Auerback: The Central Bank as “Dealer of the Last Resort”?

By Marshall Auerback, a fund manager and investment strategist who writes for New Deal 2.0.

Over the last thirty years, we have steadily moved from a bank lending credit system, to one in which capital markets have become the primary form of credit intermediation. Unfortunately, our regulatory apparatus has not kept up. The result has been a series of improvisations: filling gaps in the regulatory framework via bailouts and the steady expansion of moral hazard.

This is important because, as one of the first of the speakers at the Institute of New Economic Thinking (INET) conference, Professor Perry Mehrling, noted, the ultimate backstop implied by repeated government rescues created a set of expectations on the part of capital market participants. For any given trade in the securitized markets, there arose an assumption that an institution or individual could readily find a counterparty willing to do a trade at a price near to the last quoted price. As Mehrling noted, when the system was working, that counterparty was typically an investment bank (like Bear or Lehman) acting as a swap dealer, taking the opposite side of your trade for a fee: “They were willing to do this in part because they were committed to supporting the CDO market more generally. But they were not crazy. Ultimately they were market makers, willing to buy or sell the index at a price, but quite careful about their own net exposure.”

This meant that sustained pressure on one side of the market would be met by falling prices, and that is exactly what happened in the early stages of the crisis. The freefall happened when the failure of Lehman and AIG took a key market maker, and the key ultimate seller of insurance, out of the system. Had someone else, perhaps the government, stepped in to do what Lehman and AIG had been doing, even at a high price, the freefall could likely have been stopped in its tracks and the extent of the subsequent global financial fallout considerably mitigated.

Mehrling’s ultimate conclusion: Have the central bank become “Dealer of the Last Resort”, in effect backstopping the system by being the ultimate market maker or “insurer of last resort”.

Here’s the idea, which Mehrling delivered in his presentation dealing with the Anatomy of the Crisis. In essence, he proposed a modern day version of the old “Bagehot Rule“ — lend freely, but at a high rate, in a crisis. Mehrling argued that simply floating the system with money market liquidity, which is what the Fed initially did, failed to mitigate the intensifying financial crisis, because it wasn’t getting to the capital markets. That’s why we need a credit insurer of last resort, to put a floor on the value of the best collateral in the system. In Mehrling’s view, the 21st century equivalent of the Bagehot Rule should be: Insure freely but at a high premium.

The Fed, in other words, should be backstopping the market for securitized products simply because the government is the only entity which can freely create new net financial assets and thereby cover the potential insurance liabilities during a crisis, in a way which AIG clearly could not.

Now, personally, we tend to be more sympathetic to the view that instruments that create such huge systemic liabilities and instability (such as credit default swaps) should be outright banned. Higher capital ratios (as suggested by many of today’s participants) capital ratio rules will not in themselves solve the problem. The system was gamed by the banks via securitization and accounting subterfuge, which suggests that optimal regulation is best achieved via regulation of the ASSET side of the bank’s balance sheet, not the liability side (we received some sympathy for this view from former BIS central banker, William White, whom we had the pleasure of meeting at this conference).

The objective should not be to create reactive buffers (or “insurance policies”) when the banks’ complex derivatives products begin to go bad. Rather, the activities which fail to promote public purpose should be banned outright. The whole point of regulatory capital is to ensure buffers in case of a really bad downturn. When the really bad downturn happens the buffers will be (naturally) be used. Why not ban (or heavily tax) the activities that caused the really bad downturn in the first place?

Nonetheless we are aware that there is a distinct lack of political will to enact serious regulatory reform or impose significant legal sanctions on errant management given the contemptuous ease with which Wall Street has successfully gutted the reform bill spawned in both the Senate and House of Representatives. Mehrling’s proposals might well offer the most politically achievable and effective alternative in a way that the Volcker proposals, for example, do not (largely because Volcker does not even touch the issue of securitization).

If securitization is the problem, argues Mehrling, then insurance is another viable policy response. The financial system did insurance wrong during the run-up, and as a consequence we got an unsustainable boom and a nearly unstoppable freefall when the bubble burst largely because the “premiums” charged for the insurance via AIG were absurdly low in relation to the risks being undertaken. As Mehrling noted when we spoke to him: “If AIG is selling you systemic risk insurance for 15 basis points, that price is too low. Charging a price closer to a reasonable rate prevents people from creating financial catastrophes.”

But if we do insurance right, we can make securitization functional again, as well as deterring outright dangerous speculation by making the “premium” on such activities to be so high as to be uninsurable. It might not be ideal, but it’s far less disruptive to the existing financial plumbing and could well work more successfully than what we have today. And in contrast to insurance for “Acts of God”, the right sort of prices established by the Fed as “dealer of last resort” could well prevent an earthquake in the way that our seismologists cannot.

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  1. Andrew Bissell

    So, the same Fed which totally failed to foresee the development of the dot-com and housing bubbles will be entrusted to set “the right price” for insurance on collateral, the quality of which will of course be assessed by the crack teams of analysts at the self-same Fed. Good effing grief!

    The inflationist Bagehot Rule has already shown its utter uselessness and propensity to create moral hazard and systemic imbalances, and the best solution these INET folks can come up with is to double down and extend it to other markets besides bank lending. If Soros is really interested in challenging accepted economic and financial orthodoxies he could start with the ones propounded by Bagehot himself (and now accepted by virtually every financial and economic commentator on the planet, save Jim Grant and a few guys working in Georgia), which have turned into exactly the kind of subsidies for rank speculation and extension of bad credit which critics like Thomson Hankey warned they would.

    There’s a very simple alternative here, and one which I think would actually be quite popular politically: if a dealer purchases their insurance from a shaky counterparty that’s charging too little and setting aside insufficient reserves, they ought to bear the full risk of counterparty default. Let a few AIGs go, and not pay off the claims of their counterparties, and you’ll see the underhanded bailout-reliant tactics of the Goldmans and the Magnetars disappear overnight. All of a sudden, they’ll start paying a lot more attention to whether they can trust the ability-to-pay of the people taking the other side of their bets. See? No muss, no fuss, and no need to worry about winding up with another clown like Greenspan or Bernanke taking the controls, or worse yet, capture of the Fed by the very banks they’re selling insurance to. Why, this “letting them fail” thing is almost like magic!

    Yes, in the short term this may be a more painful solution than the kind of palliatives Mehrling would suggest, but in the Fed’s liquidity backstops of the past 20 (hell, even 50) years we can already see how these short-term cures only compound and exacerbate the eventual long-term pain. The exact same would be true of Mehrling’s fix, whether it took 2 or 5 or 20 years to sufficiently warp market participants’ decisions to precipitate a new crisis.

    Of course, the “stop bailing people out” alternative, despite its obvious political popularity and practical applicability, must be studiously ignored by all Serious Thinkers on this subject, such as the INET congregation.

  2. gordon

    Don’t be too hard on Bagehot. His “rule” was (from memory) that the central bank should lend freely, at high rates against good collateral. What has happened with bailouts is that central banks have lent against no worthwhile collateral at all, unless you believe that “mark to model” actually generates a meaningful number.

    The Bagehot rule as stated by Bagehot wasn’t followed.

    1. Andrew Bissell

      They’re not lending against good collateral? That’s not what Ben Bernanke claimed; he stated many times in public testimony that he thought there was a good chance the Fed would turn a profit on the assets it took onto its balance sheet. Hell, if investors keep reaching for yield, blinded to risk by the government’s implicit promise that no one will ever lose money by buying an asset ever, then hell, he may be right!

      If the collateral was “good” the market would lend against it and you wouldn’t need a lender of last resort in the first place! The Bagehot Rule is self-contradictory. The whole point of the Bagehot doctrine is that central bankers are supposed to assume the market is wrong (or “crazy” if you prefer Stiglitz’s term), it’s just gripped by a “temporary” “firesale” “panic” mentality, and therefore you can apply whatever value you deem reasonable to the assets being tendered. Given those premises, how do you even distinguish “good” collateral from “bad” collateral anyway? What’s a “penalty” rate of interest when the a market rate of interest is unavailable or effectively infinite?

      Banking crises are caused by banks piling up a lot of bad assets on their balance sheets and assuming they’re “money good.” If the Bagehot Rule really says to let the banks with these assets drown, then hell, I’m a Bagehot follower myself! But I don’t see why you even need a central bank in that case….

      I agree that central banking has probably become much more reckless and powerful than Bagehot ever intended. I also agree with Bagehot’s fiercest critics that his system carries within it irresistible tendencies toward that very recklessness.

      1. gordon

        What is “good collateral” in a credit crisis is certainly a good question. I don’t know exactly what was in Bagehot’s mind, maybe somebody who is more familiar with Bagehot could tell us.

        A lot of commercial lending was done against CDOs, and that turned out to be very bad collateral. That is the whole old discussion of a year (and more) ago about what the credit rating agencies thought they were doing. Aside from ratings, one avenue for reformers might be, as I commented on this blog a while ago, to look at lending against bad collateral and ask when the lending officer has breached fiduciary responsibility.

      2. Yves Smith Post author


        Gordon is correct on this point. Bernanke & Co. were in “save the banks, no matter what it takes” mode.

        Dealers had been lending against AAA rated CDOs in the repo market. As the crisis wore on, repos were being rolled daily. Haircuts rose from 2-4% (you get 96-98 cents on 100 cents of face value) to 95% (which effectively means no one will lend).

        So banks are scrambling to preserve THEIR OWN LIQUIDITY. They are not wiling to lend to each other. Even if they repo against very good collateral under those circumstances, if a dealer goes BK, they wind up with the collateral when they might have wanted or needed the money back. Plus you have costs of BK, and fear that if the dealer you lent to goes BK, no one will lend against that collateral you now have (rather than that cash you have before lending to the now-bust dealer) or will lend against it on much worse terms (as in you are again worse off than if you had never extended the loan in the first place).

        So the idea that markets can freeze for good collateral is accurate, and did happen.

        And save the first bailout of AIG (which was retraded within weeks, we have complained repeatedly about that), NONE of the Fed’s loans were at a penalty rate.

  3. gordon

    “But if we do insurance right, we can make securitization functional again…”

    Why should people do insurance right, when they only did insurance in the first place because they could get away with a scam? If insurance has to be “done right”, I doubt if anybody would want to do it at all. Mr Auerback seems to admit this point when he says that the premiums for insurance “done right” might be so high as to kill the whole idea.

    Mr Auerback basically prefers the option of “Let a few AIGs go…”, which has also been preferred by squillions of posters and commenters on this and other blogs, and I would agree with it too. Forget about insurance.

    1. Thomasina Jefferson

      Why should people do insurance right, when they only did insurance in the first place because they could get away with a scam?
      Exactly. The whole financial system is not supposed to work flawlessly or be fair in any way.
      The goal is that certain people, and I mean the Capitalists, can enrich themselves by exploiting those flaws that they helped create in the first place.

      If anyone wants to help get such a system going again, than he is either a fool, a shill or both.

    2. scraping_by

      Given the history of the traders who make money off these things, the only realistic loss reserve would be 100%. Plus expenses, so the premiums would be more than the face value of the security. Anything less would be public subsidy of private wealth.

      The only real argument for securitization as opposed to, say, banks syndicating out loans, is their use for exchange trading. Leave out the crumbcatching and arbitrage, and it’s a silly method of capital formation.

      It’s left to mainstream economics to condemn protected industries as inefficient while defending inefficient capital formation as virtuous. Sounds like a social judgement rather than an economic one.

  4. i on the ball patriot

    There is NO viable policy response without ‘political will’.

    There is no ‘political will’ because the electoral process is a bought and paid for scam that produces an endless stream of sell out politicians who are not responsive to the will of the people but rather to Wall Street (read the pawns of the wealthy ruling elite).

    Securitization is a problem because there is no serious regulation because there is no serious government. Got it?

    You can create remedial plans until the cows come home but without first demanding honest government that is responsive to the will of the people you might as well be creating designer farts for Barby Dolls.

    “Mehrling’s ultimate conclusion”, of having the central bank become “insurer of last resort”, is just another Barby Doll designer fart. The good professor needs to get real and demand an electoral process that will be responsive to the will of the people and stop trying to con everyone into fighting the factional wars of vanilla greed against pernicious greed.

    Pernicious greed has clearly won. Vanilla greed is gasping for life and its only real hope is to align with all of those it has been screwing all of these years and turn the reigns of credit over to the people and honest transparent regulation.

    Deception is the strongest political force on the planet.

    1. DownSouth

      i on the ball patriot,

      You hit the nail squarely upon the head.

      I would just add that Andrew Bissell’s “stop bailing people out” or “let a few AIGs go” alternatives are just as much “designer farts for Barbie Dolls” as is Mehrling’s “getting insurance right” alternative.

      The conversion of private debt to public debt (bailouts), as anyone who has studied the trajectory of neo-liberalism in Latin America knows, is as core to the neoliberal paradigm as is gaining control of the sovereign. As long as the crooks and thieves are in control, credit risk will be underpriced, and the crooks and thieves will be bailed out for their bad bets.

      One must realize that economists operate in a reality-free universe. Perhaps Jonathan Schell put it best:

      The advocates of laissez-faire declared the independence of economics from state power. (The eventual coining of the word “economics,” identifying a distinct realm of human activity subject to its own laws, was one sign of their faith in that independence.) The market worked best, the worldly philosophers of the late eighteenth century believed, when the government kept its hands off it. Classical economics, in fact, “had not place for the nation, or any collectivity larger than the firm.”
      –Jonathan Schell, The Unconquerable World

      Reinhold Niebuhr has called this Shangri la that exists only in the minds of classical economists a “paradise of innocence.”

      1. gordon

        “Paradise of innocence” is a good name for something which looks to be closely related to Rousseau’s “state of nature”, and is about as realistic. The idea that Govt. is somehow foreign or external to human affairs (including economic affairs) seems to have its origin in this way of thinking.

        Thanks for reminding us again to look to South America as a paradigm for US behaviour. As time passes, it seems to me that the US becomes more and more like its neighbours to the South, in whose affairs it has involved itself for generations. As Long John Silver said to Jim Hawkins (from memory), “You can’t touch pitch, son, and not be mucked”.

  5. Skippy

    Insurance from its conception (historically) is a coupon scam.

    Build any thing from houses, ships, citys, nations or financial derivatives with the belief *your insured* is tantamount to self deception, of which *peace of mind* is the sales pitch.

    With out this self inflicted mental deception, planing would have a completely different tone. Delusion or deception, which is it, that we suffer from…eh.

    Skippy…can I get some asteroid insurance please, human extinction is messing with my peace of mind.

    1. DownSouth


      As much as economists live in a reality-free world, and in spite of my unrelenting attacks upon this defactualized universe, some of our greatest philosophers, such as Nietzsche, have argued that some level of delusion and deception are necessary for human functioning. As George A. Morgan explains:

      …Nietzsche thinks of our present mental structure as a solidification of transmitted experience. In this sense we—-an entire line of life down to the present—-have created “the world which concerns us.” The world in which we consciously live, with its colors, lines, shapes, things, causes and effects, is part product of our mental activities. And since it was built with creative “errors,” “the world which concerns us is false.” Its various levels of simplification are rooted to various depths in our past. For example the “judgments” involved in sensori-motor coordination belong to the stage, chiefly pre-human, before the invention of language. The oldest “errors” are now so deeply “assimilated” that we cannot think differently and live. Such are the so-called a priori judgments: being oldest, they are unusually false, “necessary” for us now but not for all life or for the nature of things. They shape all incoming experience and require that new “knowledge” be adapted to fit them.

      But man has survived with his fictitious world: does that not prove it true? Not at all, in Nietzsche’s opinion. Man, indeed, has been an incorrigible pragmatist, like other animals, ever maintaining the truth of those beliefs which seemed to help him live. Because of the age-long selective process, surviving modes of interpretation probably do stand in some favorable relation to real conditions—-just favorable enough for survival. “We are ‘knowing’ to the extent that we can satisfy our needs.” That truth is always best for life, however, is a moral prejudice. Falsification has been shown to be essential; truth is often ruinous, and sheer illusion helpful, as experience testifies. And of course there is no certainty about even the pragmatic value of our beliefs; there is merely the fact that we have survived so far. Beliefs not immediately harmful may yet be fatal in the long run.
      –George A. Morgan, What Nietzsche Means

  6. RueTheDay

    “But if we do insurance right, we can make securitization functional again”

    Bullshit. Insurance for credit risk is an absurdity. The interest rate on a fixed income security (e.g., an MBS or CDO) is supposed to reflect, among other thing, the risk of default. The theoretical insurance premium in such a case should be equal to the credit risk premium portion of the interest rate. There is no free lunch. “Doing insurance right” is simply code for “underpricing risk”. IOW, “if we could only get markets to start underpricing risk again, by having another AIG-like entity write insurance policies via a CDS-like mechanism that they have no intention or ability of ever making good on then everything will be ok”. No thanks.

    1. gigi

      Bingo. Agree 100%. Everyone everywhere is looking for a free lunch and there is no such thing. If you can get insurance on a bond that makes it as safe as a Treasury (which itself is no longer safe but that is another discussion) then it will provide the same interest rate as a treasury.

      Insurance is a pooling of unpredictable risk against small (for the pool) uncorrelated adverse events. These conditions must hold or the purported insurance is fraud.

      Auto-insurance works because:
      – Each accident involves a small fraction of the insured
      – The accidents are mainly unpredictable

      Health insurance is a scam because:
      – Incident risk is skewed by the participants age and there are ongoing/never-ending incidents (preexisting condition)

      For Flood/hurricane insurance:
      – The events and their magnitude are uncertain
      – If an event occurs, it is likely to devastate the region and regional insurers are likely to go under
      – Unless the risk can be spread out over a large number of regions that may be affected at different times, the insurers will not be there to pay when you need them or the premiums will be exorbitant because of the requirement to hold massive capital against potential loss

      Financial insurance is a scam because:
      – The financial health of the issuing entity is evident when the bond being insured is issues/traded, i.e. difficult to argue unexpected events
      – Correlation of failure is likely to be high, i.e. recessions/financial crisis breaking many companies/entities at the same time leaving the insurer unable to pay or cost of insurance being exorbitantly high to compensate for the tied up capital
      – This is financial engineering to split the risk from the current purported zero risk interest rate (treasury). This should lower the return below the treasury if priced for profit for the insurer.

      As for making the Fed the insurer of last resort, why is it important to find some way of dumping garbage on the taxpayer? People making such suggestions are either incredibly naive or have an axe to grind. They are definitely not performing their civic duty (what a concept)

  7. ronald

    Modern economies require constant consumer demand to keep global factories running the heart of this process is cheap available credit. The crisis is finding a source willing to cover the risks associated with generating this necessary credit creation without destroying the margins generated by delivering these products and services to market.

  8. craazyman

    to quote i-on-the-ball, this central-bank-insurance scheme looks like a big “barbie fart” to me. If the parasites want to loan money at high risk and high potential reward, then get creative and make it equity or some sort of community-based equity/debt structure, so there’s room for beta blow downs and the rest of us don’t end up funding their bonuses when their gamble goes wrong and “our” Central Bank bails them out with insurance that will inevitably be underpriced and over supplied. One more of those episodes and we’ll end up like Central America and I’ll be rooting for Che Guevera. No mas, Amigo. In fact, it may already be too late culturally speaking. The trust is gone. Gone. They pyschopaths have made rhinoceroses out of everybody and even the rhinoceroses who think they aren’t really are. It takes $20 million per year for a CEO to show up for work and nobody seriously questions that? We are lost in a Roman wilderness of pain and all the children are insane, all the children . . . are insane, sayeth the late and great Jim Morrison.

  9. Yearning to Learn

    Unfortunately, I side with the naysayers on this one.

    The last crisis showed us that it is not practically viable to lend on good quality with a penalty interest rate.

    For example, the Fed couldn’t even apply this rule to a tried-and-true mechanism… the discount rate was lowered to just barely above the Fed Funds Rate. No penalty rate to be found.

    If they’ve already shown themselves incapable of following Bagehot’s rule why should we expand their authority to not follow that rule in other settings?

    In the end, the problem is that we’ve seen that theory is trumped by reality again and again.

    In theory the Fed could have raised the Fed Funds Rate earlier in the recovery. In reality they didn’t because people always squawk about killing a “real” economic boom.

    In theory the Fed could have gone in and regulated these banks and looked at their leverage ratios etc. In reality they didn’t.

    And in theory the Fed could lend at a penalty rate on good collateral, but in reality they don’t.

    There is the crux of the problem. Theory vs reality. Just like my childhood dreams of growing to 6’7″ and dominating in the NBA, I’ll have to abandon these Fed-as-solver-of-our-problems fantasies.

  10. Capricorn

    I think there is an elephant in this particular room.

    I understand that CDS’s can be bought by anyone, against any other parties’ default. Moreover, CDS’s can be bought for multiples of the value at risk.

    It doesn’t make sense to suggest that the Central Banks pick up deals like that. So, even if this suggestion has any merit, the first step has to be regulation which limits CDS’s to something more sensible.

    And that seems to be where we are having a little difficulty, no?

  11. kevinearick

    Shortly after the introduction of the Internet, the current proprietors recognized that they would run out of supply to feed the legacy ponzi schemes that they were managing, but they were just smart enough to bankrupt the entire global economy one last time, bypassing natural new family formation with economic slave formation, at the end of a demographic surge, which is exactly what they have done. All kinds of people warned them against that policy, and we all made our bets accordingly.

    Suddenly, they realize that there is no place left on this planet to hide. What else can they do, given their mentality, but extend and pretend. They need a bailout for their behavior, (which was reinforced by significant participation) but cannot bring themselves to ask for one. Instead, they keep bailing out the ponzi schemes as a buffer between themselves and others. Their entire lives are a lie, of unfortunate choices. Expert systems are invalid. No group of 5 or 30 or 500 or whatever can direct an economy of 7 billion, even if the entire 7 billion acquiesce to their control. The Fed is still arguing that it needs control to direct the economy.

    Greenspan appeared to be recovering, and then he went back on the bottle. Hard to stay away from those parties if your life is built around them. But then again, why was anyone expecting a financial alcoholic to pull away the punchbowl.

    So, we have this pyramid of ponzi schemes that needs to be transformed … and the governments, corporations, and cartels involved are not competent to do the job …

    The Internet opened the door, but it provides no map and no roadway. Despite the commercials, there is no insurance. A looking glass is just a temporary bridge. Maybe a real education system to replace the existing compliance/certification system isn’t the first step, but every journey begins with a first step, and nothing incremental is going to save the old system. That first step is a jump, across a gap.

    If History is employed as a guide, the only specification is that the bridge must increase democracy at the quantum amount required to span the gap. As more individuals make the jump, bigger groups are going to want a bridge.

    1. kevinearick

      I’ll try one last time aet (tautology):

      I have already jumped, and brought my entire crew across. They are already jumping the next gap. As far as enterprise architects go, I am ancient, so I am sitting in my rocking chair on the other side of the gap, making tools and throwing them back across, for the engineers, who have to build the bridge. Once they build the the prototype infrastructure, the process will speed up exponentially.

      In the meantime, the planet is pulling the rug out from under that cave, and rather than being all upset, focusing on the loss, others may want to spend their time pre-fabbing prototypes for the communities that everyone is going to want when they get to the other side.

      use the tools; don’t use the tools. make your own tools. profit comes from turning threats into opportunities, and the economists can talk until they are blue in the face, but that is not going to get the bridge built.

      I am primarily analytical; I do not have an artistic bone in my body, which is why I appreciate art above all other endeavors, but artists need infrastructure and liberty to pursue their practice.

      An emotional response is not going to get you across that chasm, but continue on if you like.

      good luck.

    2. kevinearick

      The engineers have homes, families, and all that good stuff. The small funds would serve their own purposes best by giving all those engineers money, or randomly if they are really small. The smart engineers will form groups and start building prototypes. Pay all those groups in the next round or a random sample, etc.

      We’ll start talking about virtual organizations in detail when congress gets back.

  12. Cathryn Mataga

    Insurance doesn’t work for the same reason
    no one wants to sell earthquake insurance.
    If you’re insuring against the possibility
    of a nationwide decline in the value of
    houses that means you need a reserve to
    cover everyone going down at once. That would
    make the insurance impossibly expensive.
    If you don’t have the reserves
    to cover the disaster scenario (AIG) then it’s
    just gambling. This can be a good short term
    business if the big event happens on someone
    else’s watch, but well, we all saw happened.

  13. AK

    Another stupid article … Man, you really don’t understand what is going on …

    The problem is not insurance. The problem is that there is no more common ground to evaluate those CDOs. It was empirically found that Li’s formula to evaluate CDOs was wrong.

    Imagine like someone would show that electromagnetic formulas were wrong. Than all existing in the world electric motors become obsolete right away.

    Until someone discovers new formulas to evaluate CDOs, the securitization market is essentially dead.

  14. joebhed

    Capital markets.
    Dedicating our monetary sovereignty to an ‘innovative’ role of Dealer at the Big Casino seems ill-advised, hardly proof or fallacy for the BagRule.
    Economic democracy.
    That essential specification for the bridge.
    A much more purposeful role for the people’s money.
    Just a thought.

    1. Ignim Brites

      Another way to look at this is that the FED has become the proverbial “BAD BANK”. When it is chock full of worthless assets it will be closed and a new currency will be issued.

  15. kstills

    I’m slow, so help me out here.

    Is the author saying that if the Fed had made the insurance market earlier in the crisis, home prices in the inland empire would still be going up?

    Sweet logic, that…

  16. Mike

    So, take the emergency policy of privatizing gains and socializing losses and make that the permanent policy of the Fed?

    Yes, I suppose that would start up the money machine at full throttle because what person would NOT want to be part of that deal. If one ignores the fact that such an arrangement forces distortions upon the market then it is a great idea. Money would flow, growth would follow and for a time things would look AMAZING.

    In fact, this time we could soar even higher than any bubble ever because there would be explicit backing, by the Fed, of pretty much any harebrained scheme that Wall Street could cook up. it would be the ultimate party. Auerback would win a Nobel Prize. Barack would win in a vast landslide.

    Actually I just talked myself into it. Carry on.

  17. Hugh

    This post is just wrong on so many levels. It really says nothing about bubble formation, or prevention. It misrepresents government policy before Stearns, Lehman, and AIG went south. The government was not seen as the backstop. There was no need for anyone at that point even to consider the government. Indeed the point was by the bubble-makers to keep the government out because this facilitated them in increasing both the size and the duration of the bubble. You see on the upside of a bubble, all bets are good. So why would they want or need even an implicit government backstop?

    Also this post seems to take Minsky’s view that bubbles are inevitable. But they aren’t. Bubbles are very, very large financial dislocations and can be seen years in advance of their busts. They almost always are built on premises and math that aren’t just wrong, but obviously wrong. Mehrling’s approach seems only about bubble mitigation, with some vague hope that such mitigation might even rise to the level of bubble prevention.

    Nor does it explore the broader effects of lending money freely but at high premia. How would this impact on credit availability for customers at the local bank? Wouldn’t credit flow away from them and to a system with higher costs but even higher returns and made even more attractive by a government backstop?

    Besides being revisionist, this idea violates common sense. It turns back the clock to a certain point in the crisis and says OK, if people had acted with common sense at this point, the effects of the bubble would have been mitigated. This ignores entirely the irrational psychology that got them to that point. If they can act with common sense then why could they not act with common sense before, and avoid the problem entirely?

    Finally, so what if the government had waited until the writing was on the wall for Bear Stearns, AIG, and Lehman? We would still have had a monster dislocation. Isn’t what Mehrling is suggesting, in terms of our present crisis, just another variant of extend and pretend?

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