The New Lombard Street

Further Thoughts

In the aftermath of the Lehman-AIG collapse of September 2008, I set myself the challenge to write a kind of update of Bagehot’s famous 1873 Lombard Street: A Description of the London Money Market. Bagehot argued, from history and the institutional structure of the British financial system, that the Bank of England not only must act as lender of last resort, but also that in fact it had so acted, lending freely at a high rate during financial crisis.

In my own book I argued, analogously and also from history and institutions, that in the rather different conditions of the American financial system as developed throughout the 20th century, the Fed not only must act as dealer of last resort, but also that in fact it had so acted, supporting liquidity in the capital market during financial crisis. Even so, in the global financial crisis that began August 2007, dealer of last resort intervention came only after the collapse of Lehman and AIG in September 2008, and only after the Fed had tried its best to stem the tide with more standard, albeit very aggressive, lender of last resort intervention.

One reason for the delay, so I argued, was that the Fed (and everyone else too) was operating with a mental framework inherited from the past, and unsuited for the actual conditions they were facing. I traced the origin of that framework to the very origins of the Fed, when popular opposition to the establishment of a central bank was overcome by public (indeed legislated) conceptualization of the Fed as an institution dedicated to provision of short term credit to the Main Street economy, i.e. nothing to do with long term capital markets and nothing to do with Wall Street.

This original conceptualization was politically attractive but unfortunately it was not well-suited to the actual organization of the American credit system. As a consequence the Fed was in effect intellectually disarmed in the face of the crisis that became the Great Depression. Remembering that failure, it did better this time around, taking advantage of the huge loophole provided by Section 13(3)for “unusual and exigent circumstances”.

The pressing task now is to learn the lessons of the crisis, which means adapting our mental frameworks to the contours of the real world as revealed in the crisis. The adaptation that I emphasize in the book involves reconceptualizing the role of the central bank for a world where the capital market, not bank lending, is the primary source of credit for the real economy.

What I did not emphasize in the book, indeed hardly even mentioned, was the international dimension of the crisis and the international dimension of the Fed’s response. Here I fear that I was myself operating under my own constraining mental framework, a particularly American deformation that abstracts from the effects of U.S. policy on the rest of the world.

This mental framework also traces to the origin of the Fed, when no one imagined that the dollar would soon enough be called upon to serve a global function as world reserve currency in replacement of the pound sterling. No such provisions are in the enabling legislation, nor could they be inserted today, but the facts are what they are. During the crisis the Fed was called upon to serve as international lender of last resort, and it answered that call, most prominently through the liquidity swap lines with foreign central banks.

Another pressing task therefore also lies ahead, as we learn the lessons of the crisis. Our financial system is not only fundamentally a capital market system, but it is also fundamentally a global system, and the global dollar funding system on which the world depends is the very same dollar funding system on which our domestic economy depends. Adapting our mental frameworks to this particular contour of the real world will pose, if my own experience is any guide, an even more wrenching intellectual challenge in the years to come.

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