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The New Lombard Street

The New Lombard Street: How the Fed Became the Dealer of Last Resort

Perry Mehrling
Copyright Date: 2011
Pages: 184
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  • Book Info
    The New Lombard Street
    Book Description:

    Walter Bagehot'sLombard Street, published in 1873 in the wake of a devastating London bank collapse, explained in clear and straightforward terms why central banks must serve as the lender of last resort to ensure liquidity in a faltering credit system. Bagehot's book set down the principles that helped define the role of modern central banks, particularly in times of crisis--but the recent global financial meltdown has posed unforeseen challenges.The New Lombard Streetlays out the innovative principles needed to address the instability of today's markets and to rebuild our financial system.

    Revealing how we arrived at the current crisis, Perry Mehrling traces the evolution of ideas and institutions in the American banking system since the establishment of the Federal Reserve in 1913. He explains how the Fed took classic central banking wisdom from Britain and Europe and adapted it to America's unique and considerably more volatile financial conditions. Mehrling demonstrates how the Fed increasingly found itself serving as the dealer of last resort to ensure the liquidity of securities markets--most dramatically amid the recent financial crisis. Now, as fallout from the crisis forces the Fed to adapt in unprecedented ways, new principles are needed to guide it. InThe New Lombard Street, Mehrling persuasively argues for a return to the classic central bankers' "money view," which looks to the money market to assess risk and restore faith in our financial system.

    eISBN: 978-1-4008-3626-0
    Subjects: Finance

Table of Contents

  1. Front Matter
    (pp. i-viii)
  2. Table of Contents
    (pp. ix-x)
  3. Acknowledgments
    (pp. xi-xiv)
  4. Introduction
    (pp. 1-10)

    The financial crisis that started in August 2007 and then took a sharp turn for the worse in September 2008 has proven to require more than theSubprime Solutionadvocated by the Yale professor Robert Shiller, and to involve significantly greater loss than theTrillion Dollar Meltdownforeseen by Charles Morris. It is instead proving to be what Mark Zandi has called an “inflection point in economic history.” That means that we need a historical perspective in order to understand our current predicament and to see beyond it to a possible future.¹

    The intellectual challenge of producing such an account...

  5. ONE Lombard Street, Old and New
    (pp. 11-29)

    Writing in 1967, before he had yet formulated his famous Financial Instability Hypothesis, the American monetary economist Hyman Minsky identified the starting point for his analysis. “Capitalism is essentially a financial system, and the peculiar behavioral attributes of a capitalist economy center around the impact of finance on system behavior.”¹ From this point of view, the key institutions of modern capitalism are its financial institutions, which make a business out of managing the daily inflow and outflow of cash on their balance sheets. And the quintessential financial institutions are banks, whose daily cash inflows and outflows are the mechanism of...

  6. TWO Origins of the Present System
    (pp. 30-47)

    Monetary thought arises from monetary experience, but with a long and variable lag. In 1913, the Federal Reserve Act established a central bank in the United States, but it could not at the same time establish any new tradition of monetary thought. There was also no American Hawtrey on hand to help out, for the simple reason that there had been no American central bank since the charter of the Second Bank of the United States had been allowed to expire in 1836. At the origin of the modern monetary system, institutional change was dramatic and rapid, but older patterns...

  7. THREE The Age of Management
    (pp. 48-70)

    The triumph of the shiftability view in the 1935 Bank Act 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. Two years later, in a communication by the Federal Open Market Committee (FOMC) issued in April 1937, the Fed went even further, committing itself to maintaining “orderly conditions in the money market” quite generally.¹ What this meant was that, instead of waiting passively for banks to request loans, the Fed was prepared to intervene proactively by buying and...

  8. FOUR The Art of the Swap
    (pp. 71-91)

    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. Indeed, it was in the international money markets that the financial innovation most crucial for breaking down Depression-era rigidities first appeared. I refer here to the “swap,” specifically the currency swap, which first made its appearance as a way to get around postwar controls on international capital flows.

    After World War II, U.S. government debt was the coin of the realm internationally as well as domestically. The Bretton Woods...

  9. FIVE What Do Dealers Do?
    (pp. 92-112)

    You don’t know what you’ve got till it’s gone.

    Liquidity is like that. One day you’ve got a nice portfolio of high-yielding fixed income securities, which you can easily finance by using the securities themselves as collateral to borrow in a deep and liquid wholesale money market. The next day, you can no longer borrow at any reasonable rate, and you can’t sell your nice portfolio either at any reasonable price. Liquidity is gone, and it is about to take you away with it.

    When this happens, there is a natural human impulse to blame your counterparties. After all, it...

  10. SIX Learning from the Crisis
    (pp. 113-135)

    From the perspective of the money view, the financial crisis that began in August 2007 and then took a sharp turn for the worse in September 2008 looks like a stress test of the brave new world of modern finance that we have been building ever since about 1970. First currency swaps, then interest rate swaps, and then credit default swaps were introduced, and the eventual result was transformation of the rigid and highly regulated financial system that we had inherited from Depression-era reform. Regulatory arbitrage was not the only driver of this transformation but the important thing is the...

  11. Conclusion
    (pp. 136-140)

    On the eve of the Fed’s centennial year, we find ourselves grappling with many of the same issues that concerned the Fed’s founders, albeit now with the benefit of a century’s experience with central banking American style. To be sure, we have our own intellectual blinders to overcome, mainly a legacy of what I have called the Age of Management, but they are different blinders from those that held back our forebears. Unlike them, we are in a position to appreciate Moulton’s emphasis on shiftability, as well as Martin’s emphasis on the dealer system as the source of that shiftability....

  12. Notes
    (pp. 141-148)
  13. References
    (pp. 149-158)
  14. Index
    (pp. 159-174)