An Indispensable Book
By Arnold Kling
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.