The New Lombard Street

1. Money View: Understanding the Financial System's Core

It is in the daily operation of the money market that the coherence of the credit system, that vast web of promises to pay, is tested and resolved as cash flows meet cash commitments.

Cash Flow is King. The "money view" emphasizes the critical role of daily cash flows in maintaining the stability of the credit system. It's in the money market where promises to pay are tested against actual cash flows, revealing the system's true health. This perspective contrasts with economics, which looks through money, and finance, which focuses on asset valuations.

Interlocking Debt. The credit system is a web of interconnected debt commitments, each a promise about an uncertain future. Failure to meet a payment can trigger a cascade of defaults, unraveling the entire system. The Fed, as a banker's bank, oversees this delicate balance, intervening to provide elasticity or impose discipline as needed.

Money View vs. Economics and Finance. The money view differs from traditional economics and finance by focusing on the mechanics of money and credit. Economics tends to "look through" money to focus on real capital, while finance focuses on asset valuations based on future cash flows. Both largely ignore the plumbing of the monetary system, which becomes critical during crises.

2. Credit's Inherent Instability: A Double-Edged Sword

In his view, the main job of the central bank is to prevent a credit-fueled bubble from ever getting started, in order to avoid the collapse that inevitably follows.

Hawtrey's Warning. Credit-fueled booms are inherently unstable, according to Ralph Hawtrey. The central bank's primary role is to prevent these bubbles from forming to avoid the inevitable collapse. This perspective emphasizes the need for discipline in credit markets.

Schumpeter's Counterpoint. Joseph Schumpeter argued that credit is essential for "creative destruction," the engine of capitalist dynamism. Instability is inseparable from growth, and central bank intervention risks stifling innovation. This view highlights the need for elasticity in credit markets.

The Central Bank's Dilemma. Central banks face a constant challenge: balancing the need for discipline to prevent bubbles with the need for elasticity to support growth. This requires careful judgment and an understanding of the specific circumstances, as credit-fueled booms often contain elements of both speculation and genuine innovation.

3. Central Banking: Balancing Discipline and Elasticity

As a banker's bank, the central bank has a balance sheet that gives it the means to manage the current balance between cash flows and cash commitments.

The Central Bank's Toolkit. Central banks manage the balance between discipline and elasticity using their balance sheets. Tools like the "lender of last resort" function and bank rate policy allow them to influence the availability and cost of credit.

The Survival Constraint. The "survival constraint" – the need for cash inflows to meet cash outflows – is the ultimate discipline in the financial system. Central banks can tighten or loosen this constraint by influencing the price and availability of funds.

The Art of Central Banking. Central banking is an "art" rather than a "science," requiring careful judgment and an understanding of the origins of instability. Central banks must choose their interventions carefully, recognizing that private credit elasticity can substitute for public credit elasticity.

4. Shiftability vs. Self-Liquidation: The American Adaptation

Liquidity is tantamount to shiftability.

The Commercial Loan Theory. The Federal Reserve Act of 1913 was initially based on the "commercial loan theory," which emphasized the importance of self-liquidating, short-term commercial loans as bank assets. This theory aimed to ensure that bank liabilities (deposits) could be readily repaid.

Shiftability Emerges. American banks, however, adapted British practices to suit their unique conditions. They relied on the "shiftability" of investment portfolios in liquid markets to meet cash needs, rather than solely on self-liquidating loans. This involved holding bonds and other securities that could be quickly sold or used as collateral.

The Triumph of Shiftability. The Banking Act of 1935 marked the triumph of the shiftability view, as the Fed gained the power to discount any "sound" asset. This effectively made all sound assets equally liquid, blurring the line between liquidity and solvency and setting the stage for the modern financial system.

5. The Fed's Evolution: From Lender to Dealer of Last Resort

In retrospect, this move can be seen as the beginning of a new role for the Fed that I call “dealer of last resort.”

Bagehot's Principle. Walter Bagehot's principle of "lend freely but at a high rate" guided central bankers for generations. This involved providing elastic lending to needy banks against good collateral, but at a high interest rate to discourage excessive borrowing.

The New Lombard Street. The 2008 financial crisis forced the Fed to go beyond Bagehot's principle. It shifted much of the wholesale money market onto its own balance sheet, becoming a "dealer of last resort" by buying assets and providing liquidity directly to the market.

Beyond Bagehot. The Fed's actions during the crisis, such as purchasing mortgage-backed securities, went beyond traditional central banking practices. This marked a transformation in the Fed's role, extending its reach into private capital markets.

6. Monetary Policy: The Age of Management and Its Discontents

In 1937, the Fed's commitment meant that it would take the “liquidity premium” as given by the market, and ensure shiftability at that premium.

The Employment Act of 1946. The Employment Act of 1946 enshrined the government's commitment to "maximum employment, production, and purchasing power." This led to a greater emphasis on active economic management and a downgrading of the role of monetary policy.

The Rise of Monetary Walrasianism. The dominant economic framework became "monetary Walrasianism," which sought to manage the financial side of the economy using simultaneous equations. This approach, exemplified by James Tobin, aimed to correct deviations from an idealized equilibrium.

Minsky's Dissent. Hyman Minsky offered a dissenting view, emphasizing the inherent instability of credit and the need for the Fed to manage that instability. He advocated for collateral policy at the discount window to discourage speculative financing structures.

7. Swaps: Circumventing Controls and Reshaping Finance

The swap idea was completely central, and it all started with the currency swap, so it is of some importance to understand how this swap worked.

Currency Swaps Emerge. Currency swaps arose as a way to circumvent postwar controls on international capital flows. These swaps involved parallel loans between companies in different countries, effectively evading restrictions on currency exchange.

The Uncovered Interest Parity (UIP) Norm. Currency swaps are organized around the UIP norm, which states that expected returns from different investment strategies should be the same. Deviations from UIP create opportunities for arbitrage and drive the development of swap markets.

Operation Twist. The 1961 Operation Twist was an attempt to manipulate the term structure of interest rates to support the dollar. This marked a departure from the "bills only" policy and a move toward active management of asset prices.

8. The Crisis Unveiled: A Stress Test of Modern Finance

Today the world that Black was only imagining has become our reality, and the instruments he was only imagining have become our interest rate swaps and credit default swaps.

Fischer Black's Vision. Fischer Black foresaw a world where risks could be unbundled and sold separately. This vision became a reality with the development of interest rate swaps (IRS) and credit default swaps (CDS).

Swaps as Risk Transfer Mechanisms. IRS and CDS allow investors to transfer interest rate risk and credit risk to other parties. This unbundling of risk was seen as improving the efficiency of pricing and making credit more freely available.

The Shadow Banking System. The development of swap markets led to the rise of the "shadow banking system," which operated outside traditional banking regulations. This system relied on short-term funding and was vulnerable to liquidity shocks.

9. Dealer of Last Resort: The Fed's New Role

Rephrased in terms that connect up with modern institutional arrangements, Bagehot can be understood as arguing that the central bank should act as money market dealer of last resort, providing both borrowers and lenders with what they want but at prices that are worse than they would be getting if they were meeting directly rather than on the balance sheet of the Bank.

The Fed's Response. In response to the crisis, the Fed stepped in as a "dealer of last resort," widening the category of counterparties and collateral it was prepared to accept. This involved providing both borrowers and lenders with what they wanted, but at prices that were worse than they would be getting in the private market.

The Bagehot Principle Reinterpreted. The Bagehot principle can be understood as recommending that the central bank post a wide bid-ask spread in the money market and use its balance sheet to absorb the resulting flow of orders. This provides incentive for borrowers and lenders to find one another again once the storm dies down.

Zero Interest Rates. Unlike the nineteenth-century Bank of England, the Fed faced no reserve constraint in terms of gold. This allowed it to lower interest rates almost to zero, but it also raised questions about whether such evasion of the reserve constraint was the correct policy.

10. Reconstructing the Money View: A Path Forward

The main lesson is that a modern money view requires updating Bagehot's conception of the central bank as a “lender of last resort.” Under the conditions of the New Lombard Street, the central bank is better conceptualized as a “dealer of last resort.”

Beyond Lender of Last Resort. The crisis revealed the limitations of the "lender of last resort" model. A modern money view requires updating Bagehot's conception to recognize the central bank as a "dealer of last resort."

Balancing Discipline and Elasticity Anew. The focus must shift to restoring the ancient central banking focus on the balance between discipline and elasticity, but under modern conditions. This requires a new understanding of the relationship between funding liquidity and market liquidity.

A Modern Money View. Reconstructing the money view for modern conditions involves recognizing the intertwining of money markets and capital markets, and the need for the central bank to manage that system as a whole. This requires a new generation of monetary policy and financial regulation.

Last updated: March 31, 2025