Perry Mehrling

Bagehot was a Shadow Banker: Shadow Banking, Central Banking, and the Future of Global Finance

At the heart of both the modern shadow banking system and the 19th century banking system described by Walter Bagehot is the wholesale money market, with the central bank providing a liquidity backstop. We characterize shadow banking as “money market funding of capital market lending” and construct a model of such a system with dealers making markets and setting prices for funding and risk. Using this model, we describe the secular expansion of the market-based credit system and its rapid collapse during the global financial crisis. The model also clarifies the economic functions of the market-based credit system, the role of the central bank in such a system, and the global character of US dollar funding markets.

A Classical Model of the Class Struggle: A Game-Theoretic Approach

The class struggle is formalized as a differential game in a strictly supply-side model, an approach that synthesizes the models of Lancaster and Goodwin. Four different steady-state equilibria are derived, each corresponding to different assumptions about the degree to which each class is organized to promote its own interests. In particular, the Goodwin growth cycle is shown to emerge from a world characterized by unorganized capitalists and workers, in which individuals ignore the effects of their own actions on economywide variables. More relevant for discussion of modern capitalism are the hierarchical equilibria, especially the codetermination equilibrium in which the existence of a full-employment equilibrium turns out to be problematic. Finally, comparative-statics results suggest that the incentives for technological change differ widely among the four regimes.

Retrospectives: Economists and the Fed: Beginnings

As usually understood, the significant debate over the founding of the Fed was between advocates of the real bills doctrine and advocates of the quantity theory of money. This understanding however conflates two different distinctions: one between the banking principle and the currency principle, and one between self-regulation and active management. It also fails to take seriously both the context of practical experience with the national banking system and the developing practical experience inside the Fed. I propose a new interpretation focused mainly on the contributions of four economists: J. Laurence Laughlin, Irving Fisher, Paul Warburg and Benjamin Strong.

Mr. Woodford and the challenge of finance

Once one recognizes that many prices (and wages) are fairly sticky over short time intervals, the arbitrariness of the path of nominal prices (in the sense of their under-determination by real factors alone) implies that the path of real activity and the associated path of equilibrium real interest rates are equally arbitrary. It is equally possible, from a logical standpoint, to imagine allowing the central bank to determine, by arbitrary fiat, the path of aggregate real activity, or the path of real interest rates, as it is to imagine allowing it to determine the path of nominal interest rates. In practice, it is easiest for central banks to exert relatively direct control over overnight nominal interest rates, and so they generally formulate their short-run objectives (their operating target) in terms of the effect that they seek to bring about in this variable rather than in one of the others.

Don Patinkin and the origins of postwar monetary orthodoxy

Don Patinkins Money, Interest, and Prices (1956) set the ground rules of postwar monetary discourse, for better or worse. A close look at the intellectual origins of the book in Patinkins own life shows it to emerge equally from the Old Chicago School of Simons/Mints/Knight and the Cowles Commission of Lange/Marschak/Haavelmo. Patinkins conception of money as essentially an outside asset is argued to emerge from the historical context of war finance, and is contrasted with the Gurley-Shaw conception of money as a form of inside credit.

Minsky and Modern Finance

Economic theory offers us two ways of understanding the events of Fall 1998: the banking approach (here associated with Minsky), and the finance approach (here associated with Merton, Scholes, and the firm Long Term Capital Management). The main lesson of the LTCM experience is that the modern theory of asset pricing (the finance approach) is incomplete and needs to be supplemented by a theory of liquidity (the banking approach).

A note on the optimum quantity of money

Abstract In a model where agents use money to offset uninsurable idiosyncratic income fluctuation, Bewley (1983) has shown that it may be impossible to satiate the demand for money as recommended by the literature on the optimum quantity of money (Friedman, 1969). This note shows, by means of an example, that even when it is possible to implement the traditional optimum quantity proposal, it may not be welfare-maximizing to do so on account of a negative distribution effect.

Monetary Policy Implementation: A Microstructure Approach

In classic central banking theory, the ‘discount house’ played a central role (Bagehot, 1873, Sayers, 1976).1 As holders of short-term commercial bills, the discount houses financed the holding of goods on their way from producers to consumers, and, in turn, financed themselves primarily by borrowing from banks. Just so, an expansion of trade went hand in hand with an expansion of both the assets and liabilities of the discount houses, and also an expansion of both the assets and liabilities of the banking system. Looking through the balance sheet relationships, it was clear to observers that the expansion of trade was financed by an expansion of bank money, meaning the deposit liabilities of the banking system.

A new measure of liquidity premium

Financial forwards and futures allow banks to align mismatched cash inflows and outflows arising from the activities of their clients in the real economy. Even with these contracts, however, banks can achieve only imperfect offsetting of cashflows, leaving them bearing residual liquidity risk. Banks charge a price for bearing this risk which is not directly measureable. Owing to the different cash-flow characteristics of the two types of contract, this liquidity-risk premium is embodied in the price difference between futures and forwards in interest rates and in foreign exchange. The premium can be measured indirectly from market data, and aids in an understanding of two asset-pricing anomalies of monetary economics.

Love and death: The wealth of Irving Fisher

This essay puts forward a new interpretation of Irving Fisher that integrates his scientific work with his moral crusades, and places both in the context of his times. The key to the new interpretation is Fishers book on The Nature of Capital and Income (1906) where he lays out his vision of the economic process and presents his theory of income, neither one of which ever gained acceptance. The new interpretation challenges the standard view of Fishers scientific work as an anticipation of the post war neoclassical synthesis.