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

As then US treasury secretary Hank Paulson beseeched Nancy Pelosi to save his $700bn rescue plan in September 2008, a darker drama was unfolding at the Federal Reserve: chairman Ben Bernanke was busy shifting much of the wholesale money market onto the Fed's balance sheet.

"In the heat of the moment, no one noticed," writes Perry Mehrling in The New Lombard Street. America's lender of last resort was becoming its "dealer of last resort". Within weeks, the Fed had more than doubled its balance sheet, expanding its liabilities as well as its assets.

Mehrling, who teaches economics at Barnard College in Manhattan, named his book after Walter Bagehot's Lombard Street, the 1873 classic that laid out the enduring prescription for central bankers facing a panic. "Lend freely but at a high rate," goes the refrain. What's often forgotten is that Bagehot's recommendation was grounded in the workaday money market, not abstract theory.

Unless you're a dealer, you probably don't think much about this market for what are considered the safest, most liquid instruments – short-term securities such as US treasury bills and negotiable certificates of deposit. It's "the plumbing behind the walls", Mehrling says, the conduit that funnels cash-flows to cash commitments. As with the pipes at home, this plumbing can make a mess when it freezes. That's what happened, pipe by pipe, starting in August 2007.

What does this perspective have to teach us? It tells us that credit, being inherently unstable, needs plumbers – central bankers to supply liquidity or impose discipline as required. "Money will not manage itself," as Bagehot said.

Central bankers can make things worse when they fail to balance elasticity with discipline. Over the decades, Fed policy-makers forgot that and became preoccupied with eliminating constraints to liquidity, Mehrling says. The need, he says, is to restore "the ancient central banking focus on the balance between discipline and elasticity".

James Pressley, Bloomberg

The New Lombard Street: How the Fed Became the Dealer of Last Resort By Perry Mehrling, Princeton University Press, £20.99