Columbia University

How the Fed Became the Dealer of Last Resort

Introduction
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The financial crisis beginning in August 2007, then turning worse in September 2008,

proved to need a more significant deal than a subprime solution backed by Professor Robert

Shriller involving more considerable damage than the dollar breakdown predicted by Charles

Morris. Instead, it proved an inflection point in economic history referred to by Mark Zandi,

meaning we need a historical reference to understand what is happening currently and predict the

future. Books still provide information to us that the Fed's main objective is to regulate interest

short-term rates to achieve an extended inflation target. However, the Fed has been fighting a

war since the beginning of the crisis. Lender of last resort is the definitive description of the

financial crisis. The majority of the central bankers' theme is lending freely at a high rate. At the

initial stages of the financial predicament, the Fed did at the initial stages by selling off its

treasury securities and lending its proceeds. After the crumbling of AIG and the Lehman brothers

and the closure of money markets at the domestic and international levels, a move initiated what

is now called dealer of last resort.

A Money View Perspective

The Fed being the heart of the response policy was no coincidence. This book's simple

idea is that the "money view" provides the required intelligent lens. The fundamental outline of

this complex crisis should be seen clearly. The reason is straightforward. In the day-to-day

functioning of the money markets, the credit system's consistency, that wide web of money

markets payment promises are tried and set by meeting cash commitments by the cash flow. Fed

is not just watching; it is intervening as well. The central bank poses a financial position

statement providing the method to handle the existing balance between monetary flows and

monetary obligations. 'Lender of last resort' illustrates where the central bank provisionally gives
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its money to satisfy obligations that otherwise wouldn’t have been fulfilled. The rate of bank

policy prolongs this intervention from catastrophic into regular periods fending off the crisis. The

Fed attempts to offer more flexibility by participating in the money markets or imposing little

discipline, adapting as conditions permit. One hundred years ago "money view" ideas of

thinking were standard at the time of the Fed's founding in 1913. Still, two distinct views

dominate the current economic debate. Economic views predict the chances of success. The

current generation relies on savings goods made by generations past. Financial view

concentrates on capital asset valuation, making them reliant on imaginary cash flows. In the

current time, cash flows originating from past investment opportunities fulfill cash obligations

and enter into anticipating imagined prospects where the economic view and the financial view

meet (Tucker, 2014). This is the usual realm of vision of money. However, economics and

finance are conceptual from cash. Both largely disregard the advanced process that channels cash

flows anywhere as they arise to fulfill cash obligations where they are pushing. As a result,

neither economic view nor financial is suitable in comprehending the crisis. We were through a

catastrophe whereby the essential financial plumbing collapsed, nearly falling through the

system.

Lesson from the crisis

One teaching from the crisis is how it goes too far with the ideal norm. Our monetary

mentality has misunderstood model characteristics that formulate economic and financial views

for actual-world properties. This mistake is intellectual, but with real critical implications, not

only placing bias to increased elasticity at the center of currency rule. The bias has rekindled the

price used to lay in the present crisis, and the bias fuels the next bubble, except we learn what the
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present situation teaches. Modern Fed maintains interest rate inlining with a natural interest rate

referred to by Swedish economist Knut Wicksell, other than checking equilibrium among

discipline and resistance. Academically, Wicksell, contrary to the view of money, saw no

inherent flaws of private credit the central bank had to handle, but somewhat that central bankers

were susceptible to mismanagement. According to him, the profit rate on capital is naturally the

interest rate; in a sense, it will bring an economic balance. Choosing a monetary rate different

from the natural rate causes problems to emerge. With a lower differential rate, an incentive is

created to fund new capital investments while spending increases the overall price. The higher

price improves profit margins and thus credit-worthy, creating incentives in an unaffordable

cumulative uptrend spiral for more bank lending. John Taylor, the Stanford economist,

recommended that the start of the current crisis is a refusal to follow such a Taylor Rule, keeping

the money rate below fueling bubble burst in 2007. This report aims to initiate the reform by

adopting a case-based approach to addressing the current financial collapse and learning lessons

for the coming years from that crisis. The key lesson is that today’s interpretation of money

needs to modify Bagehot's idea as a "lender of last resort" of central bank. Under New Lombard

Street circumstances, the central bank is conceptualized as being a last-resort dealer."

Lombard Street, Old, and New

The American financial economist Hyman Minsk outlined his analysis in 1966 before

establishing his popular Financial Instability Theory. Capitalism is an economic system, and a

capitalist economy's strange behavioral qualities center around finance's effect on the behavioral

system. Banks are the primary institution of modern capitalism, making a business from handling

the inflow and outflow of cash on balance sheets they possess. Banks, where cash inflows daily
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and outflows are traditional financial institutions, are means of the present payment system.

Everyone, households, companies, government agencies, or even the whole nation, is a financial

firm because they must take care of their operations' implications towards their daily cash flow

regarding what they do. Indeed the critical interface where each interacts with the more

significant structure is the cash flow daily and out. This system provided the money that enables

us to implement dreams and aspirations today that otherwise would be unattainable. Still, it does

so at the cost of pledging us to make payments that can more or less effectively restrict our

independence if our dreams do not work out.

The Inherent Instability of Credit

Not at each level, but the system's two parts of a credit display themselves as the cash

inflow of one individual is the cash outflow of another person ( Mehrling, 2010). If credit induces

one individual to raise expenditure, the immediate outcome is income in the system subject to

additional spending. Likewise, if the debt burden causes one person to reduce cost, the instant

result is a reduction in income somewhere else in the system and possibly a decrease in

expenditure. This balance sheet interaction is the origin of the inherent credit instability called by

the British monetary economist Ralph Hawtrey. In his view, the central bank's primary objective

is preventing the credit-fuelled bubble from starting to avoid the decline that typically follows.

The New Lombard Street

Our modern society isn't the world of Bagehot; the dollar norm has substituted the gold

standard. For us, not the exchange bill, but something called a "repurchase agreement" or repo, is

now the most crucial money market instrument. Repos are issued for failure like in Bagehot's
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world, finance the expansion of real goods towards final sales, instead of financing holding of

financial assets.

Officially, the real financial benefit, often as short as overnight, works as collateral for a

short-term loan. The 'purchase' refers to a structure in which the short period lender is organized

to sell an asset in conjunction with a deal to buy the commodity at the initial sale price plus a

specific interest. The initial sale is lower by an amount known as the "haircut" than the asset's

market value; the haircut purpose is to offer a loan with extra security, so the haircut varies with

the collateral riskiness. The lowest repo rates and weakest haircuts occur when a Treasury bill is

the collateral for the loan. It is possible to consider the primary dealers' unique position as a

World War II legacy. All these debts, all of them, holders have relied on the ability to convert

national debt into investable capital.

New Lombard Street works this way. While Bagehot's central bank applied the discounts

to make the system manageable, the Fed turned their focus on overnight price loans in the feds

market. Fed doesn't lend or borrow, so Fed funds' "effective rate varies based on supply and

demand. The Fed instead uses this to take over collecting the deposits rented and leased in the

Fed Funds market, the Treasury repo market. The monopolistic supply of bank reserves by the

Fed grants it significant market power over the Fed assets. Still, there is a gap between Fed

funds' market structure and liquidity financing more generally. In the general collateral repo

market, security dealers fund significant activities, and the Fed is a small player. So it's not at all

a player in the Eurodollar bank deposits offshore market, available to banks as an option to Fed

assets, and has grown into the world's central liquid money market place. Borrowers and lenders

find each other and do so in both the Repo and Eurodollar markets. Private credit is an extra for

the elasticity of general credit. Contrary to Bagehot's time, the Fed's discount chance has lost
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meaning under modern times. When financial institutions need money to meet their daily wiping

commitments, they usually raise it from other central money market banks. When the banking

system needs cash, the cash is generally increased by the sale of liquid-market holdings. Finally,

the Fed's willingness to maintain the Fed Funds' rate at a particular target and make advantages

through loaning in the Treasury market by its intervention is stopped by both stations. Strictly

speaking, the Fed always lends freely, to primary vendors, against Treasury security collateral it

was aimed at preventing crisis. The Fed responded to the contraction in private fluidity, widening

the lender category it was willing to loan to and broadening the type of collateral it was ready to

accept. The proceeds were used to finance additional lending.

Since the Fed can avoid the standby limit that others must obey, doesn’t mean it should.

Questions are whether avoidance is the right policy even in times of crisis and a fortiori in

regular times. From a Hawtreyan perspective, the situation was an indictment of Fed policy in

the years before it. Hawtrey, as a consequence, the current crisis would have had no difficulties

comprehending.

In conclusion:

We find ourselves grappling on the eve of the Fed's centennial year with some of the

same issues that concerned the Fed's founders, although now with the benefit of a century of

American-style central banking experience. To be sure, we have to overcome our intellectual

blinders, primarily a legacy of what I have called the Management Age, but they are different

blinders from those that have held our forebears back. We are in a position to appreciate

Moulton's emphasis on shiftability and Martin's focus on the dealer system as the source of that

shiftability, unlike them. If anything, our blinders involve an excessive appreciation of these
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stresses and inadequate appreciation of their limitations. To claim that shiftability is, the essence

of liquidity is not to say that liquidity is or should be a free good. When we can safely abstract

from liquidity, we cannot say that we can consider the monetary policy and financial regulation

questions.

The main lesson regarding the crisis is. What are the consequences for regular times of

the Fed's role of “dealer of last resort"? We have to face that question in the future, starting with

realizing that our credit system relies heavily on dealer markets that link money market liquidity

financing with capital market liquidity. The Fed has a role in supporting and managing that

system as a whole, not just setting prices in a narrow slice of funding markets.
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Work cited,

Mehrling, Perry. The New Lombard Street: how the Fed became the dealer of last resort.

Princeton University Press, 2010.

Hilt, Eric. "Perry Mehrling, The New Lombard Street: How the Fed Became the Dealer of Last

Resort." (2012): 305-308.

Øksendal, Lars Fredrik. "The New Lombard Street: How the Fed Became the Dealer of Last

Resort by Perry Mehrling." Enterprise & Society 15.3 (2014): 596-598.

ALLAN, H. MELTZER. "The new Lombard Street: how the Fed became the dealer of last

resort." (2012): 826-827.

Tucker, Paul. "The lender of last resort and modern central banking: principles and

reconstruction." BIS Paper 79b (2014).

Mehrling, Perry. "The New Lombard Street: Anatomy of Crisis." INET Conference at King's

College. Vol. 6. 2010.