MERVYN KING: All the financial crises of the past have stemmed from excess leverage. Why do we think we are so much wiser than the financers of the past?
I've never really understood what was the basis of the claim that there was some new theory of how monetary policy worked. And I think that's just false.
If you'd said to anyone in October 2008, we are going to do extraordinary things to save the banking system and the world economy, we'll cut rates to zero, we'll do QE, no one at those meetings I can promise you would have believed you.
LARRY MCDONALD: I'm Larry McDonald with the Bear Traps Report. We're really looking forward to bring you Mervyn King, former head of the Bank of England. He's going to give you a behind the scenes look at modern central banking, MMT and all the political controversies that surround it.
Mervyn King, I should say, Lord King, what a pleasure it is to have you with the Real Vision audience. Your career has been such an inspiration to so many people in the world, what you live through and the leadership that you went through in 2008. Those long nights, cold sweats in the middle of the night. I really am looking forward to sitting down and talking to you in the sense of you looking back at your career and I want to get into the financial crisis, just a touch and what you learn from that and looking forward.
But from your career, take us back to Harvard. Take us back to your education. What inspired you? Did you see yourself as one day is to become the head of the Bank of England?
MERVYN KING: No, I never thought that and indeed, I never even imagined a career in the Bank of England until the time when I was offered the job of chief economist. So, I've gone halfway through my career, exactly halfway through before the Bank of England job came up. So, I think luck matters a great deal in one's career. And I was very lucky. But the most important piece of luck I think, was I belonged to the luckiest generation. I was born in 1948. I was too young to serve in the Second World War, or in the immediate conflicts in the post-war period, but I was too old to have to pay for any aspect of my education.
So, I had a completely free education at the state grammar school. My father was a schoolteacher and he did an enormous amount to ensure that we lived in an area where I could be in the catchment area for a good school and wonderful teachers at a time when some of the best and brightest of the generation went into teaching. And then later did they go into the private sector and say the city. I then went to university, I paid nothing at all for my college education. My local authority paid for all the fees, and indeed gave me a living allowance to pay for the accommodation and living expenses.
LARRY MCDONALD: So, in that era, people, actually- even people from the private sector felt they need to contribute first in the educational.
MERVYN KING: So, I think no, the big difference was that in my cohort, only 8% of us went to university and college, and the rest didn't. So, we were a very privileged group. And it was therefore possible for the rest of society to make us- enable us to go free. And then I went to King's College at Cambridge, which was an extraordinary experience. And I think they were looking to widen the groups of people from which they were selecting students. So, that benefited me enormously.
And I did well there and then got a Kennedy scholarship to go to the United States. Scholarship in- its Britain's national memorial to President Kennedy. And I was in one of the early cohorts and later became the first person who had been a scholar, who then became a trustee of the of the trust and went to Harvard for graduate studies there.
LARRY MCDONALD: So, from the scholar side to the trustee side?
MERVYN KING: Yes.
LARRY MCDONALD: Fascinating. How did you make that jump?
MERVYN KING: Yeah. And it was a great experience. And I was very fortunate to have all these opportunities. And I think that the Kennedy scholarship to Harvard in particular was very important because my success in the area of economics stems in large part- not just from the education I received there, but from the contacts, the people I met. And I have so many friends in the United States now. And today, I spend six weeks or more teaching at New York University. And America has been a big part of my life. I went back later and taught at both MIT and Harvard as a professor. So, I have long connections with US. And it all stemmed from having that opportunity as a Kennedy scholar to which I contributed not a cent.
LARRY MCDONALD: And at what point in your life did you think, okay, I could actually be head of the Bank of England? At what point did you see that transition?
MERVYN KING: Finally, after I'd only joined the Bank of England. So, I suppose it would have been was 42 and teaching at the London School of Economics and I'd created along with Charles Goodhart, the financial markets group- it was a big research group there. And I got the invitation to be a non-executive director of the Bank of England, which just meant going for one morning a week. But canes have been a non-executive director and only one other economist that held that position.
It didn't formulate policy, it was just an oversight body, nothing very special to do, but it meant that the then Governor Robin Lea Pemberton, saw me play tennis and cricket at the annual family sports day for the Bank of England. And I hit the ball harder on the tennis court than I'd ever hit it before or since, for that matter. So, when a few months later, he had to find a new chief economist, he I think was rather reluctant to think he had to have one.
But he was persuaded. Yes, the bank does need a chief economist. He thought, well, I better have one who can play tennis and cricket. So, I was offered the job and went as chief economist with a view to staying only two years and taking leave of absence from the London School of Economics where I was teaching. And then the plan was to go back. And each time I thought of going back, something completely unexpected happened, which made it impossible to go back.
So, the first thing that happened was that we left the Exchange Rate Mechanism in Europe and the Sterling was forced out of it in September 1992. We had to come up with a new monetary policy framework. And I argued for the inflation target. And both the civil servants and politicians like the idea. So, we embraced the inflation target. And then we had to create an inflation report, which was the first time at the beginning of 1993, when the Bank of England had its own independent view of the economy, widely published.
Before that, the Bank of England Quarterly Bulletin, as it was called, was simply a document which the Treasury could edit and censor if they didn't like what the bank wanted to say. With the inflation report, that all stopped. And we then had a period of another four years, until 1997. And I remember saying to Eddie George, I think the time is really now for me to go back to academic life. And at that point, the general election took place on the first of May 1997.
And on the following Monday, which was a bank holiday, I was at home, Eddie George telephoned me at home and said I want you to come in straight away to the bank. I had no idea what the problem was. And he came in and the two of us sat alone in his office. And he was- George was the governor at the time. And he said, we're going to be independent. Gordon Brown will announce it tomorrow. You can't leave now.
So, I stayed on, and then was ready to leave again with my period of five years as deputy governor was due to come to an end in 2003. And then I was asked to stay on as governor. And then there were 10 years as governor, basically divided into four years or so of calm period, when I was able to do a fair amount of restructuring of the Bank of England itself, making appointments to senior positions in the bank, restructure the administration of it. And then we had the financial crisis, which for us began in September- August, September 2007.
And then there was a obviously difficult period in which a lot of things which no one had expected happened and we had to try and react and cope with it in just the same way as the Federal Reserve had to in the US. There were good times and bad times, but it was a tremendous experience. And I had fantastic support from my colleagues in the bank, particularly the younger ones around me. And I stayed then until 2008, when I'd serve the maximum possible term of 10 years as governor. And then left with a wonderful family sporting day, this time not playing in order to get a job but playing in order to leave.
And it was the very last day of my term of office, it was a Sunday which we had the family sports day on. And we had the England cricket captain who came and captained my team. I played for it, went on and played for a bit. And it was a dream come true to have all these tremendous players and I was out there playing and at the end of it, I came off and all the bank staff gathered around and gave us a sendoff as we literally, literally drove into the sunset. And on the first of July 2013, I started a new life.
LARRY MCDONALD: I think back to the summer of 2008. And I will look back and then look forward. You're sitting in the UK in the summer of 2008, say summer 2007. We had the Northern Rock problem here, over here in the UK. We're in London now. And then in the US, we had the subprime, New Century started to blow up then Bear Stearns had those two hedge funds in the summer. Central bankers, at least in the US, allowed Lehman to be 40 times leveraged. And Fannie and Freddie was 60 times leveraged.
And I look back over the last 150 years of finance, maybe longer. And what I think is every financial crisis, there's a different serpent, there's a different beast, there's a metamorphosis into another serpent. Clearly, leverage in the United States and the banking system and the global banking system was the problem. Central bankers looked the other way. What was the thought process around, was the banks themselves wanted to turn that leverage and why were so many central bankers, especially US, so complacent around leverage?
MERVYN KING: Well, I think there are two answers to that. One is that the firms themselves didn't want to have lower leverage than their partner firms because they felt well, we'll lose out. Our equity returns will be lower if we cut back on leverage. So, there was a competitive pressure on them all to go further in that direction. But I think I'll give you the example of Northern Rock which is a stunning example.
In the spring of 2007, Northern Rock had its annual general meeting. And at the annual general meeting, it said the UK is the first country to introduce Basel 2. So, we have calculated our capital requirements under the new Basel 2 internationally agreed regime. And under that regime, we in Northern Rock are the best capitalized bank in the United Kingdom. True, absolutely true.
And so, we're going to return, over the next few years, some capital to our shareholders. Their simple leverage ratio was at 80- 8-0 to one. That shows you everything you need to know about what was wrong with the regulatory system. So, different countries have different frameworks. The Bank of England was not a regulator at the time. So, the regulators had come up with this regime, which central banks have been involved in designing. But nevertheless, under that regime, it was actually quite difficult to argue that banks should issue more equity capital, because they met all their criteria laid down in the international regime.
And I think at the time, it's just a very natural thing in which you go through a very long period when no one seems to fail. And when high leverage seems not only natural, but obviously a highly profitable method of both earning higher equity returns, and if you can link your executive compensation to the equity return, you've got a strong incentive to do so. And nothing had happened to joke people concerned about that.
Now, it's certainly fair to say that from the spring of 2007 onwards, and obviously in the housing market from 2006 onwards- but from the spring of 2007 onwards, there were growing concerns about what was happening in the financial sector. I remember giving a speech to the annual Mansion House dinner, which took place in every June in London, the Chancellor then Gordon Brown was giving his farewell speech because he was about to become Prime Minister and I gave my speech. And these are the two big speeches at the dinner.
And in my speech, I said, I talked about the opacity of a number of financial instruments. And I remember saying it may say AAA on the bottle, but once you open the bottle, it may be flat. And I said all the financial crises of the past have stemmed from excess leverage. And then I used the sentence- why do we think we are so much wiser than the financers of the past? At which point the section of the audience at that dinner booed. Because they thought this was an attack on the financial system.
And actually, it was a statement that I think many people privately would have agreed with, which was things were getting out of hand and it had to be stopped, which I think the central bank's at that point. That was one of the reasons why they were somewhat reluctant to cut interest rates because the last thing one wanted to do was to stimulate a further credit boom, which would undoubtedly be met by the banking system by then allowing their own leverage to rise.
We've seen the balance sheets or the banking system rise pretty dramatically in the five years before the crisis. That wouldn't have mattered had the banking system issued enough equity to maintain the same leverage ratio that they had five years earlier, but they didn't. And so, the leverage ratios of most of the banks rose really quite sharply.
LARRY MCDONALD: So, today- So, in the last decade, from Lehman, Northern Rock, Lehman to today, it appears that the leverage has moved from the bank balance sheets to the sovereign balance sheets and it blows me away that what I mean by sovereign government bonds- so, 10 years ago, all the leverage was in the banks. Now, the leverage is in a lot of the governments. But why do the banks that hold a lot of these government bonds, why don't they have to put up more capital against the government bond because at the end of the day, as we've seen with Greece, you can have government bonds that go from par to 30 cents on the dollar. Shouldn't banks have to carry more capital against government bonds?
MERVYN KING: Yes, it's that simple. And I've been deeply suspicious of the risk weights applied in international regulation. And the reason is very simple- that when people sit down, very clever people from all around the world come together and design these risk weights, but they design them in normal times, by definition. And the question is, will they apply? Are they relevant in bad times when there's a crisis? And the answer is no.
We learned in the crisis that a better predictor of which banks would fail was a simple leverage ratio, rather than a risk weighted capital ratio. And I think if that's the case, since the purpose of these requirements is to ensure the banks have issued enough equity capital to absorb losses in bad times, it's the bad times that matter. And you can never tell exactly which assets will go bad in a particular crisis. What you do know is that when confidence seeps away, that assets are all much more highly correlated than they might appear in normal times.
And there was something also highly political about the risk rates constructed internationally. And the government debt was- the convention in most government debt, you don't need to hold any capital or to issue equity capital against it. No capital requirement for it, because they're safe. Well, turned out in the course of the euro area crisis, that was far from the case. And we've seen that before.
So, I can see no basis for thinking that a sensible regulatory system is one that is based on risk weights that are dreamt up by people in normal times when they simply can't imagine the nature of the next crisis.
LARRY MCDONALD: So, when you think of the amount of leverage, this move from the banks 10 years ago over to the sovereign balance sheets, the government's and you look at Italy with 810 billion of near-term debt maturities, the next three, four years- near-term debt maturities. You have a government that's controlled by a Bernie Sanders-type party and five star that wants to spend money at a much more aggressive pace. And then you have the other- their sister party, Lega, that wants to cut taxes. At the same time, you've got 810 billion of near-term debt maturities. How does this set up- this is mathematically unsustainable, where's this going?
MERVYN KING: So, let me to comment on the position in Europe first and then come back to the wider global picture. There's no doubt that in the last six or seven years, people in the markets have been relying on not just the European Central Bank but some vague political commitment to underwrite for government debt in the euro area. Without that, we'd have seen another sovereign debt crisis.
Now, as you point out, Larry, the position in Italy is sufficiently bad that its people suddenly thought that Italy would have to solve this problem on its own, then we'd have another sovereign debt crisis, I'm sure. Certainly, spreads would rise very sharply. And then you go on to the vicious downward path in which the cost of debt financing rises, and it becomes even more difficult to reduce the deficit.
So, there is a real problem. And the question is what will happen in the euro area to overcome this? I think we're moving towards a period in which the tensions within the euro area are becoming much more visible. We saw the tensions before with high unemployment and austerity in the south. And people tended to think of that as being a sign of, in some sense, bad behavior by economies in the south. I think that was a mistake. And I think it was a reflection of a loss of competitiveness in the south, and the fact that in the north, correspondingly, countries like Germany have a seriously undervalued