There has been a lot of interest in what goes on behind the appointment of heads of central banks, be it the Reserve Bank of India (RBI) or the Federal Reserve. There is always discussion on the independence of the central bank and the extent to which politics plays a role in determination of monetary policy. It is only more than timely and appropriate that these issues are taken up by Neil Irwin in his extremely engaging book, The Alchemists: Inside the Secret World of Central Bankers, where he traces the evolution of central banking and little-known facts of how decisions are taken by these so-called alchemists.
The name of the book is quite significant and interesting. Alchemists are people who turn base metal to gold. However, when you are a central banker, you turn metals, which were used in the earlier years as currency (copper) to paper money by fiat. That is how central banking began way back in 1656 in Sweden when Johan Palmstruch first brought in such money. The story also goes on to say that when things went wrong and money went missing in the vault, he was to be executed, unlike today, when bankers get away with just the critic’s censure when systems collapse. Times surely have changed. The role of alchemy is also played out when central banks go in for monetary easing when all else fails by printing more notes through the buyback of bonds and other financial instruments, which was done by the Fed, Bank of England and ECB, which is also like creating money from nothing. Irwin’s story is focused on the three honchos, Ben Bernanke, Jean-Claude Trichet and Mervyn King, who led their central banks with aplomb. An interesting anecdote here is that quantitative easing is not really a new thing and was introduced and pursued way back in 1866 in England when Overend and Gurney collapsed and there was a bank run. The Bank of England took on bills that were ‘otherwise good in normal times’ at a haircut to rescue banks. So the concept of rescue at a cost was there at that time too. The same did not quite work out in Germany when the Reichsbank printed money when the Treaty of Versailles put strain on the finances of the German economy, which Keynes had warned was not fair. The result was hyperinflation. Therefore, printing more money when all else fails is not always the right solution. In the US, just when the oil crisis had spread in 1971, the concern was on unemployment, growth and inflation. Nixon had wanted to bring the Fed under the executive so that the policies would be more positive. Therefore, politics cannot be separated from economics. Irwin explains the various pressures on the chairman of the Fed under these conditions when interest rates had to be raised, against the president’s wishes. Therefore, relentless pressure on central bankers to toe the line, especially during elections, is not really something new. Coming back to contemporary times, Irwin writes about how the three protagonists were of a different nature. Trichet, with his perfect manners, was persuasive and would ensure that the ECB took decisions and never left anything hanging. He would delay the lunch that was served until a decision was taken. Bernanke, surprisingly, even though being an academic, had to take training from a speaking coach and was consensus-driven, which was a challenge because he was dealing with 19 members. King, on the other side, was snobbish, loved sports and western classical music, and was disdainful of bankers who did not have training in economics. But he had a way with words, which was typically British. All three of them were for injecting liquidity and King did it to rescue Northern Rock Bank. In the US, it was tough considering that the investment banks were not really regulated by the Fed and hence in order to provide support, they had to invoke 13 (3) of the Federal Reserve Act, which allowed the Fed to lend to any individual or entity. Trichet had a tough time with opposition coming from Germany, which was against supporting Greece when the default happened. Under the Maastricht Treaty, such support was to be eschewed. Therefore, the idea was floated to create an SPV funded by the Euro members that would then take on these bonds and provide liquidity. Also interesting is the fact that the ECB was in general averse to aid coming from the IMF as there was a feeling that allowing such a thing to happen would mean showing some kind of subservience to the power of the US, which it is believed had supreme control over the institution. However, the interesting part is that the central bank always operates under guidance from the political leader in any territory. In the US, the appointment is political. Bernanke was not supposed to be an Obama man, as he was appointed by Bush, but his policies of being accommodative had worked and given assurance to Obama that he would be the right person to continue. At that point of time, Larry Summers, who is again today a candidate for the same position, was also in the running and supposedly closer to the democrats. However, Bernanke’s performance, as well as the fact that Summers was not a consensus person, worked against him. In fact, the entire rescue act, starting from AIG to money market mutual funds, such as Reserve Primary Fund, had the support of the government with Bernanke being backed by Tim Geithner. This had provided succor to both the funds and corporates. Again the wand of the alchemist had to be waved and Section 13 (3) invoked to transfer funds to an SPV, which, in turn, bought commercial paper offered by the funds. Quite clearly, innovative methods had to be used to resuscitate the system.Irwin also gets into the details of the Dodd formula where there was an attempt made to separate the monetary policy function from regulation and supervision. He did not quite manage to push through on this score in the Senate and went down 91-8. Banks naturally wanted the Fed, as the latter had rescued them in hard times. Meanwhile, we have had other versions of easing coming through, including Operations Twist, where the tenure of bonds was swapped to provide liquidity. On the same issue, the British experience was different. Bank of England, under King, wanted to wrest power from the FSA, which had power on regulation and King never missed a chance to have a swing at the deficit being run by the government, which gives us a sense of deja vu when one thinks of how Subbarao had also played this tune in the last couple of years. In fact, King was quite blunt when he likened central banks to the ‘nation’s economist-in-chief’ and said they should stay away from ‘politics’. The author moves adeptly between the three sets of nations and central banks to give the reader the pain and anguish that the bankers go through, even though they do appear to occupy celebrity status for the rest of the world. The decisions taken, which look as simple as lowering rates or using innovative methods, are not without opposition and severe criticism even within their own committees. Interestingly, while the Fed and Bank of England put up their minutes on their websites, the same does not hold for the ECB, where the agreement is that everything remains secret for 30 years! Therefore, we will never get to know who said what. Towards the end, and quite appropriately too, there is a chapter on how China does it. Things are very much easier when the entity conducting monetary policy, enforcing regulation, directing lending and formulating fiscal policy is the same person—the government. Things work smoothly when there can be fiscal stimulus, rates lowered, banks willingly lend and asset quality does not matter that much. That is how China got out from the possible mess.This book is easy to read with its stories. The historical backdrop is even more interesting as Bagehot had said during the crisis of 1866—Bank of England lent to merchants and banks and this man and that man to stop the run on the system. Surely, given the fragile nature of relationships between various entities in the financial system today and the domino effect of a failure, one does finally end up lending to this man and that man, almost always to avert a crisis. This tune has not quite changed over centuries now.
The name of the book is quite significant and interesting. Alchemists are people who turn base metal to gold. However, when you are a central banker, you turn metals, which were used in the earlier years as currency (copper) to paper money by fiat. That is how central banking began way back in 1656 in Sweden when Johan Palmstruch first brought in such money. The story also goes on to say that when things went wrong and money went missing in the vault, he was to be executed, unlike today, when bankers get away with just the critic’s censure when systems collapse. Times surely have changed. The role of alchemy is also played out when central banks go in for monetary easing when all else fails by printing more notes through the buyback of bonds and other financial instruments, which was done by the Fed, Bank of England and ECB, which is also like creating money from nothing. Irwin’s story is focused on the three honchos, Ben Bernanke, Jean-Claude Trichet and Mervyn King, who led their central banks with aplomb. An interesting anecdote here is that quantitative easing is not really a new thing and was introduced and pursued way back in 1866 in England when Overend and Gurney collapsed and there was a bank run. The Bank of England took on bills that were ‘otherwise good in normal times’ at a haircut to rescue banks. So the concept of rescue at a cost was there at that time too. The same did not quite work out in Germany when the Reichsbank printed money when the Treaty of Versailles put strain on the finances of the German economy, which Keynes had warned was not fair. The result was hyperinflation. Therefore, printing more money when all else fails is not always the right solution. In the US, just when the oil crisis had spread in 1971, the concern was on unemployment, growth and inflation. Nixon had wanted to bring the Fed under the executive so that the policies would be more positive. Therefore, politics cannot be separated from economics. Irwin explains the various pressures on the chairman of the Fed under these conditions when interest rates had to be raised, against the president’s wishes. Therefore, relentless pressure on central bankers to toe the line, especially during elections, is not really something new. Coming back to contemporary times, Irwin writes about how the three protagonists were of a different nature. Trichet, with his perfect manners, was persuasive and would ensure that the ECB took decisions and never left anything hanging. He would delay the lunch that was served until a decision was taken. Bernanke, surprisingly, even though being an academic, had to take training from a speaking coach and was consensus-driven, which was a challenge because he was dealing with 19 members. King, on the other side, was snobbish, loved sports and western classical music, and was disdainful of bankers who did not have training in economics. But he had a way with words, which was typically British. All three of them were for injecting liquidity and King did it to rescue Northern Rock Bank. In the US, it was tough considering that the investment banks were not really regulated by the Fed and hence in order to provide support, they had to invoke 13 (3) of the Federal Reserve Act, which allowed the Fed to lend to any individual or entity. Trichet had a tough time with opposition coming from Germany, which was against supporting Greece when the default happened. Under the Maastricht Treaty, such support was to be eschewed. Therefore, the idea was floated to create an SPV funded by the Euro members that would then take on these bonds and provide liquidity. Also interesting is the fact that the ECB was in general averse to aid coming from the IMF as there was a feeling that allowing such a thing to happen would mean showing some kind of subservience to the power of the US, which it is believed had supreme control over the institution. However, the interesting part is that the central bank always operates under guidance from the political leader in any territory. In the US, the appointment is political. Bernanke was not supposed to be an Obama man, as he was appointed by Bush, but his policies of being accommodative had worked and given assurance to Obama that he would be the right person to continue. At that point of time, Larry Summers, who is again today a candidate for the same position, was also in the running and supposedly closer to the democrats. However, Bernanke’s performance, as well as the fact that Summers was not a consensus person, worked against him. In fact, the entire rescue act, starting from AIG to money market mutual funds, such as Reserve Primary Fund, had the support of the government with Bernanke being backed by Tim Geithner. This had provided succor to both the funds and corporates. Again the wand of the alchemist had to be waved and Section 13 (3) invoked to transfer funds to an SPV, which, in turn, bought commercial paper offered by the funds. Quite clearly, innovative methods had to be used to resuscitate the system.Irwin also gets into the details of the Dodd formula where there was an attempt made to separate the monetary policy function from regulation and supervision. He did not quite manage to push through on this score in the Senate and went down 91-8. Banks naturally wanted the Fed, as the latter had rescued them in hard times. Meanwhile, we have had other versions of easing coming through, including Operations Twist, where the tenure of bonds was swapped to provide liquidity. On the same issue, the British experience was different. Bank of England, under King, wanted to wrest power from the FSA, which had power on regulation and King never missed a chance to have a swing at the deficit being run by the government, which gives us a sense of deja vu when one thinks of how Subbarao had also played this tune in the last couple of years. In fact, King was quite blunt when he likened central banks to the ‘nation’s economist-in-chief’ and said they should stay away from ‘politics’. The author moves adeptly between the three sets of nations and central banks to give the reader the pain and anguish that the bankers go through, even though they do appear to occupy celebrity status for the rest of the world. The decisions taken, which look as simple as lowering rates or using innovative methods, are not without opposition and severe criticism even within their own committees. Interestingly, while the Fed and Bank of England put up their minutes on their websites, the same does not hold for the ECB, where the agreement is that everything remains secret for 30 years! Therefore, we will never get to know who said what. Towards the end, and quite appropriately too, there is a chapter on how China does it. Things are very much easier when the entity conducting monetary policy, enforcing regulation, directing lending and formulating fiscal policy is the same person—the government. Things work smoothly when there can be fiscal stimulus, rates lowered, banks willingly lend and asset quality does not matter that much. That is how China got out from the possible mess.This book is easy to read with its stories. The historical backdrop is even more interesting as Bagehot had said during the crisis of 1866—Bank of England lent to merchants and banks and this man and that man to stop the run on the system. Surely, given the fragile nature of relationships between various entities in the financial system today and the domino effect of a failure, one does finally end up lending to this man and that man, almost always to avert a crisis. This tune has not quite changed over centuries now.
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