The New Lombard Street: How the Fed Became the Dealer of Last Resort

"Mehrling is an economist, but of a particular kind. His career, in some ways tells the story of modern economic relationships to money because, in wanting to understand actual banking practices and finance, Mehrling kept moving further and further away from the neoclassical paradigm of economics. And so far as I can tell in the late ’90s and early noughties, Mehrling was not a big name in economics. But he was developing these great models for explaining contemporary banking. He was teaching this banking and finance course that was just amazingly illuminating. And then he found himself teaching that class during and just after the great financial crisis of 2008. Whenever people say, ‘Oh, economists didn’t know what was going on. Economists have no models. They missed everything’—that’s of course, mostly true. But it has to have huge asterisks for people like Perry Mehrling because he totally knew what was going on. And so, after the crisis, when you were looking for a model, for a framework, his explanation of banking and finance explained it brilliantly. His profile has gone up dramatically since then. The New Lombard Street is a summary of his take on the financial crisis. He talks about three ‘views’. First there’s the ‘economic view’, the orthodox economic account that I’ve already mentioned; Mehrling’s critique of that would be similar to mine and other people on this list. Then there’s the ‘finance view’, which, boiled down, says you take the Black-Scholes model of how we do portfolio finance and it all works perfectly because markets are efficient. But Mehrling shows that markets are not ‘efficient’ in that way, because both the economic view and the finance view leave out what Mehrling calls, the ‘money view’. This is what actually happens with commercial banks, with money market dealers, and with central banks. We just cannot forget that money markets and the swapping of money credits for money credits is at the heart of contemporary capitalism today, and Mehrling has a better grasp on how that works than probably anyone else. A few central bankers also have that understanding. Someone like Martin Wolf at the FT has that understanding, but Mehrling is explaining— teaching it —very lucidly. So, as good as Mehrling’s book is, even better is his online course on money and banking , because he will teach you how currency exchanges work, how derivatives work, how the repo market works. The repo market is a $7 trillion overnight market in money. And the world’s global system depends on it. Sure, you can Google ‘repo’ and there’ll be simple explanations for it. But it’s not simple! Mehrling patiently explains it. He pulls this off by starting with the construction of brilliant tools that he then uses to work through really complex financial arrangements. The basic tool are so-called ‘T accounts’: draw a ‘T’; then list all assets on the left and all liabilities on the right. Mehrling’s ’money view’ means looking at each and every actor—be individual, bank, corporation, or other institution—through their T account. For every single act of economic or financial exchange, you must ‘follow the money’ by tracking the movements of assets and liabilities on the T accounts. In his online class Mehrling spends hours at the chalkboard, drawing T accounts and tracking the movements of credits and debts. By the end you are doing credit default swaps and it just make sense. He’s a brilliant teacher. “When we think about money as credit, we have to understand where the credits are and where the debts are; we have to mark them down and see how they move” So I’ve used Mehrling to make what I think is not necessarily a revolutionary, but at least a novel new argument. It goes like this: when we think about money as credit, we have to understand where the credits are and where the debts are; we have to mark them down and see how they move. There’s a traditional understanding of a bank as a place that holds ‘our’ money for us. For many people it’s intuitive to think that the money or ours that a bank holds would be an asset for them. But that’s completely backwards! If I have a deposit account, the bank becomes my debtor; they owe me . Every banker knows this, of course: customer deposits are a bank’s liabilities, and loans to customers are a bank’s assets. In one sense this is really simple, but it also turns things upside down at first. We can go back to our exchange of the sweater, and have you pay me in ‘real money’, not an IOU. (Real money is almost always bank money.) So I ship you my sweater and you pay me £20 in bank money. We’ll avoid foreign exchange complications by having you pay me in my UK bank account, and we assume we bank at different banks. To carry out this transaction the following has to occur: my deposit account will grow by 20 pounds, which means my bank now owes me 20 pounds more than it did before. Your bank account deducts your deposit account by 20 pounds, so your bank owes you 20 pounds less. I’m making a transaction with my bank, you’re making a transaction with your bank, but then our banks have to settle up because your bank owes my bank 20 pounds. And this is where Mehrling is very helpful and where it gets very interesting. My bank and your bank can’t pay one another in the money we just paid one another. We can pay each other in bank account money. You bank with TSB and I bank with Royal Bank of Scotland. That’s our bank money. I’m paying in TSB money and you’re paying in Royal Bank of Scotland money. But when they have to square up, they can’t pay each other in their own bank money. Their balance sheets list Bank of England reserves as assets, and they pay each other in Bank of England money. At first this seems like such a simple transaction—done through bank direct debit or Venmo or Apple Cash. But it actually involves: three different banks (your bank, my bank and the central bank); it involves multiple debiting and crediting, with all of that money moving around on these T accounts. The insights of people like Innes and Hawtrey when then put into the complex structure that we’re in now, Mehrling’s money view, and his ability to map this through T accounts, allows us to start seeing how money actually works and what money really is, these credit/debt relations that are transferable. Mehrling’s other powerful insight is that money is a hierarchy. That’s Mehrling’s thesis: there is a hierarchy of money. So our bank money is at one level and Bank of England money is higher. Support Five Books Five Books interviews are expensive to produce. If you're enjoying this interview, please support us by donating a small amount . It may be that the Bank of England also has some bank money that it holds in reserves on the US Fed, which for it may be a higher form of money. We can always keep moving up and down the hierarchy. Here’s another crucial insight of Mehrling: wherever you are on the ladder, when you look down, you may see credit , and when you look up, you may see real money . Because when you look up, you say ‘Oh, that’s the thing I can settle debts with.’ And when you look down, you may say, ‘Well, that’s the thing that people owe me in.’ You can even go much lower than bank money, back to my earlier example—which was trivial, but gets at a real insight—which is that you can write me an IOU, ‘I owe you five pounds’, and you sign it and I hold it in my hand. That’s ‘money’ because it’s a credit that might be transferable. Mehrling gives us the hierarchy view, he gives us the T accounts. And we start to see money move. We start to see the centrality of the dealers in money, who make all this possible. We can identify what mechanisms broke down in 2008 and the things that started to break down in 2020, but didn’t. So, for me, Mehrling is an absolutely key part of the picture. I think if you’re going to write a great book on money today, you’ve got to say something about money markets, you have to be able to explain the repo markets, someone has to be able to explain why in April of 2020, oil traded for negative $37 on the derivatives market. That’s crazy. And we don’t understand money or capitalism, or what’s going on in our social and political systems until we have that. Mehrling is thus a really key tool for me. Mehrling can explain credit default swaps, and not many people can! Good, but hard question! I’ve been studying crypto and blockchain extensively for the past five years. A few things I would say. First, your baseline is right. What we see in the Satoshi white paper that creates Bitcoin and what we see in most of the crypto imaginary is precisely an attempt to use today’s technology to create commodity money. When I say ‘crypto imaginary’ I mean this broader worldview that believes progress can come from human and technological innovation that exceeds or avoids extant social and political institutions (including formal governments). The original Bitcoin white paper is very clear: we need a ‘digital currency’ that is not dependent on third parties, whether they be commercial banks, the visa network, or a central government. And I do think the Bitcoin story, as first told in the white paper, bases itself on the old story of commodity money: money starts as a commodity with intrinsic value, and then gets chosen to be money because it’s durable and rare, etc. Now with Blockchain, and with crypto, we have to get to the explanation of why a Bitcoin would have intrinsic value, because of course, it doesn’t actually have any. In the crypto imaginary we build in this story about ‘Oh, it’s because the blockchain is a useful technology. And that’s the use value.’ That story has been told persuasively, I think. But it’s still false. Crypto’s importance today depends on a historical development that was not inevitable. People have transferred billions of dollars worth of real money in order to hold a digital token, a virtual asset—namely, a proof of work token (Bitcoin and Ether, mainly). So you rightly read narratives today about crypto as financial speculation; crypto has value because other people say it has value, and contrary to the white paper, it doesn’t perform any of the functions of money as traditional economics thinks about it. So it can’t be money in that sense. Note also that we are always talking about crypto by comparing it to its value in an actual money of account. Bitcoin is important because it trades for $27,000 a coin and its ‘market cap’ is X amount (where X is measured in dollars or pounds or euros). The interesting development for me is the huge rise of stablecoins. Right now Tether, the Circle Coin and the Binance Coin, these are all three, four, and five in the highest overall outstanding market cap (that is, total value of coins at their current price) right behind Bitcoin and Ether. Tether, by daily turnover, the amount of Tethers circulated during the day, is roughly triple Bitcoin right now, about 75 billion in Tether a day and only 25 billion in Bitcoin. “Tether and Circle… they are not crypto . They pretend to be crypto, but that’s just nonsense” Here is the shortest version I can give about this story of crypto. Most stablecoins including all the big ones, Tether and Circle… they are not crypto . They pretend to be crypto, but that’s just nonsense. Tether is a shadow bank. This is not secret knowledge on my part; you go to the Tether website, and they will show you that they have $70 billion of Tether tokens, and they (rightly!) list those tokens as the debt of the Tether institution. They then show their assets: US Treasuries, asset backed commercial paper from China. So Tether has assets and liabilities, just like a bank. Of course, they’re not regulated like a bank. Their capitalization is horrific. Where a regular commercial bank might need to be capitalized at say 8% minimum, Tether is capitalized at 0.3%. So it’s a really lousy shadow bank. But here’s why I think this is important. I gave the example earlier where we each had our bank money. To hold a Tether in my wallet is simply to hold bank money. If I have 50 tether tokens (valued at $1 each) then I hold $50 in credit against the Tether institution. They owe me $50. It’s just like a bank deposit. What that means is the Tether institution completely undermines the initial promise of crypto. Blockchain promised a decentralized ledger, where ‘money’ could be held and transferred. But there’s nothing decentralized about Tether, nothing at all. To hold Tether tokens is to hold a claim against the Tether institution. If I want to buy something from you valued at $50, I can offer you my Tether tokens. And maybe you will accept them. But if you do, you are deciding to trust the Tether institution—to trust that this debt is good debt—in just the same way that you might accept a $50 check I wrote on Bank of America. Tether has just reinvented standard banking, in less regulated fashion, while pretending to be crypto. They’ve recreated bank money. It looks like bank money looked in 15th century Venice. It looks like bank money looked in 21st century Britain and America and everywhere else. A lot of people will tell you crypto is not money. They are right. Crypto is a faux commodity, digital gold. And you can see that from the framework I’ve developed. If something’s money, then you need to be able to show me the creditor and the debtor. And with Bitcoin you can’t do that. Trading a bitcoin is just is like trading a commodity. It’s like saying, I’ll give you the title of my house. My house isn’t money. Of course it’s worth money, but it’s not money. So most crypto is not money. And we know that. What’s interesting for me about stablecoins is that most stablecoins are not crypto, but they are money. Tether is money. I don’t think it’s very good money; it’s way down here under this hierarchy, and I wouldn’t substitute it for all sorts of other money, but it’s totally money. I find it fascinating that we’ve gone from this myth that crypto will be a revolutionary new form of money, to this new point where we’ve just redeveloped money—the same old form of money. And in the process they had to abandon all the promises of crypto. With most stablecoins, the revolutionary idea of a decentralized ledger has been tossed out the window. All of the stablecoins that work under this model—Binance, Circle, Tether—you go to their websites, and they parrot a lot of crypto discourse, but they’re not crypto. I mean, they happen to issue this thing on a blockchain, but they’re just shadow banks. Get the weekly Five Books newsletter There’s one exception to this, which gets technically complicated, but it’s interesting. And that’s the realm of DeFi—decentralized finance, and smart contracts that are done on the Ethereum blockchain, which is the stablecoin Dai. The way you create the stablecoin Dai, is you take your ether, which is proof of work crypto, and you lock it up in a smart contract and the contract issues your Dai. And it is, in a certain sense, money creation, because there’s credit being issued. But it’s also operating within the crypto universe. So it’s crypto money. It basically functions like a margin account, in the same way that you could put real money in a brokerage account and have 100,000 pounds that you’re investing. And because you have 100,000 pounds with the broker, they’ll let you buy 150,000 pounds worth of stock and bonds. With Dai, you’re basically locking up this collateral in a similar fashion. The difference is the loan-to-value ratio with Dai is incredibly conservative. That is, you get far less margin trading ability—far less credit. That means we have this little space of credit creation within the crypto universe. But notice that the Dai smart contract only functions by locking up—making illiquid—some other crypto. So if I take this loan out, and the price goes down, they just sell my collateral and I lose it all. Dai is very unlikely to go to zero, but the existence of Dai increases the chances that all of crypto will go to zero. Put differently, the stability of Dai likely increases the instability of the overall crypto universe. Again, DeFi is a special case. Most of the crypto universe right now can be captured with three categories: Proof of Work coins that have become sites of speculation, but are not and cannot become money; Proof of Stake coins that aren’t really decentralized to begin with, and these days mainly function as structures to support rug-pulls and Ponzi schemes; and stablecoins that represent a reinvention of shadow bank money, but only pretend to be crypto."