The New Lombard Street by Perry Mehrling

Rating: ★★★★

This short book discusses the history of central banking in the United States and how the role of the Federal Reserve has changed. Mehrling comes at the subject from somewhere between finance and economics, and his main concern seems to be describing money as it operates in reality, not in theory. The writing is straightforward, but The New Lombard Street is dense. I think it’s great, but I’d only recommend it if you have a strong interest in central banking and the finer details of the financial crisis of 2007-2008.

I want to note that, I'm not writing up the most central theses but instead a few interesting nuggets:

Central banking and bubbles

If you don't catch a bubble early, it can be impossible to do anything using interest rate policy. On the way up, central bank lacks traction because everyone avoids central bank discipline. On the way down, they become lender of last resort. When this power is used wisely, it prevents a downturn from becoming rout. Used unwisely, it continues the bubble.

Regulatory arbitrage

Money market mutual funds started doing bank-like activities but only slightly differently to avoid regulation. Banks (correctly) complained that they couldn't compete, and their regulations were weakened so that they could. "Financial innovation" was accepted, and the financial system became more fragile.

On incrementalism

"[Any] new system must grow organically out of the old one. We are not going to start from scratch, so our reforms had better engage with the system as it is, not as it was or as we might wish it to be in some ideal world."

Shadow banking is inherently vulnerable to runs

"Since the role of deposit insurance is to prevent bank runs, it was not really surprising that the uninsured shadow banking system turned out to be vulnerable to runs."

Reflexivity in the CDS market

Dealers in the credit default swap (CDS) market relied on historical market information but they themselves were changing the way the market worked:

"Dealers thought they were taking no risk because they were calibrating their models using historical asset prices. In fact, however, their willingness to write those insurance contracts was changing the world, enabling great pockets of leverage to build up that would pose a problem of systemic risk that would overwhelm their private risk-bearing capacity."