At one point in time not all that long ago, basic economics (small “e”) ruled central banking. There was really no other choice, as out of necessity bred change and understanding. The English were perhaps first in that lead, as the Empire with greatest economic and financial reach. It is interesting what we take for granted today as if it had been intellectually settled for all human history, but in the revolutionary times of the 19th century they still struggled to understand what would be considered a modern economy.
Bank and money panics were nothing new, of course, nor were asset bubbles. For the first time, however, money and economy seemed to be more and more intertwined. In the agrarian roots of any economy, there was no business cycle to speak of. Widespread unemployment was a new development, with competing ideals setting out in all directions to explain it, and, if possible, eliminate it. At one end was people like Karl Marx and Friedrich Engels who thought they could do away with the business cycle by doing away with business; at the other end were those who sought out money and its role in revolution, industrial as well as social.
Walter Bagehot was one such researcher who in 1873 published Lombard Street: A Description of the Money Market. Written in part as a response to widespread panic in 1866, it is the first to have issued what was once central banking’s great dictum: lend freely on good collateral at high interest rates. Bagehot never wrote those words, but his meaning resonated and still does. In 2014 when former Federal Reserve Chairman Paul Volcker called for a new Bretton Woods, it was Bagehot he had in mind, particularly his admonishment that “money will not manage itself.”
Whether or not that is actually true is up for debate; what is less contentious is that money cannot manage itself under unstable and unclear terms. In our current construction, the global monetary system is a hybrid, where Bagehot’s principles supposedly guide central banks under the banner still of “currency elasticity” that for a great amount of time money markets believed in. It should be clear by now that they don’t so much anymore. Thus, the current hybrid is where private money markets know that central banks claim to manage money but also know in many cases, if not all, they really don’t or can’t. Central bankers don’t seem to know any of this.
In 1873, there was good reason for the ignorance. In Lombard Street, Bagehot felt compelled to describe the basics because at that time they weren’t fundamentally accepted propositions from among those inside, let alone known in broad fashion:
Many persons believe that the Bank of England has some peculiar power of fixing the value of money. They see that the Bank of England varies its minimum rate of discount from time to time, and that, more or less, all other banks follow its lead, and charge much as it charges; and they are puzzled why this should be. ‘Money,’ as economists teach, ‘is a commodity, and only a commodity;’ why then, it is asked, is its value fixed in so odd a way, and not the way in which the value of all other commodities is fixed?
There is at bottom, however, no difficulty in the matter. The value of money is settled, like that of all other commodities, by supply and demand, and only the form is essentially different. In other commodities all the large dealers fix their own price; they try to underbid one another, and that keeps down the price; they try to get as much as they can out of the buyer, and that keeps up the price. Between the two what Adam Smith calls the higgling of the market settles it. And this is the most simple and natural mode of doing business, but it is not the only mode. If circumstances make it convenient another may be adopted. A single large holder—especially if he be by far the greatest holder—may fix his price, and other dealers may say whether or not they will undersell him, or whether or not they will ask more than he does. A very considerable holder of an article may, for a time, vitally affect its value if he lay down the minimum price which he will take, and obstinately adhere to it. This is the way in which the value of money in Lombard Street is settled. The Bank of England used to be a predominant, and is still a most important, dealer in money. It lays down the least price at which alone it will dispose of its stock, and this, for the most part, enables other dealers to obtain that price, or something near it.
The reason is obvious. At all ordinary moments there is not money enough in Lombard Street to discount all the bills in Lombard Street without taking some money from the Bank of England. As soon as the Bank rate is fixed, a great many persons who have bills to discount try how much cheaper than the Bank they can get these bills discounted. But they seldom can get them discounted very much cheaper, for if they did everyone would leave the Bank, and the outer market would have more bills than it could bear.
By holding special privilege, the Bank of England was simply the biggest in money markets and could therefore outdistance any other prices, bids, and discounts. The money market was bigger than any single or even group of competing institutions, and therefore order could be imposed by simple economics.
But central banks are themselves constrained, by both dictum as well as operational realities. In 2007 and 2008, as well as several times thereafter, the world’s central banks felt it necessary to bend the “rules” by lending freely at low rates on pretty much any paper that might be posted by anybody demanding funds, especially if that anybody was big and systemic. Several people have called this a transformation from “lender of last resort” to “market of last resort.” Central bankers found themselves supporting not just liquidity but prices even. That would propose they failed disastrously in money, and therefore tried to “correct” the error(s) by doing far more than money. A simpler solution might have been more proficiency in money, and not just on the way down.
To my knowledge the official sector has yet to answer why. It’s not enough to simply say “2008 was bad” because we all know 2008 was bad. To undertake examination of “market of last resort” is to begin to answer why 2008 was bad and furthermore why everything after 2008 remains bad.
One of the primary issues has certainly been collateral itself, the repo market lifeblood that dictates the fluidity of so many parts of the global system. In very simple terms, the repo market exploded in the 2000’s because it was efficient on all sides (or at least appeared to be under pre-2008 assumptions). The housing bubble manufactured its own financial collateral, a form of monetary expansion, qualitative as well as quantitative, that was in many ways greater than the credit that flowed from it. When that prior collateral, MBS, was repudiated, so too was the means to resume creating more.
Worse than that, regulations that preferred any kind of government bond led a great many eurodollar institutions from “toxic” MBS straight to PIIGS “risk-free.” The repudiation of that collateral in 2010 and 2011 was in many ways a similar strain to 2007 and 2008 from which the monetary system has never recovered; there is simply no capacity left by which to satisfy continued repo demand. There was surely some attempt in the aftermath of 2011 under “collateral transformation” to turn junk bonds and even EM corporates into that role, but that all ended badly all over again starting in 2014. You get the sense that the repo market of the past few years is coming to terms with no way to solve what is really a supply problem.
Repo collateral has thus behaved in money-like ways, only in this kind of interbank money there is no huge player who has undertaken the assignment to set the market rate for collateral, good times and bad, and therefore mediate and redistribute irregularities. The Federal Reserve through its quantitative easing programs actually made it quantitatively worse, a condition that the Open Market Desk seems to have after the fact made itself aware in the early months of 2013 under QE’s 3 and 4 after stripping the on-the-run markets of too much supply. Its SOMA portfolio today is brimming with trillions in securities, including $2.463 trillion in UST’s and $1.756 trillion MBS at last update, but there is no Bagehot mandate applied in UST or MBS collateral. Instead, the repo markets are left with the RRP, which seems to have been crafted from an equal helping of ignorance and arrogance.
And so it is often difficult to think about all this in any other way. Whereas Bagehot was trying to explain the money markets and how they really worked even to the central bankers of his time, we are right back in the same position all over again today. My colleague Joe Calhoun always says that everything has happened before and in this case it might be the literal truth, trying to explain to central bankers the small truths of how things actually work in money. This time “dollars” rather than sterling, or even dollars.
Gold is collateral of last resort as it is near-universally accepted. Repo fails indicate, very strongly, collateral shortage. Put the two together and you get yet more evidence that central bankers really don’t know what they are doing. And, also like in Bagehot’s day, the repercussions are global.