Odd Lots - Perry Mehrling Explains Why "The Money View" Is Key To Understanding Financial Markets

Episode Date: January 27, 2020

Even to this day, there are economists who don't understand money or don't think that money is an important aspect of the economy. They see the world as still operating essentially under a barter system, with money only there as a means of lubricating transactions. But this is precisely the opposite way you should be looking at things, according to this week's guest. Perry Mehrling is a Professor of International Political Economy at the Pardee School of Global Studies, Boston University, and he's known for advocating what he calls "The Money View." In his framework, money is front and center (not something to be abstracted away). In our discussion, he explains how this view helps explain the financial crisis, the repo blowup, and the weaknesses of post-crisis regulations.See omnystudio.com/listener for privacy information.

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slash audio. That's vanguard.com slash audio. All investing is subject to risk vanguard marketing Corporation Distributor. Hello and welcome to another episode of the Oddbots podcast. I'm Tracy Allaway. And I'm Joe Wisenthal. Joe, we like to talk about money on this show, don't we? We sure do. Both sort of things that are implicitly about money, which is everything, and then also

explicitly about money, which is what is it, where does it come from, what are some different theories of how it exists? Definitely, I would say it's one of our favorite topics. Yeah, and we also like to talk about the repo market. And one other thing we like to talk about is the inadequacies of traditional economic models. So what if we were going to talk about all three of those in one big episode? Oh, I like that, like a true trifecta. Like we had a recent episode on the repo market with Holt and POSAR.

That was great. We had, we talked to Lord Skidelsky recently. on the failure of traditional, in traditional economists to understand money. And as you mentioned, we talk about money all the time. So I agree with that. If we could sort of combine all of these themes, economist failures, money, repo, all these things, that would be a very satisfying discussion. All right.

Well, I have a feeling you're in for a satisfying discussion because our guest today is, funny that you should mention Zolt and Pozar, but it's someone who has, worked with Zoltan in the past, someone who Zoltan actually quoted when he did that episode of AllBlots back in November, and someone who Zoltan says has informed his thinking on the repo market. And the reason we're sort of focused on the repo market particularly, but, and it's going to become clear as we embark on this conversation, but there was this moment during the big repo madness in September. where even though we had repo rates shoot up to 10%, we didn't see market participants

come in and actually take advantage of that rate and actually arbitrage it out. And this was one of the big questions of that event. Like, why didn't J.P. Morgan come in and earn 10% overnight in September in the repo market? Right. That whole incident, so we got through the year without another. major hiccup, obviously the Fed sort of realized that things were problematic, that there was a shortage of liquidity and so on. And so they took a number of steps basically in the final quarter of 2019 to prevent another blowup like we saw in early September. But that doesn't take

away from the fact that that incident in early September when repo rates soared raised a whole host of new questions about the current structure of a sort of bank liquidity system and whether it's adequate and whether people really understand it well. So even in the absence of another blowup, there's still just tons of discussion about what really needs to be done to address flaws in the plumbing of the system. That's exactly right. And we're going to be looking at that particular repo example through the prism of money and also an economic model that takes into account a sort of new definition of money. So without further ado, why don't I bring on our guest?

I'm very excited. It's Perry Merling, the professor of international political economy at the Party School of Global Studies at Boston University. Perry, thanks for coming on. Nice to be here. So you can tell Joe and I are both excited to talk with you, and we have a lot to get through. but maybe just to begin with, you walk us through your definition of what money actually is

and how you call it the money view. How does that differ from a traditional economic model? Well, the money view is an approach to thinking about economic interactions that emphasizes when you say it's a different view of money, it treats money, the essential quality of money, is that it's a means of settlement, a means of payment, that most of the economy is organized

as an interlocking on sheets promises to pay. And what you're promising to pay is money. So the settlement constraint is the essential constraint on the economy as a whole that keeps it sort of coherent that people are focusing their minds on how are going to actually satisfy that promise that I've made. And so clearing and settlement, you mentioned in the intro that that's something

that he's not really central in standard economics. Standard economics is thinking about intertemporal budget constraint and essentially a wealth constraint, that if you have wealth, then you can convert that wealth into consumption or investment or whatever. And it pretty much assumes an economy of infinite liquidity, that you can convert from one form of wealth to another form of wealth with no problem at all. Okay. Now, that's a useful abstraction for some purposes, but if what you're interested in is money, it's not a useful thing.

It's abstracting from money, essentially, and looking behind the veil of money. The money view says, let's look at the veil of money. The veil of money is the essence of what's happening in the economy, not something that's obscuring what's happening at some deeper level. So we look at the plumbing as a very serious, piece of instrumentation for a market economy. And that settlement constraint is the first key thing that we focus on. So we were talking recently with the economist Robert Skidelsky, and there's this recurring theme that mainstream economists still more or less in their head

think of the economy as a barter system. You have a couple bananas. I have some apples and money solves for the dual coincidences of wants in case there's some sort of a, you know, time lag issue. Maybe I don't want bananas, so we find someone with pairs and so on. And money solves in the mainstream view of economics, more or less, money just sort of lubricates barter. And he sort of explained all the reasons why this is a flawed view. And I guess what you're saying is the money view, which is the framework that you put in, really makes the money, the central part that our lives are not about exchanging bananas for pears or oranges or apples or whatever, but about meeting a series of financial obligations.

Yes, that's right. And what Skidowski is referring to there is that in standard economics, money is treated as a medium of exchange, okay, and that's what you're saying between the bananas and apples and so forth, that it's just greasing the wheels, not means of payment. That's the contrast that I'm trying to make. And the media, this money view I should mention, is by no means an invention of my own. There's a long tradition in economics of people thinking in this way.

And I've learned a great deal from them, but it's always been a kind of minority position. There seems to be something attractive about looking through the veil of money to see something deeper. but that does prevent you from seeing what's right in your face. And sometimes it's very much in your face as this repo business that you were mentioning. Suddenly the only thing that's important is means of payment, is means of payment. Can you just clarify something you said.

What is the difference between money as a means of payment versus money as a settlement mechanism? You sort of drew a distinction. I'm not sure if I totally know it. Those are the same thing. I'm meaning that to be settling a debt is paying the debt. Got it. I see you're saying. Yeah.

So I'm just using different words that might appeal to different people or different intuition. Yeah. So I definitely want to dig into the repo market. But before we do, I wondered if you could talk a little bit more about how the money view informs your understanding of capital markets. Because if we think that money is sort of a promise to pay and that every day those promises need to be settled, which means every day, you know, ideally you have a balance between the promises or the IOUs that were made and the actual cash inflows that are coming into the system. But I think on most days, you wouldn't have that.

You would always have some sort of borrower in the financial system that doesn't have enough cash on hand to satisfy. its promise to pay or it's IOU, and that's kind of where the capital market comes in. Well, that's where, so let me make a distinction here between the capital market and the money market. If you are in today that your cash inflows are not sufficient to meet your cash commitments, then you are a deficit agent at the settlement, and you have to find a way to meet that deficit, and that might be borrowing overnight. in the money market, in order to meet that. So you're just pushing off that day of settlement by one day.

The overnight rate of interest is essentially the cost to be one day in the money view. That's how you think of it. Now, the capital markets come in because they're a longer-term asset. There are bonds, for example, which are not promises to pay tomorrow, right? They're promises to pay in 10 years or various coupons over the next 10 years, but they have a certain market value today. So their value today is as collateral, that you can use that their form of wealth, that you can use as collateral for borrowing overnight to make your settlement.

So there's this connection between money markets and capital markets that the capital values are collateral for borrowing overnight in the money markets, and that's basically what a repo is. So repo aside, going back to just this key, key question of this of the money view as you put it you're not really the the first originator of this view but that it's kind of been a minority view all along how would you describe the negative consequences to economics and to the understanding of our system from the veil perspective from the traditional perspective on economics and banking which sort of abstracts away

money. What are the, what are the downfalls of that system, of that approach? Well, to follow up just from where we were talking about the capital market, there's one in particular, which is that you wind up having an inadequate theory of where asset prices come from, that asset prices, the price of these capital assets is formed in dealer markets by dealers who are quoting buy and sell prices and are, and so that the economics of the dealer function is key for understanding the market value of these capital assets, and hence the collateral that can be used in burying overnight. This is another thing that the standard economics view abstracts from.

There are no dealers, right, in standard economics. It's supply and demand. They're the people who want the assets and the people who want to sell them. the assets. There's no one in between them that are making market. So this market-making function of dealers is a second key piece of the money view. Those are the two key pieces. One is the settlement constraint, and the second is the dealer function, bringing those up to the center of attention, things that have been abstracted away in standard economics. You said the economics of the dealer function are crucial to understanding what's happening here. Can you walk us,

through exactly how you incorporate those into your model. And the thing I'm trying to get at, or the thing that I'm curious about, is whether or not you're sort of looking at the dealers from a behavioral perspective in the sense that they might all react in a not necessarily logical or rational way because of some behavioral pattern that they've experienced before, or are you incorporating them from a sort of purely economic, technical standpoint. How are you actually doing that? Well, so you bring up the topic of behavioral economics. The money view is not an argument that people are irrational. What the money view emphasizes is that a lot of the behavior of people is what we would call in mathematics,

a corner solution, that you're forced to do something. You know, that's what the settlement constraint does, Right? You have to pay. And you promise to pay, and now you have to pay. And if you don't pay, you are out of the game. Liquidity kills you quick. And so that means that in order to meet that settlement, you might have to pay 10% overnight. That it's not a choice, right? It's a corner solution in order to keep in the game. Now, why is it a corner solution? It's because the economy, as it actually exists in reality, is not an intertemporal general. equilibrium. It is period by period, day by day, settlement by settlement. If people behaved in the actual world, the way they behave in economic models, they would be out of the game very soon. So it's irrational to be a rational actor in the real world. In the real world, the settlement constraint actually exists. You can abstract away from it in an economic model, but not in the real world. In the real world, prices are formed by in dealer markets. You can abstract from dealers in the abstract economic model, you cannot abstract from dealer from the dealer

function in actual performance and dealing in the real world. So this is what people get, people, this is what attract people to the money view, that it's very much more rooted in the reality of market practice. And that's why the money view, as I say, is not an invention by me. It's a natural point of view of people who live in the world where you're facing these settlement constraints, where you are a dealer, you're carrying on a dealer function or something like that. You are a central banker. This is the natural point of view for somebody who lives in that part of the system. They can't abstract away from these things because that's their business.

Today's show is brought to you by Vanguard. To all the financial advisors listening, let's talk bonds for a minute. Capturing value and fixed income is not easy. Bond markets are massive, murky, and let's be real. Lots of firms throw a couple flashy funds your way and call it a day. But not Vanguard. At Vanguard, institutional quality isn't a tagline. It's a commitment to your clients.

We're talking top-grade products across the board of over 80 bond funds, actively managed by a 200-person global squad of sector specialists, analysts, and traders. These folks live and breathe fixed income. So if you're looking to give your... clients, consistent results year in and year out, go see the record for yourself at vanguard.com slash audio. That's vanguard.com slash audio. All investing in subject to risk, Vanguard Marketing Corporation distributor. I remember when we did our interview with Zoltan, he talked about

repo being, I think he described it, how you live to see another day. And of course, that's very similar to what you're saying. Talk to us a little bit about the financial crisis, because something you hear from a lot of people is that mainstream economists, traditional economics was ill-equipped to see the financial crisis coming, to explain it. It didn't fit into their sort of general equilibrium models and so forth. Connect the dots for us between the sort of corner solutions, the absolute requirements of the dealers to do whatever they had to do to survive another day and the money views perspective on how the financial crisis came about. Well, I think, written a book about the financial crisis, the New Lombard Street. The short answer is that

you're talking about the 2007-2009. Yeah, yeah. So the way that I would understand this is that this was a test of this emerging market-based credit system. And the notion of shadow banking that I would urge on your listeners is to understand shadow banking as money market funding of capital market lending. It's the form of banking that's sort of natural for a modern globalized, financialized economy where you're talking about the money market funding is wholesale funding in money markets, not deposit, right, as in banks. And the capital market lending is capital markets. You know, this is, again, wholesale pricing in dealer markets, not bank loan that are specific to the relationship between a bank and the borrower.

This is the modern form of banking that evolved as we were globalizing the market system, but we hadn't yet developed the systems for backstopping it and supporting it, and so we had a little crisis there, where when you're doing shadow banking, money market funding of capital market lending, that means that periodically you have to roll your funding. And if you can't roll your funding, you have to sell your asset. And that's a fire sale. And that's the liquidity aspect of it. The central banks put a floor on this crisis basically by taking the shadow banking system onto their own balance sheet, doing shadow banking on the balance sheet of the central bank.

And that put a floor on it, but it took a while to sort all this out. And meanwhile, there is a bit of a crisis. So what are the implications for financial stability now? based on your definition of shadow banking. So money market funding of capital market lending, when most regulators talk about shadow banking, they usually use a definition that's something like financial intermediation

by non-bank entities, which basically sounds like it's a bunch of unregulated activity that's probably nefarious in some way. But your definition seems much more neutral. you're basically talking about extending credit just through a slightly different channel. So how should we be thinking of that in terms of financial stability? Well, my definition is meant to include that form of lending, even if it's on a bank balance sheet, which in most cases in 2007, it was on bank balance sheet in Europe, okay, but it was not

on the bank balance sheet of the United States. And that had to do with regulation, okay? But the economics of it was very similar, whether it's on a bank balance sheet or on some other bank balance or some other balance sheet. That's why I want to use that definition so that we're not reifying sort of regulatory categories, but thinking about economic categories. So in today's world, the important place where you see money market funding of capital market lending is, in fact, in the emerging market. As I'm sure your listeners know, the major amount of credit growth since the financial crisis has really been in the periphery, in the emerging market. These are dollar borrowers, long-term dollar borrowers, but the actual funding of that

has been happening in the global money market, dollar money market system, sometimes using foreign exchange swaps in order to move it into domestic funding in other currencies. this is the system that's been building up since the financial crisis of 2007. And this is the system that it seems to me is most likely to be tested in the next. And hopefully we'll get through that and we'll find out where it breaks and we'll fix that. So that's the place that I'm watching. So just to spell it out for the listeners, we're talking about, okay, money market funding of capital markets, activities. you're seeing it growing in emerging markets globally.

So essentially people borrowing short-term overnight in dollars than using that funding for longer-term projects. Talk to us about, you know, you're saying this is what you're watching. What are the stresses that you're looking for? And what, you know, from a financial stability perspective, what kind of red flags or yellow light should people be on alert for? Just imagine the following, that you have a, let us say, a Brazilian national champion firm that is borrowing, and they're using those funds for whatever their business.

That bond, where does the money come from? That bond is bought, let's say, by some Asian bank that is then going to fund that in three months, dollar money markets. It's borrowing from some French bank that's issuing, that's buying that three-month paper, which is funding in overnight repo in in global money markets, which or maybe in the euro dollar market, and then the central bank of Brazil is acquiring dollar balances as its reserves. So that's, you see how that's a round trip?

Okay. So Brazil as a country is borrowing five-year-in dollars, that's the non-financial corporate, and lending in the global dollar money markets as the central bank reserve. So all of that loop work, okay, until it doesn't. There are a number of links, right, that we're looking at. And any one of those links that if it were to fail would cause problems in the system as a whole, that loop has to close in order for, in order for the system to be maintained.

One place that loop might not close is that Brazil is long and lending short, okay, and the rest of the world is long and borrowing short. So the rest of the world is acting like a bank for Brazil. And Brazil's source of liquidity is its deposits in that rest of the world bank, which is not in the United States at all, by the way. You notice that I haven't mentioned the United States. It's all in dollars, but it's not in the United States. So there's another little link. What is the link between the lender of last resort, the actual source of dollars, the Fed, okay, and this global dollar system that is offshore?

So all of these links are, they exist, there are links, and they will be tested. That's what financial crises are for at some high level to, if you have the proper links and to improve them that we learn in each crisis, where exactly is the weak link. And then we fix that link and we go on. And then we find out where the next week of slink is. And this is how the system works. I forgot to mention at the beginning, there's actually a fourth major odd lots topic that your research also touches on, and that is the dominance of the U.S. dollar in the global financial system, of course. And we've spoken to people like Hion Song Shin from the Bank for International settlements about this centrality of the dollar in global markets, mostly via funding markets and capital markets, as you point out. I do want to talk about the repo market, but before we do, and since we're on the topic of emerging markets, what does the money view actually say about China?

About China. I guess one of the things that I've said about China is that the notion that the RMB is going to be the global currency is not anytime soon. I think that's now the usual point of view. But when I was writing about this four or five years ago, maybe you're really, remember, there was some R&B replacing the dollar. But I think that's because people saw that China was a large country, and they were not understanding what does it mean to be a global reserve currency? All of the plumbing, all of the apparatus, are you really prepared to do all of that stuff? And the answer is basically no. So the world system is still a global dollar system.

and I'm glad you mentioned Hunchin. I learned very much from the reports of the BIS and from Hunchin and his whole group. So they are, I view them as fellow travelers in the money view. We're on the same point of view. And as I said, that's because it's a natural point of view for people who are in central banks. And what's more central banky than the BIS?

It's the place where the central banks all talk to each other. Yeah. Well, so you gave that example of a Brazilian company going out and borrowing for five years, maybe from an Asian bank, which then gets its funding from a French bank and so on. And as you pointed out, you could have this entire dollar system without it actually, without any involvement of a U.S. financial entity. And speaking of the centrality of the dollar, that was actually Mark Carney's speech at Jackson Hole about. how this is becoming a problem, so speak, because the U.S. is becoming a smaller and smaller share of GDP around the globe, and yet the dollar and therefore the influence of the Fed is taking this outsized role. Does that concern you? I mean, do you share that view that ultimately there's an instability there and that the longer it goes on without some sort of next thing or post-dollar or multi-currency world that that creates a problem? Or is that, more or less sustainable?

I think it can work. I think it is potentially sustainable. I would point you to a key piece of this at the moment are the liquidity swaps between the major central banks, which connect the dollar with all the other currencies as a backstop for this global dollar system. The fact that the United States is a shrinking fraction of a larger global economy, okay, does not seem to me necessarily to say that therefore we need a multi-currency system or that we can't have a global dollar system. It's just that what's happening is the internationalization of the dollar, okay, that the dollar is not just the United States problem, it's everyone's problem, it's everyone's currency. And so it's a political challenge, I think,

more than an economic challenge, like that the management of the global dollar system is not just the Fed's problem. It's the Fed, it's the problem. of all the central banks and the committee, if you will, of central banks working together to manage the global dollar system. It's not just the U.S.'s dollar anymore. It's everyone's dollar. You mentioned the coordinated role of the global central banks. And at Columbia, the professor Adam Tews wrote this book crashed.

And it really talked a lot about the various FX swap lines that the Fed set up with other central banks to ameliorate the dollar shortage during the crisis. Do you worry about the politics of that? So let's say that needed to be fleshed out. I mean, I'm trying to imagine in today's 2020 world, there's so much antipathy towards globalization, this Twitter world we live in, whether politics could get in the way of essentially creating the plumbing fixes

that would need to maintain the dollar. standard on a global basis. Yes, because I think the biggest challenge, as I said, the economics, I think is pretty clear. Once you get out of standard economics, as I say, and you start to see this through the money view, you understand what this is about. You mentioned Adam Tuesday. He was my colleague when I was at Columbia, and we talked a lot about these matters. We ran a project at the CCT together, and this foreign exchange swap, he cites my little article on foreign exchange so. So this is another fellow traveler in the money view, I would say, compatible with, and he is, as historian, thinking about the politics of this. How is this going to be, what is this, this is a challenge.

This was a global crisis, right? This was not just a domestic in the U.S. crisis in the subprime mortgage market. It was global money markets, global dollar money markets that froze up. That's why it was a global crisis. And it took form in different countries around the world, depending on in a different form, depending on where and how they kind of tacked into this global dollar system. That's the great thing about his book, is to really make clear the global character of this thing, and that it was global because the dollar system is global, that this crisis was a crisis of the dollar system.

Well, let's talk about the repo market blow up in September, because that was another crisis. in dollar funding markets that could conceivably have gone global if the Federal Reserve hadn't acted relatively quickly. What's your understanding of what happened in the repo market and the conditions through the Money View prism that led up to it? Well, I guess I do think that Zoltan, Pothar's analysis of this is basically right. I would, he's down in the weeds, you know, because he's dealing directly with people who are trading in this market. Let me just pull back to the 30,000 feet view a little bit,

thinking about what the response of regulatory authorities was to the financial crisis. And to a large extent, the response has been imagining that what we really need to do is get more capital in the system. We need to, we're thinking about this as a solvency problem, not a liquidity problem. And the way they, therefore, the regulatory apparatus with Dodd-Frank and others responded was to try to kill unsecured money market credit and to emphasize secured money market credit, which is to say to kill the Fed Funds market, to kill the Eurodollar market and to focus on the repo market as money market. Because repo is secured overnight money, right? There's some capital asset that is collateral for this borrowing, whereas Fed funds and Eurodollar are not secured.

These are just interbank borrowing. So by shifting the emphasis in what is the instrument that you're using as a deficit agent to live to fight another day, you're much, much more emphasis on that kind of credit now than there was 10 years ago. And so the shortage of collateral can cause problems. we, this is now the marginal source of overnight credit globally. So it's a much more important market than, then it was formally. And so all, that's where the stresses are going to show up. And that's what you saw in September, that that's where the stresses showed up. It wouldn't have

been so 10 years ago because there would have been alternative places where if you needed to borrow overnight, you could. And that's less so. And some of that's because of regulatory constraints, some of that's misguided. They're not understanding that there's a liquidity dimension to this thing that you need to be paying attention to, and that just making it safe, that is to say, secured credit is safer than unsecured credit, may be making it more fragile. Explain that further, because I don't think that's an intuitive concept to people generally. But this idea, and for those who haven't listened to past, the repo market, you have to post-collateral, and then you get liquidity, and in theory, that's safer.

But what you're saying, and again, this goes back to your original point, that it's not about wealth constraints or budget constraints, it's about liquidity constraints, or that's where the weakness in the system is. Explain how sort of regulators may have taken the wrong lesson from the crisis by misunderstanding the money view and how we still have things to fix. Well, some of this is about the point. politics of regulation. Right.

The, the, what was pushing the regulatory reform was the concern that the taxpayer not be on the hook. This is about solvency. We want to make, we want to make sure that the taxpayer is not, is not bailing out bankers, is not, we're not taking wealth from households like me, okay, and giving it to large banks that have made ridiculous, ridiculous death, right? It's about redistribution from the tax. taxpayer, financiers who've made bad debts. And so that's why the focus was on getting more capital in the system as a buffer that you can run through that you won't have to rely on the taxpayer.

That was the politics of it. Okay. However, a great deal of this crisis was not at all about losses like that, you know, that there were capital market assets that had a value of zero, and so therefore there were losses to be absorbed. These were liquidity problems. liquidity problems, which meant putting off the promise to pay until tomorrow, until you can pay it. So ultimately, it can be paid, just not today. That's a liquidity problem. A liquidity problem is when you can't make a payment today, but you will be able to make that payment tomorrow or in a week or in three months, and you need money to bide you over.

But that is not money that's coming from the taxpayer because it's repaid. It's not a wealth transfer, right? It's just, and so this is the alchemy of banking that we use. You expand balance sheets in order, by providing extra means of payment today, which you can then pull back later on when you get a better alignment between the pattern of cash promises and the pattern. That's what liquidity is about, is about maintaining that balance. The economy as a whole, across the world as a whole, of,

of promises to pay and the pattern across the economy as a whole, across the world with the whole capacity to make those payments. And misalignment of that, that's when you have a financial crisis. Right. So post-crisis regulators sort of focused on solvency, encouraging banks to hold all this additional capital and maybe arguably didn't focus enough on liquidity and liquidity risks. So now we have the Federal Reserve that is injecting billions of dollars worth of liquidity into the repo market. There's some talk also about creating a standing repo facility.

This is something that I think it was Bill Dudley mentioned recently. What's your preferred solution to repo market vulnerability at the moment? 30,000 feet. Let's back up. We've been shifting from a bank lending system. credit system to a market-based credit. These proposals that you're talking about are an attempt to the modern operation of central banking to this new market-based credit system, by operating in the instruments that the market-based credit system is using. So those two examples you gave that the Fed can inject more liquidity, which it has done by engaging with dealers, or it could create a repo facility. this is what we call in the economics of the dealer function,

the difference between the inside spread and the outside spread. The repo facility that you're talking about is an outside spread. It's saying if there's a problem in the repo market, the Fed will do repo with you, but at an unfavorable price. It will go either way. It's like a buy-sell spread that the Fed is offering away from the market price. So normally it's like the discount rate. for the bank lending system.

That's essentially what this is, is an analog to the discount window, but for the market-based credits intended to be exactly how to run that so that it doesn't cause moral hazard problems. You know, we have 100 years of experience running a discount window in order to make that work. We're just making it up right now for the market-based credit system. So we can learn things from the past, but we need to be a little humble and appreciate that we're inventing some new things.

for this new globalized market-based credit system. That's the context of these proposals. The right thing, from my point of view, the most important thing for a central bank to be focusing on, is the dealer of last resort function, that it is a backstop to prevent financial crises. And so that's why this repo facility, to me, is the more important thing.

when the Fed is trading with the market, injecting and pulling out, it's operating at the insides, but it's operating at the market price. But the outside spread, which is its promise, its facility that usually in normal times doesn't get used at all. It's just standing there, and dealers know it's there. And so they know that if there's a problem, that's the price that they're going to have to pay to get liquidity. and it's not a nice price and their business, so they don't have to go there.

But if they have to go there, they can go there. I want to just step back for a second to something you said because I have a feeling there's a lot of people who disagree, and I'm curious how you address it. When you're talking about the crisis, you're like, okay, regulators really put a high emphasis on capital requirements and making sure that banks are solvent and that really they sort of neglected the role of illiquidity in the crisis. And I think in the popular conception, everyone would be like, look, I saw that movie where they made really stupid loans to people in Florida and the loans were bad. And obviously bankers were doing all these, you know, ninja loans and subprime borrowers. And obviously in the popular conception, it's not about liquidity, but just about bad underwriting and greed and all that. How do you, if someone were to say that to you, how do you make the case that, yes, that, may all have existed, but still it really was, in large part, a liquidity problem as opposed to a capital shortfall problem. Well, I would say that it's true. All of that happened.

And in exuberant periods, crazy things happen, and illegal things happen. And you need to clean that up, okay? But that doesn't necessarily lead to a global financial crisis. Okay, that happened to be the trigger, okay? But it actually was not the substance of the global financial crisis. If all it had been was just a subprime mortgage crisis, there wouldn't have been a global financial crisis. And we would have been able to clean that up. And in cleaning that up, you do need to fix underwriting.

You do need to change some of that regulation. All of that was a reasonable reaction to a subprime evolution that got out of hand and Ninja loans and all of that. So I agree with all of that. It wasn't that it's just that cleaning that up was not all you needed to do, and cleaning that up is not going to prevent another global financial crisis because what actually caused the global financial crisis was the freeze-up in global funding markets. And that was a liquidity crisis largely. I mean, if you want to get down into weeds about this,

by the fact that a lot of these securitized mortgages were funded overnight, you know, on the balance sheet of Deutsche Bank and UBS in Europe, okay, and they then couldn't roll their funding. And they couldn't roll the funding for that. They couldn't roll the funding for anything. Global money markets froze up, and so there was contagion across the whole world. That's what you need to make sure it doesn't happen,

that if you have a problem in some little area, like subprime mortgages, it doesn't lead to a global financial crisis. You just deal with that little area, and meanwhile, put a floor under the system as a whole so that it doesn't proliferate. It did proliferate, right? The politics of it meant that you could focus on the subprime cleaning that up, and we did. And that's what, and putting more capital in banks allows them to take losses if they make

back bad loans. That's all fine. That's not what caused, what led to the global financial crisis. You may even remember at the, I mean, I remember, I was around when it was happening. There were many economists unnamed who said when the subprime market was melting down, small money compared to the size of the mortgage market as a whole. It's small money compared to the size of capital markets as a whole. It will, it's just pennies on the dollar.

We can absorb this. But that didn't mean that it didn't cause a global financial crisis because of the interactions between that little crisis and everything else, which they did. not realized. They were not right about that. That this was not a wealth problem. If it was a wealth problem, it would have been easily solved because it wasn't very big. There was a lot of skull dougary, but it wasn't very big compared to the size of the global market. And so it seems like we should be able to absorb this if it's just a wealth crisis. It was a liquidity crisis, and it was a global liquidity crisis, the piece of it, that you couldn't see looking at it from standard economics. But if you knew

how these things were being funded in the shadow banking system, money market funding of capital market lending, then you knew there was going to be a lot more to this. It wasn't just about a wealth transfer from people making bad loans. You were going to have a problem with rolling this funding, and that's exactly what happened. It got a lot worse. That's why economists didn't see it, because they weren't paying attention to the plumbing. They were thinking of this as a wealth problem, not as a liquidity problem. And it was a wealth problem in part, okay? But that's not what caused it. Professor Perry Merling, thank you so much for being on all thoughts. I just got to say, you know, whenever I put out something on Twitter saying, who should we have on odd lots? Your name

for like the last several months, or last year maybe is always one of the most frequent responses. So I'm really glad we finally made this. Well, probably that's because, as you know, I have this online course on Coursera. So there's now half a million people who've gone through that class. And so they think about the world in this money view way, but they don't see it in the media very much. And so that's what they're pushing for. They're pushing to see that language moving into more common usage. I'm going to go ahead and take the Coursera course. And I'm glad that... It's free, Joe. It's free. I'm going to do it. I promise. Thank you. That was great. Well, thank you for having me.

I really enjoyed that conversation. And as I said in the intro, it sort of brought together a lot of major macro themes that we've seen on odd bots recently. And I named a few. But we even got a bonus fourth one, which was the primacy of the dollar in the global financial system. Yeah. No, I totally agree. I feel like that was, no, it's like, no wonder so many people have always told us that we needed to have Perry on because it really does, his work touches on basically all of our big topics here. But I really like that because obviously we recently, you know, we talked to Skidelsky recently about the failure of economists to understand money. And I feel like Perry was really able to drill down on this idea and put some sort of meat

on the bone about how important it is to understand, to place money at the center of our understanding. So certainly if you follow finance or if you're involved in finance and if you were in any way following it back in 2008 when we had the financial crisis, this money view understanding of everything just feels kind of intuitive. And I actually like disagree with your last point about how lots of people are going to think this is about insolvency and the subprime crisis and greedy banks. It's definitely part of it. But But people who were following the issue very, very closely will know that it was actually caused by a massive crunch in the shadow banking system and in the repo market. And I don't know if you remember, but a previous odd lots guest, Matt King from Citigroup, actually wrote that amazing note in early September 2008 all about repo market funding and how it was going to end in tiers for the broker dealers.

Yeah, no, I mean, certainly people who were in the weeds on this stuff are reported obviously understood the, or many of them. I don't know, actually, if it's obvious, but many of them did understand the centrality of the money market and in short-term funding to the crisis. But I still think in the popular conception, and, you know, as Perry pointed out, and I think it's really important in all these fixes or you can't ignore the politics of this. And because, you know, as Perry pointed out, and I think it's really important, and you know, in the popular conception, the crisis was about greedy bankers making bad loans to people in Florida with no jobs or no income, that did have a very big impact on what the post-regulation landscape looked like, perhaps to our detriment and perhaps the reason why we still see these fragilities in the system. Yeah, for sure. This has been another episode of the Allotts podcast. I'm Tracy Allaway. You can follow me on Twitter at Tracy Allaway. And I'm just, Joe Wisenthall. You can follow me on Twitter at the stalwart. And you should follow Perry Merling on Twitter. His handle is at P. Merling and check out his Coursera course. I'm going to do so because it's free.

And be sure to follow our producer on Twitter, Laura Carlson. She's at Laura M. Carlson. Follow the Bloomberg head of podcasts on Twitter. Francesca Levy. She's at Francesca Today. And check out all of the Bloomberg podcasts under the handle at podcasts. Thanks for listening. June Grasso, inviting you to join me for the Bloomberg Law podcast. Every weekday, we help you make sense of the legal stories that shape the nation and the world. Listen for complete analysis of the biggest court cases, the latest actions from Congress and regulators, and the legal moves driving the markets, from corporate law to constitutional law,

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