Pipes and Pipemakers

The New Lombard Street: How the Fed Became the Dealer of Last Resort, Perry Mehrling, 2011.

Amongst the Nerves of the World, C.R Nevinson, 1930.

Central bank independence. Polanyi. Global cooperation. The central banking history I have looked into so far has been fairly abstract, focussed on the high politics of monetary policy and the international monetary order. But there is another equally important dimension to monetary history which operates on a different facet of central banking. Instead of the link between central banks and the state, it focusses on the interrelations between central banks and the private banking system. To abuse a popular metaphor, this involves looking at the relationship of the plumber to the pipes and pipemakers, not the plumber and their client.

It is this aspect of monetary history that Perry Mehrling explores in The New Lombard Street. The book is only partially a history: it is also an intervention on monetary theory, with (unsurprisingly) an eye towards the 2008 financial crisis. Furthermore, Mehrling ties these historical and theoretical threads to each other with substantial attention to the intellectual history of monetary economics and economic modelling. All this coalesces, however, under what Mehrling calls “the money view”; which, he argues, “provides the intellectual lens necessary to see clearly the central features” of the 2008 crisis.

The money view, according to Mehrling, is a perspective on monetary policy which emphasises two connected points. First, that the mission of a central bank is to balance “discipline and elasticity” in the money market, and second, that liquidity — in essence, the capacity to make economic decisions without constraints on cash — is “not a free good”. Much twentieth and early twenty-first century theory in finance and economics, Mehrling argues, fails to appreciate both these facts.

I do not want get bogged down in the theoretical side of Mehrling’s book, and I would like to avoid reproducing balance sheets here, although they are lucid and a valuable part. But the ‘money view’ and its points of emphasis are key to the economic history Mehrling presents as he traces the evolution of the Fed — and the money market — from its inception until today.

Before we get to the Federal Reserve, however, we need to consider Lombard Street: A Description of the Money Market, the 1873 book by the English writer Walter Bagehot.¹ Bagehot was explaining the workings of the London money market, and in particular, the role that had emerged for the Bank of England; which, during this period, was beginning to resemble a modern central bank. Until the mid-nineteenth century, the Bank of England conceived of itself as essentially a normal bank responsible to its shareholders. It would lend at the market rate and seek to maximise its profit. But nineteenth century financial crises taught the Bank of England that, because it was the source of reserves for Britain’s financial system, when a crisis hit the banking sector would look towards it for help.

Thus the Bank of England developed a new principle which Bagehot famously coined as the “lender of last resort”, which meant that the Bank of England, in a crisis, would lend freely on “all good banking securities”, but at a “very high rate of interest”. To facilitate this, the Bank of England would normally lend at a slightly higher than market rate, which involved the sacrifice of some profit. From the perspective of Mehrling’s money view, this policy meant completely elastic lending to any bank in need against any security acceptable in normal, ‘non-crisis’ times, but it also provided discipline via a rate of interest only attractive to the desperate.

This system, Mehrling argues, depended upon the financial plumbing which underpinned it — in particular, on the primary financial security of the time, the bill of exchange. The bill of exchange is a short-term commercial credit instrument issued by firms to buy industrial inputs, repayable over a short period. For a fee, banks would “discount” the bill, purchasing it for less than face value with the difference amounting to the rate of interest earned — the discount rate. This discount business accounted for most of financial activity, and thus banking involved managing a portfolio of bills such that inflows from maturing bills were timed with cash outflows from discounting bills in such a way as to avoid a shortfall.

Here is the difference between Mehrling’s New Lombard Street and Bagehot’s old one. In Bagehot’s era, a liquidity crisis occurred when a bank experienced a shortfall — due to failed repayments, for example. The central bank stepped in as the lender-of-last-resort, providing liquidity to the bank in question, so that it could avoid failure. Since bills of exchange are self-liquidating the issue the Bank of England needed to solve was the “funding liquidity” of the bank in question (the pressing need for cash). It was not concerned about the “market liquidity” of bills of exchange themselves — this was automatically assured.

In the United States, however, and especially after the First World War, the bill of exchange was not the primary financial security (this is still the case today, as bills of exchange, while important in international trade, are not a structurally significant security). What instead became the most important money market instrument was the repurchase agreement, or ‘repo’. With a repo, a bank sells a security to another bank, usually the central bank, for a short time at a price slightly lower than market value (as extra collateral for the loan) and agrees to repurchase the security at a higher price afterwards. The time between sale and repurchase is short, often simply overnight. The vital difference between a bill of exchange and a repo is, as Mehrling writes, that the former is issued to “finance the progress of real goods towards final sale” while the latter “[finances] the holding of some financial asset”.

This leads to the subtitle of Mehrling’s book — how the Fed became the dealer of last resort. You would be forgiven for, as I did, instinctively substituting in lender for dealer without thinking twice. But this is a mistake. As I mentioned above, Bagehot’s lender of last resort needed only to be concerned about the funding liquidity of distressed banks, given the self-liquidating nature of bills of exchange. The early-twentieth century Fed, however, eventually realised it needed to worry about market liquidity — although a little too late.

When the Great Depression began the Fed was loyal to Bagehot. It lent freely on all good commercial securities (i.e., bills of exchange). However, it was not a mismatch between inflows and outflows on commercial credit that pushed banks to insolvency in 1929, but falling values of private securities. In 1935 the Fed learnt that to stabilise the financial system it need to accept any “sound” assets, not only self-liquidating commercial bills, as collateral. And in 1937 it went further still: committing to not simply wait for banks to request loans, but to buy and sell securities on the open market to keep '“order”. In doing this, the Fed had become not just a lender but a dealer, a market-maker.

This is only really the backdrop of Mehrling’s story. After 1937, the Fed slowly increased its role as a dealer until, after 1951, it was basically the only money-market dealer. This remained so until the sixties, when the Eurodollar market sprung into action — in fact, Mehrling’s narrative is remarkably similar to that of Eric Helleiner’s I looked at recently, as both emphasise how capital controls facilitated the financial innovation which eventually undermined it. Mehrling, however, takes the discussion of the Eurodollar further — because, he argues, it contained the essence of the era of financial liberalisation: the swap. What started as a tool to evade capital controls became “over time simply a way of pricing loans”. And although eurodollars enabled pricing away exchange-risk, it was only a step to taking the same principle to carve off other risks: hence the infamous credit-default swaps. By the early 21st century, the markets for swaps had come to occupy a similar place to the market for repos in the 30s: their liquidity was structurally significant, even if the Fed wasn’t prepared to play the role of dealer — at least before the crisis hit.

There is much more to The New Lombard Street than I have managed to do justice here. As I mentioned, there is a substantial intellectual history story, the best part of which explains how postwar macroeconomic modelling left liquidity behind. Mehrling is proudly heterodox, and this comes through his analysis: it is Hyman Minsky, more pessimistic about economic management than the Keynesians and more sceptical of the stability of the private capital market than the monetarists, whom he sees as the sharpest observer of that era. But, less predictably perhaps, Mehrling also places classically heterodox figures like Minsky alongside the “great tradition of central banking thought” which runs through decidedly non-radical economists like Ralph Hawtrey — who you might remember from Clara Mattei’s The Capital Order, wherein he was presented in a very different light. This, I believe, captures part of what makes The New Lombard Street so delightful: it is historical economics at its best, using a non-facile narrative to compellingly illustrate the strength of a theory that is original and conscious of its antecedents. In other words, it is much more than just a history of the Fed.

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1. “Lombard Street” was the traditional centre of London’s financial sector.