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

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Published by EH.NET (June 2011)

Perry Mehrling, The New Lombard Street: How the Fed Became the Dealer of Last Resort. Princeton, NJ: Princeton University Press, 2011. xii + 174 pp. $30 (hardcover), ISBN: 978-0-691-14398-9.

Reviewed for EH.Net by Douglas K. Pearce, Department of Economics, North Carolina State University.

Most books on the recent financial crisis focus on one or more causes and debate the appropriateness of the extraordinary responses of the government and the Federal Reserve. Perry Mehrling, professor of economics at Barnard College, Columbia University, takes a different tack.? Mehrling?s title is taken from the original Lombard Street by Walter Bagehot, published in 1873, which is best known for its recommendation that central banks, when confronted with financial crises, should lend freely to commercial banks but at a high interest rate to reduce moral hazard problems. They should be the lenders of last resort. Mehrling?s contention is that financial markets have evolved so that now central banks must be dealers of last resort, standing ready to buy securities from banks and other institutions but at low prices.

In the introduction, Mehrling lays out his primary thesis that the Fed needs to place emphasis on managing the general liquidity needs of the financial sector, which he refers to as market liquidity, rather than concentrating on targeting the federal funds rate.? He claims that interest rate targeting such as the Taylor rule leads to excessive easing in monetary policy, but does not provide supporting evidence.

Chapter one discusses how credit can be a source of instability and how the Bank of England applied Bagehot?s policy of discount lending, constrained by potential gold outflows. Mehrling then succinctly details how the post-World War II Federal Reserve conducted monetary policy prior to the crisis by using the repo market in Treasury securities to manage the level of bank reserves and thus the federal funds rate.?

Chapter two is a brief history of the U.S. monetary system beginning with the National Banking Act of 1863.? Mehrling reviews why the Federal Reserve was formed and how it shifted from using the discount rate to open market operations as its main tool.? He argues that bank holdings of Treasury debt along with the Fed?s readiness to buy or lend on this debt was the major source of bank liquidity, replacing the need for self-liquidating commercial loans.? Mehrling refers to this source of liquidity as ?shiftability? or the ability to sell assets at predictable market prices.? He blames the Fed for fueling a speculative credit bubble that burst in 1929 and suggests that the Fed?s failure to buy or lend on banks? private securities led to the money supply collapse in the 1930s.

In chapter three, Mehrling argues that mainstream economic theory ignored the possibility of financial crises. Arrow-Debreu worlds did not have money and Tobin-type models ignored potential liquidity problems.? He singles out Hyman Minsky as one who worried about the instability of finance and inherent liquidity problems.

Chapter four explains the development of currency, interest rate, and credit default swaps and the shadow banking system. This chapter gives an excellent explanation of how swaps work.? I found the simple balance-sheet examples particularly useful in getting to the heart of the transactions.? He points out how swaps can allow institutions to conduct transactions that otherwise would be prohibited by banking regulations and that swaps allow the pricing of the different risks inherent in debt securities.? Mehrling believes that modern finance, emphasizing arbitrage pricing, forced financial deregulation and increased the likelihood of a financial crisis.?

Chapter five describes the modern money market and the role of dealers. Mehrling explains how the Fed, through its interest rate target, provides liquidity to dealers by standing ready to buy or lend on Treasury securities.? Dealers lend long and borrow short, profiting on average from the typical upward sloping yield curve. Monetary policy changes are quickly transmitted to the money market through changes in dealers? bid-ask prices.? Dealers provide market liquidity through their willingness to buy or sell assets. Mehrling sees the recent crisis as coming from a lack of market liquidity until the Fed started buying private securities.? He criticizes the Fed for following a Taylor-like rule that looks at macroeconomic outcomes but ignores asset prices.

Chapter six details lessons from the crisis.? Mehrling compares the old banking credit model in which banks take deposits and make loans to the modern credit market in which shadow banking holds securitized loans funded by borrowing in the wholesale money market.? The former has the FDIC and the Fed behind it while the latter has no government backing. Mehrling gives a chronology of the crisis and the Fed?s responses to each step, starting with the Term Auction Facility, which was close to traditional discount lending, followed by a host of programs that quickly doubled the Fed?s balance sheet and reflected its willingness to buy private securities.? He explains how dealers tried to hedge their risks from selling credit insurance but were unsuccessful, commenting that ?everyone knew that someone was selling very cheap insurance, but everyone thought it was someone else.??

In his concluding chapter Mehrling argues that the Fed must maintain its role of dealer of last resort.? While Dodd-Frank tries to re-regulate the financial system, Mehrling accepts that financial crises are inevitable and that the Fed?s role should be to limit their severity.? The key lesson for Mehrling is that the Fed can no longer concern itself only with the liquidity needs of the banks but must also worry about the overall liquidity in the economy: ?the goal of the Fed should not be to set the market price but only to set a price floor, which in normal times should be some distance away from the market price? (p. 137).

The book prompts several questions.? First, how important were the financial engineering developments compared to the government dictates to lower credit standards and the Fed?s low interest rate policy in causing the recent crisis?? Second, how would the Fed set the lower-bound prices at which it would buy private securities in a time of crisis?? If the price is too low, it would not seem to prevent collateral and net worth problems.? Third, would the policy of dealer of last resort increase the risk that financial institutions would take on, given the downside protection that the Fed would provide?? Overall, this is a thought-provoking work that deserves to be read by anyone interested in the development of U.S. financial markets or in the origins of the recent financial crisis.

Douglas K. Pearce is Professor of Economics at North Carolina State University. His recent publications include ?Professional Forecasts of Interest Rates and Exchange Rates: Evidence from the Wall Street Journal?s Panel of Economists,? (with K. Mitchell), Journal of Macroeconomics, December 2007. Doug_Pearce@ncsu.edu

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