The New Lombard Street
The central bank as dealer of last resort in a market-based system.
Summary
Perry Mehrling, an economist at Barnard and Boston University, sets out what he calls the money view: an approach to finance built on balance sheets and on the survival constraint that every entity must meet its payments each day.
His framework has a hierarchy. At the top sits the ultimate money, historically gold and now central bank reserves. Below it sit bank deposits, which are promises to pay money; below those sit securities, which are promises to pay deposits. In normal conditions the distinctions between levels are invisible because everything is exchangeable at par. In a crisis the hierarchy reasserts itself and the distinctions become everything.
The historical argument traces the Federal Reserve's evolution through three roles. It began as a lender of last resort in the Bagehot tradition set out in Lombard Street, lending against good collateral at a penalty rate. It became a monetary policy institution managing the quantity of money and then interest rates. And in 2008 it became what Mehrling calls a dealer of last resort, buying assets outright and providing bid-side liquidity in markets where dealers had withdrawn. He argues that this third role was necessary given a financial system built on market-based credit rather than on bank lending, and that it has not been acknowledged institutionally. The book is short, clear and analytically distinctive. Its framework has become influential among people analysing the shadow banking system and central bank operations.
Key takeaways 7
- Money is hierarchical, with central bank reserves at the top and each lower level a promise to pay the level above.
- The distinctions between levels of the hierarchy are invisible in normal conditions and become decisive in a crisis.
- Every entity faces a survival constraint, meaning it must meet its payments each day regardless of its solvency.
- The Federal Reserve became a dealer of last resort in 2008, providing bid-side liquidity in markets where dealers had withdrawn.
- A financial system built on market-based credit rather than on bank lending requires a market maker of last resort, not only a lender.
- Bagehot's lender of last resort doctrine addresses banks and does not address markets that have stopped functioning.
- Mehrling argues that the dealer of last resort function has been performed without being institutionally acknowledged.
Who should read it
Investors and analysts of monetary policy and shadow banking who want a balance-sheet framework for understanding what central banks now actually do.
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