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In this regard, the decision of both the economics and finance disciplines to abstract from the monetary plumbing behind the walls, the better to advance scientific understanding on other dimensions, has had fateful consequences for our ability to sustain rational discourse in the face of a systemic plumbing failure. If we don't educate ourselves about how the system works when it is working, we will have no framework for understanding what is wrong when it fails.
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These simple examples show how relaxation of the daily survival constraint depends on credit; some people can enjoy cash outflows greater than cash inflows only because other people are willing to enjoy cash inflows greater than cash outflows, and vice versa.
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Payments elasticity in our decentralized payments system thus depends on interbank credit to relax the "reserve constraint" facing individual banks.
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Typically, the repo rate is less than the federal funds rate, and the federal funds rate is less than the Eurodollar rate, but the spreads are very small, just a few basis points.
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Knowing that the Fed will intervene to stabilize the federal funds rate, dealers rationally shift their riskreturn calculus in favor of taking larger positions in the term structure arbitrage, and such a shift can be expected to move the structure of asset prices closer to the EH theoretical ideal, but not all the way.
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It is not that modern policymakers are unconcerned with liquidity but rather that they have convinced themselves, or rather have been convinced by economists, that matters of liquidity (the purview of an antiquated money view) can be conceptually as well as operationally separated from matters of economic stabilization (the purview of the modern economics view). The present crisis has posed a rather decisive challenge to this neat division of intellectual labor, but inevitably past habits of thought persist and it is these habits that must be confronted if we are to learn the lessons that the crisis has to teach us.
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Time and risk are now explicitly modeled, but that is the only substantive change; abstraction from monetary plumbing remains of the essence, even more so today than in the past through the convenient analytical assumption of a so-called representative agent.
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In a money view perspective, if the Fed fails to raise interest rates in the face of a credit-fueled asset price bubble, the bubble will feed on itself, growing ever larger and having ever greater distorting effects, until it bursts.
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The money view emphasizes the inherent instability of a credit system driven by the private profit motive, but the problem is made worse when the Fed adopts a policy rule that denies any responsibility for preventing a bubble.
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Abstracting from money may make our economic theory easier, but it does not make our economic policy better.
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At its core, our monetary system is a dealer system that supports the liquidity of our securities markets, and the Fed serves as dealer-in-chief not only in wartime but also in peacetime, and especially in financial crisis time.
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First currency swaps, then interest rate swaps, and then credit default swaps were introduced, and the eventual result was transformation of the rigid and highly regulated financial system that we had inherited from Depression-era reform.
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A rehabilitation of the nineteenth-century money view is, I have suggested, the place to start, but it is not the place to end. The concept of liquidity that seemed appropriate for Bagehot is no longer appropriate for us. Long ago we switched over from Bagehot's emphasis on the "self-liquidating" character of certain short-term commercial debts to more appropriate emphasis on the "shiftability" of certain securities in liquid markets. But we have not yet switched over from Bagehot's conception of the central bank as "lender of last resort" to the more appropriate modern conception of it as "dealer of last resort."
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The Fed intervened in the market for Treasury repo with the goal of stabilizing the federal funds rate at some target, and that was all.
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Other repo rates and the Eurodollar rate got stabilized through money market arbitrage by private dealers, and the private money market then served as the source of funding liquidity for dealer operations in securities of all kinds, producing the two-way dealer markets that are the source of market liquidity.
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That is how Martin thought the system should work, and how in fact it eventually did work, until it stopped working in August 2007.
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From a long historical point of view, the central lesson of the crisis is that the American system requires the Fed's support as dealer of last resort, not just in the money market (as emphasized by Martin) but also in the capital market, and not just for Treasury securities (as emphasized by Martin) but also for private securities.
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The practical intertwining of money markets and capital markets is the defining institutional feature of the American system, and that feature requires a similarly integrated backstop by the central bank.
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Solvency risk was about the prospect of loan default, and it was handled by a buffer of bank capital, backstopped by deposit insurance at the FDIC. Liquidity risk was about the prospect of deposit withdrawals, and it was handled by a buffer of cash reserves, backstopped by the discount window at the Fed. This is the model of banking that was in the back of most of our minds as we looked at the new shadow banking system, and from this vantage point it seemed clear that the new system involved exposure to familiar solvency and liquidity risks, but those familiar exposures were handled differently. The important thing is that in the shadow banking system neither solvency risk nor liquidity risk was backstopped in any direct way by the government.
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Lender of last resort to the traditional banking system. Like the parents of the shadow banks, the Fed professed not to be worried about the quality of the collateral, and made room for some of it at the discount window by relaxing collateral requirements and by expanding eligibility requirements.
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Finally, in September 2008, with the collapse of Lehman Brothers and then AIG, even unsecured money market funding froze up.
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The resulting scramble for funding drove LIBOR rates to unprecedented spreads over federal funds rates, and the Fed responded by extending lender of last resort even further, accepting a wider selection of collateral from a wider selection of counterparties.
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From a Jimmy Stewart perspective, this final expansion of the Fed's role, dramatic though it was, seemed to be nothing more than an extension of traditional lender of last resort support. The only difference was the scale of the lending, which meant that the Fed could no longer fund its lending simply by liquidating its holding of Treasury bills.
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The second set shows how the shadow bank parents stepped in when secured funding dried up because of concern about collateral values.
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However, September 2008 was the moment when the Fed moved from lender of last resort to dealer of last resort, in effect taking the collapsing whole sale money market onto its own balance sheet.
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When liquidity risk was thought to be the issue, it was the Fed's problem; when solvency risk was thought to be the issue, it became the Treasury's problem.
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In both respects, the fact that the shadow banking system had collapsed onto the traditional banking system made it seem as though the problem was now just a traditional banking problem.
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This financial crisis is not merely a subprime mortgage crisis or even a shadow banking crisis; it is a crisis of the entire market-based credit system that we have constructed since 1970, following Martin's 1952 report and Moulton (1918).
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The big thing that happened in September 2008 was that the system of private dealer money market arbitrage, having been under stress for more than a year, finally froze up completely. And the big thing about the Fed's response was that it stepped in as the dealer of last resort to replace the private dealer system.
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From the very beginning, the shadow banking system was completely dependent on a well-functioning dealer system in two senses.
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Using this facility, any shadow bank parent that found itself holding an MBS that it could not repo, could swap that MBS for a Treasury bond that it could repo. (Initially, the facility was limited to MBSs rated AAA.)
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In fact, however, by lending ninety cents on the dollar on a nonrecourse basis at a rate of 100 basis points over LIBOR, the Fed was doing essentially what Lehman and AIG used to do, but with less leverage and charging a higher price. (The credit risk involved in such lending was covered by funds allocated from the Treasury's Troubled Asset Relief Program under section 102, "Insurance of Troubled Assets.")
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Operating as dealer of last resort, the Fed found itself inventing a new version of the Bagehot principle to guide its operations: insure freely but at a high premium. As dealer of last resort, what the Fed was insuring, it is important to emphasize, was not the payments that the debtor had promised to make but rather the market value of the promise itself; that is the difference between dealer of last resort and credit insurer of last resort.
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As dealer of last resort, what the Fed was insuring, it is important to emphasize, was not the payments that the debtor had promised to make but rather the market value of the promise itself; that is the difference between dealer of last resort and credit insurer of last resort.
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As in the original Bagehot principle, the idea is for the Fed to charge a price that provides incentive for the private market to undercut the Fed once it recovers.
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These are bold and innovative experiments, but the basic pattern comes through clearly. The Fed now recognizes that, for our market-based credit system, it must remake itself as dealer of last resort.
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More fundamentally, we can look forward to a remake of the framework for monetary policy, going beyond the precrisis fixation on tracking the "natural" rate of interest, and taking account for the first time of the key connection to asset prices that runs from funding liquidity to market liquidity.
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To say that the essence of liquidity is shiftability is not to say that liquidity is or should be a free good, and it is not to say that we can safely abstract from liquidity when we consider questions of monetary policy and financial regulation. This is the central lesson of the crisis.
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What are the implications of the Fed's new role as "dealer of last resort" for normal times? That is the question that we must confront looking forward, starting from the realization that our market-based credit system relies critically on two-way dealer markets that link funding liquidity in the money market with market liquidity in the capital market.
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That is the question that we must confront looking forward, starting from the realization that our market-based credit system relies critically on two-way dealer markets that link funding liquidity in the money market with market liquidity in the capital market.
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A key lesson of the crisis is that funding liquidity is not enough, since in a crisis funding liquidity does not get translated into market liquidity, no matter how hard the Fed works to push funds out the door.
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The job of the Fed is not to eliminate the risk that dealers face but rather to put bounds on it, to establish an arena within which private calculation of expected profit and risk makes sense. For this purpose, it is helpful to think of the dealer of last resort function as a kind of tail risk insurance. Having set the bounds that establish the possibility of rational risk calculation, the Fed can then turn its attention to its more traditional function, setting the money rate of interest.
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The classic money view urged central bankers to attend to the balance of discipline and elasticity in the money market, in order to manage the inherent instability of credit. The classic money view urged central bankers to attend to the balance of discipline and elasticity in the money market, in order to manage the inherent instability of credit. Our modern world is not Bagehot's world, by a long shot, but at the highest level of abstraction the classic money view holds as true in our world as in his.
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