Perry Mehrling and the Dealer of Last Resort

I’m going to have a lot to say about the INET – Institute of New Economic Thinking – conference over the next few days, but I want to start by linking to this coverage of Perry Mehrling talk by Marshall Auerback’s post on it at New Deal 2.0:

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.

There is a real lack of consensus on whether or not to leave the “shadow banking system” – the system of credit-based lending – intact, and how to regulate it if we do. The counter-cyclical and liquidity capital reserving techniques I hear being developed by Basel, the Fed and others is an attempt to get at this, but ultimately we don’t have a sense on what a new expanded scope of guarantees would be or how last resort liquidity would be provided. Perry’s work is getting us there.

I got the chance to talk with Perry at the conference some more, where he reminded me that he put me on the map and was wondering if he was going to get preferred shares of rortybomb stock. I did secure a “Shadow Banking: 1 Year Later”, another interview with Perry as his new book on the shadow banking system comes out later this year.

For now, here’s a video of him discussing a potential for new economics:

And his thoughts on the very important role of blogs, and especially the financial blogosphere, in the current crisis:

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