variety of goods increased further still. That added up to 3.4 percent inflation in March, well above the 2 percent the Bank of England aimed for. King and most of his colleagues on the MPC viewed this as a one-time price jump, not the kind of ongoing inflation that might warrant raising interest rates. “In the medium term we expect inflation to come down below the target, given the extent of spare capacity in the economy,” King said in a May 12 press conference, while acknowledging “enormous uncertainties around this.”

  On top of the inflation scare, the eurozone crisis was sending British financial markets on a wild ride. About half of British trade was with nations in the eurozone, meaning their economic downfall could be catastrophic for UK companies. With the coalition not yet formed, Alistair Darling was in Brussels representing Britain that crucial Sunday of May 9 as European finance ministers raced to finalize a eurozone bailout before markets opened in Australia and Asia Monday morning. His last official assignment as chancellor of the exchequer was an especially tricky one: Britain’s economic future depended on a eurozone rescue, but Darling had to try to keep too much British money from being committed to the action. Imminent replacement Osborne had even wondered whether Darling could abstain from the negotiations due to purdah, the practice by which an outgoing government avoids binding an incoming one to policy decisions it may not support.

  Osborne and Darling didn’t support any British underwriting of a eurozone bailout, but were more enthusiastic about austerity. Whatever effort King had made before the election to curtail his overt campaigning for tighter fiscal policy went by the wayside in his press conference of Wednesday, May 12, two days after the coalition had formed. He could hardly have been blunter about what he thought the Conservatives and Liberal Democrats needed to do:

  The most important thing now is for the new government to deal with the challenge of the fiscal deficit. It is the single most pressing problem facing the United Kingdom; it will take a full parliament to deal with, and it is very important that measures are taken straight away to demonstrate the seriousness and the credibility of the commitment to dealing with that deficit. . . . I think we’ve seen in the last two weeks, particularly, but in the case of Greece, over the last three months, that it doesn’t make sense to run the risk of an adverse market reaction.

  His none-too-subtle message to the new prime minister, in other words: Do what you’ve promised. No flinching now.

  Not long after an MPC policy announcement, the committee members gather again to approve minutes of their decision-making process for public release. The discussion itself might have been lengthy and discursive, taking place over two days and six hours, but bank staffers manage to summarize it with a series of bullet points describing the various views that were expressed and the reasons for the result, all in ten pages or so. The meeting to approve the minutes is usually a speedy and civil affair: The policymakers suggest changes to the draft minutes staff have prepared—add a bit more precision here, a bit more ambiguity there—with agreement to the tweaks made by consensus.

  But when it was time to approve the minutes for the May 10 meeting, which had taken place just days after the election and the morning after the European summit, a curious thing happened: The normally collegial process became something quite different.

  The draft of the May minutes, prepared by staff directed by King, gave the full approval of the MPC to the fiscal austerity message that the governor had been sending in his own public statements. “A significant fiscal consolidation in the United Kingdom was necessary in the medium term,” the minutes said. “A more detailed and demanding path for fiscal consolidation than set out in the March 2010 Budget, upon which the Inflation Report projections had been based, might therefore be needed in order to avoid unnecessary increases in the cost of issuing public debt.” It was an attempt to give the imprimatur of the committee to King’s theory that Britain could be heading for a debt crisis if it didn’t begin austerity measures.

  But not everyone at the Bank of England was so sure. With the British economy still in a fragile postcrisis state, and now under threat from the troubles in the eurozone, some of the committee members thought it unwise to advocate so vigorously for rapid deficit cutting—all the more so given that the markets were giving only the faintest signals of losing confidence in UK government bonds and that fiscal policy isn’t the job of a central bank in the first place. King was adamant, and they voted on the material’s inclusion in the minutes. King won the vote, six to three, with the dissenters including Adam Posen, an American
economist who had joined the committee the previous fall, and Kate Barker in her final meeting after a nine-year run on the MPC.

  It was a victory for the King of Threadneedle Street—but one that would come back to haunt him.

  • • •

  The coalition government listened to the governor’s advice. On May 24, just two weeks after taking office, Osborne announced £6 billion in spending cuts for the fiscal year then already under way. That amounted to only about 0.4 percent of Britain’s economy, but given the speed with which the cuts were to be implemented, and the tepid pace of recovery, they were a surprise even to advocates of austerity. The cuts were highly concentrated in symbolic, headline-generating areas: forbidding government workers from buying first-class train tickets on official travel, for example, and freezing more than three thousand vacancies in the civil service to save on bureaucratic salaries. There was a plan to defund “quangos,” or quasi-autonomous nongovernmental organizations, such as local development agencies, regulatory commissions, and some museums and art galleries. Even though the Conservatives and Liberal Democrats avoided big-ticket areas of expenditure such as the National Health Service, they sent a clear message: “The age of plenty is over,” as Lib Dem leader Nick Clegg put it.

  The Mansion House Dinner on June 16 was a rather warmer affair than it had been a year earlier; the governor and the chancellor were, this year, in something of a mutual admiration society.

  Osborne proposed a new approach to financial regulation that would undo the structure created by the Labour government more than a decade earlier and put the Bank of England squarely in charge of overseeing Britain’s banks—granting King and his successors the very powers the governor had asked for at the same event a year before. “Only independent central banks have the broad macroeconomic understanding, the authority and the knowledge required to make the kind of macro-prudential judgments that are required now and in the future,” Osborne told the assembled tuxedo-clad financiers. “And, because central banks are the lenders of last resort, the experience of the crisis has also shown that they need to be familiar with every aspect of the institutions that they may have to support. So they must also be responsible for day-to-day micro-prudential regulation as well.” He would give details of the plan to Parliament the next day. It was evident that the chancellor and the governor had coordinated their remarks. Speaking immediately afterward, King said that a priority of the bank was to “accept the challenge of the new responsibilities that you, Chancellor, have asked the Bank to take on. . . . I welcome those new responsibilities.”

  King also offered his endorsement of the government’s fiscal measures—and strongly suggested that if there were negative economic consequences, the Bank of England would come to the rescue. “I do . . . Chancellor, welcome your commitment to put the UK’s finances on a sound footing,” the governor said. “I know there are those who worry that too rapid a fiscal consolidation will endanger recovery. . . . If prospects for growth were to weaken, the outlook for inflation would probably be lower and monetary policy could then respond.”

  The £6 billion in cuts that Osborne had put forward in May were only the beginning. A few days after the Mansion House Dinner, the chancellor unveiled his budget for the years ahead. The plan was to slash the deficit by more than 6 percent of GDP by the fiscal year that would begin in April 2014. It included increasing the value-added tax from 17.5 percent to 20 percent, which would increase the price of almost all goods on British store shelves by 2.5 percent and raise about £13 billion in extra revenue for the government. With the health service and international development protected from cuts, all other government departments were to reduce their operational expenses by an average of 25 percent over four years. In one nice touch, Osborne proposed abolishing the Treasury’s “Euro Preparations Unit,” which had been charged with laying the groundwork for Britain to join the eurozone.

  Britain—with encouragement from Mervyn King—was embarking on something that has rarely been attempted. At a time when the British government could borrow money for a decade for only 3.5 percent and unemployment was nearly 8 percent, Osborne and Cameron were cutting spending and raising taxes in a preemptive strike against the risk of a future debt crisis. In the process, they risked stopping a weak economic recovery in its tracks and had to hope that their actions would sufficiently boost confidence among consumers and businesses to ease at least some of the pain—and perhaps that King and the Bank of England would find a way to counteract any damage to the economy with easier monetary policy.

  Over the years, the governor has sometimes posed a question to his audience at the start of his annual Mansion House speech, offering his answer at the end. In 2010, he inverted the practice. The answer, he announced to the financiers, was “23.” He would tell them the question only at the conclusion of his speech:

  To what question is 23 the answer? Several plausible answers come to mind. First, 23 is the number of players in England’s World Cup squad in South Africa. Second, it is of course 23 years since England last won the Ashes “down under.” But neither of these are the right answer which is that 23 years is the age difference between the Chancellor of the Exchequer and the Governor of the Bank of England. In case there is any doubt, George is the younger. This age difference is highly desirable because the appropriate incentives are to allocate the responsibility of determining monetary policy to the older generation, which has a real interest in preserving the value of money, and the responsibility for fiscal policy to the younger generation, on whom falls the burden of excessive debt. . . . Given those incentives, Chancellor, I look forward to a harmonious coordination of monetary and fiscal policy.

  It’s a frustrating reality of economic policymaking that one receives little credit for a crisis prevented. The counterfactual is unknowable. But what’s certain is that for the British economy, the harmonious coordination between King and Osborne would prove costly indeed.

  By November, the Financial Times caught wind of internal dissent over the Monetary Policy Committee’s advocacy of austerity. Norma Cohen, Chris Giles, and Daniel Pimlott reported the evening of November 9 that “some senior staff at the Bank of England are uncomfortable with Mervyn King’s endorsement of the government’s public spending cuts, suggesting he has overstepped the line separating monetary and fiscal policy.” The next day, at King’s quarterly press conference, Pimlott put a question to the governor, directly and on the record: “Is the MPC unanimous in supporting your strong endorsement of what is essentially the political decision on the scale and size of the fiscal consolidation?” King’s response was, at best, disingenuous. “There are different views among the committee on monetary policy, so I’m sure there are probably differing views on fiscal policy,” he said. “But we don’t sit down and discuss it because it’s not the remit of the MPC.”

  In fact, they had discussed the matter quite explicitly in the vote over the minutes back in May. Posen and Barker, believing their views had been misrepresented by King, went to his press aide with an ultimatum: Unless the governor retracted his statement, they would go public with their objections. He didn’t. So they did. In a hearing before Parliament’s Treasury Select Committee on November 25, Conservative MP Andrew Tyrie asked Posen about the Financial Times article. The American laid out, albeit somewhat obliquely, what had happened with the wording of the May minutes:

  A number of people in the committee, myself plus at least one other . . . were concerned that that statement could be seen as excessively political in the context of the election and the discussion that had gone on. We expressed that point of view. We offered alternative language. The majority of the committee decided that they were comfortable with the language that appeared in the report. . . . It is factually correct, however, that at least one other member plus me were concerned that that language was too political, too much of a statement. That’s my personal opinion.

  A few days after that, another penny
dropped. WikiLeaks, the publishing cooperative led by eccentric Australian Julian Assange and devoted to exposing the world’s secrets, began unveiling a trove of diplomatic cables that U.S. embassies around the world had sent to Washington, never meant for public consumption. Among them was Ambassador Susman’s write-up of his meeting with King from earlier in the year, showing the governor offering a ruthlessly critical assessment of the men who were now in power. King’s old adversary Danny Blanchflower suggested that the governor resign, writing in the Guardian that King had a “thirst for power and influence that has clouded his judgment one too many times. He has now committed the unforgivable sin of compromising the independence of the Bank of England by involving himself in the economic policy of the coalition. He is expected to be politically neutral but has shown himself to be politically biased and as a result is now in an untenable position.”

  But while the meeting with Susman was an embarrassing disclosure, Blanchflower overstated the degree of King’s mistake. Worries about the experience levels of the young Cameron and Osborne were widespread in UK political circles, and the conversation was meant to be a private one. And the cables showed nothing inconsistent with King’s public advocacy of budget cuts. Cameron, for his part, played it cool. Speaking to reporters December 1, his spokesman said that King was doing a good job and that “the issue of confidence simply doesn’t arise. My experience is the Bank of England governor makes lots of statements on economic policy. That’s what you’d expect.” The comment seemed to split the difference between dismissing the matter entirely and allowing King to twist in the wind.