"The global financial system is badly broken. Many institutions and individuals share responsibility for the development of pathologies in and around our largest banks, but the buck stops, literally and figuratively, with the Federal Reserve. If you would like to understand how this happened--and how we (and the Fed) might inch back from the precipice--read this book."--Simon Johnson, coauthor of13 Bankers: The Wall Street Takeover and the Next Financial Meltdown

"Informed by history, a model of clear thought and lucid prose, The New Lombard Street is by far our best guidebook to the changed structure of financial markets and the new role of the Federal Reserve. It also charts a new path for monetary policymakers and--given the scale of the crisis--not a minute too soon."--James K. Galbraith, author ofThe Predator State: How Conservatives Abandoned the Free Market and Why Liberals Should Too

"In Lombard Street, Walter Bagehot laid out the financial market lore and central banking wisdom of his day--the 1870s. Today's markets are different, and so is what constitutes useful policy. InThe New Lombard Street, Perry Mehrling blends his rich historical knowledge with an acute analysis of current-day markets to suggest what constitutes sound central banking and financial regulation for our time. The result merits close attention from policymakers, and the rest of us too."--Benjamin M. Friedman, author of The Moral Consequences of Economic Growth

"No one else has come close to the achievement of this book in relating the crisis to the prior history of monetary thought and central bank practice. A masterful, original, and beautifully constructed work."--Charles A. E. Goodhart, London School of Economics and Political Science

"The New Lombard Street makes a serious and successful effort to deepen our understanding not just of the last century or more of U.S. monetary history, but also of the way in which economic analysis has evolved alongside that history. I very much enjoyed reading this book. It is timely, provocative, and well written."--David Laidler, professor emeritus, University of Western Ontario

"This is a wonderful book that offers a fresh understanding of the role of the central bank in the world of modern finance."--Roger E. Backhouse, University of Birmingham

"The global financial system is badly broken. Many institutions and individuals share responsibility for the development of pathologies in and around our largest banks, but the buck stops, literally and figuratively, with the Federal Reserve. If you would like to understand how this happened--and how we (and the Fed) might inch back from the precipice--read this book."--Simon Johnson, coauthor of13 Bankers: The Wall Street Takeover and the Next Financial Meltdown

"Informed by history, a model of clear thought and lucid prose, The New Lombard Street is by far our best guidebook to the changed structure of financial markets and the new role of the Federal Reserve. It also charts a new path for monetary policymakers and--given the scale of the crisis--not a minute too soon."--James K. Galbraith, author ofThe Predator State: How Conservatives Abandoned the Free Market and Why Liberals Should Too

"In Lombard Street, Walter Bagehot laid out the financial market lore and central banking wisdom of his day--the 1870s. Today's markets are different, and so is what constitutes useful policy. InThe New Lombard Street, Perry Mehrling blends his rich historical knowledge with an acute analysis of current-day markets to suggest what constitutes sound central banking and financial regulation for our time. The result merits close attention from policymakers, and the rest of us too."--Benjamin M. Friedman, author of The Moral Consequences of Economic Growth

"No one else has come close to the achievement of this book in relating the crisis to the prior history of monetary thought and central bank practice. A masterful, original, and beautifully constructed work."--Charles A. E. Goodhart, London School of Economics and Political Science

"The New Lombard Street makes a serious and successful effort to deepen our understanding not just of the last century or more of U.S. monetary history, but also of the way in which economic analysis has evolved alongside that history. I very much enjoyed reading this book. It is timely, provocative, and well written."--David Laidler, professor emeritus, University of Western Ontario

"This is a wonderful book that offers a fresh understanding of the role of the central bank in the world of modern finance."--Roger E. Backhouse, University of Birmingham

THE NEW LOMBARD STREET

PRINCETON UNIVERSITY PRESS

Contents

Chapter One

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." 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 the modern payments system.

Everyone else-households, businesses, governments, even entire nations-is also a financial institution since, in addition to whatever else they do, they must attend to the consequences of their activities for their own daily cash flow. Indeed, this daily cash flow, in and out, is the crucial interface where each of us connects with the larger system. This interface provides the cash that makes it possible for us to pursue today dreams for the future that would otherwise be impossible; but it does so at the cost of committing us to make future payments that can, if our dreams do not work out, constrain our independence more or less severely. The seductive allure of present credit and the crushing burden of future debt are two faces of the same creature.

The Inherent Instability of Credit

The two faces of credit show themselves not only at the level of each individual, but also at the level of the system as a whole because one person's cash inflow is another person's cash outflow. If the allure of credit induces one person to increase spending, the immediate result is income somewhere else in the system, which income is then available for additional spending. Similarly, if the burden of debt induces one person to decrease spending, the immediate result is reduced income somewhere else in the system, and thus possibly also reduced spending. This interaction of balance sheets is the source of what the British monetary economist Ralph Hawtrey called the inherent instability of credit. In his view, the main job of the central bank is to prevent a credit-fueled bubble from ever getting started, in order to avoid the collapse that inevitably follows.

But, from another point of view, the inherent instability of credit is not entirely a bad thing. On the way up, real things get built, new technologies get implemented, and productive capacity expands. The Austrian economist Joseph Schumpeter always insisted that credit is critical for the process of "creative destruction" that is the source of capitalism's dynamism, because it provides the crucial mechanism that allows the new to bid resources away from the old. Instability is, from this point of view, inseparable from growth, and a central bank that intervenes to control instability runs the risk of killing off growth by stifling the new on the way up and coddling the old on the way down.

In any concrete case, the question therefore arises: are we looking at a Hawtreyan speculative bubble that we want to rein in, or at Schumpeterian dynamic growth that we want to let run? One reason this question is hard to answer is that a credit-fueled boom typically involves a bit of both. That is why we seem always to be tempted to draw a distinction between speculative and productive credit, and to look for ways to channel credit preferentially to the latter. But in practice the distinction is often difficult to draw and, even more problematic, discrimination in credit allocation is often impossible to implement. In this latter regard, the institutional structure of finance, including the regulatory structure, is crucial. If potential borrowers and lenders can find one another and do business outside the reach of the authorities, then it will be impossible to allocate credit preferentially to socially desirable uses, even assuming they could be identified and agreed on. (In such a situation, even control of aggregate credit can be quite difficult.)

In the last analysis, the only dependable source of leverage over the system as a whole is the role of the central bank as a banker's bank. If banks are the quintessential financial institution because of their management of the retail payments system, then the central bank is the quintessential bank because of its management of the payments system that banks themselves use. When one bank makes a payment to another, the mechanism involves changing entries on the balance sheet of the central bank; there is a debit to the account of the bank paying and a credit to the account of the bank being paid. Here, in the requirement to settle net payments every day on the books of the central bank, we find the location of the ultimate discipline for the entire system.

Hyman Minsky called this requirement the "survival constraint"-cash inflows must be sufficient to meet cash outflows-and we all face such a constraint. For banks, the survival constraint takes the concrete form of a "reserve constraint" because banks settle net payments using their reserve accounts at the central bank. The leverage that the central bank enjoys over the larger system arises ultimately from the fact that a bank that does not have sufficient funds to make a payment must borrow from the central bank. In such a circumstance, the central bank must lend or else risk a breakdown of the payments system, but the lending does not have to be cheap or easy. It is the central bank's control over the price and availability of funds at this moment of necessity that is the source of its control over the system more generally.

Opportunities for such control arise naturally from time to time, simply because of fluctuations in the pattern of payments, but the central bank can also create such opportunities as the need arises. Just so, when the central bank "tightens money" by selling Treasury bills, the consequence is that the banking system as a whole has to make payments to the central bank, which amounts to tightening the survival constraint that all bankers face. Alternatively, when the central bank "loosens money" by buying Treasury bills, the consequence is that the banking system as a whole receives payments from the central bank, thus relaxing the survival constraint. The effects of these central bank interventions show up in the short-term rate of interest that banks pay as the cost of putting off to the future a payment that is due today. Historically, the art of central banking was all about the choice of whether to raise or lower that cost.

The central bank's ability to influence the degree of discipline or elasticity faced by banks at the daily clearing provides some control over the credit system as a whole, but that control is by no means absolute. Private credit elasticity is always a substitute for public credit elasticity. In its attempt to impose discipline, sometimes the most the central bank can do is to force banks to find and use alternative private credit channels. Similarly, in its attempt to impose elasticity, sometimes the most a central bank can do is to offer its own public credit as an alternative to collapsing private credit.

That's why Hawtrey referred to the "art" of central banking, rather than the "science" or the "engineering." The central bank can use its balance sheet to impose a bit more discipline when the private market is too undisciplined, and it can use its balance sheet to offer a bit more elasticity when the private market is imposing excessive discipline. But it is only one bank and ultimately small relative to the system it engages, especially so in the modern globalized financial system in which private credit markets are all connected into an integrated whole. Because the central bank is not all-powerful, it is especially important that it choose its policy intervention carefully, with a full appreciation of the origins of the instability that it is trying to counter.

According to Hawtrey, the inherent instability of credit has its origin in the way that credit-financed spending by some creates income for others, not only directly but also indirectly by pushing up the price of the good being purchased, thus producing an upward revaluation of existing inventories of the good. The capital gain for holders of inventories tends to stimulate additional spending, in part to buy ahead of rising demand in order to earn additional profit from rising prices in the future. Because revaluation of existing inventories tends to improve creditworthiness, this additional spending is easy to finance, even easier than the initial spending. The feedback loop of rising asset prices and credit expansion is the source of the inherent instability of credit emphasized by Hawtrey.

The price-credit feedback mechanism is also the reason that credit-fueled bubbles are so difficult to control, because it means that central bank interest rate policy can sometimes have very little traction. The question for the speculator is only whether the rate of appreciation of the underlying asset is greater than the rate of interest, and that is a condition often quite easily satisfied. If house prices are appreciating at 15 percent a year, it takes an interest rate of greater than 15 percent to stifle the bubble. Even supposing that the central bank is able to impose such a high interest rate, 15 percent would stifle a lot of other things as well. Conclusion: if you don't catch the bubble early, it may be impossible to do anything using interest rate policy.

Meanwhile, the larger the bubble grows, the greater the distortion in the allocation of credit and in the allocation of real resources commanded by that credit. Not only does a bubble prospect of 15 percent attract new credit disproportionately, but also it bids up the price of credit across the board. Borrowers and lenders find one another at a rising market rate of interest, and the central bank must raise its policy rate merely to keep up. Eventually, and long before interest rates reach 15 percent, the effects of higher market interest rates are felt on nonbubble balance sheets throughout the economy, and it is these effects that bring the bubble to an end.

The way it works is this. Higher interest rates mean greater cash outflows for debtors, and eventually the most vulnerable among them find their cash outflows exceeding their cash inflows. If you are one of those vulnerable debtors, Minsky's survival constraint begins to bind for you. Logically there are only three ways out. First, you can spend down any cash balances you may have, but these balances are finite and quickly exhausted. Second, you can borrow to cover the shortfall, but credit lines are also finite, and even possibly contracting in the face of declining creditworthiness. Third, you can sell some of your earning assets, for whatever price they will fetch on the market. Typically these three ways out are used sequentially, as debtors hold on for as long as they can, hoping that some other balance sheet in the system will prove to be the weakest link. The important point is that sooner or later asset prices come under pressure, not just the prices that were rising at 15 percent but all asset prices, and especially the price of the assets held by the most vulnerable debtors, who are forced to liquidate first.

When that happens, liquidity problems (the survival constraint) become solvency problems, and especially so for highly leveraged financial institutions. Even if they are not forced to sell assets in order to make promised payments, they may be forced to write down the valuation of those assets to reflect current market prices. For highly leveraged institutions, with financial liabilities many times larger than their capital base, it doesn't take much of a write-down to produce technical insolvency. And even before insolvency, asset write-downs can quickly generate serious liquidity problems as credit lines shrink to fit reduced collateral valuations. Liquidity and solvency problems thus reinforce one another on the way down, just as credit expansion and asset valuation do on the way up. This is the downside of the inherent instability of credit.

On the way up, as has been emphasized, the central bank tends not to have much traction, since borrowers and lenders share an interest in avoiding central bank discipline. On the way down a similar mutual interest, now in avoiding market discipline, brings both borrowers and lenders back to the central bank as the last available source of credit elasticity. "Lender of last resort" intervention involves the central bank extending credit when no one else will (or can); in effect, the central bank relaxes the survival constraint by providing current cash inflow to allow borrowers to delay the day of reckoning. Used wisely, such intervention can control the downturn and prevent it from turning into a rout. Used unwisely, such intervention can foster further continuation of unhealthy bubble conditions. In a crisis, as in normal times, the art of central banking is all about walking the fine line between providing too much discipline versus too much elasticity.

The Old Lombard Street

The impact and effectiveness of central bank control both depend crucially on the institutional organization of the banking system, and on its articulation with the financial system more generally. Walter Bagehot's Lombard Street explored these questions in the context of the London money market of his day, a set of institutional arrangements different in important respects from modern arrangements, but nonetheless a good starting point because the conclusions that Bagehot drew continue to shape the way we think today. The Bagehot principle that guided central bankers in the current crisis has its origin in that nineteenth-century book.

Today we summarize the Bagehot principle as "lend freely but at a high rate." Here are Bagehot's own words (1906 [1873], 197): "The end is to stay the panic. And for this purpose there are two rules:-First. That these loans should only be made at a very high rate of interest.... Secondly. That at this rate these advances should be made on all good banking securities, and as largely as the public ask for them." Why did Bagehot think this was wise policy for his world, and is it still wise policy for our own very different modern world?

Bagehot's world was based on a short-term commercial credit instrument known as the bill of exchange. Firms issued bills in order to buy inputs for their own production processes, and they accepted bills as payment for their own outputs. The bill of exchange was a promise to pay at a specific future date, perhaps in ninety days. For a fee, banks would "accept" bills, which meant guaranteeing payment. For another fee, banks would "discount" bills, which meant buying them for less than face value, the difference amounting to a rate of interest to be earned over the term to maturity. As payment for the bills, banks would offer either currency or a deposit account credit. Either way, the proceeds of the discount were most typically not held as idle balances but rather spent in payment of other maturing bills. In this way, the discount mechanism was crucial for British firms' management of their daily cash flow, in and out.

Ideally, over the ninety days between issue and maturity, the firm that issued the bill would use the inputs so acquired to produce output for sale, and then use the sale proceeds to pay the bill as it came due. Timely repayment thus depended on timely sale of the production financed by the bill. Assuming timely repayment, the banking business was all about managing one's portfolio of bills in order to match up the timing of cash inflows (from maturing bills) with the timing of cash outflows (for new discounts). If ever a firm failed to pay, however, then the accepting bank would experience a cash shortfall.

In this system, banks managed their own daily cash flow by managing the discount rate they quoted to their customers. If requests for discount were depleting one's cash reserve, one had merely to raise one's discount rate and the business would go elsewhere; if maturing bills were swelling one's cash reserve, one simply lowered the discount rate to attract additional interest-paying business. In this way, the market rate of interest fluctuated according to supply and demand. The rate of interest was high when requests for new discount were running ahead of repayments, and low when the balance went the other way.

(Continues...)

Excerpted from THE NEW LOMBARD STREETby Perry Mehrling Copyright © 2011 by Princeton University Press. Excerpted by permission.
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