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THE NEW LOMBARD STREET

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THE NEW LOMBARD STREET

HowtheFedBecametheDealerofLastResort

Perry Mehrling

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ToJudy,thekids,andthegrandkids

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Iambynomeansanalarmist.Ibelievethatoursystem,thoughcurious and peculiar, may be worked safely; but if we wish sotoworkit,wemuststudyit.Moneywillnotmanageitself,andLombardStreethasagreatdealofmoneytomanage.

—Bagehot(1906[1873],20)

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Contents

acknowledgments xi

Introduction 1 A Money View Perspective 2 Lessons from the Crisis 6

One LombardStreet,OldandNew 11 The Inherent Instability of Credit 12 The Old Lombard Street 18 The New Lombard Street 23

Two OriginsofthePresentSystem 30 From National Banking to the Fed 30 From War Finance to Catastrophe 37 Noncommercial Credit in Depression and War 43

Three TheAgeofManagement 48 Monetary Policy and the Employment Act 52 Listening to the Academics 57 Monetary Walrasianism 60 A Dissenting View 65

Four TheArtoftheSwap 71 Currency Swaps and the UIP Norm 72 Brave New World 79 From Modern Finance to Modern Macroeconomics 85

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x contents

Five WhatDoDealersDo? 92 Inside the Money Market 93 Funding Liquidity and Market Liquidity 98 Anatomy of a Crisis 103 Monetary Policy 107

Six LearningfromtheCrisis 113 The Long Shadow of Jimmy Stewart 116 A Stress Test of Moulton-Martin 123 Dealer of Last Resort 132

Conclusion 136

notes 141references 149index 159

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Acknowledgments

Thisbookhastakenmefiftyyearstoformulate,butitwasSethDitchik’s queryback inNovember2008 thatfinally gotme towriteit.Giventhedramaplayingoutbeforeoureyes,hethoughttheremightberoomforabookthatwouldputthecurrentcrisisinsomelargerhistoricalperspective,andhethoughtImightbethepersontowriteit.Idon’tknowthatIhavewrittenexactlythebookhehadinmind,butIcandefinitelysaythatIhavewrittenthebookIhadinme.ItrevisitsterrainthatIhavetouredinmypreviousbooks,The Money Interest and the Public Interest(chaps.2and3)andFischer Black and the Revolutionary Idea of Finance(chap.4),buttheperspective isnew.Thatperspectivehasbeenhard-wonfromexperienceofmorethanadecadeteachingpatientNewYorkundergraduateshowthemoneymarketsdowntownac-tuallywork(chap.5).ButitisalsofreshinthesensethatithasbeenforcedsharplyintofocusbytheeventssinceAugust2007,andbymyattempttoparticipateconstructivelyinthepolicyre-sponse to those events (chap.6).The“moneyview” that Ihadbeendevelopingintheclassroomseemedtomakesenseofwhatwashappeningevenwhenothermorefamiliarviews,fromeco-nomicsandfinanceboth,didnot.

Aboveallothers,LarryKotlikoffdeservesthanksforarrangingmyaccommodationsatBostonUniversityduringtheyear2008–2009,forpushingmeintothepolicyprocess,andthenforback-ingoffandlettingmewritethebook.ProbablyIhavenotwritten

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xii acknowledgments

thebookhewouldhave liked—hehaswritten thatbookhim-self,underthetitleJimmy Stewart Is Dead—butthebookIhavewrittenwouldbequitedifferent, inwaysthatare impossibletoimagine,withouthim.Thanksalso to JoeStiglitzand the folksatColumbiaUniversity’sInitiativeforPolicyDialogueformak-ingroomformysomewhatprematuremaunderingsaboutcreditdefaultswapsbackinMay2008,andtoJamieGalbraithandthefolksatEconomistsforPeaceandSecurityformultipleopportu-nitiestopresentmydevelopingviews,firstinNovember2008.

Thanksalsotothose,mostlyattheNewYorkFed,whoworkedtirelesslybehindthescenestocreatetheprogramsthatputafloorunderthecrisis,programsthatIbelieveshowustheroadtowardaworkablefuturebeyondthiscrisis.ItisthenatureoftheirworkthatIknowa lotmoreabouttheprogramsthanthepeople,sothey are largely unsung heroes, but heroes nonetheless. Thanksalso to my academic colleagues who, beyond the call of schol-arlyduty, found time in themiddleof theirownwork to readandcommentonchapterdraftsalongtheway:RogerBackhouse,AaronBrown,AndreBurgstaller,BenFriedman,CharlesGood-hart,RobJohnson,AnushKapadia,DavidLaidler,DanielNeil-son,GoetzvonPeter,SanjayReddy,andRogerSandilands.Prob-ablyallof these—bothFed staffandacademiccolleagues—willfind something to disagree with in the book, and that is as itshouldbe;onelessonofthehistoryIrelateisthatwhenacadem-icsandpractitionersagree,weshouldworry.

Thanksfinallytomyfamily,whomaderoomforyetanothersummer of Papa In His Study, not excluding even two AugustweeksinCortona,Italy,wherethefirstdraftofchapter3waspro-duced.Noneofthiswouldhavebeenpossiblewithoutyourlast-ingsupport.Ittakesafamilytowriteabook;youaremine,andthisisyours.

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THE NEW LOMBARD STREET

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Introduction

ThefinancialcrisisthatstartedinAugust2007andthentookasharpturnfortheworseinSeptember2008hasproventorequiremorethantheSubprime SolutionadvocatedbytheYaleprofessorRobertShiller, and to involve significantlygreater loss than theTrillion Dollar MeltdownforeseenbyCharlesMorris.ItisinsteadprovingtobewhatMarkZandihascalledan“inflectionpointineconomichistory.”Thatmeansthatweneedahistoricalperspec-tive inorder tounderstandourcurrentpredicamentandtoseebeyondittoapossiblefuture.1

Theintellectualchallengeofproducingsuchanaccountislarge,giventhescopeofthecrisisthatistransformingnotonlybankingandfinancialinstitutionsandmarketsbutalsotheregulatoryandsupervisoryapparatuswithinwhichthoseinstitutionsoperate,in-cludingmostdramaticallytheroleoftheFederalReserve.Onthislastpointalone,textbooksstillteachthatthemaintaskoftheFedistocontroltheshort-termrateofinterestinordertoachievealong-runinflationtarget.Eversincethecrisisbegan,however,theFedhasinsteadbeenfightingawar,usingeveryweaponathand,includinganumberofnewonesneverusedbefore.

“Lenderof last resort” is theclassicprescriptionforfinancialcrisis.“Lendfreelybutatahighrate”isthemantraofallcentralbankers,eversincethepublicationofWalterBagehot’smagisterialLombard Street: A Description of the Money Market(1873).ThatiswhattheFeddidduringthefirststagesofthecrisis,asitsold

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2 introduction

off itsholdingsofTreasury securities and lentout theproceedsthroughvariousextensionsofitsdiscountfacility.

Butthen,afterthecollapseofLehmanBrothersandAIG,andthe consequent freeze-up of money markets both domesticallyandinternationally,theFeddidevenmore,shiftingmuchofthewholesalemoneymarketontoitsownbalancesheet,morethandoubling its size in a matter of weeks. In retrospect this movecanbeseenasthebeginningofanewrolefortheFedthatIcall“dealeroflastresort.”

Andthen,onceitbecameapparentthattheemergencymea-sures had stopped the free fall, the Fed moved to replace itstemporary loans to various elements of the financial sectorwith permanent holdings of mortgage-backed securities, essen-tiallyloanstohouseholds.Thisissomethingcompletelynew,notBagehotatall—anextensionof“dealeroflastresort”tothepri-vatecapitalmarket.

Thetransformationof theFed’s roleduringthiscrisis isevi-dent in a simple chart showing the evolution of the Fed’s bal-ancesheet,bothassetsand liabilities, in2007–2009(seefigure1).Thestagesofthecrisisstandoutclearly,markedbykeyturn-ingpoints: thecollapseofBearStearns inMarch2008,andofLehmanBrothersandAIGinSeptember2008.Thechaptersthatfollowareanattempttoprovidethehistoricalandanalyticalcon-text necessary for understandingwhat this chartmeans for us,todayandgoingforward.

A Money View Perspective

It is no accident that the Fed has been at the center of policyresponse. Indeed, a fundamental premiseof this book is that a“moneyview”providestheintellectuallensnecessarytoseeclearly

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introduction 3

thecentralfeaturesofthismultidimensionalcrisis.Thereasonissimple.Itisinthedailyoperationofthemoneymarketthatthecoherenceofthecreditsystem,thatvastwebofpromisestopay,istestedandresolvedascashflowsmeetcashcommitments.Thewebofinterlockingdebtcommitments,eachoneamoreorlessrashpromiseaboutanuncertainfuture, is likeabridgethatwecollectivelyspinoutintotheunknownfuturetowardshoresnot

J2007 2008 2009 2010

F M A M J J A S O N D J F M A M J J A S O N D J F M A M J J A S O N D J0

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Figure 1: Fed assets (top panel) and liabilities (bottom), 2007–2009.Source:FederalReserveBoardH.4.1“FactorsAffectingReserveBalances.”Onlineatwww.federalreserve.gov/releases/h41

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4 introduction

yetvisible.Asabanker’sbank,theFedwatchesovertheconstruc-tionofthatbridgeatthepointwhereitismostvulnerable,rightattheleadingedgebetweenpresentandfuture.Herefailuretomakeapromisedpaymentcanundermineanynumberofotherprom-isedpayments,causingtheentirewebtounravel.

TheFeddoesnot justwatch; italso intervenes.Asabanker’sbank,thecentralbankhasabalancesheetthatgivesitthemeanstomanagethecurrentbalancebetweencashflowsandcashcom-mitments.“Lenderoflastresort”isoneexample,inwhichthecen-tralbanktemporarilyoffersupitsowncashtomeetcommitmentsthatwouldnototherwisebefulfilled.“Bankratepolicy”extendsthiskindofinterventionfromcrisistonormaltimes,inanattempttowardoffcrisisbeforeithappens.Byinterveninginthemoneymarket, theFedseeks toofferabitmoreelasticityor to imposeabitmorediscipline,easingortighteningasconditionswarrant.

Acenturyago,atthetimeofthefoundingoftheFedin1913,this“moneyview”wayofthinkingwasquitecommon,buttodayeconomicdiscussionisinsteaddominatedbytworatherdifferentviews.Ontheonehand,wehavetheviewofeconomics,whichres-olutelylooksthroughtheveilofmoneytoseehowtheprospectsforthepresentgenerationdependoninvestmentsinrealcapitalgoodsthatweremadebygenerationspast.Ontheotherhand,wehavetheviewoffinance,whichfocusesonthepresentvaluationsofcapitalassets,seeingthemasdependententirelyonimaginedfuturecashflowsprojectedbackintothepresent.

The economics view and the finance view meet in the pres-ent,wherecashflowsemergingfrompastrealinvestmentsmeetcashcommitmentsenteredintoinanticipationofanimaginedfu-ture.Thispresentisthenaturalsphereofthemoneyview.Butbotheconomicsandfinanceabstract frommoney; forbothof them,moneyisjusttheplumbingbehindthewalls,takenforgranted.Bothlargelyignorethesophisticatedmechanismthatoperatesto

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introduction 5

channelcashflowswherevertheyareemergingtomeetcashcom-mitmentswherevertheyaremostpressing.Asaconsequence,nei-thertheeconomicsviewnorthefinanceviewhasbeenparticularlywellsuitedforunderstandingthecrisiswehavejustbeenthrough,acrisisduringwhichthecrucialmonetaryplumbingbrokedown,almostbringingtherestofthesystemdownwithit.

Theeconomicsandfinanceviewshavetakenturnsdominatingpostwareconomicdiscussion.First,intheimmediatepost–WorldWarIIdecades,theeconomicsviewheldsway—understandablysointheaftermathofdepressionandworldwar.Privateandpub-licsectoralikebuilttheirpresentonthefoundationsofthepast,the only solid ground that remained after the dust of war hadcleared.Then,inmorerecentdecades,thefinanceviewhasheldsway—excessivelyso,asthepresentcrisisnowconfirms.Privateandpublicsectoralikedreamedfantasticaldreamsaboutthefu-ture,andfinancialmarketsprovidedtheresourcesthatgavethosedreamsachancetobecomereality.

Asaconsequenceofthislongdominanceoftheeconomicsandthenfinanceviews,modernpolicymakershave lost sightof theFed’shistoricalmissiontomanagethebalancebetweendisciplineandelasticityintheinterbankpaymentssystem.InBagehot’sday,theBankofEnglandunderstood“bankrate”asthecostofpush-ingthedayofreckoningoffintothefuture;manipulationofthatcostbytheBankwassupposedtoprovideincentiveformoreorlessrapidrepaymentofoutstandingcredit,andmoreorlessrapidexpansionofnewcredit.Nolonger.Todaypolicymakersunder-standtheFed’sjobtobetakingcompletelyoffthetableanycon-cernabout themere timingof cashflows.Themoneyviewhasbeenobscuredbyotherperspectives.

Abstractingfrommoney,boththeeconomicsandfinanceviewshaveineffecttreatedliquidityasafreegoodand,evenmore,of-fered up their theories of such an ideal world as the norm for

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6 introduction

monetarypolicy.Accordingtothatideal,liquidityshouldnotbescarceatall;usersofthemonetarysystemshouldbemakingde-cisionsbasedontheirintertemporalbudgetconstraints,nottheirimmediatecashconstraints.Ideally,moneyshouldbejustaveilobscuring the real productive economic processes underneath,andthejoboftheFedistogetasclosetothatidealaspossible.Therateofinterestshouldreflectthepriceoftime,notthepriceofliquidity.

Lessons from the Crisis

Onelessonofthecrisisisthatthisidealnormgoestoofar.Ourthinkingaboutmoneyhasmistakenthepropertiesofmodelsthatformalizetheeconomicsandfinanceviewsforpropertiesoftherealworld.Thisisanintellectualerror,butonewithsignificantpracticalconsequencesnot leastbecause it insertsabias towardexcessiveelasticityattheverycenterofmonetarypolicy.Thatbiashasfueledtheassetpricebubblethatcreatedtheconditionsforthecurrentcrisis,andthatbiaswillfuelthenextbubbleaswellunlesswelearnthelessonthatthecurrentcrisishastoteach.

Howeverdidweloseknowledgethatwasoncecommonplace,theknowledgethatcamefromtheoldermoneyview?Thisbooktracestheorigintothewell-meaningAmericaneconomistHar-oldMoultonwho, in1918,urged the importanceof commer-cialbankingforcapitalformation.AccordingtoMoulton,Ameri-canbankshadimprovedonoutdatedBritishpracticebyrelyingonthe“shiftability”(orsalability)oflong-termsecurityholdingstomeetcurrentcashneeds,ratherthanonthe“self-liquidating”characterofshort-termcommercial loans.Thischangeinbank-ingpracticemadeitpossibleforAmericanbankstoparticipateinfinancinglong-terminvestment,andthatparticipationwascru-

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introduction 7

cialforthecapitaldevelopmentofthenation.Atthetime,Moul-ton’sshiftabilitytheoryprovidedintellectualsupportforthosewhosoughttobreakfromtheconservativebankdoctrineofyesteryear,andthushelpedtoshiftthebalancefromexcessivedisciplineto-wardmoreappropriateelasticity,butitalsodidmorethanthat.

ThisbooktellsthestoryofhowthetriumphofMoulton’sshift-abilityview,asaconsequenceofdepressionandwarasmuchasanythingelse,eventuallyledtothealmostcompleteeclipseofthemoneyviewinmoderndiscourse.Todaypolicymakersfocustheirattentionontherateofinterestthatwouldbeestablishedinanideal systemofperfect liquidity. Insteadofmonitoring thebal-ancebetweendisciplineandelasticity,themodernFedattemptsto keep the bank rate of interest in line with an ideal “natu-ral rate”of interest, socalledby theSwedish reformeconomistKnutWicksell.2

Incontrasttothosewhoheldthemoneyview,theacademicWickselldidnotseeanyinherentinstabilityofprivatecreditthatcentralbankersmustmanage,butratheraninherentstabilitythatcentralbankersarepronetomismanage.Accordingtohim,theprofitrateoncapitalisa“naturalrate”ofinterestinthesensethattheeconomywouldbeinequilibriumatthatrate.Theproblemcomeswhencentralbankerschoosea“moneyrate”ofinterestdif-ferent from thisnatural rate. If lower, then thedifferential cre-atesanincentiveforcreditexpansiontofundnewcapitalinvest-ment,andthenewspendingtendstodriveupthegenerallevelofprices.Higherpricesbringimprovedprofitabilityandhencealsoimproved creditworthiness, which creates incentive for furthercreditexpansioninanunsustainablecumulativeupwardspiral.

Wicksell’sacademicwayoflookingattheworldhadclearim-plications formonetarypolicy: set themoney rate equal to thenaturalrateandthenstandbackandletmarketswork.Unfortu-nately,thenaturalrateisnotobservable,butwedoobservethe

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8 introduction

pricelevel,andsowecanusethatasanindicatorofwhetherthemoneyrate is toohighor too low.Ifpricesarerising, thenthemoneyrateistoolowandshouldbeincreased;ifpricesarefalling,thenthemoneyrateistoohighandshouldbedecreased.UnliketheclassicBritishmoneyview,Wickselltellsusthatcentralbank-ershavenoneedtopaycloseattentiontoconditionsinthemoneymarket.Theyjustneedtowatchthepricelevel.

Inmodernformulations,neo-Wicksellianpolicyrulesarede-rived fromsomewhatdifferent analytical foundations, and theyfocusattentionnotonthepricelevelbutinsteadonpriceinfla-tionasanindicatorforpolicy.3Buttheideaisthesame.Centralbankershavenoneedtopayattentiontoconditionsinthemoneymarket.Theyjustneedtowatchpricesandadjust interestratesaccordingly.Onemodernformulationofthistypeistheso-calledTaylor rule,whichuses the levelofaggregate incomeaswellasinflationasanindicatoroftheappropriatesettingforthemoneyrateofinterest.TheStanfordeconomistJohnTaylorhassuggestedthattheoriginofourpresentcrisisliesinthefailureoftheFedtofollowsuchaTaylorrule,choosinginsteadtokeepthemoneyratebelowtherulelevelforaboutfouryears,2002–2005,thusfuelingthebubblethatburstin2007.4

Taylor’sconclusionthattheunderlyingproblemwasexcessivemonetaryeaseiscompatiblewiththeoldermoneyview,butthemoneyviewwouldlooktodevelopmentsinprivatecreditmarketsaswellastoactionsoftheFedinordertounderstandwhathap-pened.Fromamoneyviewperspective,instabilityisthenaturaltendencyofcreditmarkets,notnecessarilyaconsequenceofmon-etarymismanagement;asBagehotfamouslystated,“Moneydoesnotmanageitself.”Acentralbankthatunderstandsitsroletobetheeliminationofliquidityconstraints,however,tendstoexacer-batethisnaturaltendencytowardinstabilitybecauseiteliminatesakeysourceofdisciplinethatwouldotherwiseconstrainindivid-

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introduction 9

ualsandcoordinatetheirmarketbehavior.TheproblemwefaceisnotthattheFedfailedtofollowanappropriateneo-WicksellianTaylorrulebutratherthatneo-Wicksellianpolicyrulesarethem-selvesexcessivelybiasedtowardease.

Suchabias,itisimportanttonote,wouldhavebeenimpos-sible in thecircumstances forwhichthemoneyviewwasorigi-nally developed, namely, the nineteenth-century gold standard.In thosecircumstances, excessiveeasewouldhave ledpromptlytogoldoutflows,threateningmaintenanceofgoldconvertibilityin international exchange markets. The breakdown of the goldstandard,anditsreplacementbyadollarstandard,meantthattheU.S.monetarysystemfacednosuchreserveconstraint.Herewefindfurtherinstitutionalbasisfordeclineofthemoneyview.

TheFed could, of course, have imposed such a reserve con-straintonthesystemasamatterofpolicy,butingeneralitchosenottodoso.(TheVolckerepisodeof1979–1983standsoutastheonlysignificantexception.)Forthatpolicychoice,theintellectualsupport provided by the economics view and then the financeviewwascrucial.Abstractionfromtheplumbingbehindthewallsprovidedscientificsupportforapolicystancethatwasatsystem-aticvariancewithwhattheoldermoneyviewwouldhaverecom-mended.Dominanceoftheeconomicsandfinanceviewsmeantthatpolicymakerschosefromapaletteofpolicyoptionsthatwasbiasedtowardease.

Thatsaid,releasefromtheexcessivedisciplineofthegoldstan-dardwascertainlyagoodthing,anditfollowsthatrestorationoftheBagehot-eramoneyview isnosolutionto thecurrentcrisisineconomicthinking.Biastowardexcessivedisciplineisnoan-swertothecurrentbiastowardexcessiveelasticity.Instead,whatisneededisarestorationoftheancientcentralbankingfocusonthebalance between discipline and elasticity. Furthermore, becausethemoderneconomicandfinancialworldismuchchangedfrom

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10 introduction

theworldinwhichthemoneyvieworiginallyarose,restorationofancientwisdommustbeaccompaniedbyreconstructionformod-ernconditionsandconcerns.

Thisbookseekstobeginthatreconstructionbytakingareso-lutelymoneyviewapproach tounderstanding the recent creditcrisis,andbydrawinglessonsfromthatcrisisforthefuture.ThemainlessonisthatamodernmoneyviewrequiresupdatingBage-hot’sconceptionofthecentralbankasa“lenderof lastresort.”Under the conditions of the New Lombard Street, the centralbankisbetterconceptualizedasa“dealeroflastresort.”

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ONE

LombardStreet,OldandNew

Writing in 1967, before he had yet formulated his famous Fi-nancial Instability Hypothesis, the American monetary econo-mistHymanMinskyidentifiedthestartingpointforhisanalysis.“Capitalismisessentiallyafinancialsystem,andthepeculiarbe-havioralattributesofacapitalisteconomycenteraroundtheim-pactoffinanceonsystembehavior.”1Fromthispointofview,thekeyinstitutionsofmoderncapitalismareitsfinancialinstitutions,whichmakeabusinessoutofmanagingthedailyinflowandout-flowofcashontheirbalancesheets.Andthequintessentialfinan-cialinstitutionsarebanks,whosedailycashinflowsandoutflowsarethemechanismofthemodernpaymentssystem.

Everyoneelse—households,businesses,governments,evenen-tirenations—isalsoafinancial institution since, inaddition towhateverelsetheydo,theymustattendtotheconsequencesoftheiractivitiesfortheirowndailycashflow.Indeed,thisdailycashflow,inandout,isthecrucialinterfacewhereeachofusconnectswiththelargersystem.Thisinterfaceprovidesthecashthatmakesitpossibleforustopursuetodaydreamsforthefuturethatwouldotherwisebeimpossible;butitdoessoatthecostofcommittingustomakefuturepaymentsthatcan,ifourdreamsdonotworkout,constrainourindependencemoreorlessseverely.Theseduc-tiveallureofpresentcreditandthecrushingburdenoffuturedebtaretwofacesofthesamecreature.

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12 chapterone

The Inherent Instability of Credit

Thetwofacesofcreditshowthemselvesnotonlyatthelevelofeachindividual,butalsoatthelevelofthesystemasawholebe-causeoneperson’scashinflowisanotherperson’scashoutflow.Iftheallureofcreditinducesonepersontoincreasespending,theimmediateresultisincomesomewhereelseinthesystem,whichincomeisthenavailableforadditionalspending.Similarly,iftheburdenofdebtinducesonepersontodecreasespending,theim-mediateresultisreducedincomesomewhereelseinthesystem,andthuspossiblyalsoreducedspending.Thisinteractionofbal-ancesheetsisthesourceofwhattheBritishmonetaryeconomistRalph Hawtrey called the inherent instability of credit.2 In hisview,themainjobofthecentralbankistopreventacredit-fueledbubble fromevergetting started, inorder toavoid thecollapsethatinevitablyfollows.

But, from another point of view, the inherent instability ofcreditisnotentirelyabadthing.Onthewayup,realthingsgetbuilt,newtechnologiesgetimplemented,andproductivecapacityexpands.TheAustrianeconomistJosephSchumpeteralwaysin-sistedthatcreditiscriticalfortheprocessof“creativedestruction”thatisthesourceofcapitalism’sdynamism,becauseitprovidesthecrucialmechanismthatallowsthenewtobidresourcesawayfromtheold.Instability is, fromthispointofview, inseparablefromgrowth,andacentralbankthatintervenestocontrolinstabilityrunstheriskofkillingoffgrowthbystiflingthenewonthewayupandcoddlingtheoldonthewaydown.3

Inanyconcretecase,thequestionthereforearises:arewelook-ingataHawtreyanspeculativebubblethatwewanttoreinin,oratSchumpeteriandynamicgrowththatwewanttoletrun?Onereasonthisquestionishardtoansweristhatacredit-fueledboomtypically involvesabitofboth.Thatiswhyweseemalwaysto

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lombardstreet,oldandnew 13

betemptedtodrawadistinctionbetweenspeculativeandpro-ductivecredit,andtolookforwaystochannelcreditpreferen-tiallytothelatter.Butinpracticethedistinctionisoftendifficulttodrawand,evenmoreproblematic,discriminationincredital-locationisoftenimpossibletoimplement.Inthislatterregard,the institutional structure of finance, including the regulatorystructure,iscrucial.Ifpotentialborrowersandlenderscanfindoneanotheranddobusinessoutsidethereachoftheauthorities,thenitwillbeimpossibletoallocatecreditpreferentiallytoso-ciallydesirableuses,evenassumingtheycouldbeidentifiedandagreedon.(Insuchasituation,evencontrolofaggregatecreditcanbequitedifficult.)

Inthelastanalysis,theonlydependablesourceofleverageoverthesystemasawholeistheroleofthecentralbankasabanker’sbank.Ifbanksarethequintessentialfinancialinstitutionbecauseoftheirmanagementoftheretailpaymentssystem,thenthecen-tralbankisthequintessentialbankbecauseofitsmanagementofthepaymentssystemthatbanksthemselvesuse.Whenonebankmakesapayment toanother, themechanisminvolveschangingentriesonthebalancesheetofthecentralbank;thereisadebittotheaccountofthebankpayingandacredittotheaccountofthebankbeingpaid.Here,intherequirementtosettlenetpaymentseverydayonthebooksofthecentralbank,wefindthelocationoftheultimatedisciplinefortheentiresystem.

Hyman Minsky called this requirement the “survival con-straint”—cashinflowsmustbesufficienttomeetcashoutflows—andweall face sucha constraint.Forbanks, the survival con-strainttakestheconcreteformofa“reserveconstraint”becausebanks settle net payments using their reserve accounts at thecentralbank.Theleveragethatthecentralbankenjoysoverthelarger system arises ultimately from the fact that a bank thatdoesnothavesufficientfundstomakeapaymentmustborrow

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14 chapterone

fromthecentralbank.Insuchacircumstance,thecentralbankmustlendorelseriskabreakdownofthepaymentssystem,butthe lendingdoesnothavetobecheaporeasy.It is thecentralbank’scontroloverthepriceandavailabilityoffundsatthismo-mentofnecessitythatisthesourceofitscontroloverthesystemmoregenerally.

Opportunities for such control arise naturally from time totime,simplybecauseoffluctuationsinthepatternofpayments,butthecentralbankcanalsocreatesuchopportunitiesastheneedarises.Justso,whenthecentralbank“tightensmoney”bysellingTreasurybills, the consequence is that the banking system as awholehastomakepaymentstothecentralbank,whichamountstotighteningthesurvivalconstraintthatallbankersface.Alterna-tively,whenthecentralbank“loosensmoney”bybuyingTreasurybills,theconsequenceisthatthebankingsystemasawholere-ceivespaymentsfromthecentralbank,thusrelaxingthesurvivalconstraint.Theeffectsof thesecentralbank interventions showupintheshort-termrateofinterestthatbankspayasthecostofputtingofftothefutureapaymentthatisduetoday.Historically,theartofcentralbankingwasallaboutthechoiceofwhethertoraiseorlowerthatcost.

Thecentralbank’sabilitytoinfluencethedegreeofdisciplineor elasticity faced by banks at the daily clearing provides somecontroloverthecreditsystemasawhole,butthatcontrolisbynomeansabsolute.Privatecreditelasticityisalwaysasubstitutefor public credit elasticity. In its attempt to impose discipline,sometimesthemostthecentralbankcandoistoforcebankstofindandusealternativeprivatecreditchannels.Similarly,initsat-tempttoimposeelasticity,sometimesthemostacentralbankcandoistoofferitsownpubliccreditasanalternativetocollapsingprivatecredit.

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lombardstreet,oldandnew 15

That’swhyHawtreyreferredtothe“art”ofcentralbanking,ratherthanthe“science”orthe“engineering.”4Thecentralbankcanuse its balance sheet to impose abitmoredisciplinewhentheprivatemarketistooundisciplined,anditcanuseitsbalancesheettoofferabitmoreelasticitywhentheprivatemarketisim-posingexcessivediscipline.Butitisonlyonebankandultimatelysmallrelativetothesystemitengages,especiallysointhemodernglobalizedfinancialsysteminwhichprivatecreditmarketsareallconnectedintoanintegratedwhole.Becausethecentralbankisnotall-powerful,itisespeciallyimportantthatitchooseitspolicyinterventioncarefully,withafullappreciationoftheoriginsoftheinstabilitythatitistryingtocounter.

AccordingtoHawtrey,theinherentinstabilityofcredithasitsorigininthewaythatcredit-financedspendingbysomecreatesincomeforothers,notonlydirectlybutalsoindirectlybypush-ingupthepriceofthegoodbeingpurchased,thusproducinganupwardrevaluationofexistinginventoriesofthegood.Thecapi-tal gain forholdersof inventories tends to stimulate additionalspending,inparttobuyaheadofrisingdemandinordertoearnadditionalprofitfromrisingpricesinthefuture.Becauserevalu-ationof existing inventories tends to improve creditworthiness,thisadditional spending is easy tofinance,eveneasier than theinitialspending.Thefeedbackloopofrisingassetpricesandcreditexpansionisthesourceoftheinherentinstabilityofcreditempha-sizedbyHawtrey.

The price-credit feedback mechanism is also the reason thatcredit-fueledbubblesaresodifficulttocontrol,becauseitmeansthatcentralbankinterestratepolicycansometimeshaveverylit-tletraction.Thequestionforthespeculatorisonlywhethertherateofappreciationoftheunderlyingassetisgreaterthantherateofinterest,andthatisaconditionoftenquiteeasilysatisfied.If

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16 chapterone

housepricesareappreciatingat15percentayear,ittakesaninter-estrateofgreaterthan15percenttostiflethebubble.Evensup-posingthatthecentralbankisabletoimposesuchahighinterestrate,15percentwouldstiflealotofotherthingsaswell.Conclu-sion:ifyoudon’tcatchthebubbleearly,itmaybeimpossibletodoanythingusinginterestratepolicy.

Meanwhile, the larger thebubble grows, thegreater thedis-tortionintheallocationofcreditandintheallocationofrealre-sourcescommandedbythatcredit.Notonlydoesabubblepros-pectof15percentattractnewcreditdisproportionately,butalsoitbidsupthepriceofcreditacrosstheboard.Borrowersandlend-ersfindoneanotherata risingmarket rateof interest,andthecentralbankmustraiseitspolicyratemerelytokeepup.Eventu-ally,andlongbeforeinterestratesreach15percent,theeffectsofhighermarketinterestratesarefeltonnonbubblebalancesheetsthroughouttheeconomy,anditistheseeffectsthatbringthebub-bletoanend.

Thewayitworksisthis.Higherinterestratesmeangreatercashoutflowsfordebtors,andeventuallythemostvulnerableamongthemfindtheircashoutflowsexceedingtheircashinflows.Ifyouareoneofthosevulnerabledebtors,Minsky’ssurvivalconstraintbeginstobindforyou.Logicallythereareonlythreewaysout.First,youcanspenddownanycashbalancesyoumayhave,butthesebalancesarefiniteandquicklyexhausted.Second,youcanborrowtocovertheshortfall,butcreditlinesarealsofinite,andevenpossibly contracting in the face of declining creditworthi-ness.Third,youcansellsomeofyourearningassets,forwhateverpricetheywillfetchonthemarket.Typicallythesethreewaysoutareusedsequentially,asdebtorsholdonforaslongastheycan,hopingthatsomeotherbalancesheetinthesystemwillprovetobetheweakestlink.Theimportantpointisthatsoonerorlaterassetpricescomeunderpressure,notjustthepricesthatwereris-

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lombardstreet,oldandnew 17

ingat15percentbutallassetprices,andespeciallythepriceoftheassetsheldbythemostvulnerabledebtors,whoareforcedtoliquidatefirst.

When that happens, liquidity problems (the survival con-straint)becomesolvencyproblems,andespeciallysoforhighlyleveragedfinancialinstitutions.Eveniftheyarenotforcedtosellassetsinordertomakepromisedpayments,theymaybeforcedtowritedownthevaluationofthoseassetstoreflectcurrentmar-ket prices. Forhighly leveraged institutions,withfinancial lia-bilitiesmanytimeslargerthantheircapitalbase,itdoesn’ttakemuchofawrite-downtoproducetechnicalinsolvency.Andevenbeforeinsolvency,assetwrite-downscanquicklygenerateseriousliquidityproblemsascreditlinesshrinktofitreducedcollateralvaluations.Liquidityandsolvencyproblemsthusreinforceoneanotheronthewaydown,justascreditexpansionandassetvalu-ationdoonthewayup.Thisisthedownsideoftheinherentin-stabilityofcredit.

Onthewayup,ashasbeenemphasized,thecentralbanktendsnottohavemuchtraction,sinceborrowersandlendersshareaninterestinavoidingcentralbankdiscipline.Onthewaydownasimilarmutualinterest,nowinavoidingmarketdiscipline,bringsbothborrowersandlendersbacktothecentralbankasthe lastavailablesourceofcreditelasticity.“Lenderof lastresort” inter-ventioninvolvesthecentralbankextendingcreditwhennooneelsewill (orcan); ineffect, thecentralbankrelaxes thesurvivalconstraint by providing current cash inflow to allow borrowerstodelaythedayofreckoning.Usedwisely,suchinterventioncancontrol thedownturn andprevent it from turning into a rout.Usedunwisely,suchinterventioncanfosterfurthercontinuationofunhealthybubbleconditions.Inacrisis,asinnormaltimes,theartofcentralbankingisallaboutwalkingthefinelinebetweenprovidingtoomuchdisciplineversustoomuchelasticity.

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18 chapterone

The Old Lombard Street

The impact and effectiveness of central bank control both de-pend crucially on the institutional organization of the bankingsystem, and on its articulation with the financial system moregenerally.Walter Bagehot’s Lombard Street explored these ques-tionsinthecontextoftheLondonmoneymarketofhisday,asetofinstitutionalarrangementsdifferentinimportantrespectsfrommodernarrangements,butnonethelessagoodstartingpointbe-cause theconclusions thatBagehotdrewcontinue to shape thewaywe think today.TheBagehotprinciple that guided centralbankers in the current crisis has its origin in that nineteenth-centurybook.

TodaywesummarizetheBagehotprincipleas“lendfreelybutatahighrate.”HereareBagehot’sownwords(1906[1873],197):“Theendistostaythepanic.Andforthispurposetherearetworules:—First.Thattheseloansshouldonlybemadeataveryhighrate of interest.  .  .  . Secondly. That at this rate these advancesshouldbemadeonallgoodbankingsecurities,andaslargelyasthepublicaskforthem.”WhydidBagehotthinkthiswaswisepolicyforhisworld,andisitstillwisepolicyforourownverydif-ferentmodernworld?

Bagehot’sworldwasbasedonashort-termcommercialcreditinstrumentknownas thebillof exchange.Firms issuedbills inordertobuyinputsfortheirownproductionprocesses,andtheyacceptedbillsaspaymentfortheirownoutputs.Thebillofex-changewasapromisetopayataspecificfuturedate,perhapsinninetydays.Forafee,bankswould“accept”bills,whichmeantguaranteeingpayment.Foranotherfee,bankswould“discount”bills,whichmeantbuyingthemforlessthanfacevalue,thediffer-enceamountingtoarateofinteresttobeearnedoverthetermtomaturity.Aspaymentforthebills,bankswouldoffereithercur-rencyoradepositaccountcredit.Eitherway,theproceedsofthe

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lombardstreet,oldandnew 19

discountweremosttypicallynotheldasidlebalancesbutratherspentinpaymentofothermaturingbills.Inthisway,thediscountmechanism was crucial for British firms’ management of theirdailycashflow,inandout.

Ideally,over theninetydaysbetween issueandmaturity, thefirmthatissuedthebillwouldusetheinputssoacquiredtopro-duceoutputforsale,andthenusethesaleproceedstopaythebillasitcamedue.Timelyrepaymentthusdependedontimelysaleoftheproductionfinancedbythebill.Assumingtimelyrepayment,thebankingbusinesswas all aboutmanagingone’sportfolioofbillsinordertomatchupthetimingofcashinflows(frommatur-ingbills)withthetimingofcashoutflows(fornewdiscounts).Ifeverafirmfailedtopay,however,thentheacceptingbankwouldexperienceacashshortfall.

In this system,banksmanaged their owndaily cashflowbymanaging the discount rate they quoted to their customers. Ifrequests fordiscountweredepletingone’scashreserve,onehadmerelytoraiseone’sdiscountrateandthebusinesswouldgoelse-where;ifmaturingbillswereswellingone’scashreserve,onesim-plyloweredthediscountratetoattractadditionalinterest-payingbusiness.Inthisway,themarketrateofinterestfluctuatedaccord-ingtosupplyanddemand.Therateofinterestwashighwhenre-questsfornewdiscountwererunningaheadofrepayments,andlowwhenthebalancewenttheotherway.

ItwasinthisinstitutionalcontextthattheBankofEnglandde-velopedtheprinciplesofcentralbankmanagementthatlaidthefoundationsformodernmonetarytheory.Atfirst,soBagehotre-lates,theBankthoughtofitselfassimplyoneamongotherbanks,responsible to its shareholders for theprofitability of its opera-tions,andwithnolargerresponsibilityforthesystemasawhole.Inaccordancewiththiswayofthinking,theBankmoveditsdis-countrateinlinewiththemarketinordertoattractitsrightfulshareofthediscountbusiness.

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20 chapterone

Theexperienceofperiodicfinancialcrises,however,eventuallytaughtthelessonthattheBankwasnotlikeotherbanksinsofarasitwasthecentralrepositoryofcashreservesfortheentiresystem.Intimesofgeneralcrisis,allbankslookedtotheBankofEnglandforhelp,andinordertoprepareforthatdaytheBankhadtosafe-guarditsownreserve.Thatmeantkeepingitsowndiscountrateordinarilysomewhathigherthanthemarketrate,evenatthecostofsacrificingsomediscountbusinessandthusshareholderprofit.

Inthiscontext,theBagehotprinciplecanbeunderstoodasthedistillationofhard-wonpracticalwisdomabouthowtodealwithacrisiswhenonecomes.Theproximateoriginofthecrisiscouldbemanythings,butfromthepointofviewoftheBankitalwaystooktheformofalarge,oftensudden,demandforcash.Anyhic-cupincurrentsaleswouldmeanthatmaturingbillscouldnotbepaidbytheirissuer.Asaconsequence,theacceptingbankwouldbecalledontomakegoodfromitsownresources,whichinvolveddrawing down reserves held at the Bank of England and then,shouldthatproveinsufficient,borrowingmore.

IftheBankofEnglandfailedtolendinsuchacircumstance,theneedybankwouldbeunable tomeet itscommitmentsandthose who had been expecting payment from that bank wouldsimilarly find themselves unable to meet their own commit-ments,andsoonandsoonasthecascadeofnonpaymentspreadthroughouttheeconomy.TheBagehotprinciplewasdesignedtostopthepotentialcascadebyprovidingcompletelyelastic lend-ingtoneedybanksagainstanysecuritythatwouldbeacceptableinnormaltimes.Butitwasalsodesignedtoprovidedisciplinebychargingahighrateofinterest.Onlythosewhoreallyneededthecashwouldborrowatthehighrate,andthehighratewouldalsoprovideincentivetorepaytheloanassoonaspossible.

TheproblemwithelasticlendingintimeofcrisiswasthatittendedtodrainthenotereservesoftheBankofEngland.Under

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lombardstreet,oldandnew 21

theprovisionsofPeel’sActof1844,thenoteissuewasfixed,andanyadditionalnoteshadtobebacked100percentbyadditionalgoldreserves.Innormaltimes,theBankheldasignificantfrac-tionofthenoteissueasreserveagainstdeposits intheBankingDepartment,anditwasthesedepositsthatservedasreservesforthebankingsystematlarge.Duringacrisis,thedemandforcashwasmetbothbypayingoutcashreserves(notes)andbyexpand-ingthesupplyofcashsubstitutes(deposits).Whenthecrisiswasover,theemergencyloanswouldberepaid,theemergencysupplyof cash substitutes would be extinguished, and the Bank’s cashreservewouldbebuiltupagain.Thatishowitwassupposedtowork,andhowinfactitdidwork,solongasthecrisisremainedwithintheconfinesofBritainitself.

Thepolicyofelasticlendingranintotrouble,however,when-everthecrisisassumedinternationaldimensions,whichmoreof-tenthannotitdid,giventhecentralityofthepoundsterlingintheworldtradingsystem.Thesamebillsofexchangeapparatusthat merchants used to finance domestic production was usedalsotofinanceforeigntrade,tradenotonlybetweenBritishmer-chantsandtheirforeigncounterpartiesbutalsobetweendiffer-entforeignpartiesthemselves.Nomatterwhereyouwereintheworld, if you wanted to import goods, you were likely to paybyissuingabillofexchangepayableatsomeLondonbankandyourcounterpartywaslikelytopresentthatbillofexchangefordiscountpriortomaturityinordertoraisecashtomeethisownpaymentobligations.

Theproblemwasthatforeignersdidnotconsidereithernotesordepositstobeacceptablemeansofpayment;theywantedgold.(Mechanically,paymentwouldbedemandedinnotes,andthosenoteswouldbepresentedtotheIssueDepartmentattheBankofEnglandforpaymentingold.)TheeffectofaforeigndemandforcashwasthustoreducethesupplyofcurrencyinBritainandalso,

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22 chapterone

moreimportant,todraintheBank’sholdingofgold,whichservedasreserveforthenationasawhole.

Notonlyfirmsandbanksbutalsonationshavetolookaftertheirdailybalanceofcashinflowsandoutflows,andfornationsonthegoldstandardthatmeantthedailybalanceofgoldflows.ForBritain,goldflowsweremostlyaboutthebalancebetweenpay-mentsonmaturinginternationalbillsofexchange(goldinflows)versusrequestsfornewdiscounts(goldoutflows).ThemoneyrateofinterestinLondonwasthusasymptomofinternationalaswellasdomesticbalanceand imbalance, and thecentralpositionoftheBankofEngland in theLondonmoneymarketmeant thatitsreservewasessentiallytheinternationalaswellasthenationalreserve.Innormaltimes,ifgoldwasflowingoutofBritain,theBankraiseditsdiscountrateinordertomakenewdiscountslessattractive,thusshiftingthebalanceofpaymentsbackinitsfavor.ThehighrateofinterestrecommendedbyBagehotfortimesofcrisiswasintendednotonlytolimitthesupplyoffundstothosemostinneed,butalsotosafeguardthenation’sgoldreserveinthefaceofapotentialexternaldrain.

By1873,whenBagehotwaswriting,theBankhadgottenusedto its role as lender of last resort domestically, and this was themain focus of the Bagehot principle. But the Bank had not atallgottenusedto its roleas lenderof lastresort internationally,nordidBagehotendorsesucharole.Forhim,elasticitywasallaboutdomestic lending—heretheBankshouldnotsafeguarditsreservebutrathermobilizeit,downtothelastfarthing.Butoncethosefarthingscomeintothehandsofforeignerswhoaskgoldforthem,theBankhastostop.Itcancreatemoredepositstomeetaninternaldrain,butitcannotcreatemoregoldtomeetanexternaldrain.Inacrisis,theBankcouldanddidsuspendthegoldreserverequirementfornotes,thusfreeingupitsgoldholdingsforpay-ment to foreigners.But if thatbufferwaseverexhausted, therewouldbenochoicebuttosuspendconvertibility.

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lombardstreet,oldandnew 23

Clearly,theidealsolutionwouldbetogetforeignerstobehavelikedomesticresidents,whichistosaytoacceptsterlingbalances(depositsorsecurities)assubstitutesforgold.Britain’smostsignif-icantcolonialpossessionalreadydidso,astheyoungJohnMay-nardKeynespointedout inhisfirstbook, Indian Currency and Finance (1913).AccordingtoKeynes, thecaseof India showedthatagold-sterlingexchangesystemwasaworkablearrangementforinternationalmonetaryaffairsmoregenerally.ButWorldWarI, theGreatDepression, andWorldWar IIdashed thatdream.Whatwegotinstead,afterthedustcleared,wasagold-dollarex-changesystemestablishedatBrettonWoodsin1944,whichbe-cameaplaindollarstandardin1973aftertheUnitedStatesaban-donedgoldconvertibility.

The New Lombard Street

OurmodernworldisnotBagehot’sworld,andnotonlybecausethedollarandtheFederalReservehavereplacedthepoundandthe Bank of England, and the dollar standard has replaced thegoldstandard.Forus,themostimportantmoneymarketinstru-mentisnotthebillofexchangebutrathersomethingcalleda“re-purchaseagreement,”orrepo.Reposareissuednottofinancetheprogressofrealgoodstowardfinalsale,asinBagehot’sworld,butrathertofinancetheholdingofsomefinancialasset.

Formally,theunderlyingfinancialassetservesascollateralforashort-termloan,oftenasshortasovernight.The“repurchase”referstoa legalconstructionwherebytheshort-termloanisar-rangedasthesaleofanassetcombinedwithanagreementtore-purchasetheassetattheoriginalsalepriceplussomerateofinter-est.Theoriginalsalepriceislowerthanthemarketvalueoftheassetbyanamountknownas the“haircut”; thepurposeof thehaircutistoprovideextracollateralfortheloan,sothesizeofthe

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24 chapterone

haircutvarieswiththeperceivedriskinessoftheassetbeingusedforcollateral.Thelowestreporates,andthelowesthaircuts,applywhenthecollateralfortheloanisaTreasurybill.

Inourworld,theTreasuryrepomarketplaysaspecialroleasthemaininterfacebetweenthemoneymarketandtheFed.(Ispeakhereof theway thingsworkedbefore thecrisis.)TheFedentersthatmarkettypicallyasalender,offeringshort-termloansofhigh-poweredmoney (deposits at theFed) in return forTreasurybillcollateral.Onadailybasis,theFedmight“tightenmoney”byal-lowingoutstandingrepoloanstomaturewithoutreplacement,oritmight“loosenmoney”byofferingnewandlargerloans.Theim-mediatecounterpartiestotheseloansarethe“primarydealers,”socalledfortheircommitmenttobidforTreasurysecuritieswhenevertheTreasurywishestoborrow.Innormaltimes,thefundsthatthedealersborrowfromtheFedatthedailyrepoauctionarealow-costsourceoffinancefortheirmainbusinessofmakingtwo-waymar-ketsinTreasurysecuritiesbypostingofferstobuyandsell.

ThespecialpositionoftheprimarydealerscanbeconsideredalegacyofWorldWarII,whentheU.S.governmentissuedvastvolumesofTreasurysecuritiesnotonlytofinanceitsownwaref-fortbutalsotofinancethewarspendingofitsallies.Whenthewar was over, the war debt remained, on the balance sheets ofhouseholdsthatwoulduseittopurchasehousesandcars,onthebalancesheetsofcorporationsthatwoulduseittofundconver-sionfromwartimeproduction,andonthebalancesheetsofbanksthatwoulduseittofundprivateloans.Allofthesedebtholdersdependedontheabilitytoconvertgovernmentdebtreadilyintospendablecash,whichistosayontheexistenceofthetwo-waymarketsprovidedbysecuritydealers.

Duringthewaranditsimmediateaftermath,theFeddirectlyfixedthepriceofgovernmentdebt,anddirectlybackstoppedtheconvertibilityofgovernmentdebtintocashatthatfixedprice.Af-

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lombardstreet,oldandnew 25

tertheFed-TreasuryAccordof1951,theFednolongerfixedthepriceofTreasurysecuritiesbutitdidcontinuetoprovideliquiditysupporttotheTreasurymarket.Eventually,eventhatresponsibil-itypassedontotheprimarydealers,withtheFedbackingupthedealersbyprovidingliquiditysupporttothemthroughitsdailyoperationsinTreasuryrepo.

Here then is how the New Lombard Street works. WhereasBagehot’scentralbankusedthediscountratetomanagethesys-tem,theFedfocusesitsattentiononthepriceofovernightlend-inginthefederalfundsmarket,whichisaninterbankmarketfordepositsattheFed.(Anovernightfederalfundsloaninvolvesre-ceiptofreservefundstodayinreturnforpaymentofreservefundstomorrow.)TheFeddoesnotdirectlylendorborrowinthefed-eralfundsmarket,sothe“effective”federalfundsratefluctuatesdependingonsupplyanddemand.InsteadtheFedusestheTrea-suryrepomarkettocontrolthesupplyoftheunderlyingdepositsthatareborrowedandlentinthefederalfundsmarket.

TheFed’smonopolysupplyofbankreservesgivesitconsider-able control over the federal fundsmarket, but there is quite abit of slippage between conditions in the federal funds marketand funding liquidity more generally. The Fed is only a smallplayer in the enormous general collateral repo market wheresecuritydealersfundmostoftheiractivity.AnditisnotaplayeratallintheoffshoremarketinEurodollarbankdeposits,whichisalwaysavailabletobanksasanalternativetofederalfundsand,indeed,hasgrownuptobethemostliquidmoneymarketintheworld.InbothrepoandEurodollarmarkets,borrowersandlend-ersfindoneanotheranddobusinessoutsidethereachoftheFed.5Asalways,privatecreditelasticityisasubstituteforpubliccreditelasticity,indeedoftenanattractivesubstitute.

Nevertheless,itremainstruethatbalancesheetoperationsbytheFedaffect funding liquidity, and thusalsomarket liquidity,

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26 chapterone

throughtheriskcalculusofsecuritydealers.Dealerspostpricesatwhichtheyarewillingtobuyandsellaparticularsecurity—thebuy(bid)pricelowerthanthesell(offerorask)price—andthentheyadjustthosepricesdependingoncustomerresponse.Iftheyfindthemselvesaccumulatingalargepositioninaparticularse-curity,theylowertheirpostedprices.Themainideabehindthispracticeistocontrolriskbyallowingtheirexposuretoincreaseonlyifitcomesatanattractiveprice.Buttheeffectofloweringprice isalsotocontrolcashflowbyattractingmorebuyersandfewersellers,hencemorecash inflowthroughnetsalesand lesscashoutflowthroughnetpurchases.

Actual dealing operations are more sophisticated than this,but even this simple account is enough to make clear that se-curitydealersprovideasensitivelinkbetweenconditionsinthemoney market and conditions in broader financial markets. Atoneendof the chainof causation,wehave theFed setting thefederalfundsrate;attheotherend,wehaveprivatedealersseek-ingprofitbymakingmarkets.Privatedealersborrowinthemon-eymarketinordertofinancetheirmarket-makingoperationsincapitalmarkets;thatisthewaythat“fundingliquidity”inmoneymarketsgetstranslatedinto“marketliquidity”incapitalmarkets.6ThemarketforTreasurysecuritiesisthefirstplacethismarketli-quidityshowsup,butthenitgetsspreadbymeansofarbitragemoreorlessquicklyandefficientlytootherrelatedmarketssuchasthoseforcorporatebondsand,morerecently,residentialmortgage-backedsecurities.(IremindthereaderagainthatIspeakofthewaythingsworkedbeforethecrisis.)

Bycontrast toBagehot’s time,undermodernconditions theFed’s discount window has fallen into disuse. When individ-ualbanksneedmoney tomeet their commitments at thedailyclearing,theyusuallyraise it fromotherbanks inthewholesalemoneymarket.Andwhenthebankingsystemasawholeneeds

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lombardstreet,oldandnew 27

money,thatmoneyisusuallyraisedbysellingsecurityholdingsintoliquidmarkets.BothchannelsarebackstoppedultimatelybytheFed’scommitmenttostabilizethefederalfundsratearoundachosentarget,andbyitsinterventiontomakegoodonthatcom-mitmentbylendingintheTreasuryrepomarket.Putstarkly,un-dermodernconditionstheFedisalwayslendingfreely,butonlytoprimarysecuritydealers,onlyagainstTreasurysecuritycollat-eral, andonlyat theTreasury reporate thatcorresponds to thetargetfederalfundsrate.

Thispracticewas supposed toprevent crisis.Theway itwassupposedtoworkisthattheFedwouldlendfreelytothedeal-ers,andarbitragewoulddotherest,modulosometermspreadbetween Treasury bills and longer-maturity issues, and somecredit spreadbetweenTreasuries andnongovernment issues.Byraisingthefederalfundsrate,theFedwouldraisethefundingcostofmakingmarketsandthusinducesomedeleveragingandpusharoundthespreads.Byloosening,theFedwouldlowerthefund-ingcostandthuslessenthepressuretoliquidate,againpushingaroundthespreads.Thatishowitwassupposedtoworkand,infact,howitdidworkuntiltherecentcrisis.

Inthecrisis,thissystembrokedown.Asassetvaluationscameintoquestion,haircuts forsecuredborrowingrosesharply,evenforTreasuriesbutespeciallyfornon-Treasurysecurities,andtheresultwasforceddeleveraginganddisorderedmarkets.7Theprob-lem was that, in private credit markets, collateral is marked tomarket,nottofundamentalvalue.Bagehot’sadmonitiontolendfreelyagainstanysecuritythatwouldbeacceptablecollateralinnormal times is a principle for central banks only. Individualbankshavealwaysfollowedthesave-yourselfruleoflendingonlyagainstsecuritiesthatcanbereadilyliquidatedincurrentextraor-dinarytimes.Thistimewasnoexception.

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28 chapterone

Inresponsetotheseverecontraction inprivate liquidity, theFedsteppedin,wideningthecategoryofcounterpartiestowhichitwasprepared to lend,andwideningalso thecategoryof col-lateralitwaspreparedtoaccept.BorrowersandlenderswhohadpreviouslyfoundeachotherinthewholesalemoneymarketnowfoundeachotheronlythroughtheintermediationoftheFed.Theresultwas,first,ahollowingoutoftheFed’sbalancesheetas itsoldoffitsTreasurysecurities(totheformerlenders)tofundnewloans (to the former borrowers), and then an explosion of theFed’sbalancesheetasitexpandeditsdepositliabilities(tothefor-mer lenders),andusedtheproceeds to fundadditional lending(totheformerborrowers).

TheFed’sresponsetothecrisiscanbeunderstoodasamodernadaptationoftheBagehotprinciple,atleastinpart.Rephrasedinterms thatconnectupwithmodern institutionalarrangements,Bagehot can be understood as arguing that the central bankshouldactasmoneymarketdealeroflastresort,providingbothborrowersandlenderswithwhattheywantbutatpricesthatareworse than theywouldbegetting if theyweremeetingdirectlyratherthanonthebalancesheetoftheBank.InlinewithBage-hot’sconception,notonlywouldtheborrowerpayahighborrow-ingrate,butalsothelenderwouldacceptalowdepositrate.Itisthegapbetweentheborrowingandlendingratesthatprovidesin-centiveforborrowersandlenderstofindoneanotheragainoncethestormdiesdown.Ineffect,theBagehotprinciplecanbeun-derstoodasrecommendingthatthecentralbankpostawidebid-askspreadinthemoneymarketanduseitsbalancesheettoab-sorbtheresultingflowoforders.

That ismoreor less exactlywhat theFeddid in the variousemergency liquidity facilities that it opened in response to thecrisis.TheFed’sbid-askspreadwasnotalwaysaswideasBagehotmighthavewished—theFedchargedonlyasmallspreadoverthe

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lombardstreet,oldandnew 29

federalfundstargetforitsTermAuctionFacility(TAF)lendingfacility,anditalsopaidinterestonitsdepositliabilities.Butotherfacilitieshadwiderspreads,andasaconsequencewounddownratherquickly—towit,thecommercialpaperfundingfacilityandthecentralbankswapfacility.Sofar,soBagehot.

WhatwasnotBagehotwasthelevelofinterestrates,whichfellalmosttozero.ThiswaspossibleonlybecausetheFed,unlikethenineteenth-centuryBankofEngland,facesnoreserveconstraintin terms of gold.Thewholeworld treats dollar deposits at theFednotonlyasgoodasdollarcurrency,butalsoastheultimateworldreserveinatimeofcrisis.ThatmeansthattheFed,unliketheBankofEngland,cancreatebothmoredomesticdollars tomeetaninternaldrainandmoreinternationaldollarstomeetanexternaldrain.TheFedhasnoneedtosafeguard itsholdingofworldreservesbykeepingthefederalfundsratehigh,sinceworldreservesareitsownliability.

ButjustbecausetheFedcanevadethereserveconstraintthatothersmustobeydoesnotmeanthatitshould.Therearereasonstoquestionwhethersuchevasionisthecorrectpolicyevenforcri-sistimes,andafortiorifornormaltimes.FromaHawtreyanpointofview,theveryfactofthecrisisstandsasanindictmentofFedpolicyintheyearsleadinguptoit.Hawtreywouldhavehadnotroubleunderstandingthepresentcrisisasaconsequenceofthecentralbanklosingcontrolofarunawaycreditexpansion;atroottheboommustbeaproblemofexcessiveelasticityand insuffi-cientdiscipline.Howdidithappenthattheinherentinstabilityofcreditwasallowedtoplayitselfoutasitdid?WherewastheFed?

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TWO

OriginsofthePresentSystem

Monetary thoughtarises frommonetaryexperience,butwithalongandvariablelag.In1913,theFederalReserveActestablishedacentralbankintheUnitedStates,butitcouldnotatthesametimeestablishanynewtraditionofmonetarythought.TherewasalsonoAmericanHawtreyonhandtohelpout, forthesimplereason that therehadbeennoAmericancentralbank since thecharteroftheSecondBankoftheUnitedStateshadbeenallowedtoexpirein1836.Attheoriginofthemodernmonetarysystem,institutionalchangewasdramaticandrapid,butolderpatternsofthoughtcontinuedtoorganizepublicandprofessionaldiscourse.

From National Banking to the Fed

In1913,whatAmericansknewwasnotcentralbankingbutrathertheNationalBankingSystem, an artifact ofCivilWarfinance.TheNationalCurrencyActof1863and theNationalBankingActof1864hadcreatedthenationalbanknote,whichwasissuedbyprivatebanksagainstcollateralofaspecialissueofgovernmentbondspaying2percentinterest.Themainpurposeoftheactwasto support themarket forgovernmentbonds,but the long-runconsequencewas tofix the supply of note currency.Even afterreturntothegoldstandardin1879,thisquantitativeconstrainton thenational banknote issue remained. It is because of this

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originsofthepresentsystem 31

fixednotesupplythattheNationalBankingSystemcanbesaidtohavebeenfoundedonthe“currencyprinciple,”whichunder-standsbanknotecurrencyasanalogoustogovernment-issuedfiatcurrency;suchacurrencyissupposedtoretainitsvalueonlybe-causeitiskeptscarce.

On topof the inelasticnote currency therewas apotentiallyelastic deposit currency, founded on the “banking principle,”whichanchorsthevalueofdepositcurrencybymeansofreadyconvertibility into the better note currency (or gold). Prevail-ingbankingtheory,variouslycalledthecommercialloantheoryor the realbillsdoctrine, suggested that individualbankswereonsafeground,withrespecttomaintainingall-importantcon-vertibility,solongastheyconfinedtheirassetholdingsto“self-liquidating”short-termcommercialloans.Theideawasthatthescheduled loan repayments would provide a ready mechanismforrepaymentofdeposits,andhenceforcontractionofthede-positcurrency,shouldthepublicsodesire.Thismechanismwassupposedtoworknotonlyforindividualbanksbutalsoforthebanking systemas awhole. So long asbank assetswere limitedlargelytocommercialloans,thesupplyofcreditandmoneywassupposedautomaticallytoexpandandcontractinlinewiththe“needs of trade.” No central authority was supposed to be re-quired; automatic self-regulation would make active manage-mentunnecessary.

That is how the National Banking System was supposed towork,butnotinfacthowitdidwork.IntheU.S.context,themostsignificantfluctuationintheneedsoftradewasseasonal,aconsequenceof the largelyagricultural characterof thecountryatthetime.Theinelasticityofthenoteissue,combinedwiththerigidityofrequiredreserveratios,meantthatdepositscouldnotsoeasilyexpandandcontractasneeded.An individual lendingbanksoon found itself losing reservesasnewlycreateddeposits

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32 chaptertwo

were transferred as payment to banks elsewhere in the system,andthereforefounditselfforcedtoborrowitsreservesback.Atharvest time,whencreditwasexpandinggenerally,otherbankswouldalsobeattemptingtoobtainthesamereserves,thusdriv-ingupthewholesalemoneyrateofinterest.Anticipatingthedif-ficultyofacquiringreservesintimeofneed,banksthereforeheldontoexcessreservesintimeofslack,sendingthemtotheNewYorkmoneymarketwheretheydrovedownthewholesalemoneyrateofinterest.

Reserveswerethusalwayseithertootight,pushingupinter-estratesandattractinggoldinflowsfromthemoreelasticinter-nationalmoneymarket,ortheyweretooloose,providingcheapfundsforstockmarketspeculationinNewYork.Theresultwasaregularseasonalityininterestrates,punctuatedbyregularfinan-cialcrisesin1873,1884,1893,andfinally1907.Ineachofthesecrises,bankersfoundawaytogetaroundtheacutereservescar-citybyissuingquasi-legaltemporaryemergencycurrencyagainstprivatedebtcollateral.TheAldrich-VreelandActof1908createdforthefirsttimealegalframeworkforthisemergencyprocedure.Andthen,followingtheabortive1912AldrichBill,theFederalReserveActof1913wentevenfurther.1

FortheframersoftheFederalReserveAct,theproblemwiththeNationalBankingSystemseemedclear.Depositswerenotap-propriatelyelasticbecausereserveswerenotappropriatelyelastic,and reserves were not appropriately elastic because the note is-suewasnotappropriatelyelastic.TheFederalReserveActsoughttoaddressall threeproblemsat thesametime,andthus toad-dressnotonlytheproblemofoccasionalemergencybutalsotheproblemofregularseasonalstress.Tomakethesupplyofreserveselastic, the act createdFederalReserveBanks chargedwithdis-counting commercial loans, to add reserves to the system.Andtomakethesupplyofnoteselastic,theactprovidedfor(elastic)

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originsofthepresentsystem 33

commercialloanstoreplace(inelastic)governmentbondsascol-lateralbackingforthenoteissue.Asoneobserverremarked,“Tak-ingthesystemasawhole,itwillbeseenthatitgivesathoroughlyelasticsupplyofcredit.Ithasallofthenecessaryelements:elasticnoteissue,elasticdepositsandelasticreserves.”2

TheFederalReserveSystemwasthusfoundedontheideathatthe commercial loan theory for individual banks could be ex-tendedtoatheoryofcentralbankingaswell.GoldconvertibilitywouldsafeguardthevalueofthenewFederalReservenote,andindividualReserveBankswouldbeonsafegroundinexpandingtheirdeposit liabilities so longas the correspondingassetswerelimited to self-liquidating short-term commercial loans. SincetheReserveBankswereinfactbanks,thisextensionofstandardtheoryprobablydidnotseemveryfar-fetched.

Amorecontroversialextensionwas the inclusionofbusinessandfarmingloans,inadditiontothemoreorthodoxtradeaccep-tances(theclassicbillsofexchange),aseligiblecollateral.3Eventradeacceptanceshadalreadyprovennottobedependablyself-liquidatinginacrisis—hencetheneedforacentralbanklenderoflastresort—sotheexpansiontoevenlessclearlyself-liquidatingpaperconstitutedanimportantmoveawayfromthefundamentalprincipleunderlyingthecommercialloantheory.ButthatmovehadlongbeforebeeneffectedasanadaptationofBritishinstitu-tionstoAmericanconditions.4TheplainfactofthematterwasthatindustryandfarmingwererelativelymuchmoreimportantfortheU.S.economythanfortheBritish,sotheideaoffocusingbanking narrowly around trade never had much plausibility intheUnitedStates,especiallyforbankslocatedintheindustrialoragriculturalheartland.

Notwithstanding this important nod to indigenous condi-tions,thecommercialloantheorycontinuedtoexertitsintellec-tualforceintheframers’attempttodrawalinebetweenproduc-

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34 chaptertwo

tiveandspeculativecredit,theformerbeingeligibleandthelatterineligiblefordiscountattheFed.Byinsistingonthisdistinction,theframerswerewillfullyignoringafurtherindigenousdevelop-ment,infacttryingtolegislatethatindigenousdevelopmentoutofexistence.UnliketheirBritishcounterparts,andnotwithstand-ingorthodoxbanking theory,Americanbankshadalwaysbeenmoreorlessdeeplyinvolvedwithfinancingnotonlyworkingcap-italbutalsofixedcapital.Asaconsequence,mostbankshadsub-stantialholdingsofbondsandstocks, loansonbondandstockcollateral,andloansonmortgageorrealestatecollateral,allassetsthatorthodoxbankingtheorywouldrelegatetosavingsbanksorotherlong-terminvestors.

Becauseof thisasset structure,Americanbankshadcometorelyfortheirdailyliquiditynotsomuchontheself-liquidatingcharacterof their commercial loanportfoliosbut ratheron the“shiftability” of their investment portfolios in liquid markets.Linesofcreditwithotherbankstypicallyservedasthefirstlineofdefense.Butafterthat,high-qualitybondswereusedasasecond-aryreserve,eitherbysellingthemoutrightorbyusingthemascollateraltoobtainfundsbyborrowing(repurchaseagreements).Suchshiftabilitydependedultimatelyonsecuritydealersandotherspeculatorsbeingwillingtobuytheassets thatbankswantedtosell, and so-called speculative credit was always the lifeblood ofthedealerbusiness.Thus,paradoxically,itwasspeculativecredit,not productive credit, that had been the source of liquidity formost American banks in the years before the Fed. The framersknewthis,buttheyvieweditaspartoftheproblemthattheyweretryingtofix.

Intheevent,andnotwithstandingtheframers’bestlegislativeefforts,theactdidnotsucceedinreplacingtheindigenoussystemof “artificial” liquidity with an idealized system of “natural” li-quidity.Rathertheactmerelymadeclearthatoneparticularsub-

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originsofthepresentsystem 35

setofassets,commercialloans,wouldbeshiftabletotheFedintimeofcrisis, andnot the restof theassets that thebankshadbeen more commonly using among themselves. But there wasnothingintheacttopreventbanksfromcontinuingtheirformerpractice,andsotheydid,after the foundingof theFed, justasbefore;asoneobserversummarizedin1918,“Liquidityistanta-mounttoshiftability.”5

Theproblemwouldcomenot innormal times,but intimesofcrisis.Predictably, the shiftabilityofevenhigh-qualitybondswouldproveunreliablewheneveryonewastryingtosellandtherewerenobuyers.Inthisregard,thesupposed“artificial”liquidityofshiftableassetswasnodifferentfromthesupposed“natural”li-quidityofcommercialloans.Inacrisis,liquidityalwaysdependsoninterbankaccommodation.“Itrestsupontheabilityeithertodrawuponunusedreservoirsofreserves[suchastheinternationalgold reserve]or to createnew formsof reservemoney [such asquasi-legalclearinghousenotes]thatcanbeusedasabasisforanexpansionofloans.”6

Fromthispointofview,themostimportantinnovationoftheFederalReserveSystemwastoprovidearoutinemechanismforcreationofreservemoneyintimesofcrisis.“UndertheFederalReserveSystemitisofcourseapparentthatliquidityisaquestionofshiftabilitytotheFederalReservebanks.”7Atthetimetheactwaswritten, thecommercial loan theoryofbankingwas in themindof its framers, so they favored limiting shiftability to thenormallyself-liquidatingcommercialloan.Thefatalimplicationofthislimitationwouldnotbecomeevidentuntilthebankingcri-sisthatfollowedthestockmarketcrashofOctober1929.

Meanwhile, fromthevery start itwasclear toobservers thatthesystemwasnotworkingastheframershadintended.Requestsfordiscountaccommodationbymemberbankswereneververystrong,so,inanattempttoacquiresomeearningassets,theRe-

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36 chaptertwo

serveBanksfoundthemselvesbuyingeligiblepaperintheopenmarket, which is to say from dealers in that paper rather thanfrombanks.Furthermore,inanattempttofulfilltheirremittoreplace the National Bank note with the Federal Reserve note,theReserveBanksfoundthemselvesenteringthebondmarkettopurchasetheunderlying2percentbonds.8Intheseoperationswefindtheoriginofsubsequentso-calledopenmarketoperations,which can be understood in retrospect as the Fed’s operationalrecognitionof thecentralityof shiftability,notwithstanding thelanguageoftheact.Practicewasprovingdifferentfromtheory.

Hadeventsnotintervened,theFedmighthavecontinuedtoevolveorganicallybydevelopingexplicitmechanismstosupportthe indigenous shiftability mechanism, so providing a liquiditybackstopforsecuritymarketsasawayofsupportingtheliquid-ityofbanksthatreliedontheshiftabilityoftheirassetsinthosemarkets. The ideology of the commercial loan theory stood intheway,ofcourse,butwouldhavebowedtorealityinthisasinprioradaptations.Inanalternativecounterfactualhistory,theFedmightthushaveeventuallygotaroundtodevelopingalendingfa-cilityforsecuritydealers,longbeforethecollapseofBearStearnsinMarch2008forcedittoopenthePrimaryDealerCreditFacil-ity.Anditmightalsohaveeventuallygotaroundtodevelopinga policy for accepting investment assets, maybe even includingmortgagesbackedbyrealestate,wellbeforethecollapseofLeh-manBrothersinSeptember2008forcedittoextenddiscounteli-gibilitytoanyinvestment-gradesecurity.Inotherwords,theFedmighthavebeenabletouseitsfacilitiestoshapemarketdevelop-mentsexante,ratherthanwaitingtomopupthemessexpost.

Suchanaturalprocessofinstitutionalevolutionwas,however,divertedbythecosmiccatastrophesofWorldWarI,theworld-wideDepression,andWorldWarII.Fromabankingperspective,the significantconsequenceof these eventswasanexplosionof

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originsofthepresentsystem 37

governmentdebtandanongoingresponsibilityofthenewFed-eral Reserve System to ensure liquid markets for that debt. Bycosmicaccident,andquiteagainsttheintentionsofboththeor-thodoxframersofthe1913actandtheirshiftabilityopponents,Treasurydebt,notcommercialloans,thusbecametheshiftableas-setsinequanon,andtheconsequentliquidityofTreasurymarketsbecamethesourceofliquidityfortheentiresystem.

From War Finance to Catastrophe

InpreparationforU.S.entryintoWorldWarI,theFederalRe-serveActwasamendedonSeptember7,1916,topermitFederalReservenotestobeissuedagainstTreasurysecuritycollateral.Inthis way, hardly was the ink dry on the Act before the found-ingprinciple thatnotescouldsafelybe issuedonlyagainst self-liquidatingcommercialloanswassimplyshuntedaside.(Forthesakeofappearances,eligiblenotecollateralwasextendednottothesecuritiesthemselvesbutonlytoReserveBankloansagainstgovernmentsecuritycollateral,butthatwasadistinctionwithoutadifference.)Notonlythat,butReserveBankloansagainstgov-ernmentsecuritycollateralweresubsequentlypeggedataprefer-entialrate,belowthecommercialrateandbeloweventheyieldonthesecurityitself.

Conservativebankersthussawtheirworstnightmarerealized,that thegovernmentwoulduse itsauthorityover themonetaryapparatus to gain an advantage over private borrowers.On theotherhand,theverysamebankerswerequicktotakeadvantageof the arbitrage involved inborrowing at thediscountwindowto invest ingovernment securities.Federaldebt expanded fromabout$1billionin1917to$25billionin1919,withtheFederalReserveSystemitselfabsorbingabout$2billionandactingasfis-

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38 chaptertwo

calagenttodistributemuchoftherest.9Ineffect,theFedactedasthegovernment’sprimedealerintheTreasurymarket,absorbingexcessissueintoitsowninventoryandfinancingthatinventorybyexpandingitsownmonetaryliabilities.

During thewar, theFedactedboth tomaintain liquidity intheTreasurybondmarketandtoputafloorunderthepriceofthebondssothattheTreasurycouldcontinuetoborrowcheaply.After thewar, thepricefloorwas relaxedand thediscount ratewasraised,butthepracticeof liquiditysupportcontinued.Thevauntedelasticityofdeposits,notes,andreservesinthepostwarFederalReserveSystemthusderivedfromtheirtwo-wayexchange-abilityforTreasurydebt,notfromtheself-liquidatingpropertiesofcommercialloans.Indeed,despitetheprivilegedpositiongiventocommercialloansbytheFederalReserveAct,therelativeim-portanceofsuchloanscontinuedtodeclinethroughoutthe1920sinfavorofinvestmentsinbondsandmortgagessecuredbyreales-tate.Shiftabilitythuscontinuedtobethetruesourceofliquidityinthesystem,afterthewarasbefore.Thedifferencewasthatthedependenceonspeculativecreditwaslessvisible,asTreasurysecu-ritiesandrepurchaseagreementsusingTreasurycollateralbecametheprincipalsecondaryreserve,andastheFedratherthanprivatesecuritydealersstoodastheultimateguarantorofshiftability.

ThisinvolvementoftheFedinwhatwouldformerlyhavebeenconsideredspeculativecredit isprobablyonereasonthat,attheNewYorkFedanyway,attentionshiftedawayfrom“qualitative”controlofcredit (limitingcredit toproductiveuse)and toward“quantitative”control,specificallydiscountratepolicydirectedataffectingthepriceofcredit.10Thisshiftoffocusinvolvedanaddi-tionalstepawayfrombankingorthodoxy,whichabhorredactivemanagement,butwas verymuch in linewithdevelopments inBritishcentralbankingtheorysinceBagehot,towit,thewritingsofHawtrey,whichstronglyinfluencedBenjaminStrong,thepres-

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originsofthepresentsystem 39

identoftheNewYorkFed.11Indeed,theso-calledStrongrulecanbeunderstoodinthiscontextasestablishingabenchmarkagainstwhichmoreactivistinterventioncouldbecalibrated.12

TheStrongruleinvolvedsettingthediscountrateslightlyabovethemarketrateofinterestandthenusingopenmarketoperationsinTreasurysecuritiestocontrolthequantityofdiscounts.13Theideawas that, as credit expanded,demand fordiscountswouldrise,butexpansionaryopenmarketoperationswouldmeetthatdemand shiftwithout requiring the actual volumeofdiscountstorise.Then,ascreditcontracted,demandfordiscountswouldcontract,butcontractionaryopenmarketoperationswouldmeetthat demand shift also without requiring the actual volume ofdiscountstofall.TheideaoftheStrongrulewasthustousedis-cretionaryopenmarketoperationstoachievetheidealizedresultthat the commercial loan theory imagined couldbe automatic.In thenewFederalReserveSystemoperatingunder theStrongrule,reservescouldexpandasneededandcontractwhennolon-gerneeded,butthisresultwasachievedbyactivetradinginexist-inggovernmentdebtratherthanbypassivediscountingofnewlycreatedcommercialloans.

The most immediate application of the Strong rule was totheseasonalfluctuationofthesystem.Heretherulewasusedtoachieveanapproximateneutralityacrosstheannualcyclebyex-pandingtemporarilyandthencontractingbackagain.Indeed,tosignal its intentionofneutrality, theFedengaged inrepurchaseagreements with security dealers, buying assets when seasonalcreditneedsexpandedbutatthesametimeagreeingtosellthembackatafuturedatewhentheseasonalneedwasexpectedtore-cede.NotethatwhentheFeddoesrepowithasecuritydealer,itlendsmoneytothatdealerandacceptsTreasurycollateralinre-turn.Thisisexactlythekindofspeculativelendingthatorthodoxbankingtheoryabhorred,buttheeffectwastoexpandreservesin

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40 chaptertwo

ordertoenablebankstoengageinexactlythekindofproductivelendingthatorthodoxbankingtheorycelebrated!Asalways,itisnotsoeasytoseparateproductivefromspeculativecredit.

Havingconqueredtheseasonal(farming)problem,theques-tionarosewhether theFedmightalsobeable todosomethingabout the cyclical (industrial)problem.Here, insteadof aneu-tral policy, one might conceive a countercyclical policy alongHawtreyan lines that attempts some constraint during a creditexpansioninordertoheadoffanunsustainablespeculativeup-swing,andsomeeaseduringacreditcontractioninordertoheadoffadownwardspiralofliquidation.Whenitdesiredtorestraincredit, theFedwould sell assetsuntil thequantityofdiscountsrose,andthisunusuallyhighvolumeofdiscountswassupposedtoexertarestraininginfluenceonbanklending.Whenitdesiredtoloosencredit,theFedwouldbuyassetsuntilthequantityofdis-countsfell,andthisunusuallylowvolumeofdiscountswassup-posedtoexertanencouraginginfluence.ThisisthekindofthingthatBenjaminStrongwasexperimentingwithat theNewYorkFed in the1920s,and it seemedtohelp tempercyclicaldown-turnsin1924and1927.

All of this domestic smoothing, both seasonal and cyclical,tookplacewithinthecontextofattemptsattheinternationalleveltoputback inplace someversionof theprewargold standard.Indeed,forsomepeople,thewholepointoftheFederalReserveSystem was to keep domestic seasonal and cyclical fluctuationsinside the country, and thusprevent them fromdisturbing theglobal gold market.14 When additional domestic bank reserveswereneeded,theFedwastoprovidethemitself,andwhentheywerenolongerneeded,theFedwastoreabsorbthem.Asacon-sequence,theworldwouldbebetteroff,butsowouldtheUnitedStatesbecauseitsdomesticinterestratescouldbebothlessvola-

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originsofthepresentsystem 41

tileand loweronaverage.Whyso?Therewouldbenoneedtocompensate foreigners inthegoldmarket fora seasonalround-tripjourneyintothedollarandoutagain.Andalso,intheeventofcyclicalcrises,therewouldbenoneedtospikeratestoattractemergencygoldreserves sinceallof theneededemergencycur-rencycouldbecreatedbytheFed.

ThisinternationalperspectivehelpstoexplaintheFed’spolicythroughoutthe1920sofkeepinginterestrateslowandstablewhilesterilizingtemporarygoldflowsbothinandout.Thispolicyhasoftenbeeninterpretedasanattempttohelptherestoftheworld,andespeciallyEngland,toreturntothegoldstandard.15ButtheFedcouldquitereasonablyhavebelievedthatitwassettingrateswheretheynaturallywouldbe,nowthattheUnitedStateswasnolongerreliantontheinternationalgoldmarkettomeetfluctuat-ingreservedemand.Inretrospect,however,werecognizethatthispolicywasthefuelthatfiredthestockmarketbubblethatledtothe crash in October 1929. Inadvertently, Strong’s interest ratepolicyprovedtobetheoriginalstockmarketput.

BythetimetheFedrealizedwhatwashappening,however,itwastoolate.Contractionaryopenmarketoperationsin1928and1929provedinsufficienttohalttheboom,ascreditoutsidethebankingsystemcontinuedtoexpandonthebasisofexpandingassetvaluations.At thepeakof the speculativeboom, theNewYorkbanksservedaslittlemorethanbrokers,usingtheir“brokers’loansfortheaccountofothers”tochannelfundstothestockmar-ketdespiteeffortsoftheFederalReservetostemtheflow.Hereistheoriginal“shadowbankingsystem.”Inthiscontext,theFed’sattemptstohaltexpansionbyraisingthediscountratecametoolatetobeeffectual,asrisinginterestratesmerelyattractedmorefundstothemarket,evenwhilethreateningthecapitalvaluesonwhichsomuchbanklendingwasbased.Inthelaststageofthe

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42 chaptertwo

boom,highU.S.interestratesevenattractedfundsfromabroad,thusreversingthecreditflowsthathadsustainedthepostwarpat-ternofinternationalpaymentcommitments.

Once the collapse began, expansionary open market opera-tionsprovedinsufficienttohaltit.FocusedastheFedwasonthediscountof commercial loans, itwasprepared to lend freely inacrisis,butnotagainsttheprivatesecuritieswhosefallingvaluewasunderminingthesolvencyofmemberbanks.16Shiftabilityofthoseassetsthusprovedtobeafair-weatherfriend,justasadvo-cateshadanticipated.What thoseadvocatesdidnotanticipate,however, was the inherent instability of credit, to wit, the wayfair-weathershiftabilitywouldoperatetoinflateassetvaluationsonthewayup,andthewaythesubsequentfreezewouldoperatetodeflateassetvaluationsonthewaydown.Andnobodyantici-patedhowthecollapseoftheshadowbankingsystem,whichwasoutside theFed’s control,wouldundermine the actualbankingsystem,whichwassupposedtobeundertheFed’scare.

Theimportantpoint,forourstory,isthatunderAmericancon-ditions,themoneymarketandthesecuritiesmarketshavealwaysbeencompletelyintertwinedand,asaconsequence,ithasneverbeenpossible todistinguish speculative fromproductive credit.ThisintertwiningpredatestheFed,havingitsoriginsinbankre-lianceonshiftabilityundertheNationalBankingSystem.WhatwasnewwiththeFedwastheemphasisonthecommercialloan(intheenablinglegislation)andthenongovernmentdebt(asaconsequenceofwar),buttheintertwiningofmoneyandsecuri-tiesmarketsremained.Interventiontostabilizeseasonalandcycli-calfluctuationsproducedlowandstablemoneyratesofinterest,which supported the investmentboom that fueled theRoaringTwentiesbutalsoproducedanunsustainableassetpricebubble.

Justaseasymoneyhelpedto inflatethesecuritiesbubble, sotoodidtheburstingbubbleoperatetoimplodethemonetarysys-

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originsofthepresentsystem 43

tem.As thebanking systemcollapsed in a series of crises from1931to1933,sotoodidthemoneysupply.FollowingFriedmanandSchwartz,moderneconomistscriticizetheFedforallowingthis,indeedforexacerbatingdeflationbytheill-consideredideatoraisediscountratesin1931inordertostemgoldoutflow.17Atthetime,theeconomistIrvingFishermadeasimilarargument,em-phasizinghowfallingpriceshadexacerbatedtheproblemofover-indebtednessandthusturnedabusinessdownturnintoabusinessdepression.18Writing in1933,Fisher anticipated thatPresidentRoosevelt’s efforts to reflate would quickly restore the precrisispricelevel,thusturningadepressionbackintoamorenormalre-cession—butthatdidn’thappen.Devaluationofthedollaragainstgold did not produce similar devaluation of the dollar againstcommodities,andsubsequentvigorousmonetaryexpansionwaslargelyabsorbedinexpandingbankreserves.

Inretrospect,theFedcertainlycouldhavestarteditsmonetaryexpansionearlierandproceededmoreaggressively,and itcouldhavepromptlysuspendedgoldconvertibilityin1931ratherthanraisingthediscountrate.ButunlesstheFedwaspreparedtodis-counttheprivatesecuritiesthatmadeupthebulkofbankbalancesheets, the banks would have failed anyway. Milton FriedmanblamedtheideologyofthecommercialloantheoryfordistractingtheFedfromthecollapsingmoneysupply.Perhapsmoreimpor-tant, the ideologyof thecommercial loan theoryprevented theFedfrommonetizingbankassetsduringacrisisbecausetheFedconsideredtheseassetstobeinappropriatelyspeculative.

Noncommercial Credit in Depression and War

Asthebankingsystemcollapsed,sotoodidthefragileintellectualbalancingactbetweenconservativebankingand the shiftability

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44 chaptertwo

viewthathadbeensupportingtheFed’scautiousexperimentationthroughoutthe1920s.Mostpressing,defaultsonbankdepositli-abilitiesposedagainthequestionofwhatisanappropriatebankasset,sincebankinsolvencywasmainlyaproblemoffallingmar-ketvalueofassetholdingsandofdefaultsonlong-termlending.Somesawanopportunitytoreasserttheshapingideaoftheorigi-nalFederalReserveActthatself-liquidatingcommercialloansaretheonlyappropriateassetsforaninstitutionthatissuesdepositli-abilitiesthatcanbewithdrawnondemand.Others,lookingevenfurtherback inhistory,arguedthatdeposit liabilities shouldbematchednotwithcreditofeventheverybestkind,butonlywithmonetaryreserves,thusachieving“100percentreserve”money.19

TheBankingActof1933,oftenreferredtoastheGlass-SteagallAct,camedownonneithersideofthisdebate.Instead,itmerelyrequiredseparationofcommercialandinvestmentbankingactivi-tiesintodistinctcorporateentities,ameasurethatmainlyaffectedlargeNewYorkbankssuchasJ. P.Morganandlefttheassetport-foliosofotherbankslargelyuntouched.Crucially,protectionofbankdepositswasachievednotbyregulationofbankassetsbutratherbytheadditionofdepositinsurancethroughthenewlyes-tablishedFederalDepositInsuranceCorporation.

Subsequently,theBankingActof1935,introducedbytheUtahbankerMarrinerS.EcclesafterhisNovember1934appointmentaschairmanoftheFederalReserveBoard,gavetheFedthepowertodiscountany“sound”asset,notjustcommercialloans.Theef-fect,asoneobserverlaterpointedout,wastoeliminateanydis-tinctionbetweenliquidityandsolvency.“Immediateliquidityissimply‘rediscountability’andlongrunliquidityisidenticalwithsolvency.”20 Even more, the effect was to make liquidity into amatterofgovernmentpolicy,notcommercialcalculation.“Butitnowappearsthatinstitutional,legal,orconventionalliquidity,intheformofrediscountabilityorconvertibility[,] istheonlyfea-siblearrangement.”21

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originsofthepresentsystem 45

ThisradicalredefinitionofliquidityasbeingentirelyamatterofFedpolicyfollowednaturallyfromthepriorradicalredefini-tionofsolvencyasbeingentirelyamatterofthepolicyoftheRe-constructionFinanceCorporation(established1932),theFederalHomeLoanBankBoard (1932),or theFederalDeposit Insur-anceCorporation(1933).Ifthegovernmentsaidyouweresolventthenyouwere,becausethatmeantthegovernmentwouldstandbehindyouandpropyouupwithguaranteesandloans.Thegov-ernmentdidnotbuyoutrightthetroubledassetsthatwereweigh-ingdownbankbalancesheets;ratheritrecapitalizedthesurvivingbanksinordertogivethemtimetoworktheirwayoutoftrouble.

In retrospect, the Banking Act of 1935 represents the finaltriumphoftheshiftabilityviewandthefinalrepudiationofthecommercial loan theory.22 By committing itself to lend againstanysoundasset,ineffectthegovernmentcommittedtomakingallsoundassetsequallyandfullyliquid.Thiscommitmentwouldhavefar-reachingconsequencesoncetheemergencywasover,butatthetimenoonewasthinkingaboutthat.Indeed,theradicalnatureoftheshiftwentlargelyunnoticedamongalltheotherrad-icalmeasuresbeingproposed,attempted,andabandonedinthechaoticexperimentationthatwastheNewDeal.Meanwhile,thefailureofevenveryaggressivemonetaryexpansiontoproducere-coveryhadledtodiscreditofmonetarytheoriesacrosstheboard,sopolicyattentionturnedelsewhere,specificallytodirectgovern-mentspending.

Governmentspendinghadlongbeenapartofthepolicyre-sponsetotheGreatDepression,butlargelyforthepurposeofre-lief.Then,in1936,theBritisheconomistJohnMaynardKeynespublishedhisGeneral Theory of Employment, Interest, and Money,arguingthatspendingcouldalsoproducerecovery.23Writingin1938, theHarvardeconomistAlvinHansenproposedanadap-tationoftheKeynesianideaforAmericanconditions:“Govern-mentsallovertheworldareintheprocessofbecominginterme-

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46 chaptertwo

diaries between theultimate savers and investmentoutlets, buttheprocessofproductionisstillcarriedonbyprivateenterprise.Thisisneithersocialisminproductionnorevenintheownershipofwealth.Thegovernmentisbecominganinvestmentbanker.”24

Intheevent, itwasnotthegovernment-financedinvestmentboomenvisionedbyHansenbutratherWorldWarIIthatfinallyproducedsufficientspendingtobringaboutfullemployment,aswellasanessentiallyplannedeconomyinwhichproductionforwarprioritiesdroveallinvestmentandcreditallocationdecisions.Inwartime,evenmorethanindepression,solvencyandliquiditywereamatterofgovernmentpolicy,notcommercialcalculation.Throughoutthewar,theinterestrateonTreasurydebtwasfixedat3/8percentforthree-monthbillsandbetween2and2½per-centforlong-termbonds,anditwasthejoboftheFedtosup-portthesepricesbyofferingtwo-wayconvertibilityintocash.AsinWorldWarI,governmentdebtexploded(from$48billionto$235billion)andsodidFederalReservecredit(from$2billionto$22billion).25

War, depression, and then war again thus finally expungedmemoryoftheNationalBankingSystem,aswellasanyveryclearmemoryof thecommercial loan theoryasanalternative to theshiftability concept.By the endofWorldWar II, banking andcredithadbeenamatterofgovernmentcontrolforanentiregen-eration,andthatitselfexplainswhywartimecontrolsremainedineffectsolong.WithintheFed,especiallywithintheNewYorkFedunderAllanSproul,therewassomeinstitutionalmemoryofhowthingsusedtobe.ButitwasnotuntiltheFed-TreasuryAccordofMarch1951thattheFedwasreleasedfromitswartimeresponsi-bilitytopegthepriceofgovernmentdebt.

Subsequently,underthe“billsonly”policyofthenewboardchairmanWilliamMcChesneyMartin,theFedwasalsoreleasedfrom ongoing responsibility to directly manage the market in

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originsofthepresentsystem 47

long-term debt.26 Thenceforth, the shiftability of long-maturityTreasury bonds would depend on private security dealers, whofunded themselves in the short-term money market. The Fed,operatingthroughtheTreasurybillmarket,wouldsupportshift-abilityinthesecuritiesmarketonlyindirectly,bysupportingthefundingliquidityofthedealers.Inthisway,startingwiththemar-ketforTreasurysecurities,thepre-Depression(andpre-Fed)in-tertwiningof themoneymarketwith the securitiesmarketwasputbackinplaceafterWorldWarII.

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THREE

TheAgeofManagement

Thetriumphoftheshiftabilityviewinthe1935BankActmeantthat, fromthenon, theFedwasprepared toact fullyas lenderof last resort, accepting as collateral any “sound” asset and notlimiting itself to short-term self-liquidating paper. Two yearslater,inacommunicationbytheFederalOpenMarketCommit-tee (FOMC) issued in April 1937, the Fed went even further,committingitselftomaintaining“orderlyconditionsinthemon-eymarket”quitegenerally.1Whatthismeantwasthat,insteadofwaitingpassivelyforbankstorequestloans,theFedwaspreparedto intervene proactively by buying and selling securities in theopenmarket.In1935,shiftabilitywassupposedtobeprovidedbyprivatedealers,operatingwiththeknowledgethattheFed’sdis-countwindowwouldbeavailabletothemiftheygotintotrouble.Thatwasn’tenough,soin1937theFedtookoverresponsibilityforprovidingshiftabilityitself.Ineffect,theFedcommitteditselftoactasasecuritydealer.

Inretrospect,this1937commitmentrepresentsaverysignifi-cantstep,sinceitbroughttotheforefrontofpolicyconsiderationthewholequestionofcapitalassetpricing.Afterall,howistheFedsupposedtoknowwhenthemarketis“disorderly,”andhowisitsupposedtoknowwhatkindofinterventionisneeded?Intheend,thesymptomofdisorderalwayscomesdowntodeviationofassetpricesfromsomeidealizednorm.Ifsellersoftheseven-yearbondfindthattheyhavetomakesignificantpriceconcessionsin

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theageofmanagement 49

ordertoattractbuyers,theFedissupposedtonoticeandstepinasbuyer,whileatthesametimesellingothersecuritiesforwhichbuyinginterestisstronger,saythetwo-yearbond.Suchinterven-tionrequirestheFedtohaveinmindamoreorlessclearnormindicatingwhatcurrentassetpricesshouldbe,sothatitcanusedeviationfromthatnormasanindicationofwhichissuesitoughttobebuyingandwhichissuesitoughttobeselling.

In1937, themoreor lessobvious idealizednormwas some-thing economists call the expectations hypothesis of the termstructure (EH).According to this theory, the returnon a long-termbondshouldbejustanaverageofexpectedshort-terminter-estratesoverthelifeofthebond.Thelogicissimple.Supposeyouhavemoneythatyouwanttoinvestforthenexttwoyears.Youcaneitherbuyabondwithtwoyearstomaturityoryoucanbuyashort-termbillwithonlyoneyeartomaturityandthenreinvesttheproceeds in anotherone-yearbill. Since investors can freelychoosebetweenthesetwostrategies,theymustbeequallyattrac-tiveinmarketequilibrium;bothtwo-yearbondsandone-yearbillshavetobeheldwillinglybysomeone.Onemeasureoftheattrac-tivenessofaninvestmentstrategyissimplyitsyieldtomaturity.Accordingly,theEHsuggeststhattheexpectedyieldtomaturityforeachofthetwoinvestmentstrategiesshouldbethesame.

Appealingas this theory is, it cannotbe thewhole storybe-cause in actual fact the term structure typically slopes upward.Short-terminterestratesaretypicallylowerthanlong-terminter-estrates,soalong-terminvestmenttypicallyyieldsmorethanase-riesofshort-terminvestments.Onewaytounderstandthisappar-entanomalyisthatinvestorsareinfluencedbysomethingotherthanexpectedyieldtomaturity.Maybethelong-terminvestmentismoreriskyinsomeway,andtheextrayieldiscompensationforbearingthatrisk?Certainlyitistruethatlong-terminvestmentscanpotentiallyfluctuateinvaluemuchmorewidelythanshort-

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50 chapterthree

term investments,but thisfluctuationmattersonly if for somereasonyouhavetosellbeforematurity.Thislineofthinkingthussuggeststhattheextrayieldonthelong-terminvestmentisakindof“liquiditypremium”thatcompensatesthelong-terminvestorforthefactthathemayhavetotakealossifforsomereasonheneedstoconverthisinvestmentintocashbeforematurity.

This way of thinking about the term structure was more orlessstateoftheartin1937,andtheFed’s1937commitmenttomaintainorderlyconditions inthemoneymarketcanthereforebeunderstoodasacommitmentrelativetothisnorm.In1937,the Fed’s commitment meant that it would take the “liquiditypremium”asgivenbythemarket,andensureshiftabilityatthatpremium.Overtime,interestrateswouldchange,dependingonmarket conditions. Short rates might rise or fall by more thanlongrates,makingthetermstructureflatterorsteeper,butthatwasnotsupposedtobeanyconcernoftheFed.“Orderlycondi-tionsinthemoneymarket”meantsmoothingpricechanges,in-cludingchangesintheliquiditypremium,notpreventingthem.

WhydidtheFedthinkthatsuchsmoothingwasanappropri-atepolicygoal?Here,perhapsbyanalogytopreviousexperiencewithseasonalsmoothing,theFedseemstohaveunderstooditselfasinterveningtoproducetheoutcomethatthemarketwastrying,unsuccessfully,toachieve.Behindthisapproachwastheideathat,inawell-functioningmarket,privatedealersthemselveswouldbedoing the smoothing,using theirownbalance sheets to absorbtemporaryimbalancesofsupplyanddemand.Buteveninawell-functioningmarketitmightoccasionallyhappenthatthebulkofsomeparticularsecurityissuewaslockedawaysomewhereoutofthereachofthedealers,sothatthemarketpriceofthatsecuritycametoreflectascarcitypremium.Insuchacase,theFedcouldhelp themarketbydisgorging itsownholding. If thisproblemcouldariseinnormaltimes,thenafortioriduringadepression,

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theageofmanagement 51

whenprivatedealerswereweakenedandprivateinvestorsreluc-tanttodisgorgetheironlysafesecurities,themarketcouldusetheFed’shelp.TheFed’sApril1937announcementwasintendedtosignalthatsuchhelpwouldbeforthcoming.

Hadeventsnot intervened, this reassuringsignalmighthavebeenthefirststeptowardreconstructionofprivatecapitalmarketsonanew,moresolid,foundation,basednowexplicitlyonshift-ability rather than self-liquidation. As the capitalization of thedealerswasrestored,thetimewouldeventuallyhavecomewhendealersthemselveswouldhavetakenoverthetaskofsmoothing,leavingtheFedfreetoconcentrateinsteadongeneralcreditpol-icy. In this respect, it is telling that, at the very same momentwhen theFedwas sending its reassuring signal about the shift-abilityofallgovernment securities, itwasalsodoublingreserverequirementsinanefforttoforestallapossibleunhealthycreditexpansiononthebasisoftheburgeoningexcessreservesthathadbuiltupinthebankingsystem.2In1937,theFedwaspreparingforreturntonormalcy.

Whatkindofnormalcymighthavebeenbuiltonthesenewfoundations?Asmentionedearlier,theFed’scommitmenttoen-sure shiftabilitybrought to the forefront thewholequestionofcapitalassetpricing.TheEHwasagoodstartingpoint,especiallyasaugmentedbythe ideaof liquiditypreference thatgeneratedriskpremiums in theyieldsof longer-maturityassets.Butmat-terswouldneverhaveremainedat suchaprimitive level.Onceyoustartdowntheroadofinterveningtocorrectdeviationsfromappropriatepricing, youalso startdown the roadof constantlyimprovingyourtheoryofappropriatepricing,ifonlytoprotectyourself fromprofit-seekingcounterpartieson theother sideofyourtrades.

Justso,theevolvingroleoftheFedinevitablywouldhaveledtofurtherinvestigationofthefoundationsoftheconceptof“li-

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52 chapterthree

quiditypremium”inordertounderstandwhereitcomesfrom,whyittakesonparticularvaluesforparticularinstruments,andwhy those values change over time. InBritain, JohnMaynardKeynes and John Hicks were already showing a possible roadforwardwiththeir“normalbackwardation”theoryofwhylong-term rates tend to be higher than short-term rates (see chap.4). 3Events intervened,however,andtheseearlycontributionsgotputontheshelf.Thehoped-forrestorationofprivatecapi-talmarkets,andtheinstitutionalevolutionthatwouldhavefol-lowedfromthatrestoration,werebothdiverted,firstbyrenewedeconomicdownturnin1938,andthenbyWorldWarII.

Monetary Policy and the Employment Act

DuringWorldWarII,theFedonceagaintookonresponsibilitynot only for maintaining orderly markets in government debt,butalsoforfixingpricesofthatdebt.Privatecapitalmarketses-sentiallydisappearedandwerereplacedbyanexpandedmarketforgovernmentdebt,forwhichtheFedservedasmarketmaker.Asnewcreditwentpreferentiallytogovernment,businessesandhouseholds used any excess funds first to pay down their owndebts,andthentoaccumulategovernmentdebt.After thewar,attheinsistenceoftheTreasury,theFedcontinuedtofixprices,withtheresultthatgovernmentbondsservedessentiallyasakindof interest-bearingcash.Soflushwas theprivate sectorwith itsaccumulationofwardebt that reconstructionofprivate capitalmarkets could and did wait until these wartime accumulationshadbeendrawndown.

Meanwhile,theEmploymentActof1946crystallizedthenewpoliticalconsensusinfavorofusingthepowerofthefederalgov-ernment “to promote maximum employment, production, and

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theageofmanagement 53

purchasingpower.”Theexperienceofwartimespendinghadpro-ducedanewappreciationofthepoweroffiscalmeasurestopulltheeconomyoutofdepression,whiletheexperienceofwartimewageandpricecontrolshadproducedanewappreciationofthepowerofdirectmeasurestostemevenverypowerfulinflationarypressures. Even more, the experience of low and stable interestratesduringthewarhadproducedanewappreciationofthepow-eroffinancetosupportimportantsocialgoals.Inallthesedimen-sions,wartimelessonsshapedpostwarunderstandingofeconom-icpolicyinwaysthatinvolvedasignificantdowngradeoftheroleofmonetarypolicyandtheFed.TheEmploymentActmadenomentionofapossibleroleforthemonetaryauthoritiesinachiev-ingthenewgoals;inpracticetheroleoftheFedwaslimitedtofixingthepriceofgovernmentdebtforafullfiveyearsaftertheEmploymentActwaspassed.

Nevertheless,insidetheFed,preparationswerebeingmadefora return to normalcy. The first step was to regain control overshort-terminterestrates.Peggedatonly3/8percentduringthewar,whenlongbondsweresupportedatthemoregenerousrateof2½percent,theshort-termbillhadattractedverylittleprivateinterest,withtheconsequencethattheFedwoundupowningal-mostalloftheoutstandingbills.Byraisingshort-termyieldsonassetsitalreadyowned,theFedwasfinallyabletoattractprivatebuyersandsotobegintheprocessofrebuildingapropermoneymarket.Afterafewyearsofthis,in1951theFedwasalsofinallyabletoriditselfofresponsibilityforpeggingbondprices.UnderthenewFedchairmanWilliamMcChesneyMartin,thisabdica-tionofwartimeresponsibilitywaspresentedasacrucialstepto-wardrebuildingapropermoneymarketforuseinpostwarmon-etarypolicyintervention.Thekeydocumentwasthe1952reportoftheFOMC’sAdHocSubcommitteeontheGovernmentSecu-ritiesMarket,acommitteechairedbyMartin.4

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54 chapterthree

In retrospect, this report, and the “bills only” doctrine thatemerged from it, can be understood as an adaptation of theFOMC’s1937commitment(tomaintain“orderlyconditionsinthe money market”) to the significantly changed conditions of1952.Inbothcases,thecentralideawastosupportrebuildingofthedealerinfrastructureofprivatecapitalmarkets.In1937,theFedthoughtitcouldconfineitsinvolvementtothegovernmentsecuritiesmarket,anditreliedonprivatedealerstobringorderlyconditionstoprivatecapitalmarketsastheyrecovered.By1952,however,thegovernmentmarketwasmoreorlesstheentirecapi-talmarketandtheprivatedealersystemwasessentiallymoribund.Itseemedtofollowthatthetaskofrebuildingtheinfrastructureofprivatecapitalmarketshadtobeginatamoreprimitivestagebyfirstattractingprivatedealerstoactasmarketmakersinthegov-ernmentsecuritiesmarket.

“Billsonly”wasthusawayofsignalingthattheFedwasleavingthelongendofthemarkettotheprivatedealers.(Itwasofcoursealsoawaytoavoidpoliticalpressuretokeeplongrateslowandstable.)ThenceforththeFedwouldmaintainorderlyconditionsattheshortend,andrelyonarbitrageandtheprivatedealerstobringorderlyconditionstothelongend.In1937,theEHhadservedasthenormfortheFed’sowninterventionacrossthetermstructureofTreasurydebt.In1952,thesameEHwastoserveasthenormforprivateprofit-maximizingdealers.

Inpractice,eventhissimpleidealizednormprovedtobeunre-alizableintherigidfinancialconditionsinheritedfromNewDealreforms.Regulatoryconstraintsonportfolio investmentcreateddemandforspecificissuesthatwasnotreadilydivertedintootherissuesbymerepricemovements.Thus,althoughdeviationsfromthe EH norm offered profit opportunity for dealers, exploitingthoseopportunitieswaspossibleonlyifthedealerswerepreparedtoholdtheresultingpositiontomaturity; theveryexistenceof

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theageofmanagement 55

suchdeviationswasasignthatthepositionwouldnotbeeasytoliquidate.Assetsthattheorytreatedasclosesubstitutes,andthusidealcandidatesforarbitrage,wereinfactnotclosesubstitutesatallintheportfoliosoftheultimatewealthholders,andhencenotforanyoneelseeither.

AllanSproul,thepresidentoftheNewYorkFed,hadantici-patedexactly thisproblemandthushadspokenout inopposi-tionto“billsonly.”5HethoughttheFedshouldretainitsabilitytooperateineachofthemultiplefragmentedanddisconnectedcreditmarkets,aswellasinthelongendoftheTreasurymarket.Experienceofthenewpolicyprovedhimright,butonlyintheshortrun.Overthelongerrun,thevisionofinstitutionalarrange-mentslaidoutbyMartininthe1952reportprovedremarkablyprescient,asweshallsee.Itjusttooklongerthanheanticipated.

Meanwhile, thenext step for theFedafter regainingcontroloverinterestrateswastoreviveitsownroleinmanagingthem.Wehaveseenhow,duringthe1920s,followingtheStrongrule,theFedtargetedborrowedreservesasameasureofmoneymarkettightnessandslack,andusedopenmarketoperationstoincreaseordecreaseborrowingdependingonwhether it felt thatcondi-tionswarrantedabitmoredisciplineorabitmoreelasticity.Inthe1950s,theFedadoptedaquitesimilarprocedure,basedonaquitesimilartheory.Theonlydifferencewasthatnowittargetedso-calledfreereserves,definedasthedifferencebetweenexcessre-servesandborrowedreserves.6

Thisoperationalchangecanbeunderstood,firstofall,asanodtothedevelopingfederalfundsmarket,inwhichbankswithex-cessreserveswereincreasinglyabletolendtheirexcesstobankswithdeficientreserves.Suchinterbanklendinghadtheeffectofdecreasingboththesumofexcess reservesandthesumofbor-rowedreservesbythesameamount.Oneadvantageofthefreere-servesconcept,therefore,relativetotheformerfocusonborrowed

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56 chapterthree

reservesalone,wasthatitwasnotaffectedbyfluctuationsinthevolumeofinterbanklendinginthefederalfundsmarket.

Anotheradvantagewasthatthefreereservesconceptcouldbeeitherpositive(intimesofslack)ornegative(intimesoftight-ness).Bycontrast,theborrowedreserveconceptseemedtohavea natural floor at zero since, once no bank was borrowing re-servesfromtheFed,therewasnowayfortheFedto“makedis-countrateeffective.”(DuringtheearlyyearsoftheDepression,thisapparentfloorhadledtheFederroneouslytoconcludethatmonetaryconditionsweremaximallyexpansive.)Thenewproce-durerecognizedthat,evenwhennobankwasborrowingfromit,theFedcouldstillexertadditionaldownwardpressureonshort-term interest rates by buying securities outright; the effects ofsuchopenmarketoperationswouldshowupasanexpansionoffreereserves.

As in the1920s, thepurposeof theFed’spost–Fed-TreasuryAccordoperationswasnotmerely to ensure orderly conditionsin the money market, but also to contribute to economic sta-bilization more generally by constraining speculative excess ontheupsideandbysupportingmarketsduringliquidationonthedownside.In1955,addressingajointmeetingoftheAmericanFinance Association and the American Economic Association,NewYorkFedpresidentSproulexplicitlyendorsed thegoalsoftheEmploymentAct,andurgedthe importanceof theFed forachieving those goals: “Wemust be alert to opposeboth infla-tionaryanddeflationarypressures,eitheroneofwhichcanupsettheprecariousbalanceofahigh-employment,high-production,high-incomeeconomy.”7Inthesameaddress,Sproulalsoaskedtheassembledacademicsfortheirhelp:“Itseemstomethatthismatterofopenmarkettechniquesinvolvesproblemsofeconomicsignificancebeyonditsimmediatetechnicalapplication,andthatitdeservesyourstudyandyourpublishedfindings.8

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theageofmanagement 57

Listening to the Academics

Becarefulwhatyouaskfor.Academicadvicehadnotalwaysbeenwelcomedby theFed, and forgood reason.During the1920s,theYaleeconomistIrvingFisherhadspearheadedacampaigntopasslegislationthatwouldhaverequiredtheFed,asamatteroflaw,tostabilizethepricelevel.Fisher’sanalysisrestedonhisver-sionofthequantitytheoryofmoney,developedinhis1911bookThe Purchasing Power of Money.AccordingtoFisher,bothinfla-tionanddeflationcouldeasilybeavoidedsimplybymanipulatingthemoneysupply.Sincetheycouldbeavoided,theyshouldbeavoided,bothasamatterofjusticebetweencreditorsanddebtorsandasamatterofefficiencyineconomicbehavior.Whenpricelevelsshiftaround,heargued,peopletendtomakemistakes intheir economicdecisionsbecause they fail todistinguishmove-mentsinindividualprices(whichsignalchangesinprofitoppor-tunities) from movements in the price level (which contain nosuchsignal).Thesemistakes,whichhecalled“moneyillusion,”hethoughtwereanimportantcauseofbusinessfluctuations.Thus,heconcluded,apolicyofmanipulatingthemoneysupplyinordertostabilizethepricelevelshouldalsohelptostabilizetheecon-omymoregenerally.

Inthe1920s,theFedhadresistedFisher’sattempttotieitsmis-sionexplicitlytopricestabilization,butnotbecauseofanypar-ticularobjectiontopricestabilizationasagoal.Rather,itrejectedthe idea that such stabilization was as easily achieved as Fisherthought,andrejectedfurthermoretheideathatmanipulationofthemoneysupplywasthemostefficientoperationalmechanismtowardthatend.TheyawninggapbetweenIrvingFisherofYaleandBenjaminStrongoftheNewYorkFedwasnotsomuchaboutthemissionoftheFedasitwasaboutthegapbetweenacademicmonetary theory and central banking practice. For Strong, the

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58 chapterthree

focusofattentionwasnotsomuchonthequantityofmoneyasitwasonthepriceofcredit,whichistherateofinterest.Strong’sideawasthatthepaceoflendingdependsontheprofitabilityoflending,whichisthedifferencebetweentheloanrateofinterestandthemoneymarketrateofinterest.Centralbankinterventionthusproperlyfocusedonthemoneyrateofinterest,usingcontroloverbankreservesasleverage,toinfluencethepaceoflending.

Inthe1920s,emergentcentralbankingpractice(Strong)easilytrumpedaprioriacademicmonetarytheory(Fisher),butonlytobeitselftrumpedbydepressionandwarinthe1930sand1940s.The result was a substantial downgrading of monetary policy,inboth academic andpolicy circles. In the1950s,whenpeaceandthenprosperityreturned,sotoodidtheolddebate,albeitinsomewhatdifferentformandwithdifferentprotagonists.

Inacademia,MiltonFriedman,professorofeconomicsattheUniversity of Chicago, reprised Irving Fisher with his proposaltorequiretheFedtostabilize,notpricesdirectly,butratherthegrowthofthemoneysupply.9Threepercent,saidFriedman,wasaboutrighttoachievelong-runpricestability,givenhistoricalpat-ternsoflong-rungrowthintherealeconomy.Forourstorytheimportantpointisthat,inanodtotheweakempiricalconnec-tionbetweenmoneyandpricesintheshortrun,Friedmanadvo-catedabandoningthegoalofactivecountercyclicalstabilization.Inthisrespect,Friedman’smonetarismdivergedfromIrvingFish-er’s,andinadirectionthattookhimevenfurtherawayfromcen-tralbankingpractice;thepostwargapbetweenacademictheoryandcentralbankingpracticethreatenedtoyawnevenlargerthantheprewargap.

Meanwhile,reprisingBenjaminStrongattheFed,AllanSproulandWilliamMcChesneyMartinquitedefinitely sawa role forcountercyclicalmonetarypolicy(“leaningagainstthewind”).Thedifference fromthe1920swas that,after theEmploymentAct,

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theageofmanagement 59

thecommitmenttoeconomicstabilizationwasmuchmorewidelyheld, and a broader range of instruments was available for thetask.Monetarypolicynolongerhadtodoeverything,socentralbankerscouldpickandchoosethosedimensionsofthestabiliza-tionprojectforwhichtheirinstrumentswerebestsuited.Bysta-bilizingmoneymarkets,theFedcoulddoitsownbittowardthebroader social goals of stabilizing the price level and economicactivitymoregenerally.Friedman’smonetarismwasdefinitelynotthekindofacademicworkthatSproulhadmeanttoencourage.

Closer to what Sproul probably had in mind was the workof John G. Gurley and Edward S. Shaw, who reprised HaroldMoultonintheir1960bookMoney in a Theory of Finance.Moul-ton, it will be recalled, had sparked the reconceptualization ofliquidityasshiftability,arguingthattheshiftabilityconceptwasbettersuitedtoAmericanconditionsinwhichbanksweremuchmoreinvolvedwithlong-termcapitalfinance.Takingtheirthemefrom Moulton, Gurley and Shaw expressed concern that bankregulationsintroducedduringtheNewDealwerehavingtheun-intendedconsequenceofsuppressingcapitalaccumulation.Newfinancial intermediaries, especiallypension funds and insurancecompanies,weretakingovertheroleformerlyplayedbybanks,butinadequatelyso.Theliquiditypreferenceofhouseholdsmeantthattheystilltendedtochanneltheirsavingspreferentiallytotherelativelysafeandliquidliabilitiesofbanks.

IntheGurley-Shawidealization,eachfinancial intermediaryissuesacharacteristictypeofliabilitythatattractsfundsfromadistinctsegmentoffinalsavers,fundsthattheintermediarythenusestoacquireacharacteristictypeofassetissuedbyadistinctsegmentoffinal borrowers.This imageof the institutional or-ganizationoffinancialmarketswas intended tocapture the ri-gidities thathadbeenbuilt intotheAmericanfinancial systembyregulatorystrictures(theveryrigiditiesthatSproulhadem-

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phasizedinhisoppositionto“billsonly”),butGurleyandShawwentfurther.Regulatoryconstraintsonbankingmeantthatas-set holders were not able to find in the marketplace sufficientassets to satisfy their liquiditypreference,andtheconsequencewashigherliquiditypremiumsthannecessary,whichstifledgen-eralcapitalaccumulationandlong-rungrowth.Furthermore,at-temptsbythecentralbanktomanagemoneybymanagingbankcreditriskedstiflingthoseparticularformsofcapitalaccumula-tionthatweremostreliantonbankcredit.Inbothrespects,long-run growth was being sacrificed to short-run cyclical stabiliza-tion;theFedcoulddobetter.

AttheFedandinacademia,thedecadeofthe1950swasde-votedlargelytomonetaryreconstruction,intermsofbothinsti-tutionalstructuresandintellectualframeworks.Inbothrespects,by 1960 we were more or less back to 1930; money matteredagain.Giventheenormousdiscredit thathadbefallenboththeFedandmonetaryeconomicsduringthe1930s,itwasatremen-dous achievement. But getting money back on the agenda wasonly thebeginning, sincemeanwhile theworldhadmovedon.Theproblemafter1960wastofindawaytointegratethenewappreciationofmoneywithin the larger institutionaland intel-lectualframeworkofmacroeconomics,whichhadundergonetre-mendouschangeinthedecadessince1930.

Monetary Walrasianism

OnewaytounderstandthecatastropheoftheGreatDepressionisnotsomuchasafailureofmonetarypolicynarrowlybutrath-erasafailureofthedecentralizedmarketsystemmoregenerally.Pricedeterminationinresponsetothefluctuationofsupplyanddemandwasapparentlynotsufficienttoensuresatisfactoryper-

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theageofmanagement 61

formanceoftheeconomyasawhole.Theexperienceofinstabilityandunemploymentwasunacceptable,andtheconsequencewasanopening toexplorealternatives,both institutional and intel-lectual.Onepossiblealternativewastoabandonthemarketecon-omyentirelyandreplaceitwithacentralizedcommandeconomy;the success of theU.S.war economy showedwell enough thatsuchapossibilitycouldwork.Butmaybetherewasanotherway,amiddlegroundinwhichgovernmentmanagedratherthancom-manded. The commitment to exploring that middle ground iswhattheso-calledKeynesianrevolutionwasallabout,atleastintheUnitedStates.

We have seen already how the Fed’s 1937 commitment tomaintain“orderlyconditionsinthemoneymarket”makessenseonlybyreferencetoanidealizednorm,atthattimetheliquidity-augmentedexpectationshypothesisofthetermstructure.Nolessdidthebroader1946commitment“topromotemaximumem-ployment,production,andpurchasingpower”make senseonlybyreferencetoanidealizednorm.By1960,whenmoneyfinallycamebackintothepicture,economistsandpolicymakershadal-readychosentheidealnormagainstwhichtocompareimperfectreality. That norm was the general equilibrium model first putforthbyLéonWalrasin1874.

ItseemstohavebeenJohnHicks,firstinhis1937article“Mr.Keynesandthe‘Classics’”andtheninhis1939bookValue and Capital,whomostclearlysetforththegeneralequilibriummodelof Walras as the idealized norm against which to calibrate realworlddeviations.Walrasfamouslyenvisionedtheeconomyasasetof simultaneous equations, eachone setting the supplyof aparticularcommodityequaltothedemandforthatcommodity.Theequilibriumofthesystemisthesetofpricesthatsatisfiesalloftheequationssimultaneously.By1960,ArrowandDebreuhaddevelopedtheWalrasiangeneralequilibriumideaintoafullyrig-

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62 chapterthree

orousmathematicalformalism,buttheirversionofthemodelhadaproblem;therewasnoplaceinitformoney.10

Thosewhowantedtobringmoneyintothepicturehadthere-foretofindadifferentstartingpoint,whichtheydidina1938articlebyJacobMarschaktitled“MoneyandtheTheoryofAs-sets.”HereistheoriginofmonetaryWalrasianism,theoperationalformtakenbytheKeynesianrevolutionintermsofmoney.Theideawas,byanalogytoWalras,totreatthefinancialsideoftheeconomyalsoasthesolutiontoasetofsimultaneousequations,eachoneinvolvingthesupplyanddemandforaparticularfinan-cialasset,moneybeingonlyoneofmanysuchassets.11

IttookawhilefortheMarschakapproachtogainacceptance,inpartbecauseofwar,andbecauseofmonetarydiscredittoo.Butin1952HarryMarkowitzreprisedtheMarschakapproachinhisseminal“PortfolioSelection,”andin1958JamesTobinusedtheapproach to develop a theory of money demand in “LiquidityPreferenceasBehaviortowardsRisk.”12Oncetheseworksdem-onstrated the apparent viability of the new approach, the nextquestionwashowtobringthenewapproachtomoneyintocon-tactwiththeinstitutionalspecificityoftheAmericaneconomyasemphasizedbyGurleyandShaw,ontheonehand,andwiththepractical stabilizationpolicygoals as emphasizedbySproulandMartin,ontheotherhand.That’swhatJamesTobin,amongoth-ers,wasdoingduringthedecadeofthe1960s,worksummedupinhis1969“AGeneralEquilibriumApproachtoMoney.”

Infact,GurleyandShawhadalreadypavedthewayforTobin’smonetaryWalrasianismbypresentinghouseholdliquidityprefer-enceasamatternotjustofmoneydemandbutalsomoregener-allyofportfoliochoice.IntheGurleyandShawframework,theinstitutionalspecificityoftheAmericaneconomyinvolvedvari-ousdistortions in the supplyof assets,while thepriceof assetsmovedtoensurethatallassetswereheldbysomeone.ForTobin,

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theageofmanagement 63

thesedistortionswerethesourceofdeviationsfromtheideal,buttheywerealsothesourceofleverageforpolicymakersattemptingtogetclosertotheideal.Justso,Tobinwouldemphasizehowtheabilityofthemonetaryauthoritytoaffectassetpricesandhencerealactivitystemmedfromthefactthat“theinterestrateonmoneyisexogenouslyfixedbylaworconvention.”13Otherinstitutionalrigidities,suchas“prohibitionofinterestondemanddepositsandaceilingontimedepositinterest,”providedadditionalsourcesofpolicyleverage.

Ineffect,TobinusedGurleyandShawtobridgethegapbe-tweenacademic theoryandcentralbankpractice,butonce thebridgewasbuilt the traffic thatflowedover itwas largely fromacademictheorytopractice,nottheotherwayaround.InTobin’shands,theGurley-Shawvisionmerelyenrichedthespecificationof the standardHicks-Hansen IS/LMmodel,usedbyeveryoneforshort-runcomparativestaticsexercises.14Tobin’spapercon-cludes,“Thereisnoreasontothinkthattheimpact[ofmonetarypoliciesandotherfinancialevents]willbecapturedinanysingleexogenousorintermediatevariable,whetheritisamonetarystockoramarketinterestrate.”Thisisapotshotbothatacademicmon-etaristswhofocusattentionnarrowlyonthemoneystockandatcentralbankpractitionerswho focus attentionnarrowlyon themoney rate of interest. It is also an attempt to make commoncausewiththeSproul/MartinconceptionoftheroleoftheFedasstabilizerofthefinancialsectorquitegenerally.

TheMarschak-Tobinframeworkthusbecamethetemplateformonetarypractice aswell as theory,once it gotoperationalizedasthefinancialsectoroftheFed’slarge-scaleeconometricmodeloftheUnitedStates.15Theideawastobuildanempiricallycali-bratedmodelofhowallthevariouspossibleleversofgovernmentpolicyaffectvariablesofeconomicinterest—suchasoutput,em-ployment,andcapitalinvestment—withaviewtoinformingthe

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useofthoselevers.Monetarypolicywastobeconceivedbroadlyasencompassinganyandallleversinvolvingthefinancialsectoroftheeconomy.Itwasthehighpointoftheageofmanagement,whenthenewKeynesianeconomicscienceseemedtoshowhowitwaspossible,merelybymanipulatingafewstrategicpolicyle-vers,toachievetheambitiousgoalsofthe1946EmploymentAct.

Inall theexcitement,nooneseemstohavenoticedthat themonetaryWalrasianismofTobinamountstonothinglessthananapotheosisoftheshiftabilityviewofthenatureofliquidity.Not-withstandinginstitutionalrigiditiesonsupply,allassetsinTobin’smodelareassumedtobesalableatapricedeterminedbythebal-anceofsupplyanddemand.Ineffect,marketliquidityisassumedfor all assets equally. The demand for money is not a demandfortheultimateliquidassetbutonlyademandfortheultimaterisklessasset,asallassetsareassumedtobeliquid.

Recall that the Arrow-Debreu version of Walras could notbe used as a norm for monetary policy because there was noplaceformoneyinit.Bycontrast,theMarschak-TobinversionofWalrashadsomethinginitthatcouldbelabeledmoney,butithadadifferentproblem,namely,abstractionfromliquidityasthedefiningfeatureofmoney.TheMarschak-Tobinidealizationposednoimmediateproblemintherigidinstitutionalsettingoftheimmediatepostwarperiod;afterall,theoverwhelmingma-jorityoffinancial assetsweregovernment securities, andallofthemwerefullyandequallyliquidbecauseoftheFed’sbackstop.Butoncerigiditieswererelaxedandprivatecapitalmarketsre-stored,theabstractionfromliquiditywouldbecomeincreasinglyproblematic.

Tobinhimselfhintsatwhatwastocome.Inhis1969model,allpolicy leversdependon institutional rigidities, sowhathap-pensifthoserigiditiesareeverrelaxed,astheywouldbeoverthecomingdecades?Tobinwasprescientlyclear.“Therewouldbeno

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theageofmanagement 65

room fordiscrepanciesbetweenmarket andnatural ratesof re-turnoncapital,betweenmarketvaluationandreproductioncost.Therewouldbenoroomformonetarypolicytoaffectaggregatedemand.Therealeconomywouldcallthetuneforthefinancialsector,withnofeedbackintheotherdirection.”16Thus,accord-ingtoTobin’sown model,oncerigiditiesarerelaxedtheidealnormwouldberealizedwithoutanypolicyintervention.Crucially,thatidealnormwasthefullmarket-clearingWalrasianequilibrium,amodelwithnoplaceformoney.

For the present story, the important point is that the idealnorm that emerges when all rigidities are relaxed is a world inwhichliquidityisafreegood.Inthatidealworldeverything,bothrealcommoditiesandfinancialassets, isperfectlyshiftable.Thisisthenormagainstwhichrealitywastobemeasuredandtowardwhichpolicyinterventionwastobedirected.Asameasureofhowunrealandunreachablethatnormwas,itissufficienttonotethat,inthisidealworld,theEHholdstrue,evenwithoutanyliquidity-premiumadd-factors.Nevertheless, thatwas the idealandso itbecametheFed’sjobtoachieveit.Sincetheidealwasaworldinwhichliquidityisafreegood,itseemedtofollowthatthejoboftheFedwastosupplyliquidityasafreegood.

A Dissenting View

In historical retrospect, we can appreciate that the Marschak-Tobinframeworkwasnottheonlypossibleroadforward;theroadnottakenwasareconstructedmoneyview.UnliketheMarschak-Tobinmodel,thelogicunderlyingclassiccentralbankingpracticedidnotdependonanyrigiditiesorinefficiencies.Instead,classiccentralbankingliteraturedevelopedatheoryofbankrateman-agementthatrestedultimatelyontheroleofthecentralbankas

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66 chapterthree

lenderoflastresortintimesofcrisis.Understandingtheoriginofcrisisasamatteroftheinherentinstabilityofcredit,classiccen-tralbankingpracticesoughttointervenebeforethecrisistopre-ventbuildupofspeculativeexcess.True,Americanbankingprac-ticewasdifferent,andasaconsequenceAmericancentralbankingpracticecametofocusmoreonopenmarketoperationsthanondiscountoperations.Nevertheless,theclassicvisionofthecentralbank’sproblemandmissioncouldhavebeenadaptedsimplybyfocusingontheFed’sabilitytouseitscontroloverfundingliquid-itytoinfluencemarketliquidity.

IntheAmericanacademy,themostprominentvoicethatre-tainedcontactwiththeoldertraditionsofcentralbankingthoughtwasthatofHymanMinsky,professorofeconomicsatWashing-tonUniversityinSt.Louis.17AstudentofJosephSchumpeteratHarvard,MinskyplacedatthecenterofhisownthoughtSchum-peter’sideathatthecapitaldevelopmentofthenationwascruciallydependentontheorganizationandoperationofthefinancialsys-tem,andparticularlythebankingsystem.Minsky’sfirstpublishedpaper,on“CentralBankingandMoneyMarketChanges”(1957)represents theearliestattemptbyanyacademic tograpplewiththe implicationsofnewmoneymarket instruments, specificallyinthefederalfundsandrepomarkets,fortheoperationaleffec-tivenessoftheFed.

Theelasticityprovidedbythesemarketswould,Minskysug-gested,ultimatelyundermineattemptstousemonetarypolicyforaggregatestabilization,butwouldneverthelessleaveinplacetheolder andmore fundamental centralbank function as lender oflastresort.EvenastheAmericanacademicdiscussionwasgettingorganized around a debate between monetarists (Milton Fried-man) and Keynesians (James Tobin), Minsky was working tocarveout a thirdposition that reformulatedclassicBritish cen-tralbankingpracticeformodernAmericanconditions.Minsky’s

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theageofmanagement 67

source for understanding British practice was not Hawtrey butratherRichardSayers,whosemagisterialhistoryBank of England Operations, 1890–1914explainedhowthevanishedprewarsys-tem had worked. Nevertheless, Minsky’s conclusion, which hetermed the “Financial Instability Hypothesis,” has more than alittleflavorofHawtreyinsofarastheemphasisisontheinherentinstabilityofcredit.

ThecreditthatconcernedMinskywasnotHawtrey’smerchanttradecreditbutratherbusinessinvestmentcredit,banklendingtofinancecapitalinvestmentspendingbyAmericanbusiness.Whenbusinessesborrow,theycommitthemselvestoastreamoffuturepayments,andtheirabilitytomakethosepaymentsdependsonrealizinganetpositivecashflowfromtheirinvestment.Thesol-vencyofabusinessdependsonthebalancebetweenthecurrentvaluationofpaymentcommitments(liabilities)andexpectedcashflows(assets).Theliquidityofabusiness,however,dependsonthematchbetweenthetimepatternofthosepaymentcommitmentsandrealizedcashflows.Thebasicprobleminacapital-usingecon-omyisthatilliquidityisafactoflife,giventhatlong-livedcapitalassetsarethesourceofsomuchrealizedcashflow.Suchcapitalassetsgeneratecashflowonlyoveranextendedperiodof time,whichmeansthatliquidityisalwaysaproblemfortheeconomyasawhole,andhenceforeachagentwithintheeconomyaswell.

ForMinsky,theinherentinstabilityofcreditisallabouttheshifting balance between cash commitments and cash flows.“Hedge”financestructures,inwhichpromisedfuturecashcom-mitments are always less than realized cash inflows, are inher-entlystable;abusinessfinancedinsuchawaycanneverrunintoliquidityproblemsandthereforecanfocusitsattentiononothermatters.Theproblem is that, over time,hedge structures tendtobereplacedbyspeculativeandthenPonzifinancestructures,in which firms promise payments that they cannot necessarily

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68 chapterthree

meetfromconcurrentcashflow.Ingoodtimes,thesemorefrag-ilefinancestructurescausenotrouble;whenthepromiseddebtscomedue,theyarejustrolledovertoafuturedate.Butthefra-gilityistherenonetheless,sinceanydislocationintherefinancemechanismcancausedisruption.Whenthedislocationcomes,thesizeoftheresultingdisruptiondependsontheprevalenceofspeculative and Ponzi finance structures that are vulnerable tosuchadislocation.

Why the tendency toward fragility?The reasonultimately istheliquiditypreferenceofwealthholders.Unwillingtotietheirmoneyupforthelifeoftherealcapitalassettheyarefinancing,investorsarewillingtoacceptalowerpromisedyieldinordertoacquireashorter-datedfinancialasset.Inthisway,theyessentiallybribeborrowerstoacceptsomepartoftheliquidityriskinherentinlong-termcapitalinvestment(everythingafterthematurityofthenote),whiletheytaketherest(everythingbeforethematurityofthenote).Forthelender,havingmadetheloan,theonlywaytogethismoneybackfasteristosellthatloantosomeoneelse;thisismarket liquidity.Fortheborrower,havingcommittedtotheseriesofpaymentsspecifiedintheloan,theonlywaytoputoffthosepaymentswhentheycomedueisbypayingsomeoneelsetomakethem,thatis,byrollingdebtsastheycomedue;thisisfunding liquidity.

InMinsky’sthought,thetendencytowardfragilitycomesfromthe interaction between asset valuation and creditworthiness.Whereas Hawtrey emphasized the valuation of inventories andthefeedbackofthatvaluationontheavailabilityoftradecredit,Minskyemphasizedthevaluationofcapitalassetsandthefeed-backofthatvaluationontheavailabilityofcapitalcredit.Credit-financedspendingbyonepersoncreatesincomeforothers,bothpresentandprospectiveincome,andthecapitalizationofthatin-come raises asset prices and thus improves creditworthiness for

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theageofmanagement 69

anotherroundofspending.Theresultinginstabilityismoresub-stantialthananythingHawtreyeverimagined,simplybecausethepriceofcapitalassetshasalotmoreroomtomovethanthepriceofinventories.Thatwiderangeofpricemovementmakesitalsomoredifficulttocontrolinstabilitywithmereinterestratepolicy.

In such aworld, thebest thing todo, according toMinsky,was to use collateral policy at the central bank’s discount win-dowtodiscouragespeculativefinancingstructuresandtoencour-agehedgefinancing structures. Ifpeopleknowthatonlyhedgefinancing structures will be eligible for discount when a crisiscomes,thatwilltendtomutesomewhatthepushtowardfragilityonthewayup,andhencealsothescaleofthecollapseonthewaydown.JustastheFed’soperationsingovernmentdebthadcometosupporttheuseofTreasurybillsasasecondaryreserve,sotoowouldFedoperationsinprivatehedgefinancedebtstructurescre-atealiquidmarketforthatdebt.Inacrisis,thatdebtwouldmoveontothebalancesheetoftheFed,andoncenormalcyreturneditwouldmovebackout.

That’showtheworldlookedtoMinsky,butnottoeitherthemonetaristsortheKeynesians,whosedebatedominatedtheaca-demicairwaves.Theirdebatewasall aboutmanagingaggregatefluctuations around a determinate equilibrium, and not at allaboutstemmingtheinherentinstabilityofcredit.Minsky’spes-simismaboutthepossibilityofactivemanagementputhimout-sidetheoptimisticKeynesiancamp,andhispessimismabouttheinherentstabilityofaprivatecrediteconomyputhimoutsidetheoptimisticmonetaristcamp.Minsky’sviewswerecontinuouswiththegreattraditionofcentralbankingthought,butthatcontinu-ityprovedtobeadisadvantageinapostwareralookingtoputthepastbehinditandbuildanew.

And so, insteadof aMinskian reworkingof centralbankingveritiesformoderncircumstances,wegotactivemoneymanage-

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mentalongmonetaryWalrasianlines.IntimesofrisingpricestheFed tightened monetary policy, causing money market interestratestorise,thuscreatingincentiveforprivateliquidityprovision.Asaconsequencewegotfinancialinnovationssuchasthecertifi-cateofdeposit,bankcommercialpaper,andEurodollarborrow-ing.Higherratesalsomeantthatrefinanceofmaturingspecula-tivepositionswasachievedonlybypledgingevengreaterfuturecashpayments,whichmeantthatevensuccessfulrefinancetendedtoincreasefragility.Thus,thenaturalthrusttowardfragilitywasamplified,notdampened,bytheoperationsofthefinancialau-thority.Inatypicalcycle,eventuallyrefinancewouldbecomeim-possibleforthemostoverextendedunitsandcrisiswoulderupt,forcingcentralbankinterventiontomopupthemessexpost.

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FOUR

TheArtoftheSwap

ThepatternthatMinskywasalreadynoticingindomesticmoneymarkets in 1957, namely, financial innovation as a response toactivemoneymanagement,wasalsoshowingupininternationalmoneymarkets.Indeed,itwasintheinternationalmoneymar-ketsthatthefinancialinnovationmostcrucialforbreakingdownDepression-erarigiditiesfirstappeared.Ireferheretothe“swap,”specificallythecurrencyswap,whichfirstmadeitsappearanceasawaytogetaroundpostwarcontrolsoninternationalcapitalflows.

AfterWorldWarII,U.S.governmentdebtwasthecoinoftherealminternationallyaswellasdomestically.TheBrettonWoodsagreementof1944ratifiedfactsontheground,thekeyfactsbe-ingthattheUnitedStatesheldnotonlymostoftheworld’sgoldreservesbutalsomostof itsproductivecapital.PostwarEuropewouldbeimportinggoodsofallkindsfromtheUnitedStatesandpayingforthemwithdollars,sodefactotheworldtradingsystemwouldbeon adollar standard.Nostalgia for thegold standardmanifesteditselfasanominalpegofthedollartogoldat$35perounce,butitwasdollarsthateveryoneneeded,notgold.Anditwasdollars thateveryonegot, somegranted (theMarshallPlanforreconstructionaid),someborrowed,andothersearnedbyper-sistentundervaluationofforeigncurrenciesrelativetothedollar.

Fromthestart,theBrettonWoodssystemwasbuiltonacon-tradiction. It established a fixed exchange rate system interna-tionallyevenasitendorseduncoordinatedmacroeconomicman-

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72 chapterfour

agementattheleveloftheindividualnation-state.Thesolutiontothiscontradictionwassupposedtobecapitalcontrols.Somecountries might have loose macroeconomic policy while othersmighthavetightmacroeconomicpolicy.Inorderthatthelooseones not be constrained by loss of international reserves, indi-vidual countrieswerepermitted to control international capitalflows,inandout.

Thebirthoftheswapcameasawayforindividualfirmstogetaroundthesenationalcontrols.Thefirstsuchswapswerearrangedasparallel loans,andthisparallel loanconstructionremainsthemost straightforward way to understand them, even though inlaterdevelopmentstheloansbecameimplicitratherthanexplicit.1Indeed,theparallelloaninterpretationisthemoststraightforwardwaytounderstandinterestrateswapsandcreditdefaultswapsaswell,twolaterconstructionsthatplayedakeyroleinextendingthe logicofarbitragethroughouttheevolvingpostwarfinancialsystem.Theswapideawascompletelycentral,anditall startedwiththecurrencyswap,soitisofsomeimportancetounderstandhowthisswapworked.

Currency Swaps and the UIP Norm

TheessenceofbankingisaswapofIOUs.Whenabankmakesaloan,itaddstoitsbalancesheetbothanasset(theloan)andali-ability(adepositinthenameoftheborrower).Thefirstcurrencyswapswerenothingmore thanaminorvariationon this tradi-tionalbankingidea.SupposeanAmericancompanyAhasdollarsbutneedspoundsinordertofinanceexpansionbyitssubsidiaryinEngland,andaBritishcompanyBhaspoundsbutneedsdol-larsinordertofinanceexpansionbyitssubsidiaryintheUnitedStates.Suppose further thatcapital controlsprevent themfrom

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theartoftheswap 73

trading currencies and making the desired investment directly.Theycanaccomplishessentiallythesamethingbyusingaparallelloanconstruction.

Here’show.TheAmericancompanyloansitsdollarstothesub-sidiary of the British company in the United States, while theBritishcompanyloansitspoundstothesubsidiaryoftheAmeri-cancompany inBritain.Nomoneyever travels acrossnationalborderssotheletterofthelawisrespected.Butalthoughtherearenonetflows,anyreasonablepersonwouldagreethatthedealin-volvesquitesubstantialnotionalgrossflows,whichoffset;ineffect,CompanyAandCompanyBevadetheconstraintsthatbindev-eryoneelse.WecanrepresenttheswapofIOUsasasetofentriesonthebalancesheetsoftheinvolvedpartiesasfollows.

Whataboutcreditrisk?Ifallgoeswell,theAmericancompanywillgetrepaidwithdollarsfromtheBritishcompany’ssubsidiary,butwhatifthesubdoesn’tpay?Inthatcase,theAmericancom-panyinstructsitsownBritishsubtostoppaymentontheotherlegoftheswap,andtheswapterminates.Ineffect,eachloanservesas collateral for theother, sopotential credit losses are limited.Premature termination thusdoesnot involve outright loss, butit does leave the American company with no way to repatriatepoundsearnedbyitsforeignsub.Forthat,itwouldneedtofindanewBritishcounterpartywillingtoswap.

Currency Swap as Parallel Loan

AmericanDomicile BritishDomicile

Company A Subsidiary B Subsidiary A Company B

Assets Liabilities Assets Liabilities Assets Liabilities Assets Liabilities

$loan $loan £loan £loan

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74 chapterfour

Oneway tomitigate this kindofpremature-liquidation riskis to insert abankas thecounterparty toeach legof the swap.Here, however, the parallel loan construction poses a problem,sinceeachcounterpartypositionwouldexpandthebank’sbalancesheetbythesizeoftheentireloan,thusattractingreserverequire-mentsandabsorbingscarcecapital.ThewayoutistostructurethedealasaswapofimplicitIOUs,notactualIOUs;inthiswayourparallelloanconstructionbecomesacurrencyswap.

ImaginethatourtwocompanieseachdotheirswapnotwitheachotherbutratherwithJ. P.Morgan,whichhasbranchesinboththeUnitedStatesandBritain.CompanyApromisestopaypoundsandreceivedollarsfromJ. P.Morgan;CompanyBprom-isestopaydollarsandreceivepounds;J. P.Morganpromisestobothpayandreceivebothdollarsandpounds.Becauseeveryonein thisdeal isbothpayingandreceiving,wecanbookthedealnotasasetofgrossexposures(loans)butonlyasasetofnetex-posures(swap).Theparallelloanconstructionremains,butonlybehindthescenesasbelow,whereweusebracketstodenoteim-plicitIOUs.

InthisarrangementneitherAnorBhasanyexposuretoearlyterminationoftheswapbytheother.OnlyJ. P.Morganhasthatexposure,butJ. P.Morganhasaccesstosourcesofliquiditythatarenot available to the individual companies. Ifone legof theswapterminatesearly,J. P.Morganneednotscurryaroundlook-ingforanalternativecounterparty;itcaneasilyhedgebyswap-

Company A J. P. Morgan Company B

Assets Liabilities Assets Liabilities Assets Liabilities

[$loan £loan] [£loan $loan]

[$loan £loan] [£loan $loan]

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theartoftheswap 75

ping IOUs with another bank. Concretely, suppose that B ter-minates. Then J.  P. Morgan looks for a counterparty, Bank C,willingtopaydollars(issueadepositaccountliability)andreceivepounds(holdadepositaccountasset). If thesedepositsare im-plicitIOUsratherthanactualIOUs,thenwehavewhatiscalledaforwardexchangecontractinwhichJ. P.MorganandBankCcommittoafutureexchangeofpoundsanddollarsatanexchangeratethatisfixedtoday.

Once hedging of this kind becomes readily available, J.  P.Morgancangothenextstep.InsteadofmerelybrokeringtheswapbetweenCompanyAandCompanyB,andaddingitsowncoun-terpartycreditenhancement,J. P.Morgancanbegintoactasatruedealerbypostingbidandaskpricesforcurrencyswaps,rely-ingontheinterbankmarketinEurodollardepositstohedgeanymismatchintheresultingswapbook.Inthisway,whatbeganasawayofevadingcapitalcontrolsbecomesovertimesimplyawayofpricingloans.Companiesborrowinwhatevercurrencyischeap-estforthem,andthencontractwithaswapdealertoswapintowhatevercurrencytheyneed.

ButwhydoesBankCprovide thehedge?This is clearly thekeytothewholething,andnotjustforcurrencyswapsbutalsofor the interest rate swaps and credit default swaps that camelater.Dealerswillmakemarketsintheseswapsonlyiftheycande-pendonBankCtohedgeanyunmatchedexposureononesideorthe other. Presumably, Bank C provides the hedge because it

Company A J. P. Morgan Bank C

Assets Liabilities Assets Liabilities Assets Liabilities

[$loan £loan] [£loan $loan]

[$deposit £deposit] [£deposit $deposit]

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76 chapterfour

expects toprofit, butwheredoes theprofit come from?Letuslookinmoredetailatthewaythehedgeworksasawayofbuild-ingintuition.

AtthemomentthatBankCswapsIOUswithJ. P.Morgan,ittradesapounddepositforadollardepositattheprevailingspotexchangerate,S=£/$.Then,overthetimeuntilmaturity,eachofthesedepositsaccruesinterestattheprevailingrate,(1+r)forthedollardepositand(1+r*)forthepounddeposit.Atmaturity,therefore,BankCwillhaveadollarliabilityof(1+r)andapoundassetofS(1+r*).ItsprofitwillthusdependontheprevailingspotexchangerateatmaturityS+1:profit={S(1+r*)/S+1–(1+r)}.Notethat,ifthespotexchangerateisexactlyS+1=S(1+r*)/(1+r),thenBankC’sprofitisexactlyzero.Denotingthisno-profitexchangerate as F (for “forward” exchange rate), we can write Bank C’sprofitas(1+r){F/S+1–1}.Iftheforwardexchangerateisgreaterthantherealizedspotexchangerate,BankCmakesaprofit;ifless,itmakesaloss.IftheexpectationofprofitiswhatinducesBankCtoenterintothecontractinthefirstplace,thenitmustbethattheforwardexchangerateisgreaterthantheexpectedspotrate.

Thepointofallthisistoshowhowtheinternationalcurrencyswapmarketcomesnaturallytobeorganizedaroundaparticu-lararbitragerelationship,anidealizednormthateconomistscallucoveredinterestparity(UIP).2LiketheEH,UIPsaysthatex-pected returns from two different investment strategies shouldbe the same.Supposeyouhavemoney thatyouwant to investforthreemonths.Youcaninvestitinadollarassetandearnthedollarrateofinterest.Oryoucanconvertitintoforeigncurrency,investattheforeignrateofinterest,andthenexchangethepro-ceedsbackintodollars.Sinceinvestorscanfreelychoosebetweenthetwo,theymustbeequallyattractive.UIPinterprets“equallyattractive”tomeanthattheexpectedyieldonthesetwoinvest-mentstrategiesshouldbethesame;anydifferentialbetweenthe

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theartoftheswap 77

interestratespaidonthetwoinvestmentsshouldbeexactlyequal-izedbyachangeintheexchangerate.UIPsaysthattheforwardexchangerateshouldbeequaltotheexpectedspotrate.

But,likethesimpleEH,thesimpleUIPtendsnottoholdinpractice, andourexampleofBankCsuggestswhynot. IfUIPheld,therewouldbenoincentiveforBankCtoprovidethehedgethatJ. P.Morganneedsinordertosquareupitsswapbook.Ineffect,thefailureofUIPisthesourceofexpectedprofitthatcom-pensatesspeculatorsfortheriskinvolvedinabsorbingmismatchinthecurrencyswapmarket.SpeculatorssuchasBankCarebet-tingonthefailureofUIP,borrowinginonecurrencyandlendinginanothercurrency,andearninganexpectedprofitastherewardfor taking on the risk that exchange rates might move againstthem, producing a large loss.3 The degree and the direction ofthefailureofUIPdependonthedegreeandthedirectionofthemismatchinthecurrencyswapmarket.AlthoughUIPfails,itre-mainstheorganizingnorminthesensethatitwouldholdinthespecialcasewhenthereisnomismatch.

One implication of the UIP norm is that the only way theUnitedStatescansustainsignificantlylowerinterestratesthantherestoftheworldisifthedollarisexpectedtoappreciateagainstforeigncurrencies.If,forwhateverreason,thatexpectationisnotheld then investors will not be willing to hold dollars; in fact,theywillwanttoconverttheirdollarsintoforeigncurrency.ThiswasexactlytheproblemthattheUnitedStatesfacedin1961.Inthe immediatepostwarperiod,most other currencieshadbeendeliberatelyundervaluedagainstthedollarinanattempttoeasetransitionfromwartimeconditions.Asaconsequence,by1961,thedollarwascomingunderpressureandthepegofthedollartogoldwasbeginningtobite.TodefendthegoldvalueofthedollaragainstUIParbitrage,theUnitedStateshadtoraiseshort-terminterestrates,butthatwasthelastthingthenewKennedyadmin-

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78 chapterfour

istrationwantedtodo,committedasitwastoapolicyoflowin-terestratesinordertostimulatecapitalinvestment.

Thefamous1961OperationTwistwasanattempttohaveitbothways.TheideawasthattheFedwouldraiseshort-terminter-estratesinordertosupportthevalueofthedollarbutatthesametimeinterveneinthelong-termTreasurymarketinordertopre-venttherisingshortratefrompassingthroughintothelongrate.Obviously,thisamountedtoanabandonmentofMartin’s“billsonly”policy,but evenmore it also represented thefirst step to-wardreplacementoftheEHnormwiththenewMarschak-TobinmonetaryWalrasiannorm.(Notcoincidentally,TobinheadedtheCouncilofEconomicAdvisorsunderKennedy,andinthatposi-tionpresidedovertheimplementationofOperationTwist.)

Monetary historians report that OperationTwist was largelyineffective,inpartbecauseatthesametimethattheFedwassell-ing short-termTreasuries and buying long-termTreasuries, theTreasurywasdoingthereverse,sotheneteffectonthemarketasawholewasfairlyminimal.4Thesignificanceoftheoperation,forourstory,isthatitrestsatthesametimeongrudgingacceptance ofUIPasthenormininternationalmoneymarkets,andonwill-fulviolationofEHasthenormindomesticcapitalmarkets.Byseekingtoflattenthetermstructureofdomesticinterestrates,thepolicyamountedtoanattempttosetthevalueofthetermpre-miumatalowerlevelthantheEHnormwouldsuggest.Insteadofadaptingitselftothemarketnorm,thegovernmentwasattempt-ingtoestablishitsownidealizednorm,thenormthatwouldbecrystallized inTobin’s1969article “AGeneralEquilibriumAp-proachtoMonetaryTheory.”

Asithappened,however,theswaptechnologythatwasorigi-nallydevelopedtoovercomeregulatoryrigiditiesintheinterna-tional sphere turned out to be easily adapted to overcome reg-ulatory rigidities in the domestic sphere as well. And as these

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theartoftheswap 79

rigiditieswereovercome,theEHnormwouldreassertitselfasthenaturalorganizingprinciplefordomesticmoneymarkets,muchastheUIPnormhadalreadyasserteditselfasthenaturalorganiz-ingprincipleforinternationalcurrencymarkets.Inretrospect,thehistoricaltaskoftheMarschak-Tobinnormwastocreatethear-bitrageopportunitiesthatprovidedprofitincentiveforrebuildingarobustprivatedealerfunction.

Brave New World

Fischer Black, a computer expert working at the managementconsultingfirmArthurD.Little,wasperhapsthefirsttoseethefuture,asearlyas1970:“Thusalongtermcorporatebondcouldactuallybesoldtothreeseparatepersons.Onewouldsupplythemoney for thebond;onewouldbear the interest rate risk;andonewouldbeartheriskofdefault.Thelasttwowouldnothavetoputupanycapitalforthebonds,althoughtheymighthavetopostsomesortofcollateral.”5TodaytheworldthatBlackwasonlyimagining has become our reality, and the instruments he wasonlyimagininghavebecomeourinterestrateswapsandcreditde-faultswaps.Interestrateswapscamefirst,beginninginthe1980s;creditswapsaremorerecent,beginninginthe1990s.Fromthestandpointofmodernfinance,carvingofftheserisksandsellingthemseparatelywasthekeytogettingtheirpricesright,andthusimprovingtheefficiencyofthesystemasawhole.Fromthestand-pointofthemoneyview,carvingofftheserisksandsellingthemseparatelywasthekeytounderminingtheMarschak-Tobinnormformonetarytheoryandpolicy.

Howdoesthis“carvingoff”processwork?UseofthetermswapgivesacluethatwhatisinvolvedissomekindofswapofIOUs,inwhichonecounterpartycommitstomakeonestreamoffuture

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80 chapterfour

payments and another counterparty commits to make a differ-entstreamoffuturepayments.Behindthescenes,thereisanim-plicit parallel loan construction, and we understand the swapbetterwhenwekeepinmindthatunderlyingconstruction.6Con-sider the risk exposure of the holder of a corporate bond afterengagingintwosuchswapsofIOUs,asfollows.

Inthesecondline,Mr.InvestorandMr.DefaultswapimplicitIOUs;thisistheessenceofacreditdefaultswap(CDS).Investorpromisestomakethesamepaymentsthatthecorporationmakesonitsbond,andDefaultpromisestomakethesamepaymentsthattheU.S.Treasurymakesonitsbondofthesamematurity.Becausethecorporatebondtypicallypaysahigher interest rate thantheTreasurybond,InvestortypicallywindsupmakingnetpaymentstoMr.Default.Thesepaymentscanbeconsideredakindofbondinsurancepremiumsince,intheeventofdefault,InvestorsimplydeliversthedefaultedcorporatebondtoDefault,receivinginre-turnaperfectlygoodTreasurybond,oritscashequivalent.

Inthethirdline,Mr.InvestorandMr.InterestswapimplicitIOUs; this is the essence of an interest rate swap (IRS). Inves-tor promises to make the fixed interest rate payments that theTreasurymakeson itsbond,andInterestpromises tomakethefloatinginterestratepaymentsthattheTreasurymakesonase-quenceofTreasurybillsoverthesamehorizon.Again,becausethebondtypicallypayshigherinterestthanthebill,InvestortypicallywindsupmakingnetpaymentstoInterest.Andagainthesepay-

Mr. Investor Mr. Default Mr. Interest

Assets Liabilities Assets LiabilitiesAssets Liabilities

corporatebond

[Treasurybondcorporatebond][corporatebondTreasurybond]

[TreasurybillTreasurybond] [TreasuryTreasury bond bill]

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theartoftheswap 81

mentscanbeconsideredakindofinsurancepremiumsince,intheeventthatinterestratesrise,Mr.Interestisonthehookforthecapitallossesonthebond.

Theimportantpointisthat,ifallworksasplanned,theseswapsleaveInvestorwiththesameriskexposureasifhewereholdingashort-termTreasurybillinsteadofalong-termcorporatebond.InFischerBlack’sterminology,Investoristheonesupplyingthemoneyforthebond,butheisnotbearinganyinterestrateriskorcreditdefaultrisk.Instead,Interestisbearingtheinterestraterisk;hehascommittedtopaytheshort-terminterestrateevenintheeventthattheshortraterisesabovethefixedratethatheisreceiv-ing.AndDefaultisbearingthedefaultrisk;hehascommittedtomakeaseriesoffixedratepaymentsevenifthecorporationstopsmakingpaymentsonthecorporatebond.

Inrecognitionofthistransferofrisk,wecantreatInvestorasthebuyerof“protection”andbooktheswapsasassetsforhimandasliabilitiesforhiscounterparties.Thisconventionissomewhatarbitrarybecausebothswapsbegin lifeaszeronetvalue instru-ments; atorigination the two implicit IOUshaveexactly equalvalue.Lateron,changesintherelativevalueofthetwoIOUsun-derlyingtheswapwillinevitablyshiftthevalueoftheswapintothemoney,ononesideortheother.Buttheshiftcouldgoeitherway,andatoriginationnooneknowswhichwayitwillgo.Nev-ertheless,weadopttheconventionthat thebuyerofprotectionbookstheswapasanasset,sowecanshowourimplicitswapofIOUsalternativelyasfollows.

Mr. Investor Mr. Default Mr. Interest

Assets Liabilities Assets Liabilities Assets Liabilities

corporatebond

CDS CDS

IRS IRS

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82 chapterfour

Theimportantpointisthat,becausetheswapswerearrangednot as a swap of actual IOUs but rather as a swap of implicitIOUs,theywerenottreatedasloansforregulatorypurposes.Assuch,swapsprovidedanaturalwaytogetaroundregulationsde-signedfortraditionalbankbalancesheets,regulationsthattypi-callyscaledbothrequiredreservesandrequiredcapitaltothesizeof thebalancesheet.Here is theoriginof theso-calledshadowbankingsystem.Inthisregard,notethatMr.Interestisineffectborrowing short-term and lending long-term, just like a bank,andisthusexposedtobothliquidityandsolvencyriskjustlikeabank,butwithouttheassociatedregulatoryapparatusorsup-port—nobackupliquiditysupportfromtheFed,andnobackupsolvencysupportfromtheFDIC.Iftheshort-terminterestraterisesabovethecontractedfixedrate,Mr.Interestwillfindhimselfhavingtocomeupwithliquidfundstopayoutonhis(implicit)short-termliability,evenasthevalueofhis(implicit)long-termassethasfallen,leavinghimwithacapitallossastheswapmovesintothemoneyonthesideofInvestor.

ItfollowsthatInvestor’sriskhedgeisonlyasgoodashiscoun-terparty.ThiscounterpartyriskcanbemanagedbyrequiringthatInterest(andDefault)post“margin”toensureperformance—thisis the collateral that Fischer Black was talking about—but thecounterpartyexposureremains.IfthevalueoftheswapmovesbymorethanInterest(orDefault)cantolerate,exhaustingtheirabil-itytopostcollateral, thecontinuedviabilityof therisktransferdependsonthecounterpartiesbeingabletocaptheirlossesbyen-gaginginanoffsettingswapwithsomeoneelse.Inthebravenewworldofmodernfinance, riskmanagementultimatelydependsonliquidswapmarkets,andliquiditymeansshiftability.

Now,as thepreviousdiscussionofcurrency swapshasmadeclear, the source of market liquidity in the swap market is theswapdealerwhomakesa two-waymarketbyquotingbothbid

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theartoftheswap 83

andaskprices.Intheabsenceofsuchadealer, ifacounterpar-tydefaultsbeforetheendofthecontract,whateverriskwasbe-ingtransferredbythecontractrevertstoitsoriginalholder,whomustlookaroundforanothercounterparty.Swapdealerstakeonthisrolloverriskbystandinginbetweentheultimatecounterpar-ties.Justasinthecaseofcurrencyswaps,theliquidityoftheIRSandCDSmarketsdependsonadealerinfrastructurethatmakestwo-waymarketsintheseswaps.Andjustasinthecaseofcur-rencyswaps,thewillingnessofdealerstomakemarketsdependsontheirabilitytohedgethemismatchintheirswapbook.

Fortheinterestrateswapcase,theEurodollarforwardmarketandthecloselyassociatedEurodollarfuturesmarketprovideanat-uralhedge.7ImbalanceintheunderlyingdemandandsupplyofinterestrateswapsthusshowsupasanimbalanceinthemarketforEurodollarforwardsandfuturesthatpushesforwardinterestratesawayfromexpectedfuturespotinterestrates.Itisthisgapthatcre-atestheexpectedprofitneededtoattractspeculatorstotakeuptheoverhang.TheEHsaysthattheforwardrateshouldbeanunbiasedforecastofthefuturespotrate,butempiricallytheforwardrateistypicallyhigherthanthefuturespotrate.Onepossiblereasonforthis“anomaly”isasystematicoverhanginnethedgingdemand;inthisregard,thefailureofEHintheinterestrateswapcaseiscom-parabletothefailureofUIPinthecurrencyswapcase.

Forthecreditdefaultswapcase,bycontrast,thereisnonaturalhedgeavailablefordealers,andasaresultthemarkethasremainedclosertoabrokermarketthanaproperdealermarket.8Somein-dividualcorporatenamesattractwideinterest,foronereasonoranother,andsoareavailableforuseascross-hedgesagainstposi-tionsinotherindividualnames.Variousindexswapcontracts,es-sentiallyfixedbundlesofmultiplenames,alsoattractwideinter-estandsoareavailableforuseasacross-hedge.Butthereremainsnonaturalhedgefortheindexswapcontractitself.Putsimply,al-

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84 chapterfour

thoughallcentralbanksareroutinelyinterestedinfosteringmar-ket liquidity forgovernmentdebt,no centralbank is interestedinfosteringmarketliquidityforprivatedebt.Thatisoneofthethings that will change once central banks recognize their newroleasdealeroflastresort,butuntilthenthesystemismuddlingalongwithoutamarketliquiditybackstopforprivatedebt.

Asaconsequence,thereislessabilityfordealerstohedgenetexposure in the credit default swap market, and there is corre-spondinglygreaterneedtoattractdirectcounterparties(i.e.,spec-ulators)bypushingthepriceofcreditprotectionawayfromthelevelwarrantedbyexpecteddefault.Ifmorepeoplewanttobuyprotectionthanwanttosellit,thepriceofprotectionmustriseinordertoattractspeculativesellers,andviceversaiftheimbal-anceisontheotherside.ThesamelogicthatexplainsthefailureofUIPandEHalsoexplainsthefailureofthenaturalnormintheCDSmarket,namely,thetendencyofthemarketpriceofaCDStoreflectexpectedfuturedefaultprobability.Indeedthemechan-icsoftheCDSmarketrevealthatthereisevenmorereasontoex-pectliquidityriskdistortioninCDSpricingbecauseofthelackofanaturalhedge.

Thispricedistortionwouldprovetobeacrucialmechanismofthecreditcrisis,oncetheCDStechnologygotextendedfromcorporatebondstomortgage-backedsecurities(seechap.6),butatitsinceptionnoonecouldseethatfarahead.Rather,attentionfocusedonthewaythatthedevelopmentofswapmarkets(cur-rency, then interest, and thendefault) operated to improve theefficiencyofpricing,thusmakingcreditmorefreelyandcheaplyavailable. The important point seemed to be that the prices ofthesedifferentriskexposureswereestablishedinmarketexchange,notbybilateralnegotiationsbetweenbanksandtheirclients.Acorporatebondcametobeunderstoodasnothingmorethanabundleofriskexposures,eachwithitsownprice,andfromthere

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theartoftheswap 85

itwasjustasmalladditionalsteptousetheobservedmarketpriceof the variouspure risk exposures toprice thebond itself.Thelogicofarbitragerequiredit.Thus,overtime,thelogicofarbi-tragecameto ruleeverywhere,firstcurrency, then interest,andthenfinallydefault.

From Modern Finance to Modern Macroeconomics

Asthevariousarbitragepricingnormsbeganassertingthemselvesintherealmofpracticalpricing,theyalsobegantoassertthem-selvesintherealmoftheoreticalunderstanding.Thefirststepwastheriseofmodernfinancialtheory,whichsoughttoexplainhowthelogicofarbitragedeterminespricesinfinancialmarkets.Thesecondstepinvolvedaspilloverofthatnewunderstandingfrommodernfinanceintomodernmacroeconomics.

ModernfinanceandTobin’smonetaryeconomicsshareacom-mon ancestry, from the prewar work of Jacob Marschak in his1938“MoneyandtheTheoryofAssets”tothepostwarworkofHarry Markowitz in his 1952 “Portfolio Selection.” Thereafter,however, their paths diverged. Tobin used the Markowitz ap-proach todevelopa theoryofmoneydemand inhis1958“Li-quidityPreferenceasBehavior towardRisk,”whichhe laterex-tendedintohis1969“GeneralEquilibriumApproachtoMoney.”MeanwhileBillSharpe,astudentofMarkowitz,askedwhatassetpriceswouldbeinaneconomywhereeveryonebehavedaccord-ingtothedictatesofMarkowitz’smodelofportfoliochoice.Theresultwasthecapitalassetpricingmodel(CAPM),whichusheredinmodernfinance.9

ThekeyideaoftheCAPMisthatallcapitalassetsare,inacer-tainformalsense,closesubstitutesforoneanother.Eachonehasitsownexpectedreturnanditsownindividualrisk,asmeasured

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86 chapterfour

by the varianceof its return.ButCAPMsays that thepriceoftheasset is affectednotatallby its individual riskbutonlybyitscontributiontoaggregatemarketrisk,which ismeasuredbythecovarianceof theasset’s returnwith themarketas awhole.AccordingtoCAPM,somestocksaremoreriskythanothers,butthecovariancemeasureofriskputsallonthesamefooting,andthepriceofcovarianceriskisthesameforall.

ThisCAPMideawasappliedfirsttoequitymarkets,butsim-ilar reasoning soon revolutionized thinking about fixed incomeandcurrencymarketsaswell,with importantconsequences forolder thinking such as the expectations hypothesis of the termstructure and the uncovered interest parity theory of exchangerates.Thoseconsequencesallrevolvedaroundashift intheun-derstandingofrisk.InthenewCAPMformalization,itbecameimpossibletoconceptualizeliquidityriskasaseparatecategoryofrisk.TheworldofthenewmodernfinancetheorywasaworldinwhichbothEHandUIPwereexpectedtohold,evenwithoutanyliquidityriskadd-factor.10

InpracticeEHandUIPcontinuednottofitthedataverywell.Butnowempirical failure couldbe attributed toproblemswithreality,notproblemswith theory—tocontinuing inefficiency inmarket operation, not to counterfactual theoretical abstractionfrom liquidity risk. Even more, any deviation of market pricefromidealtheorycouldbereadasanindicationofarbitrageprof-itopportunity,theexploitationofwhichwouldmakethemarketevermoreperfect,whichistosay,evermoreinlinewiththenormofmodernfinancetheory.Wherevertherewasan“anomaly”therewas a carry trade to exploit it: borrow in low-interest-rate cur-renciesandlendinhigh-interest-ratecurrencies,borrowinshort-termmarketsandlendinlong-termmarkets,borrowattherisk-free rate and invest in riskybonds. In all these trades, leveragecametobeseennotasamultiplierofriskbutmerelyasthewaytoharvestarbitrageprofits,awaytobuylowandsellhigh.

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theartoftheswap 87

Significantly, all of these arbitrage trades depended on theavailabilityoffundingliquidity,whichfluctuatedovertime.Easymoney meant increasing leverage and shrinking carry margins;tightmoneymeantdecreasingleverageandwideningcarrymar-gins.Theorysaidthatnoneofthesecarrytradesshouldbeprofit-ableinequilibrium,butinpracticetheywereallprofitableintheupswingandthenunprofitableinthedownswing,andallprofit-ableaswellonaverageoverthecycle.Credit-fueledarbitragewastheformthatHawtrey’sinherentinstabilityofcredittookinthebravenewworldofmodernfinance.ButmoderneconomistsnolongerreadHawtrey’sbooks,orevenMinsky’sattempttoupdatethe Hawtreyan money view for the world of postwar America.Bothseemedequallyoutofdate,sweptawaybytheadvancesofmodernfinancialtheory.

Afurthercasualtyofthefinancetsunamiwasmacroeconom-ics,specificallytheMarschak-Tobinframeworkformonetarythe-ory.Tobinhaddeveloped the framework, itwillbe recalled, toaid government in its ambition to manage aggregate economicfluctuation.Theideawastoconceptualizetheproblemofselect-ingappropriatepolicylevers,andtheappropriatesettingforeachlever,asanempiricalquestionamenabletoscientificstudy.Fromthebeginning,itwasrecognizedthattheanswertothatempiricalquestionwoulddependontheinstitutionalstructureoftheecon-omy.Anunderlyingpremiseof theexercise, therefore,was thatinstitutionalchangewasslowenoughtobediscountedforpolicypurposes.Thispremisewouldprovidetheopeningthroughwhichthenewfinancethinkingenteredmacroeconomics.

Therehadalwaysbeenvoiceswarningthateventhoughinsti-tutionalchange is slow, it shouldnotbeneglected,because thedirectionofinstitutionalchangewillinevitablybeinfluencedbywhateverpolicyischosen.Goodhart’sLaw,namedafterCharlesGoodhart, longtime chief economist at the Bank of England,warnedthatanyapparentlystablestatisticalrelationshipwillin-

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88 chapterfour

evitablybreakdownonceyoubegintorelyonitforpolicypur-poses.11Large-scaleeconometricmodelsbuiltontheTobinframe-workwereneveranythingmorethanacatalogofsuchpurportedlystablestatisticalrelationships.

The weakest entry in the catalog was the so-called Phillipscurve,whichshowedanapparentlystablestatisticalrelationshipbetween inflation and unemployment. Academic reputationsweremadeandlostintheargumentaboutwhetherthatrelation-shipcouldbereliedonforpolicypurposes;couldwe“tradeoff”abitmoreinflationforabitlessunemployment?12ButthepointofGoodhart’sLawwasmoregeneral,andindeedultimatelythreat-enedtheveryfoundationsoftheeconometricproject,asRobertLucas,professorofeconomicsattheUniversityofChicago,wouldpointoutinhisfamouscritiqueofeconometrics.13Itissimplyalogicalmistake, arguedLucas, to treat thebehavioral equationsinaneconomicmodelas invarianttopolicyintervention,sinceagents shouldoptimallyusewhatever theyknowabout currentpolicypracticewhentheyaredecidinghowtobehave.Changethepolicyruleandyouchangethebehaviorruleaswell.

BothGoodhartandLucaswere,ineffect,warningaboutthelimits of economic management, but toward different ends.Goodhart’saimwastosuggestthattraditionalcentralbankpol-icy,meaningmodest interestratemanagementinthetraditionofBagehotandHawtrey,mightultimatelyprovetobemorereli-ablethanMiltonFriedman’smonetaristrecommendationtosta-bilizepricesbystabilizingthemoneysupply.TheLucascritique,bycontrast,seemedtoapplytoGoodhart’sfavoredcentralbankpolicy as well.14 Lucas’s implication was that the entire coun-tercyclicalmanagementprojectmightbemisconceived.Hereisthe origin of the new macroeconomics that sought to under-standeconomicfluctuationnotasadeviation fromidealWal-rasianequilibriumbutratherastheequilibriumresponsetoanexternalshock.

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theartoftheswap 89

Ironically, the basic point of the Lucas critique had actuallybeenmootedbyTobinhimself. If you take away all the rigidi-tiesinTobin’smodel,thenyouareleftwiththemarket-clearingmodelofWalrasianequilibrium,inwhichmodelthereisnoroleforcountercyclicalpolicytoimprovewelfare.ToTobin,astomostKeynesians, such a market-clearing model was not relevant forpolicy,onempiricalgrounds,andhehasapoint.Labormarketsandgoodsmarketsalikeseemtoinvolvealotmorethanthefluc-tuationofpricesbringingmomentarydemandand supply intolinewithoneanother.Butasadescriptionofthefinancialsideofeconomic reality, the assumption of substantial institutional ri-gidityseemedincreasinglyoutofstepwithdevelopmentsontheground;increasingly,themarket-clearingmodelseemedtobetherelevantone.

Thereasonwasarbitrage.IfRegulationQ,forexample,putaceilingon the rateof interest that savingsand loan institutionscouldpayontheirdepositliabilities,theconsequencewasanin-centive tocreateanewfinancial instrument,with the lookandfeelofadepositaccountbutwithadifferentlegalstatus,towhichRegulationQwouldnotapply.Hereistheoriginofthemoneymarketmutual fund.Subsequently,whenever interest rates roseabovetheceiling,fundswouldmovefromtheregulatedtotheun-regulatedaccount,andborrowersandlenderswouldfindonean-otheroutsidetheregulatedsector,especiallythelargestandmostsophisticated borrowers and lenders. Experience with this kindof“disintermediation,”as itwascalled,producedpoliticalpres-surefromtheregulatedsectorforequaltreatment,pressurethatwasamplifiedbythevoiceofborrowerswhodidnothaveaccesstotheunregulatedsectorandsowerecutoffwhenfundsflowedelsewhere.TheresultwasgradualrelaxationofRegulationQ,andasimilardynamicledtorelaxationofotherNewDeal–eraregula-torystrictures,astheacceptanceofonefinancialinnovationem-boldenedtheinventionofothers.

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90 chapterfour

Theeconomicmanagers (suchasPaulVolcker)workedhardtoslowthisdynamic,convincedastheywerethatregulatoryri-gidities were the central guarantors of safety and soundness, aswellas thebasis forpolicy leverage.Buttheycouldnotstopit,mainlybecauseofthekeyroleofthedollarintheworldfinancialsystem.Asalways,thelogicofarbitragedominatedintheinter-nationalmarkets,whereborrowers and lendersmetoutside thereachofdomesticregulators,andthelargemoneycenterbanksallestablishedoffshoreofficesinordertoparticipate.Theseoffshoreofficesthenservedastheentrypointforthelogicofarbitragetoflowbackintothedomesticsystemandwhittleawayatdomes-ticregulation.Ittookawhile,butevenbeforederegulationpro-ceededtoitsultimateconclusion,theeffectwastocreateaparal-lelunregulatedbankingsystemalongsidethetraditionalregulatedsystem.Intheparallelsystem,realityalreadymatchedthemarket-clearingmodel.

Suchinstitutionalchangemighthavebeenexpectedtorevivethe Bagehot-Hawtrey tradition in monetary economics, sincenothinginthattraditiondependsonrigidities.Inretrospect,theinterventionsofCharlesGoodhartat theBankofEnglandandofHymanMinskyintheUnitedStatescanbeunderstoodasat-temptstodoexactlythat.AtleastintheUnitedStates,however,thetriumphoftheshiftabilityconcepthadlefttheoldtraditionsbehind.Notwithstandingtheassumedinstitutionalrigidities,allassetsinTobin’s1969modelaresalableatapricedeterminedbythebalanceofsupplyanddemand;allareassumedtobeshiftable.Asaconsequence,theeliminationof institutionalrigiditiescre-atedroom,notfortheoldwisdomtoreturn,butratherforanewillusiontoflourish,theillusionthatliquidityisafreegoodinaworldofperfectmarkets.

As infinancial theory, so too inmacroeconomic theory, theguidingnormwasanidealworldwithperfectliquidity.Asinfi-

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theartoftheswap 91

nancialpracticedrivenbytheprofitmotive,sotooineconomicpolicy practice driven by a welfare motive, deviations betweentheidealworldandtherealworldwereconceivedasopportuni-tiesforarbitrage.Mostimportant,monetarypolicycametobeseenas amatterofmaking liquidity in the realworld the freegoodthatitwasinidealtheory.Theresultwasasystematicbiastowardeasebythemonetaryauthorities,systematicbiasthatpri-vatespeculatorswereonlytoohappytoexploitforprivateprofit.Ineffect,themonetaryauthoritiesbecamepartnerswiththepri-vatespeculatorsinaquixoticdrivetomakeEHastrueinrealityasitwasintheory.

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FIVE

WhatDoDealersDo?

Youdon’tknowwhatyou’vegottillit’sgone.Liquidity is like that.Onedayyou’vegotaniceportfolioof

high-yielding fixed income securities, which you can easily fi-nancebyusingthesecuritiesthemselvesascollateraltoborrowinadeepandliquidwholesalemoneymarket.Thenextday,youcannolongerborrowatanyreasonablerate,andyoucan’tsellyournice portfolio either at any reasonable price. Liquidity is gone,anditisabouttotakeyouawaywithit.

Whenthishappens,thereisanaturalhumanimpulsetoblameyourcounterparties.Afterall,itwasonlybecausetheywerewill-ingtolendtoyouthatyouwereabletoputtogethertheportfoliothatisnowhemorrhaging,andthehemorrhagingwouldstopifonlytheystartedtolendagain.Onlyyesterday,youhadyourpickoflendersandcouldplayoneoffagainsttheotherinordertogetthebestdeal,lowratesandlowhaircutsboth.Nowallthelendersseemtobeincahootsagainstyou,allofthemwithdrawingcreditsimultaneously even when they know, better than anyone else,whattheconsequenceswillbeforyouandyourportfolio.

Theimpulsetopersonalizeanexistentialthreat isalltoohu-man,especiallysowhenthethreatcomesfromadirectionwherescientificexplanationhasyettopenetrate.Didmycropsfail?Myenemyhascastaspell.Hiscropstoo?Thegodsarepunishingbothofus.Inthisregard,thedecisionofboththeeconomicsandfi-nancedisciplinestoabstractfromthemonetaryplumbingbehind

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whatdodealersdo? 93

thewalls,thebettertoadvancescientificunderstandingonotherdimensions,hashadfatefulconsequencesforourabilitytosus-tainrationaldiscourseinthefaceofasystemicplumbingfailure.Ifwedon’teducateourselvesabouthowthesystemworkswhenitisworking,wewillhavenoframeworkforunderstandingwhatiswrongwhenitfails.

Fortunately, themoneyviewperspective thatweneed isnotcompletelygone,howeversuppresseditmaybeinacademicandpolicycircles.Intheprivatesector,tradersandspeculatorshavenever lost sight of the crucial importance of the survival con-straint;themarketwon’tletthemlosesight,anditreliablypun-ishesthosewhoignoreitswarnings.Similarly,inthepublicsector,practicalcentralbankers,whodealeverydayinthesameworldthattradersandspeculatorsinhabit,haveneverlostsightoftheirownabilitytorelaxthesurvivalconstraint,andoftheirresponsi-bilitytodeploythatabilitywisely.Thosewhoinhabittheworldofacademiceconomicsandfinancehavetheluxurytoabstractfromtheplumbingbehindthewalls,buttheplumberswhospendtheirdaysdoingbusinessinsidethemoneymarkets,behindthewalls,donot. It is theplumbers’worldviewwemust tap ifweare tolearnthelessonsofthecurrentcrisisandtobuildamorerobustsystemgoingforward.

Inside the Money Market

Thelogicaloriginsofthemoneymarketcanbetraced,perhapssurprisingly,totheoperationsofadecentralizedpaymentssystem.Consideranidealizedworldinwhicheveryonehasadepositac-countandalineofcreditatasinglebigbank.Inthisworld,allpaymentswouldinvolvenothingmorethanentriesonthebooksofthebank.NetdepositorApaysnetdepositorBsimplybyor-

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94 chapterfive

deringthebanktodebithisaccountandtocreditB’saccount,leavingtotalbankliabilitiesandassetsunchanged.Notehoweventhissimpletransfermechanisminvolvespartialrelaxationofthe“survivalconstraint”thatwouldotherwiseconstrainbothAandB; A temporarily enjoys greater cash outflow than cash inflowsimplybydrawingdownhisdeposits,whileontheothersideofthetransactionBtemporarilyenjoysgreatercashinflowthancashoutflow,anduses thedifference toaccumulatedepositbalancesforthefuture.

Linesofcreditatthesinglebigbankallowfurtherrelaxationofthesurvivalconstraint.NownetdebtorCcanpaynetdebtorDbydrawingonhiscreditlineatthebank,increasinghisowndebtwhilereducingD’sdebt,leavingtotalbankassetsandliabili-tiesunchanged.ButalsonetdepositorAcanpaynetdebtorD,causingtotalbankassetsandliabilitiestoshrink;andnetdebtorCcanpaynetdepositorB,causingtotalbankassetsandliabili-tiestoexpand.Thesesimpleexamplesshowhowrelaxationofthedailysurvivalconstraintdependsoncredit;somepeoplecanenjoycashoutflowsgreaterthancashinflowsonly becauseotherpeoplearewillingtoenjoycashinflowsgreaterthancashoutflows,andviceversa.Itallworkssolongascashinflowsandoutflowsonthebooksofthesinglebigbankareequal.

Intherealworldwedonothaveasinglebigbank,butratherasingleintegratedbankingsystem,andthekeytothatintegrationisthemoneymarket.Inoursystem,whennetdepositorApaysnetdepositorB,thereisadebittoA’saccountatA’sbankandacredittoB’saccountatB’sbank,andthereisacorrespondingdebittothereserveaccountofA’sbankandacorrespondingcredittothereserveaccountofB’sbank.Paymentselasticityinourdecentral-izedpaymentssystemthusdependsoninterbankcredittorelaxthe“reserveconstraint”facingindividualbanks;somecanenjoyreserve outflows greater than reserve inflows (A’s bank)because

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whatdodealersdo? 95

othersarewillingtoenjoyreserveinflowsgreaterthanreserveout-flows(B’sbank),andviceversa.

Inourworld,banksholdalmostnoreservesonaccountattheFed—at least thatwas the caseprecrisis—and instead settle ac-counts largelybyborrowingand lending in themoneymarket.Thecentralmechanismforthiskindofinterbankcreditisthefed-eralfunds(FF)market,inwhichbanksborrowandlenddepositsattheFederalReserveinordertokeeptheirnetreservebalancesnearzero.Justso,inthetransactionbetweenAandB,totalretailbankdepositsdonotchange,buttotalinterbankcreditdoesbe-causeA’sbankborrowsthereservesitneedsfromB’sbank.Inter-bankborrowingandlendinginthemoneymarketisthemecha-nismthatmakesitpossibleforourdecentralizedbankingsystemtoapproximatetheefficiencyofasinglebigbank.

WecouldextendthisanalysistocoverthecaseswhereCpaysD,ApaysD,andCpaysB,andtoconsideralsohowtheamountof interbank borrowing depends on the balance sheets of thebanksthatareinvolved.Sometimeswewillgetexpandinginter-bankcreditandsometimescontractinginterbankcredit;itallde-pendsonthepatternofpayments.Butyougetthepoint.Itallworkssolongascashinflowsequaloutflowsinthebankingsys-temasawhole.

Wecouldalsoextendthisanalysistocovercaseswheretherel-evantbanksarenotmembersoftheFederalReserveSystemandthereforedonothaveaccesstothefederalfundsmarket.Inthat

Person A A’s Bank B’s Bank Person B

Assets Liabilities Assets Liabilities Assets Liabilities Assets Liabilities

−deposit −deposit +deposit +deposit

+FFloan +FFloan

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96 chapterfive

case,thenecessaryinterbankborrowingmighttakeplaceintheoffshoreEurodollarmarketattheinterestrateknownasLIBOR(Londoninterbankofferrate).Inafurtherextension,wecouldcovercaseswherethepaymentdoesnotinvolvethebankingsys-tematall,andhenceinvolvesnointerbanklendingatall,insteadinvolving secured borrowing and lending in the repo marketbyA andBdirectly. In effect,A raises funds tomake its pay-mentbyselling(temporarily)someasset,andBreceivesthepay-mentbybuying(temporarily)someasset,oneborrowingandtheotherlendingthroughtheintermediationofsomesecuritydealercounterparty;onceagain,thisinvolvesexpansionofmoneymar-ketcredit.

Thesethreemoneymarketinstruments—federalfunds,Euro-dollars,andrepo—areallclosesubstitutesinthesensethattheycanbeused todomuch the same thing,butnot everyonehasequalaccesstothem,sotheirinterestratescananddovary.Typi-cally,thereporateislessthanthefederalfundsrate,andthefed-eralfundsrateislessthantheEurodollarrate,butthespreadsareverysmall,justafewbasispoints.Textbookshavethereforestudi-ouslyignoredthem,buildingtheiranalysesaroundtheusefulfic-tionthatthereisasinglemoneymarketrateofinterest,controlledunproblematicallybytheFedasapolicyvariable.1Duringthecri-sis,however,thesespreadswidenedto100basispointsormore,offeringprimafacieevidencethatthecrisiswas,atleastinpart,aboutunprecedentedstressonthepaymentsinfrastructure.Ifyoudon’thaveacceptablecollateralforrepoborrowingandyoudon’thaveaccesstothefederalfundsmarket,thenyouhavenochoicebuttobiduptheLIBORrateuntilsomeoneiswillingtolendtoyou.Thatiswhathappenedrepeatedlyasthecrisisunfolded.

Even in normal times, stress arises whenever the pattern ofpaymentsdeviatesfromtheusualsothatunfamiliarcounterpar-tieshavetofindawaytocometogetherasborrowersandlenders.

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whatdodealersdo? 97

Since thepayments systemclearseveryday, there isalways thepossibilitythatthemomentofclearingcomesbeforethedecen-tralizedmoneymarkethasfoundawaytoequalizecashinflowsandoutflows.Inthatcase,thebalancesheetoftheFedisavail-ablethroughthediscountwindowastheultimatebackstop.Us-ingthediscountwindow,theFedstandsreadytoequalizecashinflowsandoutflowsbylending(cashoutflows)andborrowing(cash inflows) as needed. If for some reason A’s bank and B’sbankcannotfindeachotherintheinterbankmarket,theycanmeetthroughtheintermediationoftheFed,withAborrowingandBlending.

Inmodern arrangements, thispublicdiscountmechanism isintendedtobeabackstoponlyforindividualnecessityandonlyuntilaprivateinterbankloancanbearranged;toprovideincen-tiveforrapidunwindthediscountrateissetatapenalty100basispointsoverthefederalfundstarget.Normally,therefore,thedis-countwindowishardlyusedatall,sincefederalfundsarecheaper.Morecommonly,wheneveranunusualpatternofpayments re-quiresageneralexpansionofinterbankcredit,theFedfacilitatesthe expansionby adding reserves to themarket asneeded.Themechanismforthese“openmarket”operationsisrepolendingtosecuritydealersatthemarketreporate,notapenaltyratelikethediscountwindow.

TheFed’sgoalistoactasmuchaspossiblebeforethestressac-tuallyoccurs,soitintervenesdailyinanticipationofpressureintheinterbankmarketthatmightotherwisedrivethefederalfundsrateawayfromthetarget.TheeffectoftheFed’sopenmarketrepo

A’s Bank Fed B’s Bank

Assets Liabilities Assets Liabilities Assets Liabilities

+discountloan +discountloan +reserves +reserves

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98 chapterfive

lendingistoincreasereservesatthedealer’sbankforthetermoftherepoloan,thusprovidingfundsforthatbanktolend(intheinterbankmarket)wherevertheyareneededtofacilitatethepat-ternofpayments.DailyinterventionofthiskindbytheFedcanthusbeunderstoodasthefinalpieceofthemoneymarketmecha-nismthatmakesourdecentralizedbankingsystemoperateasifitwereasinglebigbank.

Funding Liquidity and Market Liquidity

Historically,aswehaveseen(chap.3),therepomarketpredatesthe federal funds market. Before the establishment of the Fed,banks used a kind of primitive repo system to transfer fundsaround the system in their own attempt to create a single-big-bankapproximation.Thefirstlineofdefenseforabankrunningshort of cash reserveswas interbank lending (so-calledbanker’sbalances)analogoustotoday’sEurodollarlending.Butafterthat,privatebondsofvariouskindsservedascollateral for interbanklending.2Herewefindthehistoricaloriginoftheconnectionbe-tween funding liquidity and market liquidity that is so centralto modern arrangements. To understand how that connectionworks,weshiftourfocusawayfrombanks’useofthemoneymar-kettofacilitateelasticpayments,andtowardsecuritydealers’useofthemoneymarkettofundprovisionofmarketliquidity.

Iftherewerenorepomarket,asecuritydealerthatsoughttoprofitbyquotingatwo-waymarketinsomesecuritywouldhave

Fed B’s Bank Security Dealer

Assets Liabilities Assets Liabilities Assets Liabilities

+repo +reserves +reserves +deposits +deposits +repo

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whatdodealersdo? 99

tofinanceitsinventoryofsecuritieswithitsowncapitaloralineofbankcredit.Withthedevelopmentoftherepomarket,repocredit becomes theprimary sourceof funding fordealers,withbankcreditservingonlyasaprivatelenderoflastresort.(Bankloanstodealersaretypicallyarrangedataspreadovertheeffec-tivefederalfundsrate,thatspreadbeingthebank’sprofitoveritsmarginal cost of funds.) Market liquidity (shiftability) dependsonthewillingnessandabilityofdealerstomakeatwo-waymar-ket,andthatdependsonthewillingnessandabilityofdealerstoborrowandlendinthewholesalemoneymarket.3Inmodernar-rangements,theFedservesasbackstoptothisdealersystembothdirectly,throughitsdailyfundingoperationsintherepomarket,andindirectly,throughlenderoflastresortsupportforthebank-ingsystem.

The following stylized balance sheets make clear how it allworks.Tobringintheroleofarbitrage,Idepictthesecuritydealerasharvestingtheliquiditypremiuminthetermstructurebyhold-ingalongpositionintheTreasurybond(shownasanasset)anda short position in theTreasury bill (shown as a liability). Thedealerachievesthesepositionsbyquotingpricesforbothbondsand bills, both buying and selling prices, with an eye towardachieving a target portfolio that balances expected profitabilityagainst risk. (Givenpricequotes imply a specific targetportfo-liothroughtheireffectonorderflowbytheultimatebuyersandsellersofsecurities.)Thedealerfinancesbothpositionswithrepo,usingthebondascollateralforrepoborrowingandacceptingthebillascollateralforrepolending.Someofthedealer’srepobor-rowingisrepolendingbytheFed,butmostofitisrepolendingbyotheragentsnotshown(suchascorporationsormoneymarketmutualfunds).Themarginalsourceofdealerfinanceislendingbythebankingsystem.

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100 chapterfive

Becauseweareconcernedwithissuesofliquidity,notsolvency,I abstract in these balance sheets from the net worth (or capi-tal)ofeachofthesethreeentities.Forourpurposessuchcapitalis importantnot somuchas abuffer againstpotential lossbutratherasaconstraintontheabilityandwillingnessofdealerstoprovide market liquidity by expanding their balance sheets.4 Aprofit-maximizing dealer will have in mind the expected profitfromitstermstructurearbitrageandwillweighthatprofitagainstpotentialrisk.Oneriskisthatbondpricesfall,whichthreatenscapitallossandpossibleinsolvency,buttypicallythedealer’smoreimmediateconcernwillbenotwithsolvencybutwithliquidity,becausethequantityofovernightrepoborrowingdependsonthemarketvalueofbondcollateral.Fallingcollateralvaluesmeanlessavailablerepocredit,andhencegreaterrelianceonmoreexpen-sivebankborrowingand/ortheneedto liquidatesomeportionofthebondinventoryinafallingmarket.Thisliquidityrisk,aswemaycall it, iswhatlimitsthedealer’sabilityandwillingnesstoleverageagivencapitalbase,andthislimitationhasimportantconsequencesforassetprices.

To see the consequences clearly suppose, hypothetically andcounterfactually,thattherewerenosuchlimitation.Then,solongastheexpectedprofitonthetermstructurewaspositive,dealerswouldhaveanincentivetoincreaseleverage,buyingbondsandsellingbills.5Competition amongdealerswoulddrive expected

Fed B’s Bank Security Dealer

Assets Liabilities Assets Liabilities Assets Liabilities

Treasurybills reserves reserves deposits Treasurybond Treasurybill

repolending repolending repoborrowing

loans loans

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whatdodealersdo? 101

profitonthetermstructurearbitragetozero,andtheexpectationshypothesisofthetermstructurewouldcomeintoitsown.Thishypotheticalandcounterfactualworldis,ofcourse,theidealizedworldimaginedbybotheconomicsandfinancetheoryasawayofabstractingfromfeaturesofthemonetarysystemthatdonotin-terestthem;itisaworldinwhichthereisnosurvivalconstraint,hence no liquidity risk, hence no liquidity premium in assetprices.Itisaworldwithoutdealers.

Intherealworldtherearedealers,anddealersfaceaveryrealsurvivalconstraint,butoneconsequenceoftheFed’sbackstopoffunding liquidity is toweaken the forceof thatconstraint.Thequestionis,byhowmuch?KnowingthattheFedwillintervenetostabilizethefederalfundsrate,dealersrationallyshifttheirrisk-return calculus in favor of taking larger positions in the termstructurearbitrage,andsuchashiftcanbeexpectedtomovethestructure of asset prices closer to the EH theoretical ideal, but not all the way.Therehastobesomeexpectedprofitonthetermstructurearbitrageornodealerwoulddoit.Inotherwords,theonly way the EH theoretical ideal could ever be fully achievedwouldbetohavetheFeditselfdothenecessaryarbitrage,becauseonlytheFedislimitedbyneitherprofitconsiderationsnorasur-vivalconstraint.Thatmaywellbehowthingsworkinwartime(aswehaveseen)butitisnothowthingsworkinpeacetime.

In peacetime, notwithstanding the Fed’s backstop, the sur-vivalconstraintlimitsdealerleverageandsomaintainspositiveexpectedprofit for the term structure arbitrage,onaverage, aswell as for other forms of liquidity risk bearing. At any mo-ment,thedealerhasinmindatargetportfoliothatbalancesex-pectedprofitagainstliquidityrisk,andquotestwo-waypricesinanattempttoachievethatportfolio.Anythingthatchangesthetargetportfoliowillthereforecausedealerstochangethepricestheyquote.

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Inthisregard,consideragaintheeffectofexpansionaryopenmarketoperations,nowfromtheperspectiveofthedealersratherthantheirclearingbanks.ExpansionaryopenmarketoperationsmeanincreasedrepolendingbytheFedtothedealers.Theimme-diateeffectistoincreasetheliquidfundsavailabletothedealer,fundsthatsubstituteforexpensivebankborrowingandthusfa-cilitatean increase in thescaleof thedealer’s targetportfolio—specifically,morelongbonds.Toachievethisnewtargetportfoliorequiresincreasingthepricequotedforbonds.Inthisway,openmarketoperationsinthemoneymarketaffectassetpricesinthecapital market immediately, through the risk-return calculus oftheprimarydealers.

Thisdirect and immediate effectonassetprices canbe con-trastedwiththeindirectandlaggedeffectonthelargereconomythateconomistsusuallyemphasize,aneffectthatissupposedtooperatethroughtheincentiveofbankstoexpandcustomerlend-ingwhentheyfindthemselvesholdingexcessreserves.Therecanbe no question which effect is the more immediate. Monetarypolicy works, in the first instance, by affecting the behavior ofdealers,notbanks,andbypushingaroundassetprices,notbanklending.Maybeeventuallythelendingmechanismkicksin,butonatimescalemuchlongerthanthedailysurvivalconstraintthatisatthecenterofamoneyviewperspective.

Thisaccountofhowthesystemworks issimplifiedandstyl-ized,butwecouldeasilyextendittoinclude,forexample,deal-erswhomakemarketsinnon-Treasurysecurities,andwhothere-forefindthemselvesinvolvedinotherkindsofriskarbitrage.Andwe could also extend it to include dealers who do not engagedirectlywith theFed, since any general ease in funding condi-tionswillaffecttheirbehavioraswell.Thegeneralpointisthat,astheprimarydealerschangethepricestheyquoteonTreasurybondsandbillsinanattempttoinfluencetheirownorderflow,

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whatdodealersdo? 103

otherentitiescometofeeltheeffectoftheFed’sinterventionandthey too respond by changing the prices they quote on othersecurities.Interventioninthemoneymarketthusaffectsnotonly(andmaybenotevenmainly)theTreasurybondpricebutalsotheprice of corporate bonds,mortgage-backed securities, and evenforeignsecurities.

Wecouldalsoextendouranalysisinanotherdirection,toin-cludeotherformsofinterventionthatmightinfluencethedealer’srisk-returncalculus,andhencealsoassetprices.Forexample,be-causebanksarelendersoflastresorttothedealers,anythingthataffectsthewillingnessandabilityofbankstoserveinthatcapacitywillinfluencethedealers’estimateofriskandhencetheirwilling-nesstoexpandthesizeoftheirpositionsonagivencapitalbase.Indeed,theprospectoffutureliquidityavailabilitymaybemoresignificanttoarationalriskcalculusthantheavailabilityofpres-entliquiditythatmightwellbetemporary.Survivalrequiressat-isfyingnotonlythepresentsurvivalconstraintbutalsoallfuturesurvivalconstraints;anysinglefailurecanmeantheend.Inthisrespect,apubliccommitmenttokeepthefederalfundsratelowforanextendedperiodoperatesasanencouragementfordealerstoexpandtheirbalancesheets,anencouragementthatcanbeex-pectedtoshowupinassetpricestoday.

Anatomy of a Crisis

Supposethatthereisasuddenshift,forwhateverreason,inpref-erencesbyultimatewealthholdersinfavorofmoneyandagainstsecurities.Furthersupposethattheshiftisnottoolargeandnottoolong-lasting,soitcanbereadilyabsorbedbythedealersytemas follows.Dealersbuythesecurities,financingtheirexpandedbalance sheets by borrowing from banks; banks expand dealer

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loans,financingthoseloansbyexpandingtheirdepositliabilities;andultimatewealthholderssatisfytheirpreferenceshiftbyhold-ingtheexpandeddepositholdings.Callthisa“normalcrisis,”ascaled-downversionofatruecrisis.

Thebalance sheets showhowthepreference shift canbeac-commodated,butnotwhyitisintheinterestofdealersandbankstodoso.Presumablydealerswillbewillingtoincreasetheirhold-ingofsecuritiesonlyiftheycangetagood(low)price,andbankswillbewillingtoincreasetheirholdingofdealerloansonlyiftheycangetagood(high)rate.Thesizeoftherequiredpricefluctua-tionpresumablydependsonthesizeoftheportfolioshockthatthedealersystemisbeingaskedtoabsorb,but,undertheassump-tionthatwearedealingwithasmallshock,asmallfluctuationinpriceshouldbesufficienttobringforththerequiredaccommo-dation.Suchsmallaccommodationsareaneverydayoccurrence;marketliquidityissustainedeverydaybecausefundingliquidityiselasticallyforthcominginthisway.

How,ifatall,willtheFedbeinvolvedintheseeverydayfluc-tuations?Fromthestandpointof thepaymentssystem,ourhy-potheticalportfolioshockisnothingmorethananunusualpat-ternofpayments.Ineffect,wealthholderswanttheircashinflowstoexceedcashoutflows,anddealersarewillingtoaccommodatethembyallowingtheirowncashoutflowstoexceedcashinflows.Inasingle-big-banksystem,thiswouldbehandledbyapairofbook entries. In our decentralized payments system, however,

Wealth Holders Dealers Banking System

Assets Liabilities Assets Liabilities Assets Liabilities

−securities +securities +dealerloans +dealerloans

+deposits +deposits

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whatdodealersdo? 105

thereisaproblembecausehouseholdsareunwillingtoholdthekindof liabilities thatdealers issue.The solution is tohave thebankingsystemacceptthe liabilitiesofthedealers,andto issueliabilitiesthathouseholdsfindmoresatisfactory.Itfollowsthat,totheextentthattheFedseestheportfolioshiftasmerelyafluc-tuationinthepatternofpayments,itwillaccommodatethenec-essaryexpansionofbankcreditbymeansofexpansionaryopenmarket operations in the repo market. If the Fed is successful,thenthefederalfundsratewillremainunchangedandbanksmayevenbewillingtoabsorbfluctuationsindealerborrowingatanunchangedspreadoveranunchangedfederalfundsrate.

Whataboutthepriceofsecurities?Iffundingcostsdonotrisethendealerswillnotrequirequiteaslargeapricediscountasin-centiveto increasetheirholdingofsecurities.Butthedegreeofassetpricemovementwilldependonwhattheassetsarethatthewealthholdersaretryingtoexchangeformoney,andwhattheas-setsarethattheFediswillingtoacceptascollateralforitsrepolending.Atoneextreme,wecanimaginethatwealthholderssellTreasurysecuritiesandtheFedlendsagainstTreasurycollateral,sotheneteffectisnochangeatallinanyassetprice;ineffect,theFed’srepolendingabsorbstheentireportfoliopreferencefluctua-tion.Attheotherextreme,wecanimaginethatwealthholderssellsomethingmoreexotic,perhapssomethingforwhichnodealermakesaregulartwo-waymarket,andcertainlysomethingthattheFeddoesnotacceptasrepocollateral.ThentheeffectonsecuritypriceswillbelargeeveniftheFedstabilizesthefederalfundsrate.Thedealersystemmaystillbeabletoaccommodatetheportfolioshift,butnotwithoutsignificantassetpricefluctuation.

WhataccountsforthedifferencebetweentheTreasurycaseandtheexoticcase?Manythings,probably,butfromtheperspectiveofthemoneyview,onethingstandsout:liquidity.Byhypothesisthereisnodealermakingaregulartwo-waymarketintheexotic

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security,andthatmeansthattheyieldspreadbetweentheexoticsecurityandTreasuries,aspreadthatmightingoodtimesbeonlyafewbasispoints,willhavetowidenuntilareal-moneyinvestoriswillingtotaketheothersideofthetrade.TheimportantpointisthateveniftheFedensuresratherelasticfundingliquidity,thatdoesnotnecessarilytranslateintoperfectmarketliquidityforallassets.Marketliquiditywillbehighestforthoseassetsthatareim-mediatelyshiftabletotheFedbecausetheyareacceptableascol-lateralforborrowing.Otherassetswillbeliquidonlytotheextentthatsomedealerfindsitprofitabletomakeatwo-waymarketinthem, and that can easily change over time, perhaps even sud-denly.OnedayLehmanBrotherswasmakingatwo-waymarketinvariousderivativesofmortgage-backedsecurities,andthenextdayitwasn’t.

Considernowthecaseofa largeportfolioshift.Supposethatdealersdotheirthing,andbanksdotheirthing,andtheFeddoesits thing, so the federal fundsrate stays stablewhilebankcreditanddealerbalancesheetsexpandtoabsorbtheshock.Butsecuritypricesfallacrosstheboard,mostsharplyfortheleastliquidsecuri-ties.Holdersofthosesecuritieswhomarktheirholdingstomarketareforcedtorecognizelosses,andleveragedholdersfindtheircred-itworthinessimpaired.Thesurvivalconstraintbindsforthem,andperhapsthesolvencyconstraintaswell.Failureofonesuchinstitu-tionbringsotherinstitutionsundersuspicion,soeveryonelookstocontractthecredittheyareofferingwhilehoardinganyliquidreservestheymayhave.MoneyratesspikeintheEurodollarmar-ket,notwithstandingFedinterventiontostabilizethefederalfundsrate.Liquidityislikethat.Heretoday,gonetomorrow.

Thepoint is that, ina really severecrisis,market liquidity isnolongeramatterofthefundingliquidityofprivatedealersbutratherofshiftabilitytotheFed.IfanassetisnotshiftabletotheFed,itmaynotbeshiftableatall,oronlyatanunacceptablylarge

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whatdodealersdo? 107

pricediscount.TheFedinacrisisisnotsomuchthelenderoflastresort(fundingliquidity)asitisthedealeroflastresort(marketliquidity). If thedealerscannotorwillnotabsorbtheportfolioshiftandtheFedcontinuestotreattheportfolioshiftassimplyanunusualpaymentspattern,thentheFed’sbackstopofthepay-mentssystemultimatelyrequires it toabsorbtheportfolioshiftonitsownbalancesheet.Hereiswhatsuchanextremecasemightlooklike.

Notethat,inthishypothetical,theFedisdoingexactlywhatthedealerwasdoinginwhatIcalleda“normalcrisis.”Itisbor-rowingfromthebankingsystembyexpandingitsreserveliabil-ities rather than dealer loans, but everything else is the same.Think of “securities” as “mortgage-backed securities” and youhaveafairlyaccuratestylizedpictureofhowbalancesheetsac-tuallystandasofthiswriting(recallfigure1).Ittookawhiletogetthere(seechap.6)butgettherewedid.Undermoderncon-ditions,backstopofmarketliquidityrequirestheFedtoserveasdealeroflastresort.

Monetary Policy

From theperspective of the classicmoney view,monetarypol-icywas all aboutusing “bank rate” to influence thebalance ofelasticityanddisciplinethatisimposedbythesurvivalconstraint

Wealth Holders Fed Banking System

Assets Liabilities Assets Liabilities Assets Liabilities

−securities +securities +reserves +reserves

+deposits +deposits

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108 chapterfive

that faceseach individualentity in the system.The ideawas tointervenebefore thecrisis inordertoavoidlater interventionoflastresort.

Inmodernarrangements,theimportantpolicyrateisthefed-eral fundsrate.TheFederalReserveBoardannouncesaspecifictargetrateatregularintervals,andtheopenmarketsdeskenforcesthattargetbyinterveningdailyintherepomarkettoabsorbfluc-tuatingdemand.ThefederalfundsrateisthemodernanalogtoBagehot’sbankrate,butinmoderndiscussionBagehot’slanguageofelasticityanddisciplineislargelygone,asishisfocusoncon-ditionsinthemoneymarket.Todaypolicymakerstalkalanguageofeconomicstabilizationandtheyfocusattentiononmacroeco-nomicconditions,ashiftinlanguageandfocusthatremainsasalegacyoftheAgeofManagement.

It isnot thatmodernpolicymakersareunconcernedwith li-quiditybutratherthattheyhaveconvincedthemselves,orratherhavebeenconvincedbyeconomists,thatmattersofliquidity(thepurviewofanantiquatedmoneyview)canbeconceptuallyaswellasoperationallyseparatedfrommattersofeconomicstabilization(thepurviewofthemoderneconomicsview).Thepresentcrisishasposedaratherdecisivechallengetothisneatdivisionofintel-lectuallabor,butinevitablypasthabitsofthoughtpersistanditisthesehabitsthatmustbeconfrontedifwearetolearnthelessonsthatthecrisishastoteachus.

Currentmacroeconomic thinking isorganizedaroundsome-thingcalledthedynamicstochasticgeneralequilibrium(DSGE)model,whichwecanunderstand looselyas a jazzed-upversionoftheWalrasianequilibriummodelthatwasatthecenterofthethinkingofapreviousgeneration.Timeandriskarenowexplic-itlymodeled,butthatistheonlysubstantivechange;abstractionfrommonetaryplumbingremainsof theessence,evenmore sotodaythaninthepastthroughtheconvenientanalyticalassump-

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whatdodealersdo? 109

tionofaso-calledrepresentativeagent.(Ifthereisonlyoneagent,therecanobviouslybenoprivatecredit.)Insome“NewKeynes-ian”versionsofthemodel,thekindofinstitutionalrigiditiesandfrictionsthatTobinonceemphasizedareaddedontopoftheba-sicDSGE,withrigiditiesseparatedinto“nominal”and“real”sub-categories;essentiallyallacademicdebateisabouttheempiricalimportanceoftheserigidities.Itisnotsurprising,therefore,thatthe impulse of academic economists, faced with the crisis, hasbeentoaddacategoryof“financial”rigidities(andshocks)tothebasicmodel;thisprogramiswellunderway.6

Wherethisstandardeconomicsviewconfrontsthemoneyviewmostdirectlyisonthequestionofhowtosetthefederalfundsrate,aquestiononwhichproponentsoftheeconomicsviewhavedevelopedacommonstancethatgoesundertheheading“Infla-tionTargeting.”Theideaisthattheoverridingpurposeofmon-etarypolicyislong-runstabilizationofthepricelevel,andforthatpurpose the important thing is to signalcredibly to themarketthatrisingprices(perhapsevenmereexpectationofrisingprices)willbemetwithfirmlyrisingpolicyinterestrates.Knowingthispolicyrule,marketparticipantsaresupposedtoformlong-runex-pectationsofastablepricelevel,expectationsthatthenfeedintotheirinvestmentandconsumptionbehaviorintheshortrun.Inthatshortrun,rigiditiesandfrictionsmaycausetheeconomytodeviateabitfromtheideal,sothepolicyrulemaywanttodevi-ateabitaswell,andthatiswhattheacademicdebateisallabout.

Moreor less allmodern academicdebate is organized as ar-gumentabout theappropriatequantitative settings foraTaylorrule.7Theunderlyingideaoftheruleisthatthemarketbyitselftendstosetthenominalinterestrateequaltothenaturalrateplusexpected inflation—this is theFisher effect,named after IrvingFisher—butthatisnotenoughtostabilizepricesorincome.TheroleoftheFedinstabilizingthelong-runpricelevelshowsupin

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110 chapterfive

aparameterthatdescribeshowtheFedrespondstodeviationsofinflationfromthetarget.Theroleof theFed instabilizingem-ployment shows up in a parameter that describes how the Fedresponds todeviations from full employment.This construct issupposedtobeanalternativetotheoldKeynesianandmonetaristconstructs,andassuchitissupposedtoreplaceMarschak-Tobinastheframeworkforpolicymakerstothinkabouthowtosetthefederalfundsrate.

Fromamoneyviewperspective,theimportantquestionishowaninterestratepolicyguidedbyaTaylorrulefeedsintothebe-haviorofthedealersystem,thecentralinstitutionthattranslatesfundingliquidityintomarketliquidity.SofarinthischapterwehavefocusedontheroleoftheFedinstabilizingfundingcostsforthedealersandontheconsequenceofsuchstabilizationforassetpricesbothinnormaltimesandduringcrises.NowweextendtheanalysistoconsidertheroleoftheFedinchangingfundingcostsforthedealers.Translatedintothelanguageofthemoneyview,the inflationtargetingapproachcouldbesaidtoadvocate lean-ingtowardadditionaldisciplinewhenpricesarerisingfasterthantheinflationtarget,andleaningtowardadditionalelasticitywhenpricesarerisingslowerthantheinflationtarget.

Fromthemoneyviewperspective, themostremarkableblindspotintheTaylorruleframeworkistheimplicationthatinterestratepolicyshouldnottakeanynoticeofassetprices.Theinherentinstabilityofcreditoperates,afterall,throughadestabilizingfeed-backbetweenexpansionofcreditandarisingmarketpriceofcol-lateral.Themoneyviewdoesnottelluswhichassetpricestowatch,sincethedynamiccanoccurincommodities,financialassets,andevenrealassetssuchaslandandhouses;we’vegottobewatchingthemall.Bycontrast,theTaylorrulesayswedon’thavetowatchanyofthem;weonlyhavetowatchtheindexofconsumerprices,whichdoesnotincludeanyassetprices.Thatcanbeaproblem.

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whatdodealersdo? 111

Inamoneyviewperspective, if theFed fails to raise interestrates in the face of a credit-fueled asset price bubble, the bub-blewillfeedonitself,growingeverlargerandhavingevergreaterdistorting effects, until it bursts. Concretely, if funding liquid-ityistoocheap,thenmarketliquiditywillbetoocheapaswell.Themechanismthatconnectsthetwoisleverageonthedealer’sbalancesheet—toomuchleveragewhenfundingliquidityistoocheap.Lowfundingratesthussupporthighassetprices,andpar-ticularlysointhecaseofassetsthatarenotusuallysupportedbyatwo-waydealer(suchasresidentialhousing).Thesearetheassetsthataremostlikelytobecomeovervaluedontheupside,andthesearealsotheassetsthataremostlikelytosufferthelargestcorrec-tiononthedownside.

Whyso?WehavealreadyseenhowfundingliquiditydoesnottranslateperfectlyintomarketliquidityforanyassetsthatarenotimmediatelyshiftabletotheFed,andespeciallynotforanyassetsthatlackthesupportofatwo-waydealer.Itfollowsthatiffund-ingcostsaredistortedbymonetarypolicy,thenafortiorisowillbeassetprices;excessliquiditymayhavelittleeffectonthepriceofassetsthatarealreadyliquid,andmosteffectonthepriceofassetsthataremostilliquid.Onewaythateffectistransmittedisthroughextensionoftwo-waydealersupporttonewclassesofas-setsduringtheboom.

Itcanallworkfineforawhile,asmoneymarketsdotheirjobofchannelingfundsfromthosewithexcesscashinflowtothosewithexcesscashoutflow,whiletheFedprovidessupportforanynecessaryexpansionofbankcreditbystabilizingtheeffectivefed-eralfundsrate.(Inpractice,intherun-uptothepresentcrisis,theEurodollarmarketandtherepomarketofferedquitesatisfactorysunny-daysubstitutesforexpansionoffederalfundscredit.)Themoney view emphasizes the inherent instability of a credit sys-temdrivenbytheprivateprofitmotive,buttheproblemismade

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112 chapterfive

worsewhentheFedadoptsapolicyrulethatdeniesanyrespon-sibilityforpreventingabubble.“Aslongasthemusicisplaying,you’vegottogetupanddance,”saidChuckPrince,thentheCEOofCitibank,inJuly2007.

Theproblemisthatthemusicdoesnotjuststop,itswitchesintoreverse.Suddenly,thosewithexcesscashinflowswanttoholdcash assets,not loans, and thosewith excess cashoutflowsfindthemselvesface-to-facewiththesurvivalconstraint.Publicfund-ingliquiditymaystillbeflowingatthecenterofthesystem,inthefederalfundsmarket,butitnolongertranslatesintoprivatemarketliquidityontheperiphery.Asmarketliquidityvanishes,collateral values crumble and private funding liquidity—bothsecured repo funding andunsecuredEurodollar funding—con-tracts.Sharpcutsinthefederalfundsratemayoffercheappublicfunding liquidity as a substitutebut, as always, there aremanyslipsbetweenthefundingliquiditycupandthemarketliquiditylip.Intheend,itallcomesdowntothequestionofshiftabilitytothebalancesheetofthecentralbank.

Thesimplepointthathasbeenmadeabundantlyclearbythepresentcrisisisthatitisnotatalleasytoseparatemattersofli-quidityfrommattersofeconomicstabilization;bothconceptuallyand operationally they are intertwined. Abstracting from mon-eymaymakeoureconomictheoryeasier,but itdoesnotmakeoureconomicpolicybetter.Atitscore,ourmonetarysystemisadealersystemthatsupportstheliquidityofoursecuritiesmarkets,andtheFedservesasdealer-in-chiefnotonlyinwartimebutalsoinpeacetime,andespeciallyinfinancialcrisistime.Thesoonerweconfrontthisinstitutionalreality,thebetterwewillbeabletofacethereconstructionthatliesahead.

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SIX

LearningfromtheCrisis

Fromtheperspectiveofthemoneyview,thefinancialcrisisthatbeganinAugust2007andthentookasharpturnfortheworseinSeptember2008lookslikeastresstestofthebravenewworldofmodernfinancethatwehavebeenbuildingever sinceabout1970. First currency swaps, then interest rate swaps, and thencreditdefaultswapswereintroduced,andtheeventualresultwastransformationoftherigidandhighlyregulatedfinancialsystemthatwehadinheritedfromDepression-erareform.Regulatoryar-bitragewasnottheonlydriverofthistransformationbuttheim-portant thing is the consequence, a capital-market-based creditsystem that isnowamore important sourceof credit than thetraditionalbankingsystem.Itakeitasgiventhatthisbravenewworldisheretostay,moduloacertainamountoftinkering.Whatdoesthecrisishavetoteachusaboutthekindoftinkeringthatmaybenecessary?

Tinkeringmaybeabadchoiceofwords,sinceitsuggeststhatnotmuchneedstobedone,butIchooseitadvisedlybecauseItakeittobethelessonofhistorythatanynewsystemmustgroworganically out of the old one.We arenot going to start fromscratch,soourreformshadbetterengagewiththesystemasitis,notasitwasoraswemightwishittobeinsomeidealworld.Asalways,themainobstacletochangeisthelagofthinkingbehindexperience.Inthisrespect,thegreatpositivecontributionofthecrisis hasbeen tomake that lag evident, and thus toopenour

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114 chaptersix

mindstothepossibilityofnewwaysofunderstandingthesystemthathasgrownupinfrontofoureyes.

A rehabilitation of the nineteenth-century money view is, Ihavesuggested,theplacetostart,butitisnottheplacetoend.TheconceptofliquiditythatseemedappropriateforBagehotisno longer appropriate for us. Long agowe switchedover fromBagehot’semphasisonthe“self-liquidating”characterofcertainshort-term commercial debts to more appropriate emphasis onthe “shiftability” of certain securities in liquidmarkets.ButwehavenotyetswitchedoverfromBagehot’sconceptionofthecen-tralbankas“lenderoflastresort”tothemoreappropriatemodernconceptionofitas“dealeroflastresort.”Themostimportantcon-tributionofthecrisishasbeentoforceustomakethatconceptualleap inpractice, as apractical response to the exigenciesof thecrisis.Thejobnowisfortheorytofollowpractice,reconstructingthemoneyviewformoderntimes.

In historical retrospect, McChesney Martin’s 1952 policy of“billsonly”establishedtheinstitutionalfoundationsforourmod-ernsystembysettingthedivisionoflaborbetweentheFedandtheprivatedealersystem.InMartin’svision,theFedwouldpro-videfundingliquiditythroughitssupportforthemoneymarket,andthedealersystemwouldtranslatethatfundingliquidityintomarket liquidity in support of the longer-term capital market.Thisvisionprovedprescient.In1952,Martin’smainconcernwasaboutleavingtotheprivatedealersthemarketforlong-termTrea-surybonds.Butasprivatecapitalmarketsrecoveredandgrew,thesamedivisionoflaborwasextendedtocorporatebondsandthen,withsomehelpfromFannieMaeandFreddieMac,tohouseholdmortgage bonds as well. At the peak in 2006, household debt(mostlymortgagedebt)accountedfor44.3percentofoutstand-ingnonfinancialdebtintheUnitedStates,comparedto32.1per-centcorporatedebtandonly23.6percentgovernmentdebt.1

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learningfromthecr isis 115

Even as the financial system evolved, the overarching visionofhowthedivisionoflaborwassupposedtoworkremainedthesame.TheFed intervened in themarket forTreasuryrepowiththegoalofstabilizingthefederalfundsrateatsometarget,andthatwasall.OtherreporatesandtheEurodollarrategotstabi-lizedthroughmoneymarketarbitragebyprivatedealers,andtheprivate money market then served as the source of funding li-quidityfordealeroperationsinsecuritiesofallkinds,producingthetwo-waydealermarketsthatarethesourceofmarketliquid-ity.Monetarymanagementwaslargelylimitedtomanipulationofthefederalfundsrate.Achangeinthefundsrateaffectedmarketliquidityandthusassetpricesbyaffectingothermoneyratesandfundingliquidity.ThatishowMartinthoughtthesystemshouldwork, and how in fact it eventually did work, until it stoppedworkinginAugust2007.

Martin’svisionwasbased,aswehaveseen,onhistoricalAmeri-canpracticethathadbeenhighlightedbyHaroldMoultonasearlyas1918,practicethatpredatedtheestablishmentoftheFedandthatMoultonhopedtheFedwouldfindawaytosupportratherthantoreplace,all intheinterestofthecapitaldevelopmentofthenation.Depressionandwarinterruptedtheevolutionarytra-jectoryfromthoseearlydays,butonlytemporarily.Fromalonghistoricalpointofview,thecentrallessonofthecrisisisthattheAmericansystemrequirestheFed’ssupportasdealeroflastresort,notjustinthemoneymarket(asemphasizedbyMartin)butalsointhecapitalmarket,andnotjustforTreasurysecurities(asem-phasizedbyMartin)butalsoforprivatesecurities.Thepracticalintertwiningofmoneymarketsandcapitalmarketsisthedefin-inginstitutionalfeatureoftheAmericansystem,andthatfeaturerequiresasimilarlyintegratedbackstopbythecentralbank.

ItistheFed’sacceptanceofitsroleasdealeroflastresortthatfinallyputafloorunderthecrisis,asIwillargueindetaillaterin

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thischapter,butthatleavesopenthequestion,whatnext?Inthisregard,itisworthrecallingthat,oncetheBankofEnglandrec-ognizeditsroleaslenderoflastresort,thelogicalnextstepwastofindwaystoavoidevergettingtothatlastresort;thishasbeenthegoalofmonetarypolicyandoffinancialregulationeversince.Byanalogy,nowthattheFedhasrecognizeditsroleasdealeroflastresort,thenextstepwillbetousethatnewawarenessasthefoun-dationfordevelopmentofanewgenerationofmonetarypolicyandfinancial regulation.Thecrisismarks thebeginningof thatprocess,butmeanwhileoldpatternsofthoughtstandintheway.

The Long Shadow of Jimmy Stewart

From a money view perspective, the so-called shadow bankingsystemwasonlyonepartofalargerintegratedsysteminwhichfundingliquidityinthemoneymarketwastranslatedintomar-ket liquidity inthecapitalmarket.But that isnothowmatterslookedtomostpeople.Theveryterm shadow bank revealshowthe new market-based credit system was viewed initially (andstillisviewed)fromtheperspectiveofthetraditionalbank-basedcreditsystem.

Inpartialdefenseofthatpopularview,itiscertainlytruethatthenewsystememergedoutofthetraditionalsystem,andalsoreliedsymbiotically—somemightsayparasitically—ontieswiththatsystem.Moreover,thosetiesturnedouttobecrucialduringthe crisis, since,when the shadowbanking systemcollapsed, itcollapsedfirst onto the traditional banking system.Onlywhenthe resulting loadproved tooheavy for the traditionalbankingsystemtobeardidthesystemofgovernmentbackstopscomeintoplay,asystemofbackstopsthathadneverbeenintendedtosup-portthemarket-basedsystem.

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learningfromthecr isis 117

Thusthegovernmentwoundupsupportingthenewsystemin-directlyandunintentionally,ratherthandirectlyandonpurpose.Insteadofputtingafloorunderthenewmarket-basedcreditsys-tem,thegovernmenthasbeeninterveningtopropupandrestoretheoldbank-basedcreditsystem.Oneconsequencehasbeentoraisetheprospectthatthemarket-basedsystemmighthavebeennothingmorethanatemporaryaberration,andthatitmightbepossible(evendesirable)torollbackhistorytoanearlierandsim-plertime.Thisiswishfulnostalgiaforaworldthatneverwas,nos-talgiafortheJimmyStewartbankingofblessedholidaymemory;butnostalgiaisapowerfulforceandweneglectitsinfluenceonourthinkingatourperil.

In traditional banking, so nostalgic memory reminds us,banks took deposits from households in their community andmadeloanstootherhouseholdsintheircommunity.Itwasasim-plebusiness,anditsmainrisksweresolvencyriskandliquidityrisk.Solvencyriskwasabouttheprospectofloandefault,anditwashandledbyabufferofbankcapital,backstoppedbydepositinsuranceattheFDIC.Liquidityriskwasabouttheprospectofdepositwithdrawals,anditwashandledbyabufferofcashre-serves,backstoppedbythediscountwindowattheFed.Thisisthemodelofbankingthatwasinthebackofmostofourmindsaswelookedatthenewshadowbankingsystem,andfromthisvantagepoint itseemedclearthatthenewsysteminvolvedex-posuretofamiliarsolvencyandliquidityrisks,butthosefamiliarexposures were handled differently.To make the analogy withtraditionalbankingclear,Ishowthetwostylizedbalancesheetssidebysidebelow.

FromaJimmyStewartperspective,thecentralfeatureofshad-ow banking involved a financial institution holding securitizedloans (rather thanwhole loans) and funding those loans in thewholesalemoneymarket(ratherthanwithretaildeposits).Inthe

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118 chaptersix

shadowbankingsystem,solvencyriskwashandlednotsomuchby means of capital buffers as by means of insurance of vari-ouskinds,whichIshowasthepurchaseofacreditdefaultswap(CDS).And liquidityriskwashandlednot somuchbymeansofcashreservesasbyusingthesecuritizedloansascollateralforborrowinginthewholesalemoneymarket.Ishowthisborrowingasasset-backedcommercialpaper(ABCP)andrepo(RP),instru-ments typically held as investments by an institutional moneymarketmutualfund(notshown).2Theimportantthingisthatintheshadowbankingsystemneithersolvencyrisknorliquid-ityriskwasbackstoppedinanydirectwaybythegovernment.ShadowbankingwasJimmyStewartbankingwithouttheregula-tion,butalsowithouttheprotection.

Wasthatabadthing?Itcouldbeargued(andindeedwasar-gued)thatsolongasthegovernmentisnotonthehookasback-stop,thereisnogreatneedforregulation.WidowsandorphansarepresumablynotholdingABCPandRP,somaybewecandis-pense with deposit insurance (and the resulting moral hazard).Furthermore,ABCPandRParenotpartofthemoneysupply,somaybethereisnomacroeconomicreasontoworryeitherandwecandispensewithreserverequirementsaswell.Inretrospect,thepremisesofbothconclusionswerefaulty,buttheimportantpointtoappreciate ishowtheiracceptancewasshapedbytheJimmyStewartconceptionofbanking.

Traditional Bank Shadow Bank

Assets Liabilities Assets Liabilities

cashreserves deposits securitizedloans moneymarketfunding

loans capitalbuffer CDS —ABCP

—RP

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learningfromthecr isis 119

Thesamedistortingperspectivehasshapedourunderstandingofthesubsequentcollapse.Intheearlydaysofthecrisis,itseemedto be nothing more than a classic bank run playing itself outamongtheunregulatedshadowbanksratherthantheregulatedtraditionalbanks,involvingannoyingdisruptionofthewholesalemoneymarketratherthandreadcontractionofretailbankdepos-itsandthemoneysupply.Sinceoneroleofdepositinsuranceistopreventbankruns,itwasnotreallysurprisingthattheuninsuredshadowbankingsystemturnedouttobevulnerabletoruns.AllittookforthemoneymarketmutualfundholdersofABCPandRPtotakeflightwastheslightestanxietyaboutthevalueofthecol-lateralthatwassupposedtobesecuringtheirloans.Thus,sothestorygoes,asaresultofnothingmorethaninitialanxiety,shadowbanksfoundthemselvesunabletorollovertheirmoneymarketfunding;thetypicalconsequencewastotriggerbackupliquiditysupportfromsomeparententity,whichwasusuallyabank.3

Thefirstmarket tocollapsewasABCP, in fall2007.Butex-pansionofRP funding tookupmuchof the slack, andexpan-sionofunsecuredborrowingbyshadowbankparentstookuptherest.(Inunsecuredborrowingthebalancesheetoftheborroweristhesecurity,insteadofsomespecificfinancialinstrument.)RatesspikedinEurodollarandfinancialcommercialpaper(CP)mar-ketstoattracttheneededfunding,butthefundinggotdone.Theholders ofABCPwereworried about theunderlying collateral,but theparentsof the shadowbanksapparentlywerenot (yet),since they were willing to take it back onto their own balancesheets;andthemarketwasnotworriedabouttheparents(yet),sinceitwaswillingtolendtothem.Thus,inthefirststageofthecrisis,thetraditionalbankingsystemwaswillingandabletoactasprivatelenderoflastresorttotheshadowbankingsystem.

Meanwhile,theFedserveddutifullyaslenderoflastresorttothe traditionalbanking system.Like theparentsof the shadow

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120 chaptersix

banks,theFedprofessednottobeworriedaboutthequalityofthecollateral,andmaderoomforsomeofitatthediscountwin-dowbyrelaxingcollateralrequirementsandbyexpandingeligibil-ityrequirements.TheTermAuctionFacility(TAF),introducedinDecember2007,wasthemostimportantfundingchannel,serv-ingasananonymousdiscountwindowwherebankscouldbidforfunds,fortermsuptoninetydays.TheFedfundeditslendingbysellingTreasurybills,ineffectofferingTreasurybillsasasubstitutefortheABCPthatthemarketnolongerwanted.Thus,allthosewhoshunnedABCPgotofferedtheirpickofalternativemoneymarketassets:RP,financialCP,andalso(forthosewhowereveryafraid)Treasurybills.Andforawhileitseemedtobeworking.

Butthen,inMarch2008,BearStearnscollapsedandthecrisisenteredanewphase.NowitwastheRPmarketthatcollapsed,ashaircutsdemandedby lenders soared.4Lenderswere focusing, itseems,notonthefundamentalvalueofthecollateralbutratheronitslikelysalepriceindisorderedmarkets.Evenso,unsecuredborrowingmarketswereabletotakeupmostoftheslack,againbackstoppedbytheFed,whichnowextendedlenderoflastresortsupportdirectlytodealersthroughanewPrimaryDealerCreditFacility(PDCF),andalsothroughtheTermSecuritiesLendingFa-cility(TSLF)whichlentTreasuriesagainstnon-Treasurycollateralthatwasnolongeracceptableforprivaterepo.Againitseemedtobeworking.Eurodollarratesstabilizedatahighspreadoverfederalfundsrates;theFedwaslendingfreelyandthemarginalborrowerwaspayingahighrate,justasBagehotrecommended.

Finally, in September 2008, with the collapse of LehmanBrothersandthenAIG,evenunsecuredmoneymarketfundingfrozeup.Indeed,eventheTreasuryRPmarketfrozeaseveryonepreferredtoholdontoTreasurycollateral;whenthemusicstopsyouwantthegovernmenttobeyourcounterparty.Throughoutthesystem,everyonefacedtheproblemoffindingdollarmoney

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learningfromthecr isis 121

marketfunding,buttheproblemwasmostacuteforthosewhodidnothaveaccesstotheFed.TheresultingscrambleforfundingdroveLIBORratestounprecedentedspreadsoverfederalfundsrates, and theFed respondedby extending lenderof last resortevenfurther,acceptingawiderselectionofcollateralfromawiderselectionofcounterparties.

Onemajorcategoryofnecessitousborrowerwaseveryonewhodepended on commercial paper borrowing for funding, whichmeant nonfinancial borrowers as well as financial borrowers.Tohandlethisproblem,theFedcreatedtheCommercialPaperFundingFacility,whichusedtheFed’sbalancesheettolenddi-rectlytosuchneedyborrowers.5Anothermajorcategoryofneces-sitousborrowerwasthemanyforeignbanksthathadbeenforcedtoabsorbtheirownshadowbanks,andthereforenowfacedtheproblemofrollingtheirdollarmoneymarketfunding.Tohandlethis problem, the Fed used its liquidity swap line with foreigncentralbanks,aprogramthatinitsessentialsamountedtoanex-tensionofdiscountwindowborrowingtoforeignbanks,butwithforeigncentralbanksasintermediarytakingallthecreditrisk.6

FromaJimmyStewartperspective,thisfinalexpansionoftheFed’s role,dramatic though itwas, seemed tobenothingmorethananextensionoftraditionallenderoflastresortsupport.Theonlydifferencewasthescaleofthelending,whichmeantthattheFed could no longer fund its lending simply by liquidating itsholdingofTreasurybills.Nowithadtoexpandits liabilitiesaswell,mainlybyborrowingfrommemberbanks(payinginterestonreservesforthefirsttime),andbyborrowingfromtheTreasurytomakeupanyfundingdifference.

TheJimmyStewartperspectivecanbesummarizedinthefol-lowingseriesofbalancesheets.Thefirstsetshowshowtheshadowbankingsystemfunded itselfbefore thecrisis,mainlyby issuingmoney market securities that were purchased by money market

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122 chaptersix

mutual funds.Thesecondset showshowthe shadowbankpar-entssteppedinwhensecuredfundingdriedupbecauseofconcernaboutcollateralvalues.ThethirdsetshowshowtheFedsteppedintosupporttheshadowbankparentswhenunsecuredfundingalsodriedup.FromaJimmyStewartperspective,thesebalancesheetstellastoryoflenderoflastresort,firstprivateandthenpublic.

Fromabroadermoneyviewperspective,however,September2008wasthemomentwhentheFedmovedfromlenderoflastresorttodealeroflastresort,ineffecttakingthecollapsingwhole-

Funding the Shadow Banking System

Shadow Bank Money Market Mutual Fund

Assets Liabilities Assets Liabilities

securitizedloans ABCP ABCP “deposits”

CDS RP RP

Private Lender of Last Resort

Shadow Bank Parent Money Market Mutual Fund

Assets Liabilities Assets Liabilities

securitizedloans Eurodollardeposit Eurodollardeposit “deposits”

CDS financialCP financialCP

Public Lender of Last Resort

Shadow Bank Parent Fed

Assets Liabilities Assets Liabilities

securitizedloans TAFloan TAFloan currency

CDS PDCFloan PDCFloan bankreserves

liquidityswap liquidityswap Treasurydeposits

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learningfromthecr isis 123

salemoneymarketontoitsownbalancesheet.Butintheheatofthemoment,noonenoticed.AttheverymomentwhentheFed’sbalancesheetwasdoublinginsize,publicattentionwasinsteaddiverted from the problem of liquidity to the problem of sol-vency, focused in that direction by theTreasury’s request for a$700billionCongressionalauthorizationtobuytroubledassets.LatertheTreasury’sstrategywouldmorphintoaplantorecapi-talizethebanks,buttheimportantpointtoemphasizeishowtheJimmyStewartparadigmshapedtheimmediatepolicyresponse.Whenliquidityriskwasthoughttobetheissue,itwastheFed’sproblem;whensolvencyriskwasthoughttobetheissue,itbe-cametheTreasury’sproblem.Inbothrespects, the fact that theshadowbankingsystemhadcollapsedontothetraditionalbank-ingsystemmadeitseemasthoughtheproblemwasnowjustatraditionalbankingproblem.Theproblembecamehowto savethebankingsystem—abigproblem,tobesure,butatleastacom-fortablyfamiliarproblemintellectually.

A Stress Test of Moulton-Martin

Unfortunately,withinthisintellectualcomfortzoneitwasimpos-sibletoconfrontthecentralquestionposedbythecrisis:whydidtheshadowbankscollapseinthefirstplace?Indeed,itisnotjusttheshadowbanksbut,moreimportant,thelargercapital-market-basedcreditsystemthatfailed,anditisthatfailurethatwemustunderstandifwearetoputthesystembacktogetheragain,andonmore solid foundations this time.Thisfinancialcrisis isnotmerelyasubprimemortgagecrisisorevenashadowbankingcri-sis;itisacrisisoftheentiremarket-basedcreditsystemthatwehaveconstructedsince1970,followingMartin’s1952reportandMoulton(1918).

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124 chaptersix

Fromthisstandpoint,whatimmediatelydrawsattentionistheutterbreakdownof theunderlying systemof funding liquidity.Thisistheplumbingbehindthewalls,anditfailedverydramati-cally.Beforethecrisis,almostallfundingoftheshadowbankswassuppliedbyprivatelendinginbothsecuredandunsecuredmoneymarkets. From this point of view, the successive breakdown ofABCP,thenRP,andthenthefinancialCPmarketswasnotjustabouttheshadowbanksnotbeingabletoborrow,butalsoandmorefundamentallyaboutabreakdowninthedealersystemthathadensuredliquidityinthosewholesalemoneymarkets.

ThebigthingthathappenedinSeptember2008wasthatthesystemofprivatedealermoneymarketarbitrage,havingbeenun-derstressformorethanayear,finallyfrozeupcompletely.AndthebigthingabouttheFed’sresponsewasthat it steppedinasthedealeroflastresorttoreplacetheprivatedealersystem.BanksthatneededfundsborrowedfromtheFedthroughthediscountwindow,whilebankswithsurplusfundslentthemtotheFedbyholdingexcessreservebalances.Banksthatwereshortofcollat-eral eligible fordiscountborrowed insteaddirectly through thenewcommercialpaperfacilityortheliquidityswapfacility,andmoneymarketmutual funds that couldnotdeposit at theFedinsteadboughtTreasurybillsandtheTreasurydepositedthepro-ceedsattheFed.

The contemporaneous economists’ debate about the expan-sionof theFed’s balance sheet largelymissed thismost impor-tantpoint.Bernankeandhissupporterstalkedaboutcrediteas-ing(Fedlending)whilehiscriticstalkedaboutquantitativeeasing(Fed borrowing that expanded the reserve base), so reprising alargelyirrelevantprecrisisdebateabouttherelativeimportanceofthe“creditchannel”andthe“moneychannel”inthetransmissionof monetary policy. Meanwhile, the fact that the Fed’s balancesheethadexpandedonbothsidestellsusthatsomethingelsewas

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learningfromthecr isis 125

goingon.TheFedwasmovingthewholesalemoneymarketontoitsownbalancesheet,steppinginasdealeroflastresortforthemoneymarket.(InSeptember2008,itwasyetunwillingtogothenextsteptoserveasdealeroflastresortinthecapitalmarket,butthatwouldcomesoonenough.)

OncewethinkabouttheFed’sbalancesheetexpansioninthisway,thedoublingseemsinfactrathersmall.Afterall,thewhole-salemoneymarketismuchlargerthanthemeretrillionorsothattheFedtookon.ButthereasontheFeddidnothavetodoevenmorethanthatwasthat,byactingasdealeroflastresort,theFedoperatedalsotosupportcontinuedlendingintheprivatemoneymarket,whichwouldotherwisehave frozen. In effect, theFedwasofferingstandingfacilities,bothbuyingandsellingmoney,atpricesawayfrommarketpricessoonlythosewhomostneededit tookadvantage.SimplyknowingthattheFedwasthereasabackstopmadeotherswilling todealprivately inside theFed’sbid-askspread.

But why did private funding liquidity disappear in the firstplace?The sequential characterof the collapsemakes clear thattheunderlyingproblemwaswiththecollateral,firsttheexplicitcollateralintheformofsecuritiesusedforsecuredmoneymarketfunding,andthentheimplicitcollateral intheformofbalancesheetnetworthusedforunsecuredmoneymarketfunding.Whencollateralvaluationscameunderthreat,sotoodidtheabilitytousethatcollateraltoraisefunding.Butwhydidcollateralvalua-tionscomeunderthreat?Fundamentalvaluationwasdefinitelyaconcern—badloanshaddefinitelybeenmade—butfromamoneyviewperspective,priceisfirstofallamatterofmarketliquidity,andthisperspective focusesattentiononthedealer systemthattranslatedfundingliquidityintomarketliquidity.

From the very beginning, the shadow banking system wascompletely dependent on a well-functioning dealer system in

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126 chaptersix

twosenses.First,thedealersystemdeterminedthesecurityprices(marketliquidity)thatestablishedthevalueofcollateral.Second,thedealersystemdeterminedthepriceandavailability(fundingliquidity)ofthemoneythatcouldberaisedusingthatcollateral.Inbothcapitalmarketsandmoneymarkets,dealersquotedpricesandallowedtheirbalancesheetstoabsorbtheresultingorderflow,bothbuyingandselling.Fromthisperspective,theshadowbank-ingsystemwasasourceoforderflow,ademanderofliquiditythattheprivatedealersystemsupplied.

Tounderstandhowthisworked,andthereforehowitbroke,itishelpfultosituatetheshadowbanksmorepreciselywithinthelargerfinancialsystem.Theplacetostartistorecognizethattheshadowbankswereholding(andfunding)onlytheveryhighest-ratedtranchescreatedbyalargersecuritizationprocessthatpack-agedloansandthenslicedanddicedthepackageintosecuritieswithspecificallytailoredriskcharacteristics.Riskiertrancheswereheld—indeed,weredesignedtobeheld—bypensionfunds,in-surancecompanies,andhedgefunds.Bycontrasttotheshadowbanks,theseotherinstitutionseachfundedtheirownslicewiththeirowncharacteristicliabilities,notwithmoneymarketfund-ing.7Theywere, thus,notdemandersof funding liquidity.Buttheyweredemandersofmarketliquidity,atleastpotentially,sincetheydependedontheshiftabilityoftheirassetholdingstolimittheirriskexposure.

Thesourceof thatmarket liquiditywasnot,however, in themarket for the assets themselves. The underlying securitizationtranchesweredesignedtobeheld,nottraded,andingeneraltheywereheld,nottraded,andhereisthesourceofapersistentchal-lengeforthemarket-basedcreditsystem.If there isnotrading,thenwherearethepricessupposedtocomefrom?Andif therearenomarketprices,howarewesupposedtoreassureanABCPorRPlenderthatthecollateralsupportingitsshort-termmoney

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learningfromthecr isis 127

loanisadequate?8Inprinciple,wecouldgivethelenderexplicitrecoursetothebalancesheetoftheparententity—thatwasthesolutionfoundwhenthecrisisfirststruck—butthewholepointofthesystemwastoavoidsuchexplicitrecourseinordertoavoidtheregulatoryrestrictionsthatconstrainedtheparent.Sowheredidthepricescomefrom?

Inretrospect,itisclearthatthesourceofmarketliquidity,andhenceprice,wasinthemarketforcreditinsuranceontheassets,oronassetsofsimilarrisk.Thekeytothewholethingwasthecreditdefaultswapmarket,andthekeysupplierofmarketliquidityforcreditdefaultswapswastheinvestmentbanks,especiallythein-vestmentbanksthatputtogethertheoriginalsecuritizationdeals.Whenthesystemwasworking,investmentbanksstoodreadytomaketwo-waymarkets inCDSsonsecuritizationtranches thattheyhadsoldtoclients.Thatwasthesourceofmarketliquidityfortheentiresystem,andthatwasthesourceofthepricesusedtovalue theunderlyingassets.When the investmentbanks ranintotroubleandthereforepulledbackfromtheirmarket-makingactivity,marketliquiditycontractedandpricesslumped.Thatex-plainswhythecollapseofBearStearnsinMarch2008,andthenLehmanBrothersinSeptember2008,weresuchbodyblowsforthemarket-basedcreditsystem.Theywerebothmomentsofstep-wisecontractionofmarketliquidity.

Butwhydidtheinvestmentbanksgetintotrouble?Totheex-tentthattheywereactingstrictlyasdealers,theywouldhavetriedtomaintain amatchedbook, inwhichpurchasesofprotectionfromsomeclientsservedtohedgesalesofprotectiontoothercli-ents.Onewaythatinvestmentbankdealersdidthiswasbypack-agingupcreditriskinaso-calledsyntheticCDO(collateralizeddebt obligation) and selling it to a client. In a cashCDO, thecredit riskexposurecomes fromowningabasketofunderlyingactualsecurities;inasyntheticCDO,thecreditriskcomesfrom

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128 chaptersix

sellingcreditprotectiononabasketofunderlyingsecurities.Dur-ingtheboom,whenclientswerebeatingdownthedoorsforprod-uct, itwasa relativelyeasymatter to sell such syntheticCDOsand, as a consequence, itwas relatively easy for the investmentbankdealerstoachievematchedbook.9

Anotherwaytheyachievedmatchedbookwasbybuyinginsur-anceontheuppertrancheswhilesellinginsuranceonthelowertranches.Indoingso,however, theyfacedtheproblemofbasisrisk.Whenyousellprotectionononeassetandbuyprotectiononanother,youaredependingoncorrelationbetweenthetwoassetprices,andthatcorrelationimpliesahedgingratio.Forexample,supposeyousellprotectionontheBBtrancheandbuyprotec-tionontheAAAtranche,andyouknowthat insuranceontheAAA tranchemoves$1whenever insuranceon theBB tranchemoves$10.ThenyouneedtenAAAcontractstohedgeasingleBBcontract.That’sa lotofAAAcontracts,anditexplainswhyproblemswiththeAAAtrancheweresodevastatingforthesys-temasawhole.

Ifboth the shadowbanking systemand the investmentbankdealersystemwerenetbuyersofAAAprotection,thenwhowasthenetseller?Theanswer,aswelearnedinthecrisis,wastheinsur-anceindustry,includingtraditionalbondinsurerssuchasAmbacandMBIA,butalsonewentitiessuchastheFinancialProductsDi-visionofAIG.ByinsuringonlytheAAAtranches,theyconvincedthemselvesthattheyweregettingmoneyfornothing,sincetheirmodelstoldthemthattheinsuredriskwasextremelyimprobable.And yet, theirwillingness toprovideAAAprotectionwas com-pletelyessentialtothesystem;withoutit,dealerswouldnothavebeenabletosquareuptheirCDSbooksand,hence,wouldnothavebeenabletoprovidethemarketliquidityonwhichtheentiresystemdepended.Theinsurersweregettingmoneyforsomething,butwithoutrealizingwhatthatsomethingwas.

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learningfromthecr isis 129

Thestylizedbalancesheetsbelowshowhowthesystemworked,whenitworked.Investmentbankswerethesourceofmarketli-quidity,astheywerepreparedbothtobuyandtosellCDSs.Al-thoughnodoubttheywerealsospeculating,Itreatthemstrictlyasdealers,choosingtheirbid-askpricesinanattempttoachievematchedbook;thistreatmentmakesclearhowthesinequanonofthesystemwasthedealers’abilitytobuyAAAprotectionfromthe insurance industry.10 The typical insurance company per-suadeditselfthatbysellinghigh-trancheinsuranceitwasgettingmoneyfornothing.Thetypicalinvestmentbankpersuadeditselfthatbybuyingsufficienthigh-trancheinsuranceitwasachievingmatchedbook.Bothwereprovedwrongbysubsequentevents.

This way of understanding how the system worked when itwasworkinghelpstoexplainoneofthedeepestpuzzlesabouttheboomthatprecededthepresentcrisis,namely,theextremelylowcreditspreadsthroughoutthemarket.Everyoneknewthatsome-onewassellingverycheapcreditinsurance,buteveryonethoughtitwassomeoneelse.Inthecrisiswefoundoutthatthenetsellerwasboththeinvestmentbanksandtheinsurancecompanies.Andthekeymistakethatbothofthemmadewasinnotappreciatingtheliquiditydimensionofthesystem.

Fromamoneyviewperspective,theinvestmentbanksandtheinsurancecompanieswereactingassuppliersofmarketliquidity.The insurers thought theywere insuring a low-probability risk,whereasinfacttheywereactingasaprivatedealeroflastresort,

Investment Banks Insurance Companies

Assets Liabilities Assets Liabilities

high-trancheCDSs mid-trancheCDSs high-trancheCDSs

low-trancheCDSs

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130 chaptersix

sellingmarketliquidityandatapricethatprovedtobetoogen-erous.Thedealersthoughttheyhadmatchedbooks,whereasinfacttheywerespreadingthemarketliquidityinthehightranch-esintothelowertranches,takingonliquidityriskoftheirown.Itallworkedfinesolongasthemusicwasplaying.Onthewayup,amplefundingliquidityinprivatemoneymarketssupportedtheextensionofmarketliquidityintopreviouslyunchartedterri-tory,andthatextensionsupportedcollateralvaluationsthatsup-portedfurtherextensionoffundingliquidity.Onthewaydown,thesamereinforcingcycleworkedinreverse.Thisistheinherentinstabilityofcredit,twenty-first-centuryedition.

Fromthispointofview, the fundamentalproblemwas thattheinsurancecompanieswerewritingcontractsthattheynevershouldhavebeenpermittedtowrite.Likelenderoflastresort,dealer of last resort is inherently a public function, not a pri-vatefunction.Dealersthoughttheyweretakingnoriskbecausetheywere calibrating theirmodelsusinghistorical assetprices.Infact,however,theirwillingnesstowritethoseinsurancecon-tractswaschanging theworld,enablinggreatpocketsof lever-agetobuildupthatwouldposeaproblemofsystemicriskthatwouldoverwhelmtheirprivaterisk-bearingcapacity.WhenAIGstoppedwriting these contracts, thegamewasover.Market li-quiditydrainedfromthesystem,andtheentireself-reinforcingcyclebegantoworkinreverse.

We can read that downward spiral in the chart of the AAAtrancheoftheABXindex,anindexofthepriceofthetoptranchesofCDOsholdingsubprimemortgages(figure2).TheAAAratingreferstotheratingoftheunderlyingcomponentsoftheindexatthetimeofinception(2006and2007vintages).Obviously,manyoftheunderlyingcomponentshavesubsequentlybeenverysub-stantiallydowngraded.TheimportantpointisthatinJuly2007,

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learningfromthecr isis 131

where thechartbegins, thekindof liquidityeffects that Ihavebeendescribingprobablyconspiredtodrivepricesabovevalues.AAAtranchesofCDOsbackedbysubprimemortgageswerebe-ingvaluedasiftheywereTreasurysecurities.

Then, when crisis came, the same liquidity effects conspiredtodrivepricesbelowvalues.Asthecrisisdeepened,fundamentalvaluesalsofell,ofcourse,causingfurthercontractionofmarketliquidityanddrivingpricesdownevenfurther.Butatthecenterofthedownwardspiralwasacollapseoftheprivatedealersystemthattranslatedfundingliquidityintomarketliquidity.Atthecen-terofpolicyresponsetothecrisiswastheFed,whichsteppedinaspublicdealerof last resort tobackstop thecollapsingprivatedealersystem.

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Figure2:Thepriceofmortgage-backedsecuritycollateral.Source:Markit

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132 chaptersix

Dealer of Last Resort

Intheinitialphaseofthecrisis,aswehaveseen,theFedfocusedits interventionon funding liquidity, dependingon theprivatedealer systemto translate that funding liquidity intomarket li-quidity.Thatwouldhavebeenenoughina“normalcrisis,”butthiswasnonormal crisis.As the initial policy responseprovedinsufficient,theFedbegantopaymoreattentiontothemarketliquiditydimensiondirectly.

Wecandatethebeginningofthatattentiontotheintroduc-tion,afterthecollapseofBearStearnsinMarch2008,ofthenewTermSecuritiesLendingFacility.TheTSLFofferedtoswapbonafideTreasury securities for private-label mortgage-backed secu-rities (MBSs). Using this facility, any shadow bank parent thatfounditselfholdinganMBSthatitcouldnotrepo,couldswapthatMBSforaTreasurybond that it could repo. (Initially, thefacilitywas limitedtoMBSsratedAAA.)Legally, theswapwasstructuredasaloan,buttheriskexposurewasthatofacreditde-faultswap,andthestandingcharacterofthefacilitymeantthattheFedwasineffectputtingaceilingonthepriceofoneparticu-larkindofcreditprotectioninsurance,andhenceafloorunderthepriceoftheunderlyingreferencedsecurity.11TheFedwasbe-ginningtodo,initsownsmallway,whatAIGhadbeendoinginamuchbiggerway.Itwasbeginningtoactasdealeroflastresorttothecapitalmarket.

Inretrospect,thisearlyoperationwasacarefultoetestingthewaters in which the Fed, and the government more generally,wouldsoonbepaddlingdesperately.OnSeptember7,2008,theTreasuryputFannieMaeandFreddieMacintoconservatorship,ineffectswappingTreasurydebtforthedebtofFannieandFred-die.Andthen,onSeptember16,theFedtookoverAIG’sbook

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learningfromthecr isis 133

ofcreditderivativesinexchangeforan80percentequitystakeinthecompany.ThusthegovernmentacquiredtheCDSportfoliothathadbeensupportingtheentiresystem;subsequentlyitactedtoensureperformanceofexistingcontracts,butnotyettowritenewones.12

Various facilities to write new CDS contracts, or their eco-nomicequivalents,weresoonforthcoming,however.13OnOcto-ber21,anewMoneyMarketInvestorFundingFacilitywasan-nounced,underwhichtheFedessentiallyprovidedapricefloorat90percentof amortizedcost forhighly ratedmoneymarketassetsheldbymoneymarketmutualfunds.14Therewerenotakersbecauseexpansionofdepositinsurancetomoneymarketmutualfundaccountshadalreadystoppedtherun,butthisearlyfacilityseemstohaveprovidedthemodelforlaterfacilities.InNovember2008, incooperationwith theFDICandtheTreasury, theFedwrotetailcreditriskinsuranceonacollectionof$306billionofmortgage-relatedassetsownedbyCitigroup,followedbyasimilardealfor$138billionofassetsheldbyBankofAmerica.Butbothofthesewereone-offdealstohandleproblemsfacedbyparticu-larlytroubledinstitutions.

Mostsignificant,inanexplicitefforttorestartthesecuritizationapparatus,inMarch2009theFedopenedtheTermAsset-BackedSecuritiesLoanFacility(TALF)tosupporttheAAAtranchesofnew securitized lending.15The ideawas to startwith consumerloans(suchascreditcardreceivablesandautoloans)andthentomove on to mortgage-backed securities, to start with newly is-suedsecuritiesandthentomoveontolegacysecuritiesforwhichthemarketwasfrozen.BecausetheFed’schartergivesitlendingauthority,notinsuranceauthority,thefacilitywasstructuredasaloan.Infact,however,bylendingninetycentsonthedollaronanonrecoursebasisatarateof100basispointsoverLIBOR,theFedwasdoingessentiallywhatLehmanandAIGusedtodo,but

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134 chaptersix

withlessleverageandchargingahigherprice.(Thecreditriskin-volvedinsuchlendingwascoveredbyfundsallocatedfromtheTreasury’sTroubledAssetReliefProgramundersection102,“In-suranceofTroubledAssets.”)

ThusdidtheFedexpanditsdealeroflastresortinterventionfromthemoneymarkettothecapitalmarket.Operatingasdealeroflastresort,theFedfounditselfinventinganewversionoftheBagehotprincipletoguideitsoperations:insure freely but at a high premium.Asdealeroflastresort,whattheFedwasinsuring,itisimportant to emphasize,wasnot thepayments that thedebtorhadpromisedtomakebutratherthemarketvalueofthepromiseitself;thatisthedifferencebetweendealeroflastresortandcreditinsureroflastresort.AsintheoriginalBagehotprinciple,theideaisfortheFedtochargeapricethatprovidesincentiveforthepri-vatemarkettoundercuttheFedonceitrecovers.

Sofar,itseemstohaveworkedaccordingtoplan,asanumberofconsumerasset-backedsecuritizationdealshavecometosuc-cessfulfruitionthroughTALF,whileothershavecometosuccess-fulfruitionoutsideofTALF.Thegoalwastorestartsecuritization,andthatiswhathasbeenachieved.Thescaleoftheprogramhas,however,beenmuchsmallerthanwasanticipatedatthelaunchandthereasonforthatseemstobethatthedetails forexpand-ingTALFto includemortgage-backedsecuritiesnevergot fullyworkedout.

Instead,theFedhasembarkedonaseparateprogramofdirectlypurchasingmortgage-backedsecuritiesthatarebackedbyoneoranotherofthegovernment-sponsoredenterprises(GSEs)suchasFannieMaeandFreddieMac.TodatetheFedhasaccumulatedmorethan$1trillionofsuchsecurities,doingsobypostingabidpricethatishigherthanthemarket.TheFedhasbeenactingasdealeroflastresort,notjustinthecreditinsurancemarket,which

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learningfromthecr isis 135

wasthesourceofmarketliquidityprecrisis,butnowinthecapitalmarketdirectly.

Theseareboldandinnovativeexperiments,butthebasicpat-terncomesthroughclearly.TheFednowrecognizesthat,forourmarket-basedcreditsystem,itmustremakeitselfasdealeroflastresort.ThevariousfacilitiesthattheFedhaslaunchedhavebeencobbledtogetherinordertofitunderexistinglegislativeauthor-ity;inthelongerrun,legislationcanbeexpectedtoadapttothenewreality.Morefundamentally,wecanlookforwardtoaremakeoftheframeworkformonetarypolicy,goingbeyondtheprecrisisfixationontrackingthe“natural”rateofinterest,andtakingac-countforthefirsttimeofthekeyconnectiontoassetpricesthatrunsfromfundingliquiditytomarketliquidity.

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Conclusion

OntheeveoftheFed’scentennialyear,wefindourselvesgrapplingwithmanyofthesameissuesthatconcernedtheFed’sfounders,albeitnowwiththebenefitofacentury’sexperiencewithcentralbankingAmericanstyle.Tobesure,wehaveourownintellectualblinderstoovercome,mainlya legacyofwhatIhavecalledtheAgeofManagement,but theyaredifferentblinders fromthosethatheldbackourforebears.Unlikethem,weare inapositiontoappreciateMoulton’semphasisonshiftability,aswellasMar-tin’s emphasis on the dealer system as the source of that shift-ability.Ourblindersinvolve,ifanything,excessiveappreciationoftheseemphasesandinsufficientappreciationoftheirlimitations.Tosaythattheessenceofliquidityisshiftabilityisnottosaythatliquidityisorshouldbeafreegood,anditisnottosaythatwecansafelyabstractfromliquiditywhenweconsiderquestionsofmonetarypolicyandfinancialregulation.Thisisthecentralles-sonofthecrisis.

WhataretheimplicationsoftheFed’snewroleas“dealeroflastresort”fornormaltimes?Thatisthequestionthatwemustconfrontlookingforward,startingfromtherealizationthatourmarket-based credit system relies critically on two-way dealermarkets that link funding liquidity in themoneymarketwithmarket liquidity in the capitalmarket.TheFedmust thinkofits roleas intervening to supportandmanage that systemasawhole,notjusttosetthepriceinanarrowsliceofthefundingmarkets.

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conclusion 137

In the money market, the Fed’s responsibilities clearly mustinvolveongoingoversightofprivatefunding liquidity,inRPandEurodollarmarketsaswellasfederalfunds,sincetheFedinevita-blyservesasdealeroflastresorttothesewholesalemoneymarkets.Thisisnew,butarguablyastraightforwardextensionofBagehot.

WhatisnotastraightforwardextensionofBagehotistheFed’slikelyongoingconcernwithmarket liquidity,andnotjustinTrea-sury securities but also in private securities, most importantlymortgage-backedsecurities.Akeylessonofthecrisisisthatfund-ingliquidityisnotenough,sinceinacrisisfundingliquiditydoesnotgettranslatedintomarketliquidity,nomatterhowhardtheFedworkstopushfundsoutthedoor.Asdealeroflastresort,thegoaloftheFedshouldnotbetosetthemarketpricebutonlytosetapricefloor,whichinnormaltimesshouldbesomedistanceawayfromthemarketprice.

Tofixideas,considerthestylizedbalancesheetbelow,whichshowstheprivatedealersystemengagedinharvestingoneliquid-itypremiuminthetermstructureofinterestrates(firstline),andalsoanotherliquiditypremiuminthecreditstructureofinterestrates(secondline),inbothcasesfinancingitspositionsintherepomarket(thirdline).Thisisastraightforwardextensionofthestyl-izeddealertreatedinchapter5.TheonlydifferenceisthathereIamconcernedaboutmarketliquidity,notfundingliquidity.Thebehavioroftheprivatedealersystemisdrivenbythetradeoffbe-tweenexpectedprofitandrisk.

Private Dealer System

Assets Liabilities

Treasurybonds Treasurybills

mortgage-backedsecurities Treasurybonds

RPlending RPborrowing

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138 conclusion

ThejoboftheFedisnottoeliminatetheriskthatdealersfacebutrathertoputboundsonit,toestablishanarenawithinwhichprivatecalculationofexpectedprofitandriskmakessense.Sinceriskisnoteliminated,neitherisexpectedprofit;liquidityisnotafreegood.Weshouldthereforeexpectthetermstructurearbitragetomakemoneyonaverage,butthatisbecauseitisrisky;thesamegoesforthecreditstructurearbitrage.ThegoaloftheFedshouldnotbetogetascloseaspossibletotheimpossibleidealofperfectliquidity,butonlytosetboundsthatkeepthesystemfromrun-ningofftherails.

Forthispurpose,itishelpfultothinkofthedealeroflastre-sortfunctionasakindoftailriskinsurance.Forexample,thinkoftheFedasstandingreadyalwaystobuysomeselectgroupofAAAprivatesecuritiesateightycentsonthedollar;thisisakindoflimitorder,anout-of-the-moneytradingoption,butitcanalsobeviewedasakindofcreditprotectionthatinsuresthepriceofthereferencedsecuritywillnever fallbeloweighty.Thetwenty-centhaircutistheretoservethesamefunctionthatthehighinter-estratedoesinclassiclenderoflastresortintervention:itensuresthatthosewhousethefacilitydosoonlyasalastresort.

Inpractice,duringnormaltimes,probablynoonewillusethefacilityatall;theFedwantstobeartailliquidityrisk,nottailcredit risk,andinordertoavoidthelatter,itsdealeroflastresortpricemayhavetobesetratherfarfromthemarketprice.Someotherarmofgovernment,nottheFed,mayberequiredtobeartailcreditriskinordertoestablishsomewhattighterboundswithinwhichprivatedealerscanreasonablybeexpectedtooperate.(Injustthisway,theTreasuryhastakenonthecreditriskinvolvedintheFed’sTALFprogramandtheGSEshavetakenonthecreditriskintheFed’sMBSpurchaseprogram.)Butthereisanimportantdiffer-encebetweenacreditinsureroflastresortandadealeroflastre-sort;forthelatter,thegoalisguaranteeingshiftability,notindem-

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conclusion 139

nifyingforlossesofwealth.ThisconceptualdistinctionhasbeencharacteristicofalloftheFed’sinterventionsduringthecrisis,anditseemstobeamodelthatcouldworkinnormaltimesaswell.

Havingsettheboundsthatestablishthepossibilityofrationalriskcalculation, theFedcanthenturn itsattentionto itsmoretraditional function, setting the money rate of interest. It will,however,nolongerbepossibletomaintaintheillusionthatmon-etarypolicyisaboutmacroeconomicmanagement,separatefromliquiditymanagement.TheFedhastwoinstrumentsandtwotar-gets, but both instruments influence both targets and must beconsideredtogether.Thedetailsofhowexactlythiswouldworkcanbeleftforfuturework.Here,itmustsufficetoobservethatpushing around the money rate of interest inevitably pushesaroundtheexpectedprofitfromtermstructureandcreditstruc-turearbitrage,andhencethewillingnessofthedealersystemtoexpand,thussupportingmarketliquidityandhenceassetprices.

Theclassicmoneyviewurgedcentralbankerstoattendtothebalanceofdisciplineandelasticityinthemoneymarket,inordertomanagetheinherentinstabilityofcredit.Ourmodernworldis notBagehot’sworld, by a long shot, but at thehighest levelofabstractiontheclassicmoneyviewholdsastrueinourworldas inhis.Themoneymarket iswherepromisesmade aremea-suredagainstresultsachieved,andcommittedcashoutflowsareweighedagainst realizedcash inflows.Thesurvival constraint isthedisciplinethatmaintainsthecoherenceofourdecentralizedmarket system, andmanagementof that constraint is themostimportantdutyofthecentralbank.

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Notes

Introduction

1. Shiller(2008),Morris(2008),Zandi(2009).2. Wicksell(1936[1898]).3. Woodford(2003).4. Taylor(2009).

ChapterOne:LombardStreet,OldandNew

1. Minsky(1967,33).2. Hawtrey(1923).3. Schumpeter (1934). There is, of course, also risk on the other

side—risk of fostering excessive growth on the way up and excessivedestructiononthewaydown.This is theriskemphasizedbymodernneo-AustrianwriterssuchasClaudioBorioandWilliamWhite(2004).

4. Hawtrey(1934).5. Generalcollateral repotypicallypaysahigher interest rate than

Treasuryrepo,butbothratesaretypicallylowerthanthefederalfundsrate. Quoted Eurodollar rates are typically higher than federal fundsrates,butusuallybyonlyafewbasispoints.

6. BrunnermeierandPedersen(2009).7. AdrianandShin(2009).

ChapterTwo:OriginsofthePresentSystem

1. Sprague (1910) is the classic account of pre-Fed crisis. For thepost-FedperiodIrelymainlyontheaccountofWood(2005),butother

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142 notestochaptertwo

classichistoriesoftheFedincludeHarding(1925),Wicker(1966),Tim-berlake(1993),D’Arista(1994),andMeltzer(2009).

2. Young(1999[1924],304).3. FederalReserveAct,section13(2),“DiscountofCommercial,Ag-

riculturalandIndustrialPaper.”4. Theoriginof this adaptation isCharlesF.Dunbar (1885), but

themainadvocateforthispositionatthetimeofthefoundingoftheFedwasLaurenceLaughlin(1903),andhisstudentHenryParkerWillis(1914).SeeMehrling(1997,33–39).

5. Moulton(1918,723).Moultonistheoriginoftheshiftabilityhy-pothesis,butseealsoMitchell(1923,1925)andCurrie(1931).

6. Moulton(1918,726).7. Moulton(1918,723n.1).8. D’Arista(1994,chap.1).9. D’Arista(1994,31–32).10. Outside theFed,othervoicesurgedanotherversionofquan-

titativecontrolfocusedonthenarrowergoalofstabilizinganindexofpricesandoncontrollingthemoneysupply(notthepriceofcredit)inordertoachievethatgoal.TheYaleeconomistIrvingFisherpositionedhimselfastheintellectualleaderofthatmovement(FisherwithCohrs-son1934).

11. Laidler(1993).12. Wicker (1969) coined the phrase Strong rule. See also Wood

(2005,206–208).13. Thisrulecanbeunderstoodasanadaptation,forAmericancon-

ditions,ofclassicBritishcentralbankingpractice.BecausecommercialloansplayedalessimportantroleintheUnitedStates,openmarketop-erationsto“makebankrateeffective”werecorrespondinglymoreimpor-tantthaninBritainandnotlimitedtotimesofexceptionalslack.

14. Forexample,Warburg(1930).15. Eichengreen(1992,chap.7).16. Wood (2005, 201) argues that, by the measure of the Strong

rule,theFedrespondedveryaggressively,sinceitdrovediscountsdownfrom$329millioninJuly1929toonly$9millioninJuly1930.

17. FriedmanandSchwartz(1963).SeealsoCurrie(1934).

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notestochapterthree 143

18. Fisher(1933).SeealsoHart(1938).19. Phillips(1993)providesausefulhistoryoftheinfluenceofthese

largelyacademicreformersonsubsequentlegislation.AccordingtoSan-dilands(1990),thekeypolicyactorwasLauchlinCurrie,butseealsoFisher(1935),Simons(1934),andHart(1935).

20. Morton(1939,281).21. Morton(1939,283).22. Thus,Mints (1945) isbeatingahorse thathadbeendead for

quitesometime.23. Laidler (1999) places Keynes in the larger context of de-

velopments in macroeconomic thought during the interwar period.Mehrling(1997)showshowthereceptionofKeynes inAmericawasimportantly conditioned by the indigenous intellectual tradition ofinstitutionalism.

24. Hansen(1938,318).25. Wood(2005,226).26. Hetzel and Leach (2001a, 2001b). See also the biography of

Martin(Bremner2004).

ChapterThree:TheAgeofManagement

1. QuotedinSproul(1980,53).2. Theincreasehappenedinthreesteps:August15,1936;March1,

1937;andMay1,1937.3. Keynes(1930,2:143),Hicks(1939,146–147).4. FederalOpenMarketCommittee(1952);andseeWood(2005,

247–252).5. Sproul(1980,105–111).6. BrunnerandMeltzer (1964)offeran influentialcritiqueof this

procedure.7. Sproul(1980,155).8. Sproul(1980,160).9. SeeFriedman(1959).Notwithstandinghisroleintheunfolding

drama,Friedmanhimself is best understood,not through the lens of

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144 notestochapterfour

IrvingFisher,butratherthroughthatofHenrySimons(1934)andhisproposalfor100percentmoney.SeeFriedman(1948).

10. Debreu(1959),ArrowandHahn(1971),Hahn(1965).IthankDouglasGale(1982)forfirstbringingmyattentiontotheimportanceofthisproblem,almostthreedecadesagowhenIwashisstudentattheLondonSchoolofEconomics.

11. MarschakexplicitlyrecognizedHicks(1935)asaprecursor.12. OtherearlyattemptstoreprisetheMarschakapproachinclude

Modigliani(1944)andPatinkin(1956).13. Tobin(1969,26).14. FriedmanandMeiselman(1963),AndoandModigliani(1965).15. AndoandModigliani(1969).16. Tobin(1969,26).17. Minsky (1982,1986), and seeMehrling (1999).Other voices

includeFandandScott(1958),Leijonhufvud(1968),Clower(1984),Goodhart (1975b), Kindleberger (1978), and Hicks (1989) in hislatework.

ChapterFour:TheArtoftheSwap

1. StigumandCrescenzi(2007,869–873).2. Asearlyas1913,KeynesusedUIPtoanalyzetheforeignexchange

relationshipbetweentheBritishpoundandtheIndianrupee(Keynes1913).Hereistheoriginofhislaterthoughtsonforwardinterestparity(1923,124)andnormalbackwardation(1930,2:143).

3. Typically, but not always, this bet involves borrowing at a lowrateinonecurrencyandlendingatahighrateinanother,andthebetiscalleda“carrytrade”becauseofthepositive“carry”involvedintheinter-estdifferential.

4. OperationTwistwasfollowedbyotherincreasinglyinventiveat-temptstohaveitbothwaysuntil1971,when,underPresidentNixon,thedollarwasdevaluedagainstgold,andthen,in1973,allowedtofloatfreely. From thenon,UIP arbitrage continued, butwithout anyoffi-

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notestochapterfour 145

cialsupportoftheexchangevalueofthedollartoactasananchorforexpectations.

5. Black(1970,5).6. HereIfollowDuffieandSingleton(2003,180).7. Thereliableavailabilityofthishedgeisthereasonthatinterestrate

swapcontractsaremosttypicallywrittenintermsoftheLondoninter-bankofferedrate (LIBOR)rather thanTreasuryrates.TheavailabilityofdeepmarketsinTreasurysecuritiesofmultiplematuritiesmeansthatthereisalwaysliquidityintherelatedTreasuryforwardandfuturescon-tracts,whichcanalsobeusedtohedge.ButbecauseinterestrateswapsreferenceLIBOR,nottheTreasuryrate, thehedgeisnotperfect.It ispossible tomanagetheremaining“basis risk”bytradingtheso-calledTED(Treasury-Eurodollar)spread,whichthereforebecomesasensitiveindicatorofsystemwidestress.

8. ThelackofanaturalhedgeisakeyobstacleinthewayofcurrentproposalstomoveCDSsontoanexchange.

9. Sharpe(1964).SeeMehrling(2005)forthefullerstory,whichisacaseofmultipleinventioninvolvingJohnLintneratHarvardandalsoJackTreynor.

10. Moreprecisely, thekey issuewaswhether the risk involved inEHandUIParbitrageisdiversifiableornot,anissuethatwasunder-stoodasamatterofcovarianceriskwiththemarketasawhole.

11. Goodhart(1975a).12. Friedman(1968),Phelps(1968).13. Lucas(1976).14. TheLucascritiquewasaimeddirectlyat theMarschak-Tobin

framework,andTobinrespondedinkind,characterizingLucas’squiet-istpositionasMonetarismMarkII(Tobin1980),thuspaintingitasthesuccessortoMiltonFriedman’sMonetarismMarkI.Infact,how-ever,Friedmanhadneverquestioned thecountercyclicalproject, andhadconfinedhiscritiqueofKeynesianeconomicmanagementtothequestionofwhichlevertouse(monetaryversusfiscal)andhowbesttouseit(rulesversusdiscretion).

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146 notestochaptersix

ChapterFive:WhatDoDealersDo?

1. ButseeMehrling(2010b).2. Onereasonforthedevelopmentofcreditratingagencieswastofa-

cilitatethiskindofoperation.SeeFlandreau,Gaillard,andPacker(2009).3. BrunnermeierandPedersen(2009).Thefollowinganalysistakes

itsinspirationfromthefinanceliteratureonmarketmicrostructure,es-peciallyTreynor (1987),Harris (2003), andBiais,Glosten, andSpatt(2005).SeealsoHicks(1989).

4. AdrianandShin(2009).5. Thisargumentcanbemademorerigorousbyassumingthatthe

dealerhedgesinterestrateriskexposureintheinterestratefuturesmar-ket.SeeMehrling(2010b).

6. WoodfordandCurdia(2009).7. TaylorandWoodford(1999).

ChapterSix:LearningfromtheCrisis

1. FederalReserve,flowoffundsstatistics,availableatwww.federa-reserve.gov/releases/z1.Author’scalculation.

2. ABCPwasimportantfortheoff–balancesheetstructuredinvest-ment vehicles, a versionof shadowbanking inwhichCitibankwas adominant player. RP was more important for on–balance sheet arbi-trage,aversionofshadowbankinginwhichtheUnionBankofSwitzer-landwasadominantplayer.

3. Gorton(2010)providesthedefinitiveaccountofthecrisisfromthisperspective.

4. GortonandMetrick(2009).Fedpolicyreactionsduring2008arewelldocumentedinFederalReserveBankofNewYork(2009).

5. Adrian,Kimbrough,andMarchioni(2010).6. McGuire andvonPeter (2009),Goldberg,Kennedy, andMiu

(2010).7. Hedgefundsusedmoneymarketfundingindirectly,sincethey

reliedonloansfromtheirprimebrokers,whotypicallyfundedtheloanswithwholesalemoneymarketborrowing.

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notestochaptersix 147

8. Attheinitialoffering,creditratingagenciesplayedaroleines-tablishingpricebyputtingtheirAAAimprimaturonthetoptranches.Buttheydidnotbuyorsellinsupportofthoseprices,eitherinitiallyorinthesecondarymarket.

9. Indeed,atthepeak,someinvestmentbanksapparentlyusedthissyntheticCDOmechanismnotmerelytohedgecreditprotectionthattheyhadsoldtoclients,butevenmoretoestablishanetshortpositionbeforethecrash.That,ofcourse,isnotmatchedbook;itisspeculation,notdealing.

10. Tett(2009)tellsthestoryofhowJ. P.MorganfirstdevelopedthissystemforcorporatebondsandcorporateCDSs.BankforInterna-tionalSettlements(2008)tellshowthesystemwasadaptedtosecuritizedconsumerloansandmortgages.

11. TSLFoperated throughperiodicauctions,but the sizeof theauctionswasscaledtotheneed,andeveryoneknewit.Thisisthesenseinwhichthefacilitycouldbeconsidered“standing.”

12. The main beneficiaries were Societé Générale and GoldmanSachs.SeeSIGTARP(2009).

13. I had been concerned about the lack of public backstop forCDSssincetheearlydaysofthecrisis(seeMehrling2010a).OnSep-tember23,2008,IpublishedaletterintheFinancialTimesurgingtheTreasurytostepinas“marketmakeroflastresortintheindexcreditde-faultswapsontheABX.”ThisistheseedoftheidealaterdevelopedwithmycoauthorsKotlikoffandMilneunderthename“creditinsureroflastresort”(KotlikoffandMehrling2008;MehrlingandMilne2008).Thekey idea,however,was always to ensure shiftabilitybyprovidinga li-quiditybackstop,nottosocializeprivatelossesofwealth.“Dealeroflastresort”isthereforeabetterdescriptorthan“creditinsureroflastresort.”Arelated,butnotidentical,setofproposalswasputforwardearlyoninthecrisisbyBuiterandSibert(2007).

14. Davis,McAndrews,andFranklin(2010).15. Ashcraft,Malz,andPozsar(2010).

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AAAtranche,128–33,138,147n8ABXindex,130academicadvice,56–60AdHocSubcommitteeontheGov-

ernmentSecuritiesMarket,53AgeofManagement,136;academ-

icsand,56–60;arbitrageand,54–55;“billsonly”policyand,54–55,60;EmploymentActof1946and,52–53,56,58–59,64;expectationshypothesisand,49,51,54,65;Fed-TreasuryAccordand,56;freereservesconceptand,55–56;Gurley-Shawidealizationand,59–60,62–63;liquidityand,50–52,59–62,64–70;Marschak-Tobinmodeland,63–65,78–79,87,110,145n13;Minskyand,66–69;normalcyand,51,53,69;pricesand,48–54,57–64,68–70;shiftabilityand,48–51,59,64;Walrasianismand,60–65,70

AIG,2,120,128,130,132–34AldrichBillof1912,32Aldrich-VreelandActof1908,32Ambac,128AmericanEconomicAssociation,56AmericanFinanceAssociation,56

arbitrage,138–39;AgeofManage-mentand,54–55;learningfromcrisisand,113,115,124,146n2;NewLombardStreetapproachand,26–27;privatedealersand,99–102;swapsand,72,76–79,85–91,144n4,145n9;uncoveredinterestparity(UIP)and,76–79,83–86,144nn2,4,145n9;warfi-nanceand,37

Arrow,Kenneth,61–62,64,144n10ArthurD.Little,79asset-backedcommercialpaper

(ABCP),118–26,146n2

Bagehot,Walter,1,137,139;activemanagementand,38;learningfromcrisisand,8–10,114,120,134;“moneydoesnotmanageitself,”8;moneyviewand,2,5;NewLombardStreetapproachand,25–29;OldLombardStreetapproachand,18–20,22–23;pri-vatedealersand,108;swapsand,88,90

balancesheet:creditchanneland,124–25;moneychanneland,124–25;NewLombardStreet

Index

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160 index

balancesheet(cont’d )approach,23–29;OldLombardStreetapproach,18–23.See alsoFederalReserve

BankingActof1933,44BankingActof1935,44–45,48bankingprinciple,31BankofAmerica,133BankofEngland,5,29;Ageof

Managementand,67;financialcrisisand,20–23;Goodhartand,87–88,90;IssueDepartmentof,21–22;aslenderoflastresort,22–23,116;OldLombardStreetapproach,18–23

Bank of England Operations(Sayers),67

bankrate,4–5,7,65,107–8,142n13bankruns,119BearStearns,2,36,120,127,132Bernanke,Ben,124“billsonly”policy,46–47,54–55,60,

78,114Black,Fischer,79–82BrettonWoods,23,71,71–72Britishsystem:Bagehotand,1–2,5,

8–10,18–20,22–23,25–29,38,88,90,108,114,120,134,137,139;Hawtreyand,12,15,29–30,38,40,67–69,87–88,90;LIBORand,96,121,133,145n6;Minskyand,66–67;Sayersand,67;swapsand,72–74

Brunnermeier,Markus,146n3bubbles:instabilityofcreditand,12,

15–17;learningfromcrisisand,6,8;moneyrateofinterestand,8;privatedealersand,111–12;re-

sponsibilityand,112;stockmar-ketcrashof1929and,35,41–43

capital,45;AgeofManagementand,48,51–54,59–70;fixed,34;instabilityofcreditand,15,17;learningfromcrisisand,6–7,113–18,123–26,132–35;moneyviewand,2,4(see alsomoneyview);NewLombardStreetap-proachand,26;privatedealersand,99–103;shadowbankingsystemand,41,113–18,123–26;swapsand,71–82,85–86;working,34

capitalassetpricingmodel(CAPM),85–86

capitalism,11–12cashflows:FinancialInstability

Hypothesisand,11,67;hedgefinancestructuresand,67–68;instabilityofcreditand,12–17;Minksyand,11,13,16,66–69,71,87,90;moneyviewand,3–5;NewLombardStreetap-proach,23–29;OldLombardStreetapproach,18–23;Ponzifinancestructuresand,67–68;reserveconstraintand,9,13,29,94;shiftabilityand,6–7,34,38,42–51,59,64,82,90,99,106,112,114,126,136–39,142n5,147n13;survivalconstraintand,13–14,16–17,93–94,101–3,106–8,112,139;swapsand,71–91;timingof,5

“CentralBankingandMoneyMarketChanges”(Minsky),66

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index 161

centralbanks:academictheoryon,56–60;AgeofManagementand,57–60,63–66,69–70;artof,15;BankofEngland,5,19–23,29,67,87,90,116;bankrateand,4–5,7,65,107–8,142n13;dealeroflastresortand,2,10,28,84,107,114–16,122–25,129–38,147n13;disciplineand,4–9,13–15,17,20,29,55,92,107–10,139;discountaccommodationand,35–36;FinancialInstabilityHypothesisand,11,67;haircutsand,23–24,27,92,120,138;instabilityofcreditand,12–17;learningfromcrisisand,7–10,112–15,121;lenderoflastresortand,1–2(see alsolenderoflastre-sort);Marschak-Tobinmodeland,63–65,78–79,87,110,145n13;moneyviewand,2–10,65,79,87,93,102,105–16,122–25,129–30,139;NationalBankingSystemand,30–37;NewLom-bardStreetapproachand,23–29;OldLombardStreetapproachand,18–23;repurchaseagree-mentsand,23,34,38–39;reserveconstraintand,9,13,29,94;SecondBankoftheUnitedStates,30;shiftabilityand,6–7,34,38,42–51,59,64,82,90,99,106,112,114,126,136–39,142n5,147n13;stockmarketcrashof1929and,35,41–43;survivalconstraintand,13–14,16–17,93–94,101–3,106–8,112,139;swapsand,71–91;tightening/

looseningmoneyand,4,14–15,24,27,40,70;Wicksellianismand,7–9.See alsoFederalReserve

Citibank,112Citigroup,133collateral,39,141n5;AgeofManage-

mentand,48,69;BankingActof1935and,48;instabilityofcreditand,17;learningfromcrisisand,118–27,130;NationalBankingSystemand,31–34;NewLom-bardStreetapproachand,23–24;privatedealersand,92,96–100,105–6,110,112;shadowbankingsystemand,118–27;swapsand,73,79,82;U.S.Treasuryand,37;warfinanceand,37–38

collaterizeddebtobligation(CDO),127–31,147n9

commercialloantheory,31commercialpaper,29,70,118–19,

121,124CommercialPaperFundingFacility,

121convertibility,9,22–24,31,33,

43–44,46CouncilofEconomicAdvisors,78creativedestruction,12credit:aggregate,13;bubblesand,12,

15–17;creativedestructionand,12;debtand,3–4(see alsodebt);depressionand,43–46;elastic-ityand,14,17,25;FinancialInstabilityHypothesisand,11,67;Hawtreyand,12,15,29–30,38,40,67–69,87–88,90;hedgefinancestructuresand,67–68;in-herentinstabilityof,12–17;

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162 index

credit(cont’d )lessonsfromcrisisand,6–10;mar-ket-basedcreditsystemand,113,116–17,123,126–27,135–36;moneyviewand,3–6;NewLom-bardStreetapproachand,23–29;OldLombardStreetapproachand,18–23;private,7–8,14–15,25,27,69,109;privatedealersand,92–100,105–6,109–11;productive,13,34,42;public,14,25;qualitative/quantitativecontrolof,38–39;reserveconstraintand,9,13,29,94;seductiveallureof,11;speculative,13,34,38,40;Strongruleand,38–40;survivalconstraintand,13–14,16–17,93–94,101–3,106–8,112,139;swapsand,72–75,79–84,87,113,118,121,124,127,132;tightening/looseningmoneyand,4,14–15,24,27,40,70;WorldWarIIeraand,46–47

creditchannel,124–25creditdefaultswap(CDS):failureof

naturalnormand,84;IOUsand,72–76,79–82;learningfromcri-sisand,113,118,127–29,132–33,147n13;liquidityand,83

currency:“billsonly”policyand,46–47,54–55,60,78,114;discountaccommodationand,35–36;Eu-rodollar,25,70,75,83,96,98,106,111–12,115,119–20,137,141n5,145n6;exchangerateand,71,75–77,86;mismatchand,75,77,83;NationalBankingSystemand,30–37;OperationTwistand,78,144n4;realbillsdoctrineand,

31;swapsand,71–91,113,118,121,124,127,132;Treasury-Eurodollar(TED)spreadand,145n6;U.S.dollar,9(see alsodol-lar);warfinanceand,37–38

currencyprinciple,31

dealeroflastresort,2;implicationsofinnormaltimes,136–39;learningfromcrisisand,10,114–16,122–25,129–35,132–35,147n13;NewLombardStreetapproachand,28;privatedealersand,107;swapsand,84;shiftabilityand,138,147n13;TermAsset-BackedSecuritiesLoanFacility(TALF)and,133–34

Debreu,Gerard,61–62,64,144n10debt,3,39,94;AgeofManagement

and,52–54,57,68–70;collateral-izeddebtobligation(CDOs)and,127–31,147n9;crushingburdenoffuture,11;dealersoflastresortand,132–34;depressionand,46–47;EmploymentActof1946and,52–53,56,58–59,64;Fan-nieMaeand,114;FreddieMacand,114;instabilityofcreditand,12–17;IOUsand,72–76,79–82;NationalBankingSystemand,32;NewLombardStreetapproachand,24;Ponzifinancestructuresand,67–68;stockmarketcrashof1929and,42–43;swapsand,71–76,79–82,84;Treasury,37–38,46,54,132

decentralizedpaymentssystem,93–98,104–5

deflation,43,56–57

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index 163

depression,5,7,36;AgeofManage-mentand,50–53,56–60;learningfromcrisisand,113,115;NewLombardStreetapproachand,23;noncommercialcreditand,43–47;smoothingand,50–51;stockmarketcrashof1929and,35,41–43;swapsand,71

discipline:AgeofManagementand,55;elasticityand,4–10,13–15,17,20,29,55,92,107–10,139;instabilityofcreditand,13–15,17;learningfromcrisisand,6–9;moneyviewand,4–6;NewLom-bardStreetapproachand,29;OldLombardStreetapproachand,20;privatedealersand,92,107–10;tightening/looseningmoneyand,4,14–15,24

divisionoflabor,114–15dollar,9;BrettonWoodssystemand,

23,71;as“coinoftherealm,”71;devaluationof,43;Kennedyad-ministrationand,77–78;MarshallPlanand,71;NewLombardStreetapproachand,23–29;OperationTwistand,78,144n4;swapsand,71–78,90;Treasury-Eurodollar(TED)spreadand,145n6

Dunbar,CharlesF.,142n4dynamicstochasticgeneralequilib-

rium(DSGE),108–9

Eccles,MarrinerS.,44economicsview,4–6,9,108–9elasticity:AgeofManagementand,

55,66;bankingprincipleand,31;credit,14,17,25;currencyprincipleand,31;disciplineand,

4–10,13–15,17,20,29,55,92,107–10,139;inelasticityand,31;Minskyon,66–69;NationalBankingSystemand,31–33;NewLombardStreetapproachand,25,29;OldLombardStreetapproachand,22;privatedealersand,94,107–10;solvencyand,17,42,44–46,67,82,100,106,117–18,123;tightening/looseningmoneyand,4,14–15,24,27,40,70;warfinanceand,38

EmploymentActof1946,52–53,56,58–59,64

equilibrium,7,49,69;dynamicstochasticgeneralequilibrium(DSGE)and,108–9;naturaltendencytoinstabilityand,8–9;solvencyand,17,42,44–46,67,82,100,106,117–18,123;swapsand,70,78,85–89;Walrasianismand,60–65,70,78,88–89,108

Eurodollar,70,137,141n5;learn-ingfromcrisisand,115,119–20;NewLombardStreetapproachand,25;privatedealersand,96,98,106,111–12;swapsand,75,83;Treasury-Eurodollar(TED)spreadand,145n6

exchangerate,71,75–77,86expectationshypothesis(EH):Ageof

Managementand,49,51,54,65;privatedealersand,101;swapsand,76–79,83,86,91,145n9

FannieMae,114,132,134farming,33,40FederalDepositInsuranceCorpora-

tion,45,82,117,133

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164 index

FederalHomeLoanBankboard,45FederalOpenMarketCommittee

(FOMC),48,53–54FederalReserve:academicadviceand,

56–60;AgeofManagementand,48–70;balancesheetfor,2–5;bankrateand,4–5,7,65,107–8,142n13;“billsonly”policyand,46–47,54–55,60,78,114;cen-tennialyearof,136;convertibilityand,33;creditand,3–4(see alsocredit);dealeroflastresortand,2,10,28,84,107,114–16,122–25,129–38,147n13;discountac-commodationand,35–36;Ecclesand,44;econometricmodelof,63–64;EmploymentActof1946and,52–53,56,58–59,64;es-tablishmentof,30,33;farmingproblemand,33,40;fiscalagencyof,37–38;governmentdebtand,24–25;haircutsand,23–24,27,92,120,138;interventionsby,4;learningfromcrisisand,113–35;aslenderoflastresort,1–2,115–16,119–20;liquiditypremiumand,50–52;Marschak-Tobinmodeland,63–65,78–79,87,110,145n13;Martinand,46,53,55,58,62–63,78,114–15,123,136;moneyviewand,2–10,65,79,87,93,102,105–16,122–25,129–30,139;NationalBankingSystemand,30–37;NewLombardStreetapproachand,23–29;noncommercialcreditand,43–47;normalcyand,51,53,69;OperationTwistand,78,

144n4;privatedealersand,95–112;repurchaseagreementsand,23,34,38–39;shiftabilityand,6–7,48–49(see alsoshiftability);smoothingand,40,50–51;stockmarketcrashof1929and,35,41–43;Strongruleand,38–40,55,142n16;Taylorruleand,8;tightening/looseningmoneyand,4,14–15,24,27,40,70;transformedroleof,1–2;Volckerepisodeand,9;Walrasianismand,60–65;warfinanceand,37–38

FederalReserveAct,30,32,37–38,44,142n3

Fed-TreasuryAccord,25,46,56feedbackmechanisms,15,65,68,110financeview,4–6,9financialcrisis:actionlagand,113–

14;anatomyofa,103–7;asset-backedcommercialpaper(ABCP)and,118–26,146n2;bubblesand,6,8,12,15–17,41–42,111–12;depressionand,5,7,23,36,43–47,50–53,56–60,71,113,115;divisionoflaborand,114–15;freefalland,2;as“inflec-tionpointineconomichistory,”1;learningfrom,6–10,113–35;lenderoflastresortand,1–2(see alsolenderoflastresort);market-basedcreditsystemand,113,116–17,123,126–27,135–36;Marschak-Tobinmodeland,63–65,78–79,87,110,145n13;moneyviewand,2–10,65,79,87,93,102,105–16,122–25,129–30,139;Moulton-Martin

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index 165

modeland,123–31;NewLom-bardStreetapproachand,23–29;noncommercialcreditand,43–47;normalcrisisand,104,107,132;OldLombardStreetap-proachand,20–23;stockmarketcrashof1929and,35,41–43;subprimemortgage,123,130–31;tinkeringapproachand,113–14;warfinanceand,37–38

FinancialInstabilityHypothesis,11,67

Fisher,Irving,43,57–58,109,142n10,143n9

Fishereffect,109–10FreddieMac,114,132,134freereservesconcept,55–56Friedman,Milton,43,58–59,66,

88,143n9,145n13

“GeneralEquilibriumApproachtoMoney,A”(Tobin),62,78,85

General Theory of Employment, Inter-est, and Money(Keynes),45

Glass-SteagallAct,44gold,29,40,42,144n4;Bretton

Woodssystemand,23,71–72;convertibilityand,9,22–24,31,33,43–44,46;devaluationofdol-larand,43;dollarstandardand,9,23,71;Kennedyadministra-tionand,77–78;NationalBank-ingSystemand,30–37;OldLom-bardStreetapproachand,21–23;warfinanceand,41

Goodhart,Charles,87–88,90Goodhart’sLaw,87–88governmentbonds,30,33,52

government-sponsoredenterprises(GSEs),134–35,138

GreatDepression,35,47,71;AgeofManagementand,56,60;govern-mentspendingand,45–46;insti-tutionalevolutionand,36;Keynes-ianismand,23;learningfromcrisisand,113,115;noncommercialcreditand,43–46;stockmarketcrashof1929and,35,41–43

Gurley,JohnG.,59–60,62–63

haircuts,23–24,27,92,120,138Hansen,Alvin,45–46Harvard,45,66,145n8Hawtrey,Ralph:AgeofManagement

and,67–69,87–88,90;counter-cyclicalpolicyand,40;instabil-ityofcreditand,12,15;NationalBankingSystemand,30;NewLombardStreetapproachand,29;Strongand,38

hedges,146n5;AgeofManagementand,67,69;learningfromcrisisand,136–38,147n9;swapsand,74–77,82–84,145nn6,7

Hicks,John,52,61Hicks-HansenIS/LMmodel,63households:FannieMaeand,114;as

financialinstitutions,11;Fred-dieMacand,114;moneymarketand,2,11,24,52,59,62,105,114,117

Indian Currency and Finance(Keynes),23

inflation,1;AgeofManagementand,53;deflationand,43,56–57;

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166 index

inflation(cont’d )Fisheron,57;learningfromcrisisand,8;privatedealersand,110;targetingand,109;swapsand,88

insurance,44–45;AAAtrancheand,128–33;AgeofManagementand,59;learningfromcrisisand,117–19,126–34,138;swapsand,80–81

interest,6,137–39,141n5;AgeofManagementand,49–58,63,69–70;goldflowand,41;governmentspendingand,46;inflationand,1,8,53,56–57,88,109–10;insta-bilityofcreditand,14–18;learn-ingfromcrisisand,115,121,135;LIBORand,96,121,133,145n6;moneyrateof,7–8,22,32,42,58,63,106,115,139;NationalBankingSystemand,30–32;natu-ralrateof,7,65,109,135;NewLombardStreetapproachand,23,29;OldLombardStreetapproachand,18–23;perfectliquidityand,7;privatedealersand,96,101,104,109–12,146n5;Strongruleand,39–40;swapsand,71–72,75–89,113,144n2,145n6;Taylorruleand,8–9,109–10;TermAuc-tionFacilityand(TAF)and,29;uncoveredinterestparity(UIP)and,76–79,83–86,144nn2,3,4,145n9;warand,46

interestrateswap(IRS),80–83investment:ABCPand,146n2;capi-

talassetpricingmodel(CAPM)and,85–86;collateralizeddebtobligation(CDOs)and,127–31,

147n9;economicsviewand,4–6,9,108–9;expectationshypothesis(EH)and,49,51,54,65,76–79,83,86,91,101,145n9;financeviewand,4–6,9;market-basedcreditsystemand,113,116–17,123,126–27,135–36;NewDealreformsand,54;Ponzifinancestructuresand,67–68;price-creditfeedbackand,15,65,68,110;privatedealersand,106,109;profitand,7,15,19–20,26,51,54,57–58,76–79,83,86–87,91,98–101,106,111,137–39;riskand,12,14,24,26,49–51,60–64,68,73–74,77–86,99–103,108,117–18,121,123,126–34,137–39,141n3,145nn6,9,146n5;shiftabilityand,6–7,34,38,42–51,59,64,82,90,99,106,112,114,126,136–39,142n5,147n13;swapsand,71–91;uncoveredinterestparity(UIP)and,76–79,83–86,144nn2,4,145n9

IOUs,72–76,79–82

JimmyStewartperspective,117–18,121–23

J.P.Morgan,44,74,74–77,147n10

Kennedyadministration,77–78Keynes,JohnMaynard,23,45,52,

61,143n23,144n2Keynesianism,61,69,89;Hansen

on,45–46;institutionalismand,143n23;Marschakapproachand,62;New,64,109;Tobinand,62–

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index 167

66,78–79,85,97–100,109–10,145n13

Kotlikoff,LaurenceJ.,147n13

LehmanBrothers,2,36,106,120,127,133–34

lenderoflastresort,4,138;AgeofManagementand,48,66;Bank-ingActof1935and,48;BankofEnglandand,22–23,116;crisisstrategyand,1–2;FederalReserveand,1–2,115–16,119–20;in-stabilityofcreditand,17;JimmyStewartperspectiveand,117–18,121–23;learningfromcrisisand,10,114–16,119–22,130;mantrafor,1–2;NationalBankingSys-temand,33;OldLombardStreetapproachand,22;privatedealersand,99,107

liquidity:AgeofManagementand,50–51,59–62,64–70;artificial,34–35;asset-backedcommer-cialpaper(ABCP)and,118–26,146n2;BankingActof1935and,44–45;capitalassetpricingmodel(CAPM)and,85–86;convert-ibilityand,9,22–24,31,33,43–44,46;FinancialInstabilityHypothesisand,11,67;funding,25–26,47,66,68,87,98–101,104–7,110–16,124–26,130–37;Gurley-Shawidealizationand,59–60;hedgefinancestructuresand,67–68;instabilityofcreditand,17;interbankaccommoda-tionand,35;JimmyStewartper-spective,117–18,121–23;learn-

ingfromcrisisand,7–8,113–35,147n13;macroeconomicsand,85–87,90–91;market,25–26,64,68,82,84,98–100,104,106–7,110–16,125–39;moneyviewand,5–6;NationalBank-ingSystemand,34–37;natural,34–35;NewLombardStreetap-proachand,25–29;noncommer-cialcreditand,44–47;normalbackwardationtheoryand,52,144n2;perfect,7,90–91;Ponzifinancestructuresand,67–68;preference,51,59–60,62,68;premium,50–52;privatedealersand,92,98–112;redefinitionof,44–45;self-liquidationand,6,31–38,44,48,51,114;shadowbankingsystemand,116–28,132;asshiftability,35,59(see alsoshiftability);solvencyand,17,42,44–46,67,82,100,106,117–18,123;swapsand,74,82–87,90,113,118,121,124,127,132,145n6;tendencytoinstabilityand,8–9;warand,38

“LiquidityPreferenceasBehaviorto-wardRisk”(Tobin),62,85

loans,2,132–34,142n13;AgeofManagementand,58,68;Bank-ingActof1935and,44;commer-cialloantheoryand,31;farm,33,40;FederalReserveActand,38;freereservesconceptand,55–56;haircutsand,23–24,27,92,120,138;instabilityofcreditand,12–17;interbank,55–56,96–98;learningfromcrisisand,6,

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168 index

loans(cont’d )117–19,122,125–27,146n7,147n10;market-basedcreditsystemand,113,116–17,123,126–27,135–36;NationalBank-ingSystemand,31–37;NewLombardStreetapproachand,23–29;noncommercialcreditand,43–47;OldLombardStreetapproachand,18–23;parallel,72–74,80;privatedealersand,95–100,104,107,112;repur-chaseagreementsand,23,34,38–39;reserveconstraintand,9,13,29,94;self-liquidating,31;shadowbankingsystemand,41,117–19,122,125–27,132;shiftabilityand,6–7,34,38,42–51,59,64,82,90,99,106,112,114,126,136–39,142n5,147n13;Strongruleand,38–40;survivalconstraintand,13–14,16–17,93–94,101–3,106–8,112,139;swapsand,72–75,80,82;TermAuctionFacility(TAF),29,120

Lombard Street: A Description of the Money Market(Bagehot),1,18

Londoninterbankofferrate(LIBOR),96,121,133,145n6

Lucas,Robert,88–89,145n13

macroeconomics,139,143n23;deal-ersand,108;intellectualframe-workof,60;shadowbankingand,118;swapsand,71–72,85–90

Markowitz,Harry,62,85Marschak,Jacob,62–64,85

Marschak-Tobinmodel,63–65,78–79,87,110,145n13

Martin,WilliamMcChesney:FederalReserveand,46,53,55,58,62–63,78,114–15,123,136;stresstestofMoulton-Martinmodeland,123–31

MBIA,128Mehrling,Perry,142n4,143n23,

144n17,145n8,146nn1,5,147n13

Milne,Alistair,147n13Minsky,Hyman:AgeofManagement

and,66–69;FinancialInstabil-ityHypothesisand,11,67;hedgefinancestructuresand,67–68;instabilityofcreditand,13,16;swapsand,71,87,90

mismatch,75,77,83MonetarismMarkII,145“MoneyandtheTheoryofAssets”

(Marschak),62,85moneychannel,124–25Money in a Theory of Finance(Gurley

andShaw),59–60moneymarket,32;AAAtrancheand,

128–33;AgeofManagementand,48–70;bubblesand,6,8,12,15–17,41–42,111–12;capi-talassetpricingmodel(CAPM)and,85–86;cashflowand,3–5,11,19,26,67–68;collateraland,17,23–34,37–39,48,69,73,79,82,92,96–100,105–6,110,112,118–27,130,141n5;creditand,3–12(see alsocredit);depressionand,5,7,23,36,43–47,50–53,56–60,71,113,

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index 169

115;disciplineand,4–9,13–15,17,20,29,55,92,107–10,139;elasticityand,4–10,14–15,17,22,25,29,31,38,55,66,94,107–10,139;EmploymentActof1946and,52–53,56,58–59,64;equilibriumand,7,49,61–62,65,69,78,85–89,108;exchangerateand,71,75–77,86;expecta-tionshypothesis(EH)and,49,51,54,65,76–79,83,86,91,101,145n9;FederalOpenMar-ketCommittee(FOMC)and,48,53–54;feedbackand,15,65,68,110;freefalland,2;haircutsand,23–24,27,92,120,138;hedgefundsand,126,146n7;house-holdsand,2,11,24,52,59,62,105,114,117;inflationand,1,8,53,56–57,88,109–10;learn-ingfromcrisisand,8,113–35;logicaloriginsof,93–98;market-basedcreditsystemand,113,116–17,123,126–27,135–36;Minskyand,11,13,16,66–69,71,87,90;mortgage-backedsecuritiesand,2,26,84,103,106–7,132–34,137;naturaltendencytoinstabilityand,8–9;NewLombardStreetapproachand,23–28;OldLombardStreetapproachand,18–22;Ponzifinancestructuresand,67–68;privatedealersand,92–112,137–38;profitand,7,15,19–20,26,51,54,57–58,76–79,83,86–87,91,98–101,106,111,137–39;rebuildingpostwar,53–

54;repurchaseagreementsand,23,34,38–39;shadowbankingsystemand,41–42,82,116–28,132,146n2;shiftabilityand,6–7,34,38,42–51,59,64,82,90,99,106,112,114,126,136–39,142n5,147n13;smoothingand,40,50–51;stockmarketcrashof1929and,35,41–43;swapsand,71–91;Treasurybillsand,14,24,27,47,69,80–81,99,120–21,124

MoneyMarketInvestorFundingFa-cility,133

moneyrateofinterest,7–8,22,32,42,58,63,106,115,139

moneyview,87,139;bankratepolicyand,4;cashflowand,3–5,11,19,26,67–68;clearpercep-tionofissuesand,2–6;economicsviewand,4–6,9,108–9;expecta-tionshypothesis(EH)and,49,51,54,65,76–79,83,86,91,101,145n9;financeviewand,4–6,9;futureand,4;ideal,5–6;learningfromcrisisand,6–10,113–16,122–25,129–30;naturaltendencytoinstabilityand,8–9;pastand,4;presentand,4–5;pri-vatedealersand,93,102,105–12;shadowbankingsystemand,116,122–25

Morris,Charles,1mortgage-backedsecurities(MSBs),

2,26,84,103,106–7,132–34,137,138

Moulton,Harold,7,115,136;AgeofManagementand,59;shiftabi-

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170 index

Moulton,Harold(cont’d )ityhypothesisand,6,136,142n5;stresstestofMoulton-Martinmodeland,123–31

“Mr.Keynesandthe‘Classics’”(Hicks),61

NationalBankingActof1864,30NationalBankingSystem,42;bank-

ingprincipleand,31;Britishinstitutionsand,33;CivilWarfinanceand,30;collateraland,31–34;convertibilityand,31;currencyprincipleand,31;cur-rencysupplyand,30–31;depres-sionand,46;discountaccommo-dationand,35–36;elasticityand,31–33;goldand,30–31;govern-mentbondsand,30;interestand,31–32;liquidityand,34–37;loansand,31–37;problemswith,31–33;realbillsdoctrineand,31;shiftabilityand,34;U.S.contextof,31–32;warand,46

NationalCurrencyActof1863,30NewDeal,45,54,59,89NewLombardStreetapproach:dealer

oflastresortand,28;elasticityand,25,29;haircutsand,23–24,27,92,120,138;liquidityand,25–29;mechanismsof,25–29;repurchaseagreementsand,23,34,38–39

NewYorkFederalReserve,38–41,46,55–57

Nixonadministration,144n4normalbackwardationtheory,52,

144n2normalcrisis,104,107,132

OldLombardStreetpolicy,18–23

OperationTwist,78,144n4

parallelloans,72–74,80Pedersen,Lasse,146n3Peel’sActof1844,21pegging,37,46,53,71,77–78Phillipscurve,88policy:academicadviceand,56–60;

Americanbanksand,6–7,34,66;balanceand,9–10;BankingActof1935and,44–45;bankrate,4–5,7,65,107–8,142n13;“billsonly,”46–47,54–55,60,78,114;disciplineand,4–9,13–15,17,20,29,55,92,107–10,139;eco-nomicsviewand,4–6,9,108–9;EmploymentActof1946and,52–53,56,58–59,64;financeviewand,4–6,9;Goodhart’sLawand,87–88;haircutsand,23–24,27,92,120,138;interestratesand,7(see alsointerest);Keynes-ian,45,61–66,69,89,109–10,145;“leaningagainstthewind,”58–59;lenderoflastresortand,1–2,4,10,17,22,33,48,66,99,107,114,116,119–22,130,138;Marschak-Tobinmodeland,63–65,78–79,87,110,145n13;moneyviewand,2–10,65,79,87,93,102,105–16,122–25,129–30,139;NationalBankingSystemand,30–37;NewDeal,45,54,59,89;NewLombardStreetapproach,23–29;OldLombardStreetapproach,18–23;OperationTwistand,78,144n4;

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index 171

perfectliquidityand,7;privatedealersand,107–12;realbillsdoctrineand,31;shiftabilityand,6–7,34,38,42–51,59,64,82,90,99,106,112,114,126,136–39,142n5,147n13;smoothingand,40,50–51;Strongruleand,38–40,55,142n16;swapsand,71–91;Taylorruleand,8–9,109–10;tightening/looseningmoneyand,4,14–15,24,27,40,70;Walrasian,60–65,70,78,88–89,108;Wicksellian,7–9

Ponzifinancestructures,67–68“PortfolioSelection”(Markowitz),

62,85prices:academicadviceand,56–60;

AgeofManagementand,48–54,57–64,68–70;capitalassetpric-ingmodel(CAPM)and,85–86;dealeroflastresortinnormaltimesand,136–39;Employ-mentActof1946and,52–53,56,58–59,64;feedbackmechanismsand,15,65,68,110;Fishereffectand,109–10;governmentdebtand,24–25;instabilityofcreditand,12–17;privatedealersand,92,99–111;swapsand,75,79,83–90;Walrasianismand,60–65;warfinanceand,38

PrimaryDealerCreditFacility(PDCF),36,120

Prince,Chuck,112privatedealers,26,137–38;Ageof

Managementand,48–51,54;anatomyofacrisisand,103–7;arbitrageand,99–102;“bills

only”policyand,46–47,54–55,60,78,114;creditand,92–100,105–6,109–11;decentralizedpaymentssystemand,93–98,104–5;dynamicstochasticgeneralequilibrium(DSGE)and,108–9;elasticityand,94,107–10;Euro-dollarand,96,98,106,111–12;FederalReserveand,95–112;Fishereffectand,109–10;insidethemoneymarketand,93–98;investmentand,106,109;largeportfolioshiftand,106–7;learn-ingfromcrisisand,114–16,120,122,124–35;liquidityand,92,98–112;monetarypolicyand,107–12;openmarketoperationsand,97–98;pricesand,92,99–111;repossessionand,96–102,105,108,111–12;shiftabilityand,99,106,112;solvencyand,100,106;Taylorruleand,109–10

profit,7,137–39;AgeofManage-mentand,51,54,57–58;in-stabilityofcreditand,15;NewLombardStreetapproachand,26;OldLombardStreetapproachand,19–20;privatedealersand,98–101,106,111;swapsand,76–79,83,86–87,91

Purchasing Power of Money, The(Fisher),57

realbillsdoctrine,31ReconstructionFinanceCorpora-

tion,45repossession,39;AgeofManagement

and,66;learningfromcrisis

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172 index

repossession(cont’d )and,115,118,119–20,124–27,132;NewLombardStreetap-proachand,23–27;privatedealersand,96–102,105,108,111–12;shadowbankingsystemand,115,118–20,124–27;Strongruleand,39–40;Treasury,24–25,27,115,141n5

repurchaseagreements,23,34,38–39reserveconstraint,9,13,29,94risk,137,141n3;AAAtranche

and,128–33,138,147n8;AgeofManagementand,49–51,60–64,68;asset-backedcommer-cialpaper(ABCP)and,118–26,146n2;capitalassetpricingmodel(CAPM)and,85–86;collater-alizeddebtobligation(CDOs)and,127–31,147n9;hedgesand,67,69,74–77,82–84,126–28,145nn6,7,146nn5,7,147n9;instabilityofcreditand,12–17;insuranceand,44–45,59,80–81,117–19,126–34,138;learningfromcrisisand,117–18,121,123,126–34;market-basedcreditsystemand,113,116–17,123,126–27,135–36;NewLom-bardStreetapproachand,24,26;price-creditfeedbackand,15,65,68,110;privatedealersand,99–103,108,146n5;reservecon-straintand,9,13,29,94;shadowbankingsystemand,117–18,121,123,126–28,132;survivalconstraintand,13–14,16–17,93–94,101–3,106–8,112,

139;swapsand,73–74,77–86,145nn6,9;tailcredit,138;tailli-quidity,138

RoaringTwenties,42Roosevelt,FranklinD.,43

Sayers,Richard,67Schumpeter,Joseph,12,66,141n3Schwartz,AnnaJ.,43SecondBankoftheUnitedStates,30securities:AgeofManagementand,

48–49,51,53–56,64;stockmar-ketcrashof1929and,35,41–43;warfinanceand,37–38.See alsomoneymarket

shadowbankingsystem,41–42,82;asset-backedcommercialpaper(ABCP)and,118–26,146n2;collateraland,118–27;emer-genceof,116–17;JimmyStewartperspectiveand,117–18,121–23;liquidityand,116–28,132;loansand,117–19,122,125–27,132;moneyviewand,116,122–25;repossessionand,115,118–20,124–27;riskand,117–18,121,123,126–28,132;swapsand,82

Sharpe,Bill,85Shaw,EdwardS.,59–60,62–63shiftability,38,42;AgeofManage-

mentand,48–51,59,64;Bank-ingActof1935and,48;dealeroflastresortand,138,147n13;FederalReserve’stakeoverof,48–49;Gurley-Shawidealizationand,59–60;learningfromcrisisand,6–7,114,126;Moultonand,6,136,142n5;NationalBanking

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index 173

Systemand,34;noncommercialcreditand,43–47;privatedealersand,48,99,106,112;swapsand,82,90

Shiller,Robert,1smoothing,40,50–51solvency,42;AgeofManagement

and,67;instabilityofcreditand,17;noncommercialcreditand,44–46;FinancialInstabilityHy-pothesisand,11,67;learningfromcrisisand,117–18,123;pri-vatedealersand,100,106;swapsand,82

Sprague,OliverM.W.,141n1Sproul,Allan,46,55–56,58–59,

62–63stockmarketcrashof1929,35,

41–43Strong,Benjamin,38–40,57–58Strongrule,38–40,55,142n16subprimemortgagecrisis,123,

130–31Subprime Solution(Shiller),1survivalconstraint,139;instability

ofcreditand,13–14,16–17;pri-vatedealersand,93–94,101–3,106–8,112

swaps:arbitrageand,72,76–79,85–90;Blackand,79–82;Bret-tonWoodssystemand,71–72;Britishsystemand,72–74;capitalassetpricingmodel(CAPM)and,85–86;cashflowsand,71–91;collateraland,79,82;creditdefaultswap(CDS)and,72,75,79–84,113,118,127–29,132–33,147n13;debtand,71,

84;dollarand,71–78,90;Euro-dollarand,75,83;exchangerateand,71,75–77,86;expectationshypothesis(EH)and,76–79,83,86,91,145n9;Goodhart’sLawand,87–88;grossflowsand,73;hedgesand,74–77,82–84,145nn6,7;indexcontractsand,83–84;interestrate(IRS),72,75,79–83,80–83,113,145n6;IOUsand,72–76,79–82;Kennedyad-ministrationand,77–78;learningfromcrisisand,113,118,121,124,127,132;liquidityand,74,82–87,90;loansand,72–75,75,80,82;macroeconomicsand,71–72,85–91;MarshallPlanand,71;mismatchand,75,77,83;modernfinanceand,85–91;OperationTwistand,78,144n4;parallelloansand,72–74,80;Phillipscurveand,88;postwarcontrolsand,71;pricesand,75,79,83–90;riskand,73–74,77–86;shadowbankingsystemand,82;shiftabilityand,82,90;Trea-surybillsand,80–81;uncoveredinterestparity(UIP)and,76–79,83–86,144nn2,4,145n9;UnitedStatesand,71–74,77,90

Taylor,John,8Taylorrule,8–9,109–10TermAsset-BackedSecuritiesLoan

Facility(TALF),133–34,138TermAuctionFacility(TAF),29,120TermSecuritiesLendingFacility

(TSLF),120,132,147n11

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174 index

Tett,Gillian,147n10theoryofmoneydemand,62,85tightening/looseningmoney,4,14,

14–15,24,27,40,70Tobin,James:AgeofManagement

and,62,66;Lucascritiqueand,89;Marschak-Tobinmodeland,63–65,78–79,87,110,145n13;OperationTwistand,78;privatedealersand,109–10;swapsand,78,85,87–90;Walrasianismand,62–65

Treasurybills,69;instabilityofcreditand,14;learningfromcrisisand,120–21,124;NewLombardStreetapproachand,24,27;non-commercialcreditand,46–47;privatedealersand,99;swapsand,80–81

Treasury-Eurodollar(TED)spread,145n6

Treasuryrepo,24–25,27,115,141n5Trillion Dollar Meltdown(Morris),1

uncoveredinterestparity(UIP),76–79,83–86,144nn2,4,145n9

UnitedStates:BrettonWoodssystemand,71;CivilWarfinanceand,30;econometricmodelof,63–64;federaldebtof,37–38;Ken-nedyadministrationand,77–78;MarshallPlanand,71;Minskyapproachand,66–69;NationalBankingSystemand,30–37;

Nixonadministrationand,144n4;OperationTwistand,78;stockmarketcrashof1929and,35,41–43;swapsand,71–74,77,90;warfinanceand,37–38

UniversityofChicago,58,88U.S.Treasury:debtand,37–38,

46,54,132;FederalReserveActamendmentand,37;Fed-TreasuryAccordand,25,46,56;reposses-sionand,24–25,27,115,141n5;securitycollateraland,37;Strongruleand,38–40;WorldWarIIfundingand,24

Value and Capital(Hicks),61Volcker,Paul,9,90

Walras,Léon,61–62Walrasianism,60–65,70,78,88–89,

108Wicksell,Knut,7–9WorldWarIera,23,36–38,46WorldWarIIera,5,24,36;Employ-

mentActof1946and,52–53,56,58–59,64;governmentspendingand,46–47;MarshallPlanand,71;noncommercialcreditand,46–47;swapsand,71;U.S.Trea-suryfundingand,24

Yale,1,57,142n10

Zandi,Mark,1

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