The Wall Street Journal-20080128-Bank of England Chief Changes Tack in Crisis- Mr- King Scolded Lenders But Had to Rescue Them- Now He-s in Jeopardy
Return to: The_Wall_Street_Journal-20080128
Bank of England Chief Changes Tack in Crisis; Mr. King Scolded Lenders But Had to Rescue Them; Now He's in Jeopardy
Full Text (2288 words)Mervyn King, the silver-haired governor of the Bank of England, has guaranteed himself a chapter in future textbooks on central banking. The lesson: Standing on principle is a dangerous game.
In the years of financial euphoria, Mr. King stood out as a scold. In August, he admonished British financiers that "interest rates aren't a policy instrument to protect unwise lenders from the consequences of their unwise decisions." When money markets froze and the Federal Reserve and European Central Bank pumped in billions of credit, Mr. King at first refused to follow suit. "The provision of large liquidity," he said later, "encourages herd behavior, and increases the intensity of future crises."
But events overwhelmed Mr. King's principles. In September, Britain weathered its first bank run in more than a century, on Northern Rock. Days later, Mr. King, believing the financial system was threatened, launched the kind of cash injections he had criticized. The British press dubbed him "Swervin' Mervyn." Willem Buiter of the London School of Economics and Political Science, a former member of the Bank of England's Monetary Policy Committee, says the BOE "deepened the crisis" because of Mr. King's "strong moralistic streak."
Over the weekend, a parliamentary committee reporting on Northern Rock declared itself "unconvinced" that Mr. King's stance was appropriate, and said the BOE should have "adopted a more proactive response" to the loss of confidence in money markets. The report also said the U.K.'s chief regulator, the Financial Services Authority, had "systematically failed in its duty as a regulator" and the whole affair had been "damaging to the financial services industry in the United Kingdom." The report recommended creating a new high-level central-bank post to oversee expanded financial stability powers, including a fund to protect deposits.
Now, the once-unassailable Mr. King waits to learn whether he will be reappointed for a second five-year term in June, a delicate moment as the British economy slows, housing prices slump and inflation pressure mounts. In the face of a weakening economy, the central bank cut its key interest rate by one-quarter point in December, and Mr. King last week suggested another cut is on the way. The current betting in London is that Prime Minister Gordon Brown will keep the bank chief in his job despite the criticism. The bank said it wanted to study the report carefully before commenting; the FSA has acknowledged mistakes and is doing its own review.
Mr. King confronted a dilemma that central bankers always face in a crisis: Let financial fires blaze until they extinguish themselves, or try to put out the fire -- even if that encourages investors to keep playing with matches. Central bankers loathe contributing to "moral hazard," a term coined by 19th-century insurers to describe the recklessness that is encouraged by protecting individuals from the consequences of their bad decisions.
Fed Chairman Ben Bernanke -- Mr. King's office neighbor when they both taught economics at the Massachusetts Institute of Technology in the 1980s -- faced the same quandary last August, but set aside concerns about moral hazard and repeatedly injected cash and cut interest rates to cushion the economy. Last week, he responded unusually overtly to market concerns with a surprise 0.75-percentage- point rate cut.
Many central bankers initially welcomed the market's downturn last summer as a much-needed return of sanity. Mr. King had already been saying that lending standards had become too lax and investors too complacent. One symptom: the ease with which even dicey debtors could borrow. Citing a spam email he received -- "We have the solution, Mervyn, for your bankruptcy" -- he hectored London bankers and merchants last June: "'Be cautious about how much you borrow' is not a bad maxim for each and every one of us here tonight."
He cast the emerging crisis as the consequence of imprudent behavior encouraged over the years by repeated, government-backed bailouts. "I do not believe that moral hazard is just some dry academic concept," he told Parliament last September. "It is moral hazard that has actually led us to where we are . . . . If you always provide ex-post insurance you can be quite sure that in five or 10 years' time another crisis will come. That is exactly what we have seen in the last 20 years."
In Britain and in central bankers' circles world-wide, debate continues to rage over Mr. King's decisions last summer. The Bank of England made a small amount of extra funds available to U.K. financial institutions in early September, though it was far more modest than the Fed and ECB interventions. Some, including Mr. King, contend the central bank could not have averted the Northern Rock run, in part because the scale of help it needed was too great to provide through normal money market operations.
Others charge that his disdain for the financial industry's expectation of special treatment led him to fail a central banker's most fundamental test: to provide enough liquidity for a market economy to function. Richard Lambert, who sat on the Monetary Policy Committee from 2003 to 2006 and now heads Britain's Confederation of British Industry, assailed Mr. King for blaming the run on Northern Rock on a patchwork of flawed U.K. financial regulation.
"You don't wait for the cinema to catch fire before you check out whether the fire precautions are working," Mr. Lambert said in a September speech. "A run on a bank is something that happens in a banana republic. That one should have happened, under our noses, in a mature and prosperous country is almost unimaginable."
Mr. King's initial stance and subsequent reversal may have weakened confidence in his stewardship of the British economy at a moment of peril. Michael Saunders, a Citigroup economist in London, rues "a bit of lost faith on the part of the public in the ability of the authorities in general to manage the economy." With consumer demand showing signs of faltering, the prospect of slower growth and falling rates has pushed the pound down nearly 5% against the dollar since November. Northern Rock is up for sale, with bids due next Monday, and its reported $49.5 billion in debt to the central bank is to be packaged into government-backed bonds. If a sale fails, the government may have to take over the lender.
But as time passes, some more sympathetic views are emerging. "Mervyn King's position is almost surely going to look much better in a few years with the benefit of hindsight, especially if the world is hit with a much larger financial crisis, as well it might," says Harvard University's Ken Rogoff, a former chief economist at the International Monetary Fund. "Policy makers are far too quick to buy the argument that no large financial institution should ever be allowed to fail."
Mr. King remains unrepentant. "The role of the Bank of England is not to do what banks ask us to do," he told the BBC in November. "It's to do what's in the interest of the country as a whole." In a speech in Bristol on Tuesday, he recalled with satisfaction his warning two years ago that investors' willingness to take ever-greater risk without demanding higher returns couldn't persist. "And, as we've seen, it hasn't," he said. He added, "The re-pricing of risk . . . is not a process that we should try to reverse." Mr. King may win reappointment partly on the strength of the British economy over most of his time at the Bank of England: 62 quarters of uninterrupted growth, the longest postwar expansion of any of the seven major industrial economies.
Born in 1948 to lower middle-class parents, Mr. King has his roots in Britain's faded industrial might, not its current glittering financial-sector wealth. Mr. King grew up near the industrial stronghold of Birmingham. As a teenager riding the train home on dark afternoons, he could see the skies lit by blast furnaces. His father was a schoolteacher; his mother, a seamstress who once sewed curtains for the ocean liner Queen Mary. A sports fan, he keeps a soccer ball in his office signed by members of his favorite team, perpetual underdogs Aston Villa.
Though he lacks a Ph.D., Mr. King, a Cambridge graduate, is one of central banking's leading intellectuals. He has taught at the London School of Economics and, briefly, at Harvard and MIT, where he befriended Mr. Bernanke. Both are students of economic history; Mr. King sat in on some of Mr. Bernanke's Great Depression lectures. Today, Mr. King joins other economists, central bankers and financiers for occasional dinners to discuss financial history.
Blunt and bespectacled, Mr. King joined the Bank in 1991 and has been its governor -- the equivalent of Fed chairman -- since 2003. He has kept his academic bent, littering speeches with historical and literary references, many gleaned from solitary visits to a private lending library near the central bank. He keeps his mornings meeting- free, reserved for thinking and writing. He writes most of his own speeches, often gathering staff economists in his office, seminarlike, to discuss topics.
Mr. King helped devise the bank's current approach to setting a public inflation goal -- now 2%. After the bank won independence from the elected government in 1997, he helped develop public reports that show how policy makers plan to keep inflation on target; the reports have become a model for Mr. Bernanke's efforts to increase transparency at the Fed.
Mr. King's determination to avoid bailing out those who lend or borrow too much goes back years. In his view, central banks and the IMF have long fueled moral hazard by failing to limit bailouts for imperiled debtors, going back to moves to keep Latin American countries from defaulting on their bank loans in the early 1980s. The beneficiaries, in his view, haven't been the borrowing countries, but financial institutions. They have been willing to lend more, on ever riskier terms, confident central bankers or the IMF will always step in and never accept the consequences of a serious financial failure.
During international debt crises of the 1990s, the U.S. advocated lending vast sums of money to restore investor confidence and contain the damage. British officials -- including then-Chancellor Brown and Mr. King, then a deputy central bank governor -- pressed to impose limits in advance on IMF bailouts. The U.S. resisted. Lawrence Summers, then a top U.S. Treasury official, says today: "Moral hazard and confidence are different sides of the same thing. Sustaining confidence and preventing panics is itself a source of stability. It also economizes on capital and can encourage desirable risk taking."
When Mr. King became governor of the Bank of England, he tried to wean the U.K. financial sector, known as the City, from its long-held expectation of special treatment. The Old Lady of Threadneedle Street, as the 314-year-old central bank is known, is laden with tradition. Porters in top hats and pink jackets open doors on its stately first floor. By its charter, the bank had been an advocate for Britain's financiers -- one of its core purposes was promoting the competitiveness of the financial sector. "Historically, the bank was right at the center of the City, a mother hen type fighting for City interests," says David Lascelles of the Centre for the Study of Financial Innovation, a London think tank whose funders include commercial banks and the Bank of England.
Mr. King asked the BOE's governing board to remove the advocacy goal in 2003, saying it posed a conflict; they did so. To distance the bank from its old City coziness and emphasize its responsibility to the entire U.K. economy, he began meeting monthly -- more often than his predecessors -- with manufacturers and nonfinancial firms outside London.
Mr. King counts it as a particular triumph that U.K. manufacturers are less likely to demand relief from the central bank, understanding the virtues of a steady monetary policy. "It's much better to be in a stable environment when you're manufacturing and exporting products," says John Patterson, chief executive of construction-equipment maker JCB. Economic stability "has allowed us to plan and develop our business with a higher degree of confidence," he says.
All central banks, whether explicitly in law or simply in practice, have responsibility for keeping funds flowing smoothly through the financial system and avoiding instability great enough to put the whole system at risk. Yet former Bank of England staff and policy makers say the bank's financial-stability unit has been a backwater under Mr. King. "Mervyn was less interested in financial stability and more in monetary policy, because the intellectual tools of monetary policy are those with which he's familiar," says Geoffrey Wood, a retired financial-stability consultant at the central bank and now a professor at Cass Business School in London, who believes Mr. King made the right call in August.
Even some of Mr. King's admirers say by distancing himself from the financial sector and emphasizing monetary policy over financial stability, he left the bank unprepared for the credit crunch. "Financial stability is about having a contingency plan, and they were uninterested in planning what they'd do about it in the event there was a problem," says a person familiar with the bank's workings.
The bank's financial stability report did foresee a possible liquidity lockup last June, saying markets were underpricing risk and a re-pricing could halt lending -- exactly what happened. That only gives Mr. King's critics more ammunition. "It's very difficult to accept both that the Bank of England had been warning for months about the underpricing of risk and a possible liquidity squeeze, and that it was a complete surprise when it happened," says Danny Gabay, a former Bank of England economist now running Fathom Financial Consulting in London.
