When Mervyn King, the governor of the Bank of England, stood up in the grand setting of the Mansion House in the City of London on the warm evening of 17 June, with the Chancellor Alistair Darling sitting just a few seats away, he did what he has done throughout the financial crisis: he challenged the government directly. National debt, he warned, was dangerously high, “at more than double the levels before the crisis”.
Banks had become too big and the Bank of England itself needed greater powers. “The Bank finds itself in a position rather like that of a church whose congregation attends weddings and funerals, but ignores the sermons in between.”
In a televised appearance in front of the Treasury select committee just a week later, King went further and all but accused the Prime Minister of carelessness with the public finances. “We are confronted with a situation where the scale of the deficits is truly extraordinary,” he said, and noted, in an aside that perplexed the Treasury, that the Chancellor had not bothered to consult him on changes to banking legislation that would directly affect the Bank of England.
King is an unlikely rebel. Quietly spoken and cerebral, he is the first governor of the Bank of England to have been a full-time academic: before joining in 1991, he was a professor of economics at the London School of Economics. Yet, since the credit markets first froze over in August 2007, he has been in pugnacious mood and continuously in conflict with the Treasury and the Prime Minister. At times, throughout what is the worst financial crisis since the period leading up to the First World War, the relationship between King and the government has been radioactive.
Some Treasury insiders go so far as to accuse King of being concerned about protecting his reputation and that of the Bank to the detriment of everyone else involved in stabilising the financial system and preventing a cataclysmic collapse.
The authority of Bank of England governors once stemmed from the dignity of the office they held. The authority of the present governor stems entirely from his intellect. In the past, governors were drawn largely from the banks of the City of London. When these stately figures moved from the parlours of the old merchant and clearing banks to Threadneedle Street, to be protected from the outside world by the great curtain wall designed by Sir John Soane, they transmogrified into something far more majestic. The visitor to the Bank would be guided through a maze of spacious corridors, under the vaulted ceilings, to the almost-hidden entrance to the governor’s drawing room. On their journey, they would pass portraits of past governors and deputy governors. The escorts, pink-frock-coated “waiters”, nearly all veterans of the armed forces, marched at a formidable pace. In the presence of the governor, all it required was a lift of the eyebrow for the attendant banker to recognise the game was up.
Today, the Bank’s corridors are as magnificent as ever, the marbles, mosaic floors, Persian rugs and Chippendale furnishings unchanged, and the mystique remains intact, but its new core is that of rigorous analysis. The bankers and brokers, who were on easy terms with the governor, are no longer the insiders. King, who took an academic route to the top of the Bank, is a trenchant critic in public and private of the bankers, of their risk-taking, profiteering and greed. And it is King’s cerebral approach and tendency to subject all he does to rigorous intellectual stress-testing that has opened a chasm between himself and Gordon Brown.
Downing Street was especially enraged when, on the eve of the G20 summit in London in April, King warned against “significant fiscal
expansion”. In so doing, he thwarted the Prime Minister’s hopes of forging an agreement with President Obama and other global leaders on a second round of anti-recessionary stimulus packages. King’s views accorded with those of the Treasury, which was putting the final touches to a Budget that projected unprecedented levels of new borrowing – £703bn by 2013-14, or an astonishing 76.2 per cent of national output.
But King has exasperated the Treasury, too. In private, the Chancellor was incandescent with anger when King, at his May inflation report press conference, laid out a far gloomier prospect for the British economy than that described by Darling in the Budget. The Bank forecast output could fall by as much as 4.5 per cent in 2009 and that recovery could be delayed well into 2010. King was downbeat, in sharp contrast to the message of Darling, who had been making the case for recovery by the end of the year.
The differences of tone provided a sharp reminder of how hard it had been throughout the crisis for the Treasury to coax King into
responding to the need for decisive action, notably over the creation of the special liquidity scheme – which was designed to clear the bank balance sheets of mortgage debts. King delayed, demanded late-night meetings and relentlessly analysed the plan – “nitpicking it to death”, as one insider put it.
Brown was expected to have taken the decision on King’s reappointment to a second five-year term in late 2007, when the scale of the disaster affecting the world’s financial markets was increasing. The Prime Minister hesitated in approving the reappointment, and leaks pointed to King’s position as governor being in danger. But Brown eventually recommended a second term for King on 30 January 2008. His aides warned that discarding King in the middle of the crisis could provoke havoc on financial markets.
Having kept King in office, the government had little choice but to work with him. Nevertheless, at the Treasury, King is regarded as difficult to the point of obstreperous.The paradox of his position is that the power and moral strength that he exercises is largely the result of one of
the earliest decisions taken by Brown as chancellor in May 1997, when, following Labour’s landslide general election victory, he set the Bank of England free of Whitehall and granted it full independence over monetary policy and the setting of interest rates. Now, 12 years later, Brown, in his beleaguered frame of mind, imagines that King is betraying him by daring to associate with the chancellor-in-waiting, George Osborne. What he and his aides have forgotten, or perhaps have chosen to forget, is that in the months leading up to the 1997 election, King, who was then deputy governor to the late (Lord) Eddie George, had been as helpful to Brown and his top economic aide, Ed Balls,
as he is being to the Tories.
Born in 1948, Mervyn King attended Wolverhampton Grammar School, where he dreamed of playing football for Aston Villa and cricket for Worcestershire, and then King’s College, Cambridge, taking a First in economics. After Cambridge, he went as a Kennedy Scholar to Harvard, before becoming professor of investment at Birmingham University at the age of 29, the youngest person to hold a chair in Britain. In 1984, he spent a year as a visiting professor at Massachusetts Institute of Technology, in Boston. It was there that he got to know another brilliant young academic economist, Ben Bernanke, a student of the Great Depression
and now head of the US central bank, the Federal Reserve Board. King later became professor of economics at the LSE. “He was fantastic to work with,” recalls Ros Altmann, a former PhD student of King’s and later a Downing Street adviser on pensions. “He always managed to explain and get down to student levels.”
King remains a keen sports fan and regularly plays tennis (he was in the Royal Box during this year’s men’s Wimbledon final); he often took
on Alan Greenspan on the courts of the British embassy during breaks from the biannual meetings of the G7 and International Monetary Fund in Washington. King prefers to walk to work from his flat in Notting Hill in west London, his route taking him through Hyde Park and then into the City.
Yet, for all his academic distinction, King is accused of being slow to have recognised the scale of the crisis when the credit crunch hit in August 2007, in sharp contrast to his opposite number at the European Central Bank in Frankfurt, Jean-Claude Trichet. King has since moved an enormous distance, but not at a speed fast enough or in a responsive enough way for Downing Street. His critics say that it was only when the Bank realised that there was very little choice, if the nation was not to have a major bank failure on its hands, that he decided on the Bank’s role as “lender of the last resort” and began pumping ever-increasing quantities of loans into Northern Rock when it hit trouble in August 2007.
He similarly prevaricated in April 2008, only reluctantly signing up to the government’s special liquidity scheme, under which the Bank would take securitised mortgages held by banks on to its balance sheet in exchange for short-term paper – the equivalent of cash. The initial £50bn plan, intended to revitalise Britain’s moribund home loans market, would eventually soak up more than £200bn of taxpayers’ money.
The Bank also changed the way it conducted its operations in the money markets, or the inter-bank market, where banks lend to each other. Previously it had provided money to the banking system through a series of daily, weekly and monthly auctions, at which authorised financial institutions would bid for money when they could not square their books. This process had sometimes proved embarrassing, as happened in the summer of 2007, when the names of those banks (notably Barclays) which had temporarily run short of cash was publicised. (The Bank
of England would eventually move to a US-style “discount” window arrangement, whereby banks can borrow directly without the risk of their identity being disclosed and becoming stigmatised in the financial markets.)
King claims he was at the forefront of the dramatic move by the government, in September 2008, which resulted in the recapitalisation of British banks and their part-nationalisation.
Where the Brown government led, other countries followed, or so it was said. Brown, in a slip of the tongue in the Commons, told MPs he “had saved the world”. Most recently, King has embarked on an ambitious programme of quantitative easing, or printing money. This involves buying up government and corporate bonds for cash in an effort to head off deflation and refloat the economy – a bold move.
The rise of Mervyn King through the Bank of England can be traced back to 1992 and Britain’s ejection, under the Tories, from the Exchange Rate Mechanism, forerunner of the single currency and the eurozone. In 1991, the then governor, Eddie George, scouted around for a new chief economist and King, still at the LSE, had become an obvious replacement. At the LSE, with his fellow economist Charles Goodhart, he had launched the Financial Markets Group. It was their way of making direct connections between the LSE and City banks.
King saw his appointment as an “interesting secondment” and not necessarily as a long-term career move. On Black Wednesday, 16 September 1992, when Britain was left without a monetary framework following ejection from the ERM, it was King who picked up the pieces; he invented and personally wrote the first of the Inflation Reports that were to become the centrepiece of policymaking. When the Bank was given its independence on 6 May 1997, his future path was all but set. In 1998, he was elevated to deputy governor, with responsibility for monetary policy, and became the first governor from academe when George retired in 2003.
Yet, in retrospect, the seeds of the credit crunch were planted with independence when Brown announced that banking supervision
was to be moved from the Bank to a newly created Financial Services Authority, against the wishes of Eddie George. “Financial stability
became the least interesting part of the Bank,”
a former member of the Monetary Policy Committee, which sets interest rates, told me. “Until the crisis no one who wanted to be successful wanted to work there.”
King denies such criticism. He believes that the Bank’s financial stability wing was ahead of the game in warning about the dangerous build-up of debt and credit that ultimately contributed to the implosion of the financial system. If this is true, why did the Bank not do more to prevent disaster happening? An important reason is that few people were prepared to listen.
At the end of 2005, shortly before he left the Bank of England, I took a call from Sir Andrew Large, the then deputy governor responsible for financial stability. He had a keen market instinct. His parting shot was to express concern that banks, given the volume of transactions in which they were now involved as well as the complexity of the transactions, did not hold enough liquidity (spare cash on their balance sheets). In the event of a swing in mood in the credit markets or an unexpected calamity, the banks would lack the means to deal with the crisis. King had his own concerns. “After the hectic pace of house prices over the past year,” he told the Scottish CBI in June 2006, in an attempt to prick the housing bubble, “it is clear that the chances of falls in house prices are greater than they were.”
His comments temporarily slowed the housing boom, but prices quickly started to race ahead again. A year later, in a set-piece speech at the Mansion House and just two months before the credit crunch brought finance to a shuddering halt, King, in the presence of the then chancellor Brown, issued another warning. He cautioned that “new and ever more complex financial instruments create different risks”. He argued that the risks of the entire return “being wiped out” were greater than they would be with simpler
However, when weeks later the great ship of toxic debt hit an iceberg – and Northern Rock came close to drowning – the governor was off the pace. Downing Street was desperate for a swift market solution to the crisis of the Rock, and Chancellor Darling summoned bankers to Downing Street demanding intervention. But when the Chancellor asked King for advice on a market-based solution, the governor insisted it could not be done. King later told the Treasury select committee that he lacked the legal powers to intervene. “King was very slow off the mark at the beginning of the crisis,” Willem Buiter, a former member of the MPC and currently professor of political economy at the LSE, says now. “He messed up the Bank’s lender of last resort operations with Northern Rock.
“He obviously got the wrong legal advice on what the Bank could and could not do, including his ludicrous assertion to the treasury committee that the EU’s Market Abuse Directive stopped him from acting. When your legal honcho tells you things that don’t make sense, why not get on the phone and call Neelie Kroes [the EC’s competition supremo]? But Mervyn never even knew the area code for Brussels.”
Members of the Court, the Bank of England’s body of non-executive directors, were also frustrated by King. One member told me that the Bank failed to deliver on a promise to explain fully to the Court how the Bank’s financial stability wing worked. “They just ignored us.”
During the Northern Rock crisis, King was determined to keep his distance from the banks. He believed, rightly, that they were the victims of their own misfortune.
He also thought that the Federal Reserve Bank of New York was a captive of the Wall Street bankers. With the governor’s confidence in his ability, and his preference for acting alone, he was reluctant to take into his confidence senior Bank officials, including the deputy governor for financial stability, the former Treasury mandarin Sir John Gieve. “I have no idea what Mervyn is up to,” Gieve privately complained.
Through the autumn of 2007, as the government struggled with the collapse of Northern Rock, King sought to improve his understanding of the crisis and what steps needed to be taken. He reads deeply in financial history and has set up his own book club, which enables him to play host at his home in west London to leading economic and financial historians. During this long period of intense reading and deep introspection, as he consulted the Bank of England archives looking for historical parallels to the present crisis, King came to believe that the crisis facing the banking system was certainly the worst since the period of near-meltdown before the First World War. From among the extensive literature of financial crashes, he regarded J K Galbraith’s The Great Crash, 1929 (first published in 1954) as the most insightful, and also admired Walter Bagehot’s Victorian classic Lombard Street (1873).
King’s reading led him to accept that the problems of the banking system were not just those of liquidity, but of capital – the equity and other top-grade securities that underpin lending. Historically, the ratio of capital to lending was seven to ten times. In the run-up to the credit crunch, some of the investment banks were lending 60 or 70 times capital. Because banks were insufficiently capitalised for the vast lending they had done, fear and loathing stalked the money markets. The governor believed that trying to persuade banks to increase lending would be a waste of time until they had restored their capital bases and trust resumed on the money markets.
The Treasury, however, differed. Brown was fearful that the crash in the housing market would intensify and that first-time buyers would be excluded. He wanted a comprehensive scheme to support mortgage lending. Though actions taken by the Bank to supply the banking system with credit were useful, they were not helping to restart lending. The danger was that Britain, as subsequently happened, could be thrust deeper into recession. King outlined his views at Bristol City’s football ground, Ashton Gate, on 22 January 2008. “Banks must reveal losses promptly, and, most importantly, must raise new capital where necessary,” he said.
The governor was becoming more confident in the crisis and his remedy, dramatically, was adopted by the government in September 2008 following the collapse of Lehman Brothers, the 158-year-old Wall Street dealer-brokerage firm. A former LSE colleague, John Kay, believes that King was at this point showing himself to be a “Roosevelt-calibre politician” in his handling of the crisis. Yet, at the same time, King, newly appointed to a second term, found himself in open conflict with the Treasury. Darling wanted a scheme directly to support the mortgage market. King wanted nothing to do with any package that rewarded the banks for their mistakes. Eventually, after much prompting and political prodding and severe irritation on Downing Street’s part, the special liquidity scheme, under which banks could exchange mortgages, was born on 21 April 2008.
It was not an easy birth. Hunkered down in his office at Threadneedle Street, King delayed and fussed about the detail of the scheme, much to the irritation of the Treasury and the elected politicians, who were not convinced he had grasped the gravity of what was happening. In spite of the seriousness of events, King never lost his sense of humour. At the height of the storm, he had to fly to Japan for a routine session of G7 finance ministers. One participant recalls how King regarded the exercise as futile and, to pass the time, “decided to mark the finance leaders out of ten for their sartorial elegance”.
King had critics outside government as well. Among the most severe was David “Danny” Blanchflower, an academic economist and former member of the Monetary Policy Committee. Blanchflower had consistently voted to lower interest rates in the early months of 2008 to help ease conditions in the credit markets, but King and other Bank officials were resistant, concerned as they were about rising inflation. “It’s quite clear . . . that right through 2008 the economy was slowing, output was slowing, confidence surveys were slowing, the labour market had slowed,” Blanchflower says now.
King’s lieutenants were unimpressed. One senior MPC member told me that “it was easy for Danny to catch the media headlines with claims that he was right all along. But at MPC sessions he was far from convincing, repeating predictions of recession and mass unemployment but providing no backing for his claims.”
When the special liquidity scheme was unfurled, there were immediate fears that the rules King had imposed on the £50bn initial fund (which would eventually expand to four times that) would kill it. In August 2008, King found himself under pressure from Darling to increase the size of the now £200bn scheme and allow new mortgage loans to be swapped for cash. King insisted that direct funding “was not something a central bank can supply”.
Buiter argues that King’s resistance was fatal. “This was the end for Halifax Bank of Scotland,” he says. “King did not grasp that a fixed terminal date for a facility like this creates a natural focal point for co-ordinating speculative attacks on weak institutions.”
Over the weekend ending 15 September 2008, Lehman was allowed to collapse by the US authorities. Meanwhile, frantic phone calls were taking place across the Atlantic, but no one at the Bank or the Treasury was quite prepared for the chaos that followed. Indeed, on the night of the collapse of Lehman, King himself rang Britain’s top bankers to reassure them that the wind-down of the Wall Street firm would be orderly.
But Lehman was different; its collapse came on the most shocking weekend in modern finance, when Merrill Lynch was swallowed by Bank of America and the Federal Reserve moved to bail out the world’s biggest credit insurer, AIG, American International Group. The combined impact of this triple shock to the financial system was so intense that, for the next few days, it was touch and go whether global capitalism as we know it would survive. “Not since the beginning of the First World War has our banking system been so close to collapse,” King said. “It would
be a mistake, however, to think that had Lehman not failed, a crisis would have been averted. The underlying cause of inadequate capital would eventually have provoked a crisis of one kind
King likes to believe that it was his bold thinking which eventually led Brown and the government to recapitalise the British banks on 13 October 2008. The dramatic decision left the British government with majority stakes in Royal Bank of Scotland and Lloyds Banking Group. The implementation may have been carried out by the Treasury, but it was King and the Bank which made the case in Whitehall for a comprehensive bailout. King is of the view that the solution had to be an economic one, not the partial solutions and spatchcock bailouts being demanded by individual banks. He was determined that top bankers should be made to pay for their sins with their jobs. The government should draw the line under “fat-cat” bonuses, he said, and insist in future on counter-cyclical banking under which bankers would build cash reserves during the good years instead of paying them out to staff through bonuses.But one MPC member believes King – and, by implication, the government – was wrong on recapitalisation. “If you look closely at what happened, all it did was savage the share prices of the banks,” this person told me. “It was crazy and completely wrong and made nationalisation more likely. The banks could have continued to operate with less capital.”
King was emboldened. After output plunged in the first quarter of 2009, he rapidly redirected the Monetary Policy Committee and the Bank to start a programme of quantitative easing. Once again, the governor had reached into the past for clues about how to combat deflation. He concluded that the Japanese response to deflation in the 1990s and the Federal Reserve’s failure to provide adequate money in the 1930s offered the best answers.
“The amounts of money being printed are so huge and the effectiveness of the policy so uncertain that I am sure QE is a huge policy error,” says Ros Altmann, who still talks with the governor. “The inevitable outcome will be high inflation. The Bank will not be able to unwind its easing just as the economy picks up.”
Throughout the financial crisis, King never lost his intellectual bearings. Certainly his early responses to the credit crunch and the collapse of Northern Rock were feeble, but as the crisis intensified he came to be seen as
a voice of sanity amid the claims of “saving the world” coming from Downing Street. In retrospect, King’s insistence that the Bank should be given huge new powers to intervene in future banking crises made eminent sense.
King is likeable, and he is able to explain financial complexities in a direct and understandable way. But protecting his own reputation often seems as important to him as looking after colleagues or the actual results of the Bank’s actions. He has taken independence to the limit, publicly challenging the government, and speaking out whenever he can, so that there is no ambiguity about his own position, even if it means placing himself in direct opposition to the Prime Minister. If his decision – gamble, really – to flood the economy with cash achieves the desired objective of refloating the British economy, the governor rather than Gordon Brown could yet emerge as a hero of the crisis. l
Alex Brummer is the author of “The Crunch” published by Random House Business (£7.99)