Arnold Kling  

An Indispensable Book

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Hating on Econ... Self-Recommending...

I've read through Perry Mehrling's The New Lombard Street, and I need to read it again. Meanwhile, some thoughts.

1. Mehrling is an outstanding and engaging intellectual historian, but he fails to appreciate financial crisis porn. I'll explain below.

2.Tyler Cowen recommends the last two chapters, which are not intellectual history and I think are somewhat off base. In my view, it is the first three chapters that are indispensable.

3. I strongly recommend reading his book rather than relying on my summary. The book itself is terse, and Mehrling has a knack for boiling down major theoretical works to a few sentences. For me to try to boil it down further risks doing more harm than good, but here goes, anyway.

In the last two chapters, Mehrling views the financial crisis as a liquidity crisis, and he sees the Fed's response as largely correct. I think of it as a solvency crisis, and I think that the Fed bailed out Wall Street, using our money.

Mehrling thinks that the financial system that emerged in the last ten years is a natural evolution, as if it sprang from Fischer Black's theory of general equilibrium. Mehrling's previous indispensable book, Fischer Black and the Revolutionary Idea of Finance, is one that I cannot recommend highly enough. In The New Lombard Street, Black plays a small but vital role, presaging the separation of liquidity, credit risk, and interest-rate risk.

Instead, I think that the financial system that emerged in the last ten years is an artificial evolution driven by regulatory arbitrage and misguided housing policy. In my view, Mehrling needs to read All the Devils are Here and The Greatest Trade Ever in order to appreciate the utter absurdity of what was taking place. On p. 125, Mehrling writes,


Fundamental valuation was definitely a concern--bad loans had definitely been made--but from a money view perspective, price is first of all a matter of market liquidity.

That is the only place in the book where he uses the phrase "bad loans." If you didn't know better, you would come away thinking that nothing was really wrong with the mortgage securities, and if we hadn't been subjected to a self-reinforcing panic things woud be ok.

But the book as a whole is much, much better than its chapters on the financial crisis. As I say, it is indispensable.

Mehrling sorts thinkers into those taking an economics view, a finance view, and a money view. I have written about all three views. Within his framework, he takes the money view, as do I.

The economics view is what you would get from most academic economists, such as John Taylor. What the Fed should worry about is aggregate economic activity, and if it follows rules that are tied to the behavior of those aggregates, we will be fine. I discuss the economics view in The Macro Doubtook, Installment 6, but if you have been following any of the discussion with Scott Suimner, you know the economics view.

The finance view is a world with perfect markets and rational expectations. Some of what Mehrling has to say about the finance view overlaps with what I wrote in The Macro Doubtbook, Installment 7. You might wish to go back and read that in order to get a flavor of the finance view.

On p. 5, Mehrling writes,


in more recent decades, the finance view has held sway--excessively so, as the present financial crisis now confirms. Private and public sector alike dreamed fantastical dreams about the future, and financial markets provided the resources that gave those dreams a chance to become reality.

That last sentence is riddled with ambiguity, if not outright contradiction, leaving it unclear where Mehrling really stands. For me, this sentence cried out for follow-up, but it never received any.

What Mehrling calls the money view is close to what I expressed in thoughts on finance. If you recall, I said that the nonfinancial sector wants to issue long-term, risky liabilities and hold short-term, riskless assets. The financial sector accomodates by doing the reverse.

Mehrling adopts this view, which he traces back to Bagehot and Hawtrey. Mehrling stresses, as I do, the Minsky problem that financial intermediation is unstable. Mehrling views the central bank as playing an essential role as a lender of last resort. In this role, if the central bank is too forgiving, bubbles will ensue. If the central bank is too unforgiving, the post-crash suffering will be too great.

If Mehrling is correct, then Scott Sumner would not make a good Fed Chairman. He would do too much to start bubbles and be unable to alleviate crashes. What we want are not rules tied to aggregates but instead discretion tied to financial conditions.

I have two problems with that. First, I only believe the money view with p = .6 (with .3 for the economics view and .1 for the finance view). In case the economics view is correct, I want Sumner there. Second, I do not trust the Fed to use discretion wisely. As you know, my recommendation is to try to make the financial system easy to fix, rather than hard to break. In particular, don't encourage excessive leverage, as we do with our tax policy and housing policy, and as you inevitably do if the government is the liquidity provider of last resort.

The crux of the last two chapters is that securities dealers have become the key financial intermediaries, and the Fed has necessarily become the dealer of last resort. My view, which I may need to reconsider, is that securitization got way out of hand, and we should not be trying to restore that status quo. I am, in Mehrling's view, a "Jimmy Stewart banker," hopelessly out of date. I wish Mehrling had a blog, and that we could argue this issue back and forth.

I really value Mehrling's framework of the three views, and the way that he uses that framework to organize a lot of intellectual history. My worry is that if you don't have the background, you won't be able to follow it. On the mechanics of the repo market, you may need to read Stigum's Money Market first--a recent edition is cited in Mehrling's references.

On the theoretical stuff, you may have to dig up the reading lists from some of the old courses I took. I worry because, for example, in a couple of places Mehrling brings up Gurley and Shaw. I remember that this was on the reading list, but for the life of me I cannot give a good account of what was in it, and Mehrling's discussion is too brief to help. Either (a) the book did not really say much, so that the whiff I pick up from Mehrling is adequate, or (b) he is too terse all around, and the only reason his discussion of Minsky, Tobin, Friedman and others makes any sense to me is that I really studied them in depth.


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COMMENTS (5 to date)
Robert Simmons writes:

"My worry is that if you don't have the background, you won't be able to follow it."
Definitely this. I read The Revolutionary Idea of Finance. Initially I thought that he explained some ideas very well, and others poorly. Afterwards I realized that pretty much all of it was explained poorly, I just didn't notice when it was something that I already knew well. Still a good book, but could use some work to be a great one.

Frank Howland writes:

I really liked the way Mehrling used balance sheets to make his description and analysis clearer in the latter chapters of his book. I agree that he is too terse. The point of this comment is to suggest some additional reading which may help some people to understand part of the story that Mehrling tells.

On what went on in the repo markets, let me recommend (1) Gary Gorton, Slapped by the Invisible Hand, which describes the shadow banking system and puts its crisis in historical context (http://www.amazon.com/Slapped-Invisible-Hand-Management-Association/dp/0199734151/) (2) a paper by economists at the New York Fed: The Tri-Party Repo Market before the 2010 Reforms by Adam Copeland, Antoine Martin, and Michael Walker; November 2010 (http://www.newyorkfed.org/research/staff_reports/sr477.html); and (3) Duffie, Darrell. 2010. "The Failure Mechanics of Dealer Banks" Journal of Economic Perspectives, 24(1): 51–72 (http://www.aeaweb.org/articles.php?doi=10.1257/jep.24.1.51--this article is freely avaialble)

Gorton's book is very much worth reading for its appreciation of the historical context and its clearly articulated interpretation of events (even though I think Gorton is only partly right); the New York Fed paper is much narrower, but goes into more depth on one corner of the repo market (perhaps 15-20% according to Gorton, who cites a private communication on p. 134). Duffie has recently come out with a short book on the same subject: How Big Banks Fail: and What To Do About It, Princeton University Press, 2010 (http://www.amazon.com/How-Banks-Fail-What-about/dp/0691148856/). This book has lots of useful references and is more current than his JEP article.

Another interesting paper is Shadow Banking by Zoltan Pozsar, Tobias Adrian, Adam Ashcraft, and Hayley Boesky New York Fed Staff Reports, Number 458; July 2010 (http://www.newyorkfed.org/research/staff_reports/sr458.html). Only the first part of this paper has been published thus far. It is full of complicated charts showing the relationships between different parties in the shadow banking system and how their balance sheets are connected.

A major difficulty for those trying to figure out what was going on in the shadow banking system is that those balance sheets are largely hidden. No one knows, for example, how large the repo markets actually were.

Nick Rowe writes:

Gurley and Shaw: There's outside money and inside money. Outside money is net wealth, and inside money is not net wealth (because it has an offsetting liability).

Pesek and Saving: G&S are wrong. There's monopoly money and competitive money. Monopoly money is net wealth, and competitive money is not net wealth. The wealth equals the Present Value of the seigniorage profits.

I think P&S were right.

It was a footnote to Patinkin, and the real balance effect. Is helicopter money net wealth?

(Not sure if this is the bit of Gurley and Shaw that Mehrling is referring to.)

ed writes:

"I think of it as a solvency crisis"

You keep saying this, but how could it have been a solvency crisis when the banks were able to so quickly pay back the TARP loans, with generous interest?

Maybe I don't know what you mean by solvency. Please explain.

Arnold Kling writes:

Ed,
You may recall that a number of the banks that took TARP money were forced to do so. No surprise that they would repay the loans.

On the other hand the survival of Citigroup may support your view. Did they get by because their mortgage assets actually did not lose as much value as the 2008 market prices indicated? In that case, the liquidity view seems correct. But there may be other reasons for Citigroup's revival--it could be that they were genuinely insolvent in 2008, but they have had good luck since then and have been able to make up the losses.

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