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Subtitle: How the Fed Became the Dealer of Last Resort, Princeton Univ.
Press, Princeton, 2011, 174 pgs., index, references, notes
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Reviewer comment:
Note the subtitle: "dealer of Last Resort". The author plays off of
Bagehot's idea that the Bank of England became the 'lender of last resort' with
the implicit mission to rescue banks in difficulty by lending them funds
temporarily, backed by good collateral, and at significant interest rates. He
shows that in the financial crisis of 2008 the Federal Reserve, and then other
foreign banks bought up securities including mortgage paper from the commercial
markets, to protect the investors in commercial paper such as money market
funds, in effect becoming a financial dealer as well as a bank. His principle
focus is on the 2007-8 crisis, but he provides a look back into several
centuries of history to show how the situation of finance is different today.
He relates this to Lombard Street in London, the historical center of
international finance there. And the term 'Lombard' comes from it being a locus
of the Italian (Lombard) bankers and their factors in late middle ages.
(Today's market economy is now termed 'financial capitalism')
The book is written in 'bank speak' for professional members of the financial
industry including not only bank officials but also government financial
ministry officials and regulators. It is about what they DO and also about
their theories about what they are DOING or should be DOING and why. His focus
is on 'credit' the central financial instrument that funds economic activity.
But he equates 'credit' with 'money'. There is a difference between 'credit'
BEING 'money' and credit being valued (measured) in terms of 'money'. He also
uses the term 'cash' when he does not mean currency. The book was published in
2011 in time for a discussion of the origin, action and immediate results of
the 2008 financial crisis. Throughout the book he contrasts the changing
development of academic financial theories, naming some of the more famous
creators, with the reality of financial actions in the material world credit
markets. And he focuses on the differences and links between the financial
market and the capital market..
In his conclusion chapter he accepts this new role of the FED as 'dealer of
Last Resort' as a given condition and recommends that academic economic theory
needs to 'fix the ideas' about what this means and how it should function. The
reader here could skip the other chapters and read the conclusions.
But huge changes have taken place since then in fiscal and monetary actions
that have created the massive 'debt' on the balance sheet of the FED. He want's
FED intervention and 'management', but that has already shown its results in
the 10 years subsequent to this book. So this is a history. It should be
studied along with Chambers, Cooper, Reinhart/Rogoff, Prins, DiMartino Booth,
and Fox, plus many more, including the host of authors writing about MMT.
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Introduction:
The author wrote this book to answer the need to provide a financial history
that can explain the crisis of 2007-8. He states: that "we need a
historical perspective in order to understand our current predicament and to
see beyond it to a possible future." "The intellectual challenge of
producing such an account is large, given the scope of the crisis that is
transforming not only banking and financial institutions and markets but also
the regulatory and supervisory apparatus within which those institutions
operate, including most dramatically the role of the Federal Reserve". He
cites Walter Bagehot's "magisterial Lombard Street; A description
of the Money market (1873)". But, he points out, the FED then did much
more, which he terms "dealer of last resort". What the FED did and
continues to do is "something completely new". He also includes Hyman
Minsky and other academic financial theoreticians to discuss their theories
about credit in the 'modern' that is current economy.
"A Money View Perspective"
"The fundamental purpose of this book is that a 'monetary view' provides
the intellectual lens necessary to see clearly the central features of this
multidimensional crisis. The reason is simple. It is in the daily operation of
the money market that the coherence of the credit system, that vast web of
promises to pay, is tested and resolved as cash flows meet cash commitments.
(He considers credit as cash because it is transferable and acts like physical
coinage did in past times, we purchase things; that is, engage in an exchange
of assets by using credit as the asset on one side of the exchange while the
other side is a material asset, But in contrast to exchanging currency that
credit creates a debt, a promise to create a material asset to complete the
exchange.) And when an exchange is credit for credit more debt is created. In
the era prior to 'financial capitalism' it was expected that the exchange would
be completed by material assets, thus the credit/debt would be extinguished.
"The web of interlocking debt commitments, each one a more or less rash
promise about an uncertain future, is like a bridge that we collectively spin
out into the unknown future toward shores not yet visible." He describes
two different points of view about the market - an economics view and a
financial view. These are very different in their focus on past versus future
and present. He believes the 'present is the natural sphere of the money view.'
But both the economics and financial based viewers ignore the 'money view'.
"As a consequence of this long domination of economics and then finance
views, modern policymakers have lost sight of the Fed's historical mission to
manage the balance between discipline and elasticity in the interbank payments
system." "The rate of interest should reflect the price of time, not
the price of liquidity."
" Lessons from the Crisis"
He writes that "Our thinking about money has mistaken the properties of
models that formalize the economics and finance views for properties of the
real world." This "has fueled the asset price bubble that created the
conditions for the current crisis, and that bias will fuel the next bubble as
well unless we learn the lesson that the current crisis has to teach."
And we have not learned. Moreover, we don't understand the real nature of a
role of 'money'. And Dr. Mehrling uses the term 'money' when he means credit.
Money actually is a metric, created to quantify 'value' of assets, goods and
services, intellectual property, debt, credit, transgressions; everything.
Since 'value' is a human concept the 'value' of anything and everything changes
- it is relational- determined by time, scarcity, alternatives, - supply and
demand for the asset being valued. So credit, which he correctly sees as the
asset that performs the functions that popular nomenclature calls 'money'
itself can and does change in value during its exchange and retention over
time. He repeatedly states that 'credit is changing in value' at various times.
Of course it does. This means that 'credit' has changed in the metric by which
it is valued - that is money.
The basic problem in economic theory is that while the metric in which value of
all assets is measured - that is 'money', at the same time the value of 'money'
itself is changing. Consider an example from a different concept - length: it
is measured in inches or meters or other materials. But when the length of
something changes (expands or contracts) the size of the metric does NOT
change. Simply, money is to value as the meter is to length.
Dr. Mehrling finds the origin of the financial problem in the concept developed
by Harold Moulon in 1918, when the FED was first in action. He points to:
"According to Moulton, American banks had improved on outdated British
practice by relying of the 'shiftability' (or salability) of long -term
security holdings to meet current cash needs, rather than on the
'self-liquidating' character of short-term commercial loans."
What this economic jargon means is this. Credit creates debt. Debt is a promise
to PRODUCE something of value to complete an exchange transaction. One party
exchanges some EXISTING asset for the promise that the other party will
reciprocate in the future by providing some asset in return. In general, an
asset he does not have at the moment. In British and general bank and market
practice it was presumed that the debt would be canceled (and credit would
disappear) within a short time. It was not presumed that the credit-debt
instrument (paper) would be 'shifted' (meaning transferred) from its original
owner as one side of another asset exchange in exchange for a current
reciprocator to use a credit in another exchange, creating a long -term
expansion of credit-debt in the total financial market. Credits are considered
assets and debts are accounted for a liabilities. Thus, now the bank system has
created a web in which the credit assets of parties are the liabilities of
other parties and the reverse.
But Dr. Mehrling forgets that this kind of system, although not as wide spread,
did exist in 16th-17th-18th century European markets and did enable financial
crises when one bank or major merchant company did default of its debt
liabilities triggering a wider financial 'bursting bubble' as debts lost by one
party (its assets) then were lost causing debt defaults throughout the market
system. His focus is on the "present system' which means the creation of
the US Federal Reserve in 1913. He begins with a short discussion of the
previous US banking system, but does not include a history of banking and
credit during prior centuries, including details about the British Bank.
But Dr. Mehrling is correct in describing the modern examples. "This book
tells the story of how the triumph of Moulton's shiftability view, as a
consequence of depression and war as much as anything else, eventually led to
the almost complete eclipse of the money view in modern discourse." He
adds discussion of the theories developed by Knut Wicksell about interest
rates. He sees the problem as: 'Instead of monitoring the balance between
discipline and elasticity, the modern Fed attempts to keep the bank rate of
interest in line with an ideal 'natural rate' of interest', the concept
developed by Wicksell. He continues his critique: "Dominance of the
economics and finance views meant that policymakers chose from a palette of
policy options that was biased toward ease." He recommends his idea of
'money view' instead.
He then identifies his purpose: "This book seeks to begin that
reconstruction by taking a resolutely money view approach to understanding the
recent credit crisis, and by drawing lessons from that crisis for the
future." That was written in 2011, now we can see that his recommendations
were not accepted. The financial distortion as described by Nomi Prins and many
others is worse today.
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Chapter One - Lombard Street: Old and New
Dr. Mehrling gets right to the center of the financial problem. He quotes Hyman
Minsky. "Capitalism is essentially a financial system, and the peculiar
behavioral attributes of a capitalist economy center around the impact of
finance on system behavior". (In other words, exchange of assets in the
material world has been superceded by exchange in the financial (imaginary)
world - ergo 'Financial capitalism'. He believes, correctly, that what is
missing is a 'bridge' connecting the two. And he wants the central banks
including the FED to build and control that bridge.
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Chapter Two - Origins of the Present System
He opens by noting that when the creation of the FED created a different money
system in 1913 the economic theories espoused by academics and financial
operators did not change. "but it could not at the same time establish any
new tradition of monetary thought." There had been no central bank since
the Second Bank of the United States had been forced to expire by President
Andrew Jackson in 1936.
'From National Banking to the Fed"
Dr. Mehrling discusses the Fed in relation to the prior National Banking System
created during the Civil War to enable the Union government to finance its
wartime expenditures. This was not a central bank. This was designed to force
private banks to buy Federal government bonds with 2% interest and count these
as its assets when generating liabilities as it issued 'note currency'. This
was inflexible (inelastic) because it fixed the note supply, which was
considered analogous to actual treasury issued currency. The required reserve
ratios were also rigid. He describes how this system supported the market. He
comments: "This is how the National Banking System was supposed to work
but not in fact how it did work".
One problem was that the annual, seasonal shifts in the agricultural economy
from planting to harvesting created the seasonal shift in the demand for credit
denominated as money. The seasonal changes created seasonal changes in interest
rates and financial crises in 1873, 1884, 1893 and 1907. He does not mention
that there were similar financial crises prior to the Civil War and even prior
to the American Revolution. He does not mention that a major political battle
throughout the century was between creditors and debtors - the former demanding
'hard money' (that is fixed supply) and the debtors demanded 'soft money ( that
is elastic money supply) which played out among other ways in the conflict
between supporters of currency limited mostly to gold and supporters of
expanding creation of currency out of silver.
Another topic he discusses in the prevalent theory of commercial loans. The law
creating the Fed the requirement to address 'elasticity' in the money supply by
dealing in commercial loans issued by the private banks. The commercial bank
loans were to replace the Treasury government bonds as the collateral backing
note issue (notes - that is credits, being the money used in market
transactions. He comments that: "From this point of view, the most
important innovation of the Federal Reserve System was to provide a routine
mechanism for creation of reserve money in times of crisis." He believes
that absent the catastrophe of World War I the bank might have developed
organically
"From War Finance to Catastrophe"
The Federal reserve Act had with good reason prohibited the FED to buy Treasury
credit as collateral securities. The conservative authors had recognized that
would open the way for unlimited Treasury spending. But the Act was amended in
September 1916 in order for the FED to help the Treasury to finance government
expenditure on World War I.
He notes the origin of the subsequent problem. "hardly was the ink dry on
the Act before the founding principle that notes could safely be issued only
against self-liquidating commercial loans was simply shunted aside." and
"Not only that, but Reserve Bank loans against government security
collateral were subsequently pegged at a preferential rate, below the
commercial rate below even the yield on the security itself."
When notes were exchanged for self-liquidating loans the credit-debt involved
disappeared thus the money supply was not increased.
Mehrling sees the disaster: "Conservative bankers thus saw their worst
nightmare realized, that the government would use its authority over the
monetary apparatus to gain an advantage over private borrowers." But the
same bankers quickly took advantage. "Federal debt expanded from about $1
billion in 1917 to $25 billion in 1919, with the Federal Reserve System itself
absorbing about $2 billion and acting as fiscal agent to distribute much of the
rest." He also notes that: "During the war, the Fed acted both to
maintain liquidity in the Treasury bond market and to put a floor under the
price of the bonds so that the Treasury could continue to borrow cheaply."
A similar policy was used during World War II.
Mehrling identifies the results: "This involvement of the fed in what
would formerly have been considered speculative credit is probably one reason
that, at the New York Fed anyway, attention shifted away from 'qualitative'
control of credit, (limiting credit to productive use) and toward
"quantitative' control, specifically discount rate policy directed at
affecting the price of credit."
Here he has identified today's even more massive cause. Credit is not issued
for productive use, but to finance consumption by favored groups who do not
produce and have no other source of credit. But credit's other side is debt,
the promise to produce in future something to complete the market exchange. The
Fed absorbs that debt for the Treasury. Since the government cannot produce, it
must confiscate production from private producers and also simply add to the
debt ledger. Mehrling
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Chapter Three - The Age of Management
Dr. Mehrling places great store in 'shiftability". I believe the transfer
of an asset from one owner to another, as well as the use of an asset as
collateral supporting a loan/debt is not so new. But he is focusing on the role
of the FED in this regard. He cites the 1935 Bank act which 'meant that, from
then on, the Fed was prepared to act fully as lender of last resort, accepting
as collateral any' sound' asset and not limiting itself to short-term
self-liquidating paper." It soon went further. In 1937 it took on the role
to maintaining 'orderly conditions in the money market' quite generally."
He considers this a very significant step. By providing 'shiftability' it took
on the role of a security dealer.
Interesting is that his comments on the problems that created seem to be
ignored in his conclusions.
He turns to describe the theory on his the interest created by a long term bond
is the sum of the interest rates created by the short-term interest rates of
the intervening years - except that in practice it is not. This has to do with
the 'term structure' of interest rates (credit and debt). From this he narrates
the financial market theories during the 1930's including EH - the expectations
hypothesis. For example he writes: "Appealing as this theory is, it cannot
be the whole story because in actual fact the term structure typically slopes
upward."
This observation also applies to much of the difference between academic
financial theories and the actual facts in the market place.
He devotes a section to the "Monetary Policy and the Employment Act"
of 1946.
Another example. "In practice, even this simple idealized norm proved to
be unrealizable in the rigid financial conditions inherited from the New Deal
reforms." Then he turns to: "Listening to the Academics". Be
careful what you ask for. Academic advice has not always been welcomed by the
Fed, and for good reason." He points to the failure of Irving Fischer and
then many others from divergent economics departments. Among the more famous
are Leon Walras, Jacob Marschak, Harry Markowitz, James Tobin, and John Hicks,
and of course Lord Keynes. These individuals competed for attention and
acceptance by the government politicians.
For instance: "The Marschak-Tobin framework thus became the template for
monetary practice as well as theory, once it got operationalized as the
financial sector of the Fed's large-scale econometric model of the United
States." He finds reason for plenty of concern about that model.
A choice comment: "Nevertheless, that was the ideal and so it became the
Fed's job to achieve it.".
Ha - now we see another villain - the creation of econometrics as the standard
basis for economics teaching in the famous universities.
Next, he enunciates "A Dissenting View"
Enter Hyman Minsky. But only long after Minsky's predictions came to fruition
were they recognized. Rather, academic volleys were fired back and forth
between Keynesians and Friedmanites.
Re his conclusions: But now the FED is stuffed full of these academic narrowly
trained individuals who set policy according to preconceived concepts depicted
in complex mathematical equations as the basis for econometrics. If not the MMT
model, then which one rules today.
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Chapter Four - The Art of the Swap
Dr. Mehrling continues with discussion of what took place despite Minsky's
warning. "The pattern that Minsky was already noticing in domestic money
markets in 1957, namely, financial innovation as a response to active money
management, was also showing up in international money markets."
"After World war II, U.S. government debt was the coin of the realm
internationally as well as domestically".. "Postwar Europe would be
importing goods of all kinds from the United States and paying for them with
dollars, so de facto the world trading system would be on a dollar
standard."
Rather than gold, it was dollars that everyone received - some borrowed, some
granted by the Marshall Plan and some by under valuing their foreign currency
relative to the dollar.
There are several interesting points in this. Observant critics note that the
real purpose of the Marshall Plan was not mainly to help Europe but to enable
Europeans to buy U.S. production, thus helping avert unemployment. Undervaluing
foreign currency, of course, over valued U.S. Dollars to the American domestic
profit. And foreign borrowing U.S. dollars also helped the U.S. economy.
"From the start, the Bretton Woods system was built on a contradiction. It
established a fixed exchange rate system internationally even as it endorsed
uncoordinated macroeconomic management at the level of the nation
state."... "The birth of the swap came as a way for individual firms
to get around these national controls."
Currency Swap and the UIP Norm
"The essence of banking is a swap of IOU's"
This fact is not understood or appreciated by the general public, such as bank
depositors or borrowers.
He discusses the 'swap' of currencies and the first example. He provides clear
tabular depictions to show how these functioned. But the purpose, which he
indicates, is what is particularly interesting. That purpose was to avoid ( get
around) the legal regulations that governments placed in international currency
flows. The politicians did not like it when their favored interest rates could
result in investors generating a shift of their capital in response to higher
interest rates elsewhere. And the expanding U.S. debt was pushed out by the
Bretton Woods agrement. (U.S debt was created by U.S. purchasing materials by
exchanging a credit instrument, that is a promise to exchange something of
value later).
So not only investors, but manufacturers, and business men wanted to - needed
to - move capital around in response to the results of normal import- export
requirements. They achieved their goals by exchanging loans in different
currencies. And they could protect from default risk by engaging a third party
(in particular J.P Morgan bank) to generate a 'hedge'. At first J.P Morgan was
a broker, but it soon became a dealer, the swaps were then intermediated,
investable assets that unrelated entities could buy. Soon a currency market
(actually credit/debt instruments) could be traded by entities using them as
investments rather than to facilitate trade.
"One implication of the UIP norm is that the only way the United States
can sustain significantly lower interest rates than the rest of the world is if
the dollar is expected to appreciate against foreign currencies." ...
"This was exactly the problem the United States faced in 1961". It
needed to protect the relationship of he dollar to its value in gold. He
describes the famous 'Operation Twist' as "an attempt to have it both
ways".
But the concept and employment of the 'swap' mechanism was easily adapted for
use in other exchanges.
Brave New World
Enter Fischer Black and his idea that a long term corporate bond could be
divided into three 'tranches', each having a different risk and paying a
different rate of interest. And these would then be held by different persons.
The concept is to transfer risk. This involves different swaps of IOUs. Dr.
Mehrling again provides balances sheet tables to illustrate the concept. He
identifies the result. "The important point is that, because the swaps
were arranged not as a swap of actual IOU's but rather as a swap of implicit
IOU's they were not treated as loans for regulatory purposes."
Another effort to get around government financial controls. Now for the
'kicker'.
"It follows that Investor's risk hedge is only as good as his
counterparty." ... "Now, as the previous discussion of currency swaps
has made clear, the source of market liquidity in the swap market is the swap
dealer who makes a two-way market by quoting both bid and ask prices. In the
absence of such a dealer, if a counterparty defaults before the end of the
contract, whatever risk was being transferred by the contract, reverts to its
original holder, who must look around for another counterparty," ..
"For the interest rate swap case, the Eurodollar forward market and the
closely associated Eurodollar futures market provide a natural hedge." ..
"For the credit default swap case, by contrast, there is no natural hedge
available for dealers, and as a result the market has remained closer to a
broker market than a proper dealer market." ... "The same logic,
absence of someone wanting to speculate by selling risk when there are others
who want to buy risk".
(Remember, selling risk means taking ON risk and buying risk means passing risk
to some one else.)
"The same logic that explains the failure of UIP and EH also explains the
failure of the natural norms on the CDS market, namely, the tendency of the
market price of a CDS to reflect expected future default probability."
This is the cause he identifies, for the liquidity collapse in 2008. And his
conclusion is that the FED must become that 'dealer of last resort' that will
take on the risk.
From Modern Finance to Modern Macroeconomics
Dr. Mehrling notes that as the logic of arbitrage pricing norms occurred in the
material sector - the real market, they also began to be recognized in the
imaginary sector - the realm of theoretical understanding. This resulted in
modern financial theory, and it then entered modern macroeconomics. He
describes the history of this move in the writing of Tobin, Marschak,
Markowitz, and Sharpe. "The result was the capital asset pricing model
(CAPM) which ushered in modern finance." ... "This CAPM idea was
applied first to equity markets, but similar reasoning soon revolutionized
thinking about fixed income and currency markets as well, with important
consequences for older thinking such as the expectations hypothesis of the term
structure and the uncovered interest parity theory of exchange rates." ...
"In practice EH and UIP continued not to fit the data very well."
Think of Yogi Beria when you read the next bit. "But now empirical failure
could be attributed to problems with reality, no problems with theory -- to
continuing inefficiency in market operations, not to counterfactual theoretical
abstraction from liquidity risk." He continues by describing how arbitrage
trades depended on market liquidity. He discussed further casualty of the
"finance tsunami" in macroeconomics.
Tsunami - ha ha - if 2008-9 was a 'finance tsunami', what was 2020 -2021 and
now 2022?
Yes, he mentions 'warning voices' such as Charles Goodhart and Robert Lucas who
warned about the 'limits of economic management for other reasons.
Consider what 'disinermediation' means for the banking and 'shadow banking'
systems.
"As in financial theory, so too in macroeconomics theory, the guiding norm
was an ideal world with perfect liquidity,. as in financial practice driven by
the profit motive, so too in economic policy practice driven by a welfare
motive, deviations between the ideal world and the real world were conceived as
opportunities for arbitrage."
The result, he states, is that the financial regulators became complicit
partners with investors in the market in their attempt to make liquidity in the
real world a free good as it was considered to be in the imaginary, ideal
economic theory.
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Chapter Five - What Do Dealers Do?
Well, they deal. They live and function in either or both the material market
world and the imaginary financial world. There is a theoretical concept about
liquidity in the imaginary sector and a practical result of liquidity in the
material sector. In the first it is ignored and in the second it is critical.
Dr. Mehrling's central concern is the practical loss of recognition of the
"money view perspective."
Inside the Money Market
"The logical origin of the money market can be traced, perhaps
unsurprisingly, to the operations of a decentralized payment system."
Dr. Mehrling considers what the credit-debt system that funds the market would
be if the US had but one bank in which everyone deposited and from which
received loans. But we actually have a "single integrated banking system,
and the key to that integration is the money market." One result is that
banks depend for 'payments elasticity' on interbank credit swaps. Each bank
must end each day with a positive balance. But they hold almost no reserves and
instead will loan and borrow from each other over night in the federal funds
market held at the Federal Reserve so that the net result is zero. For banks
not members of the FED system they can borrow and loan in the Eurodollar market
or directly between each other in the 'repro market'. Of course these loans
generate various sized interest. It is during a crisis that these interest
rates can and do greatly increase. To borrow the bank must present collateral
acceptable to the loaning bank. In case of a mismatch a bank can go to the FED
'discount window', but banks hate to do that because it can be seen as
'questionable' bank, and the 'discount window' demands a significant fee. The
FED will try to act before stress takes place by intervening daily. The purpose
and goal of all this is to make the entire banking system function as if it
were a single bank.
Funding Liquidity and Market Liquidity
Actually, the 'repro system' was created before there was a federal funds
system. During the 19th century the independent banks would transfer money
between each other to accomplish the same purpose. This system created
'dealers' in the repro market. Again, a dealer establishes his own capital or
line of credit and that enables him to stand as an intermediatory by offering a
two-way market in buying and selling securities in this repro-market.
"Here we find the historical origin of the connection between funding
liquidity and market liquidity that is so central to modern arrangements."
This is the author's central subject - establishment of a dealer system
supported by creating a bridge between the two is the task he wants the FED and
central banks in general, to assume officially and continuously, not only as an
emergency measure. He illustrates this with more balance sheets. It depicts
buying and selling in both the Treasury bond and 'bill' markets, funding its
operations in the repro-market. The entire activity appears to be complex, and
it is, but he attempts to make is seem simple.
Anatomy of a Crisis
He uses examples of shifts in the balance sheets of participants during a
crisis created by a shift in the desires of wealth holders for money instead of
securities. It is all about the cash flows - in and out - for private wealth
holders versus the dealers and banks. Again, he is considering liquidity.
"The Fed (in his example and his desire) in a crisis is not so much the
lender of last resort (funding [financial] liquidity) as it is the dealer of
last resort (market liquidity).
Again, I explain, this is a bridge between the imaginary financial world and
the material market world.
His claim is: "Under modern conditions, backstop of market liquidity
requires the Fed to serve as dealer of last resort"
Monetary Policy
Here he discusses what he identifies as a fundamental difference between
earlier bank - monetary - operations based on a 'money theory' and the modern
academic economic view which ignores it. "From the perspective of the
classic money view, monetary policy was all about using 'bank rate' to
influence the balance of elasticity and discipline that is imposed by the
survival constraint that faces each individual entity in the system." ..
"Current macroeconomic thinking is organized around something called the
dynamic stochastic general equilibrium (DSGE) model, which we can understand
loosely as a jazzed-up version of the Walrasian equilibrium model that was at
the center of the thinking of a previous generation." ... "Where this
standard economics view confronts the money view most directly is on the
question of how to set the federal funds rate, a question on which proponents
of the economics view have developed a common stance that goes under the
heading "Inflation Targeting". ... "More or less all modern
academic debate is organized as argument about the appropriate quantitative
settings for a Taylor rule."
"In the money view perspective, if the Fed fails to raise interest rates
in the face of a credit -fueled asset price bubble, the bubble will feed on
itself, growing ever larger and having ever greater distorting effects, until
it bursts." ... "It follows that if funding costs are distorted by
monetary policy, then a fortiori so will be asset prices that are already
liquid, and most effect on the price of assets that are most liquid." ...
"The money view emphasizes the inherent instability of a credit system
driven by the private profit motive, but the problem is made worse when the Fed
adopts a policy rule that denies any responsibility for preventing a
bubble." "The problem is that the music does not just stop, it
switches into reverse." ... "At its core, our monetary system is a
dealer system that supports the liquidity of our securities markets, and the
Fed serves as dealer-in-chief not only in wartime but also in peacetime, and
especially in financial crisis time."
Sounds like today.
But the academic economics industry does not recognize a 'money view
perspective'. Ignoring it, or refusing to admit it was the central goal of the
progressives in creating the FED and then abandoning any restraint on the money
supply by linking it to gold was essential for funding the 'welfare state'. ...
Now we have moved even further into imaginary theory with the advocacy of
"Modern Money Theory - MMT".
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Chapter Six - Learning from the Crisis
Dr. Mehrling comments that from the money perspective the financial crisis of
2007-8 was a stress test of the new world modern finance system. It featured
the creation of currency swaps, then interest rate swaps and then credit
default swaps which resulted in a 'transformation' of a rigid and highly
regulated financial system. "The result is that now we have a
capital-market-based credit system that is now a more important source of
credit than the traditional banking system."
(That is the 'shadow bank' system). In this chapter Dr. Mehrling narrates and
analyses the change that has taken place between the role of the central bank
in Bagehot's time. He states that the reality of the capital markets
(credit-debt) is different now, but the economic theory that explains it has
not kept up. So we need a new understanding of monetary policy and financial
regulation. Our memory remains thinking of the traditional local bank that took
in deposits and used that capital to make local loans. The liquidity risk
amounted to depositors withdrawing their money while the bank had invested it
or lent it for longer terms. Since the great depression these deposits have
been insured by the government. He shows with sample balance sheets what
happens when 'shadow banks' enter the money arena. They fund their operations
by issuing money market securities purchased by money market mutual funds.
Their assets are ABCP - asset-backed commercial paper and repro (RP)
instruments. Their solvency and liquidity risks are not protected. During the
financial crisis in 2007-8 it was these accounts that collapsed. They were
rescued temporarily. But when Bear and Lehman collapsed and then AIG as well.
Not only did the FED become a dealer of last resort but the Congress had to
enable the Treasury to step in as well. Still, the thinking about the needed
response was outdated.
He summarizes the thinking: "When liquidity risk was thought to be the
issue, it was the Fed's problem; when solvency risk was thought to be the
issue, it became the Treasury's problem "It became not a need to save a
bank but to save the entire banking system (including international banking).
The entire market-based credit system was at risk. It was the inability to fund
liquidity. He states that the economists largely missed the most important
point."
Here is a key explanation.
What had happened was that the liquidity of the securities in the money market
was based on 'implicit' collateral - the net worth on the balance sheets that
was used for unsecured money market funding. When that collateral had an
unreliable value it was worthless as a security.
"But why did collateral valuations come under threat? Fundamental
valuation was definitely as concern - bad loans had definitely been made - but
from a money view perspective price is first of all a matter of market
liquidity, and this perspective focuses attention on the dealer system that
translated funding liquidity into market liquidity."
What does he mean by this? It rests on the real meaning of 'money' and the
concept of' 'value'. He takes pages to explain, bringing in the investment
banks and the=CDO (collateralized debt obligations) Dealers in this balance
their own sheet by matching sales of risk to those asking for it and buying
risk from those willing to sell it. But nothing has 'intrinsic' value.
Something has the relative value (quantified by the metric "money') set by
the entity willing to take it in exchange for something it will give up. But in
the crisis no one could determine what the relative monetary value of the
collateral at offer was. And much of the collateral at offer was one 'tranch'
part of a complex underling debt (for instance a mortgage.). Worse, prior to
the crisis both investment banks and insurance companies were selling very
cheap credit insurance. From Dr. Mehrling's discussion it is apparent that many
actors did not know what they were really doing, not what they thought they
were doing.
Dealer of Last Resort
In this section Dr. Mehrling describes what the FED and the Treasury did to
rescue the financial system. For the FED it included creation of an allthabet
soup of special purpose offices that could lend (created credit to specific
entities and create a balance sheet for imaginary assets and liabilities) The
TSLF - Term securities Lending Facility - a Money Market Investment Funding
Facility - A Term asset-Backed Securities Loan Facility (TALF) . The Treasury
put Fannie Mae and Freddie Mac into conservatorship by exchanging Treasury debt
for the debt of Fannie and Fredie. The FED took over AIG's book of credit
derivatives - the CDS portfolio. He does not include it, but the FED also
engaged in currency swaps with foreign banks to enable them to bail out their
investors who held US investments.
He sees that: "The Fed has been acting as dealer of last resort, not just
in the credit insurance market, which was the source of market liquidity
precrisis, but now in the capital market directly.".. The Fed now
recognizes that, for our market-based credit system, it must remake itself as
dealer of last resort.".
Danielle DiMartino Booth gives a much longer list of these FED special
organiztions created to rescue specific parts of the 'shadow banking system.
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Conclusion:
The author considers that the 'intellectual blinders' (that is antiquated
economic theory) that he describes in Chapter Three include excessive
appreciation of Moulton's shiftability and Martin's dealer system and
insufficient appreciation of their limitations.
But the Rubicon has already been forded. He presumes: "What are the
implications of the Fed's new role as 'dealer of last resort' for normal times?
Yes , no longer a response to a 'once in a lifetime emergency', but a constant
standard function of the central bank. His basis is: "the realization that
our market-based credit system relies critically on two-way dealer markets that
link funding liquidity in the money market with market liquidity in the capital
market."
Here is the core of the take over. "The Fed must think of its role as
intervening to support and manage that system as a whole, not just to set the
price in a narrow slice of the funding markets." YES 'support and manage'.
Yes, this is management by academic 'know-it-alls' who could not manage the
Fed's check book and have no personal experience in business, large or small.
He elaborates on the theory of his proposal. But throughout the book he
stresses the difference between the activity in the theoretical concepts and
the actions in real money markets. In his chapter on Management he cites
mismanagement. "Yet in his conclusions he gives scant attention to the
bias, skill, preconceptions, not to mention political agendas of the personnel
IN the FED; the political self-preservation of the FED institution; and the
political desires of the FED's overlords.
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Walter Bagehot, Lombard Street
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Wikipedia entry, Lombard Street
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Carmen Reinhart and Kenneth Rogoff, This Time is Different
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David Chambers and Elroy Dimson, Financial Market History:
Reflections on the Past for Investors Today
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Barry Eichengreen, Exorbitant Privilege: The Rise and Fall of
the Dollar and the Future of the International Monetary System
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Justin Fox, The Myth of the Rational Market,
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George Cooper, The Origin of Financial Crises
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Nomi Prins, Collu$ion, How Central Bankers Rigged the World
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Danielle DiMartino Booth, FED UP: An Insider's take on Why the
Federal Reserve is Bad for America
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L. Randal Wray, Modern Money Theory: MMT
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William Bonner and Lili Rajiva, Mobs, Messiahs, and Markets
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