The New Lombard Street: How the Fed Became the Dealer of Last Resort by Perry Mehrling (review)

The inverted relationship between the business cycle and the quest for insights from the past is recognized by economic historians. Perhaps in no subfield is this relationship as pronounced as for financial and monetary history. In times of crisis, demand for insights from the past climb sharply. This partly reflects the very nature of crisis as something “outside the box.” Since present expectations tend to be built on experiences gathered in the near past, say the last couple of decades or so, a shattering of those ultimately encourages interest in a more long-term view. This involves, perhaps for the professional historian rather naïvely formulated, urge to learn something from history. The past is not a buffet menu of lessons learnt but rather the basis for some important questions or at least some kind of inoculation against blind trust in contemporary wisdom.

As windows of opportunity tend to be exploited, it follows that the years since 2007–2008 have been good for financial and monetary history. Research output has skyrocketed: some good, some bad, some indifferent. In this body of literature, a few contributions are potentially important. Perry Mehrling’s short book belongs to this category.

The New Lombard Street can be read in a number of ways: as a chronology of the changing character of central banking, as a history of financial market transformation, and as a series of policy advices for the present. Read as a whole it represents a coherent argument based on historical insights advocating that central bank thinking has to adapt to the changing character of financial markets as well as the actual crisis management of central banks highlighted by the latest crisis.

Mehrling’s arguments are based on “the money view” where the fragile day-to-day operations of the financial markets play center stage. Old fashioned central banks in the tradition of Lombard Street are seen as guarding the fragile bridge between loan-takers and savers, guided by striking the right balance between discipline and elasticity. In times of financial crisis, central banks secured that bridge by functioning as lender of last resort, by providing liquidity relief based on the Bagehotian formula of lend freely on good (i.e., pre-crisis criteria) collateral, but at a high price.

As Mehrling eloquently shows, much has changed since Walter Bagehot in 1873 laid down the principles of crisis management in Lombard Street. His world was one of simple commercial banking with the self-liquidating commercial bills of exchange as key instruments. Modern financial markets are based on “shiftability,” the notion that good long-term papers can always be converted to cash, creating a world without boundaries between banking and capital markets. Moreover, according to the author central banks, at least until 2008 had forgotten the emphasis on providing both discipline and elasticity in the money market as monetary policy had been reduced to inflation targeting.

Blatant disregard of liquidity works well most of the time, but obviously not when it is called upon the most, in times of crisis where the underlying soundness of any long-term commitment is under question. This is what happened in 2008 when the Fed’s balance ballooned as it took on major parts of the wholesale credit market on their books only to later be replaced by the Fed holding waste quantities of mortgage backed securities, i.e., in reality household long-term debts. This is the situation the author claims is the Federal Reserve System becoming the dealer of last resort. For a non-English native speaker whose card playing skills are substandard, the dealer concept was hard to fathom at first, but reflects, I guess at least three key novelties compared with the old lender: First, lending de facto not only to banks, but to the entire financial industry. Second, a radical broadening of what collateral is deemed sufficient with regard to maturity, issuer...