The last three or four decades have seen a remarkable evolution in the institutions that comprise the modern monetary system. The financial crisis of 2007-2009 is a wakeup call that we need a similar evolution in the analytical apparatus and theories that we use to understand that system. Produced and sponsored by the Institute for New Economic Thinking, this course is an attempt to begin the process of new economic thinking by reviving and updating some forgotten traditions in monetary thought that have become newly relevant. Three features of the new system are central. Most important, the intertwining of previously separate capital markets and money markets has produced a system with new dynamics as well as new vulnerabilities. The financial crisis revealed those vulnerabilities for all to see. The result was two years of desperate innovation by central banking authorities as they tried first this, and then that, in an effort to stem the collapse. Second, the global character of the crisis has revealed the global character of the system, which is something new in postwar history but not at all new from a longer time perspective. Central bank cooperation was key to stemming the collapse, and the details of that cooperation hint at the outlines of an emerging new international monetary order. Third, absolutely central to the crisis was the operation of key derivative contracts, most importantly credit default swaps and foreign exchange swaps. Modern money cannot be understood separately from modern finance, nor can modern monetary theory be constructed separately from modern financial theory. That's the reason this course places dealers, in both capital markets and money markets, at the very center of the picture, as profit-seeking suppliers of market liquidity to the new system of market-based credit.
Reading: FOMC Report (1952)
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Economics of Money and Banking
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Banking as Advance Clearing, continued
In the modern economy, the price of risk is determined in swap markets that distinguish specific forms of risk, most importantly interest rate swaps and credit default swaps. The Treynor model can be adapted to understand how the price of risk is formed in dealer markets.
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Perry G MehrlingProfessor
Economics, Barnard College
[CROSSTALK]
So let me say something about this, this,
this, this is a, just an incredibly interesting thing.
I mean, it doesn't sound interesting, does it?
Federal open market committee report of ad hoc
sub-committee on the government securities, November 12th, 1952.
Okay.
So, the date is interesting. It's a long time ago.
and this it turns out there's some preamble
there that says that this was a secret document.
That it was, was internal inside
the Fed and only came to light when there was this congressional investigation.
And what this document is, is the Fed's own internal
judgment about how they're going to be running monetary policy from 1952 on.
Okay.
and, it's incredible, partly because it's, it's quite similar
to some of these money view ideas that we've had.
And not very similar to what showed up in the academic textbooks.
which were written before this document came, became public.
what the academic textbooks picked up was this sort of public version of this.
Okay.
Which isn't exactly what they themselves thought they were doing.
so let me just give you two passages here.
this is from the preamble. Page 2007 here,
we're only going to read part of this and I'll send you some
pages so that you can, you don't have to read the whole thing.
because a lot of it's technical.
but, they say here it's important that the technical operating
procedures and practices conceived in the atmosphere of war finance.
And developed to maintain a fixed pattern of prices and
yields in the government securities market be reviewed to ascertain whether.
Or not they tend to inhibit or paralyse
the development of real depth, breadth and resiliency
in today's market that operates without continuous support.
Okay, that's a long sentence.
What they're, what they're saying there is during the war, war finance, okay.
The fed pegged treasury rates.
It said the treasury bill rate I don't have
it here but let's say it was 1%, okay?
And if it deviates from that you know, if it tends to go up we're buyers.
And it
pegged the ten year rate.
Let's say it's 2%, and said if it deviates from that, we are buyers.
So there was continuous support for the market, you know, the, the Fed
was not the dealer of last resort, it was the dealer of first resort.
It was actually issuing these bonds in a sense, and, and was the underwriter.
Who was saying, we're, we're going to hold these prices here for
the duration of the war and not only that, after the war.
So, when the war was over, bondholders were
assured that the Fed would continue that so
they wouldn't have to take capital loss.
Because of course, if the yields on the long
term bonds rose, you would take a capital loss.
The price would, the price would fall.
So the Fed maintained that fixed price Eventually it got its own authority back.
Okay.
In the famous Fed treasury accord, when it
was allowed to move short term interest rates.
It was allowed to get some authority over moving short term
interest rates and that's the birth of monetary policy after the war.
And this is the document in which the Fed
explains what they intend to do with that new authority.
Okay.
That's what this is all about.
And its secret. Okay, that's one thing.
They talk about this government securities market.
By 1952, the, the, there has been a
development of a dealer market in government securities.
Where there're dealers buying and selling.
They talk about arbitrage on the yield curve.
They talk about this business about
depth, breadth and resiliency. They're, they're talking about liquidity.
Okay. Market liquidity.
They're saying that the government
securities market is now sufficiently liquid
through the, through the involvement of
private dealers, private profit driven dealers.
That the Fed no longer needs to support prices in the way that it, it was doing.
It will continue intervening but around the edges.
and to try to influence the shape of the yield curve and so forth.
So they're very explicitly talking about a world in which there
are treasury securities of various
maturities, okay?
During the war, the Fed was pegging the one year,
the ten year, the, the, and, and all the different maturities,
okay? After the war, it's dealers.
Its private security dealers. And they're making markets.
And in, in between in all the different ranges in, in between.
And they're doing arbitrage, okay, between all, all of these.
Using arbitrage or like use, using notions like
the forward interest parity and thing, things like that.
So the Fed is saying that it is going to continue
to intervene in the money market in order to maintain the tone
of the money market.
It understands that dealers are financing their holdings of
long term bonds by borrowing in a money market, okay?
So, that these are leveraged dealers. They understand all of this and it's 1952.
You know, this is a very advanced document, a very advanced
understanding of how modern securities markets would work just for governments.
There's almost no, there's no discussion here of
bond markets or stock markets or anything like that.
You know, this stuff was still on it's back.
You know
it, it after they all closed down during the depression and the war.
It's all about governments, okay, at this moment.
And how do they think they're going to, to influence?
They talk here, their, their, understanding
of open market operations is quite fascinating.
They say it's a very different way
of intervening than changing the rate of interest.
Okay.
In any modern macroeconomics textbook, you will,
you will hear that these are equivalent.
Change in the rate of interest and open market operations are equivalent.
They don't think so, they're not thinking those.
They say, any purchase or sale of government securities by the committee.
So that's open market operations, any purchase or sale of
government securities by the committee, the, the federal open market committee.
Adds to or substracts from the reserves of the member banks.
And it's promptly reflected in the tone of the money market.
A relatively small injection of funds through
the purchase of bills will ordinarily find
a response in the market for long term securities.
Large purchases of bills could scarcely fail to illicit such a response.
Okay, so they're talking, this, this reminds me of, remember those diagrams
we had when I was talking about the transmission of monetary policy?
Okay.
About how the Fed is, is operating in the overnight money market, okay.
And that has consequence for the term funding markets.
Which has consequences for the long term, long term, bond prices.
That is exactly what they're saying there.
They're saying that, that purchases and sale of, of bills,
so they're talking, bills, treasury bills are less than one year.
Okay, and open market operations were going
to be about buying and selling bills.
So, in this, that, that is going to effect this whole curve here.
So they're talking about a transmission mechanism to asset prices.
None of this story that you get in standard
macroeconomics textbooks about how well, you're going to change the interest rate.
And you're going to increase the reserves and then banks are going to lend that out.
And it's going to cause credit expansion.
The first thing, the only thing they're talking about at
here, is transmission along the yield curve to asset prices.
That's, that's it.
And that's what I've been emphasizing in this, in this course.
That, that's how you should think of the money market.
The money market is connected to the capital market.
Okay. And in, in a, in a lot of ways.
Okay.
And not just through the expectations hypothesis of the term structure.
It's the fact that many of these dealers are highly
leveraged, they're holding bonds and they're financing the repo market.
So, like, like that, they're shadow banks,
essentially, in the, in the government securities market.
So, I find this a fascinating document.
Have I, have I gotten that clear? By now?
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