So, so far I've treating, I've been thinking about the banking system,

as if it's made up of these profit maximizing kinds of,

I mean we haven't really addressed that.

These people, these institutions,

security dealers, bank, they're not really doing this for their health.

They're not doing it, creating liquidity to be nice to us or something,

to help us trade apple stock, isn't that nice?

No, they're doing it to make money, and they're motivated by profit,

and that, we'll analyze how do you make profit by making markets.

What is the source of that profit, we will do that in this course.

What I want to emphasize though, is that one entity.

Once the Central Bank becomes not a private bankers bank, but

actually a sort of public entity, an agent of the state, an agent of the people.

[COUGH].

It doesn't necessarily, focused entirely on profit maximization or

maybe, not entirely on short term profit maximization.

This happened overtime.

Bank of England, was a private bank for a long time.

But because it's sitting at the top of the hierarchy, sitting at the top of

the hierarchy, and it's noting this fluctuation, okay and it's noting when

things get really really bad, what people really want are my own liabilities.

I have the best liabilities in the system, and

so in a certain way, I can help them out if I want to.

And Lender of last resort, budget.

Or JP Morgan in the United States, helping out his friends, okay.

He was essentially a private central bank, before we got the fed.

So you could do this in a profit maximizing way,

as JP Morgan maybe did, in 1907.

But once you realize,

that there's this sort of quasi public function of the Central Bank,

up at the top, are particularly managing these turning points.

There's this idea that some of these entities,

might be focusing on short term profit maximization.

[SOUND] Profit maximization and

others, might be focused on,

economic stability.

[SOUND] Making sure, that the system doesn't collapse.

Lender of last resort is the ultimate, making sure the system doesn't collapse.

Lender of last resort is saying,

when the principle of scarcity, is causing the economy to melt down.

The market-makers are ceasing to make markets there's no and so therefore,

nobody can trade, and the whole system is in disarray.

I can because I'm at the top of the system, introduce a little elasticity.

Because I can accept securities as collateral,

for expanding the money supply.

Something like that.

So I can join the layers of the hierarchy, that have all broken down,

because the market makers aren't making markets.

That's what lender of last resort is.

That's an economic stability function.

And over time Central Banks, have come to accept that and to say that's our job.

That has evolved over time, that role of economic stabilization.

>> [COUGH] >> It's evolved over time.

[SOUND] What do Central Banks do?

[SOUND] What do

Central Banks do?

The most primitive, if you look back in history,

one thing that obviously a Central Bank has to worry about, is the exchange rate.

So that the mid par of interna- and you could just say that's

the Central Banks job, is to just defend the exchange rate and

let the whole rest of the economy go to hell.

There are Central Banks that have done that, but they've come to realize that,

that's not such a good idea.

That they will be sta- if the whole rest of the economy goes to hell,

they're going to be sucked down with it.

So they might, [SOUND] Expand their remit to say,

well we have some responsibility also, for

helping the banking system maintain par.

So that when they are experiencing a run, people want more currency and

they don't want deposits.

We're the Central Bank,

we can help out, because we can create currency, so we can help out.

So Central Banks take responsibility, for financial stability.

Bagehot book, Lombard Street, was, in fact, I have it here, I'll show it to you.

Bagehot book, Lombard Street, a description of the money market here.

This is a, I got this, a used book.

Merry Christmas to father, from Ed, 1907, i love that 1907.

Financial crisis of 1907.

Some Ed is giving his father the key to understanding,

what's happening in the financial crisis.

The Lombard Street inscription of the money market, pounds, shilling,

pence here is what that's about.

So it's about the London money market.

And what Bagehot, what Bagehot tried to convince the world with this book,

is that Central Banks, that the Bank of England, a private central bank.

Had in fact, during previous crisis, been acting as a lender of last resort.

It is sort of involved in that way, without intending to.

And that, it should bring this up to consciousness and embrace it.

And say, what we're going to do in a financial crisis as lend freely

at a high price against good collateral?

That's what we're going to do.

And you should just embrace that.

It was very controversial, when he first published this and

then it became orthodoxy.

That Central Banks all say yes, this is all orthodoxy, we must do this.

What I want to just draw your attention to now,

is that once you have embraced that and said, that's what we're going to do.

If we get to the ultimate scarcity of ultimate money and

this causing trouble, that the economy is breaking down, we are going to step in.

That then makes the bank,

if you've taken that responsibility on yourself, that then makes you want to say.

You know would be kind of good,

if we can prevent ever getting to that point in the first place, actually.

If somehow, we could intervene in the economy before it got that bad,

we know that it's going to be all on our balance sheet, if we get there.

So let's try to have monetary policy.

This is actually the origin, of monetary policy,

the notion that by manipulating the interest rate or something like that,

you can somehow prevent this fluctuation, from getting too extreme.

You can lean against the wind.

When it gets too boomy, you raise interest rates,

you try to implement scarcity when the economy, is all about elasticity.

And then on the other side when its all collapsed,

when the economy is all about discipline, you try to implement some elasticity.

So this counter cyclical kind of effect,

counter cyclical policy, comes from the inevitability

of thinking of hoping that you can do something about that.

It comes from taking responsibility for the crisis.

That you're going to intervene in a crisis.

So let's try to prevent a crisis.

And not just counter cyclical policy, but also prudential policy.

Let's try to regulate banks and make sure, they don't get over extended.

Let's make sure, they don't buy crap assets.

Let's do, all this stuff that you see as regulation is ultimately coming from

the fact, that the Central Bank is taking responsibility for the ultimate crisis,

so let's try to prevent this crisis from happening in the first place.

How does the Central Bank do that, this is my last image for you.

[SOUND] Interest rate.

[SOUND] The Central Bank intervenes,

most Central Banks intervene by manipulating,

a very short term interest rates.

The fed's fund rates in the United State some policy rate,

over night rate, very short term rate.

There is a term structure of interest rates,

that typically looks something like this.

So down here at the short end, you are talking about overnight money,

one day and out here at the long end.

You're talking about 30 year, treasury bonds.

This is called, the term structure of interest rates.

[SOUND] Here at the short end,

we have the policy rate.

[SOUND] Here at the long end.

We have the market rate.

In general, private markets, security markets,

these are securities thirty year bonds.

So, private market securities are determining these rates here.

And Central Banks, are determining these rates here.

So, who wins?

There's this theory which you've probably seen, in other economics classes.

The Expectations Theory, of the term structure.

Which is to say well, the thirty year bond should just be, the rate that yielded

run really should be the expected overnight rate for the next thirty years.

Just rolled it over, it should be exactly equal to that.

And this theory is wrong, empirically wrong.

It's rejected basically all the time.

But we don't, economist don't have a very good understanding of why, actually.

We're going to talk about that, in this class.

It's the sort of thing, it seems arbitrage to be, why would it be rejected?

It seems like it really should be true, but it is not true empirically.

And that tells you, that there's something else going on here and

I'm going to argue, that it has to do with liquidity.

But we need to get clear on what liquidity means,

before I can make these kinds of arguments.

What I'm emphasizing right now at the beginning,

big picture, is that we have a policy rate, we have a market rate.

Policy is trying to move the market around,

by moving this interest rate around.

But the market is also creating constraints, on what policy can do.

You can't make the market, do just anything you want.

But on the other hand, if you let the market dictate what you do,

you're just accepting the hierarchy as it is.

Monetary policy, is all about creating an artificial hierarchy.

[SOUND] Of money and credit.

[SOUND]

Okay.

Partly you can see that in this, remember that hierarchy I told you that it was like

gold at the top, then currency, deposits, securities?

Well here, we have basically overnight money at the Fed, so this is currency.

And here's securities.

And the Fed, it's a attempt to influence this pyramid.

It plays out in these prices.

It's an attempt to influence the prices,

of these securities out here and the steepness of that.

When a central wants to impose more discipline, what you'll is this.

A negatively sloped term structure,

where short term money is ridiculously expensive.

More expensive, than long term money.

This is ultimate scarcity.

[SOUND] And when it wants to.

[SOUND] Make the pyramid.

>> [COUGH] >> More elastic,

short-term interest rates are lowered way below, long-term interest rates.

So the attempts, what we call monetary policy,

is really the attempt of the Central Bank.

To say, well, the system has a certain balance between elasticity and

this one right now, but I don't like it.

I think it should be more elastic.

I think it should be less elastic.

So monetary policy is about that, is about choosing where to be on that.

And there's politics about that and all of that.

And we can talk something about that.

But the actual mechanics of it, are pretty interesting by themselves.

And that's what mostly, this course is about.

Is to try to really understand, this seems a very thin read

to hang your whole monetary policy on.

An overnight interest rate, what is the connection?

How does changing that rate, do anything to the pyramid?

Where exactly is the transition mechanism?

The transmission mechanism of monetary policy, how does it really work?

The market is enormous.

Remember this pyramid.

The credit market is enormous, really, really enormous.

How is it that puny little Fed, can have any weight on it at all?

Any influence on it at all.

I think really, it's a serious question.

Once we get inside the system and we understand, we'll

be able to ask those questions more precisely.

What I want to leave you with here is,

the evolution over time of the role of the Central Bank.

From defending the exchange rate, defending par,

to more broad [SOUND] concerns about economic stability.

Ultimately there was a period in time, when the Central Bank thought,

maybe we can eliminate the business cycle.

Remember I said, this fluctuation thing happens at all time scales.

Maybe the Central Bank, can create an artificial hierarchy and

just eliminate the business cycle.

Whenever it looks like it's going to slack in, we'll create more elasticity maybe,

that was an ambition.

One of the central questions we are going to be concerned with in this course,

this semester.

Is, what is the proper role of the Central Bank today, in this financial crisis?

We started today by talking about Mario Draghi.

[COUGH] And his attempt to put a floor under the crisis, that is happening

in Europe, by putting a floor under the price of short term peripheral bills.

By buying them himself.

He was being a security dealer.

He's buying, Portuguese debt.

He's buying Spanish debt, he's buying Italian debt.

This is a new role.

He's not supposed to do this.

It wasn't anticipated, that he was going to do this.

This is a new role.

Similarly when the Fed in our crisis, 2007,

it bought a trillion dollars' worth of mortgage-backed securities.

There'd been any mortgage backed securities,

on the balance sheet of the Fed.

Not since 1913, never, there had never been mortgage

backed securities on the balance sheet, of the Fed.

And suddenly in three months, there's a trillion dollars worth.

So I'm just alerting you, that we're living in a brave new world, where we're

reinventing, trying to figure out what is the appropriate role ,of the Central Bank.

For our modern times, for our modern global financial system.

For the shadow banking system, for all that.

And we don't know the answer.

We don't know the answer.

We're going to be,

we're making it up, the central banks are all kind of just reacting.

But we're living in a Bagehot moment.

Bagehot was writing in 1873, when he looked back and

he said, all this stuff you were doing.

It's lender of last resort and you done good.

Bring it up to consciousness and embrace it.

Lend freely at a high interest rate, against good collateral,

during a crisis and you won't have any crisis anymore.

You'll be able to put a floor on them, all the time.

We don't have a simple rule like that anymore, for

the world that we're living in.

And we're looking for one.

So that's part of what this course is about, is that sort of search.

And seeing how this kind of rule, is emerging in practice.

What are Central Banks actually doing?

They're responding to where the stresses are.

Step back, what did they actually do, and why did it work?

Or what did they do, and why didn't it work?

There's lessons to be learned from this crisis.

And the clock is ticking.

We don't have a lot of time.

The stakes are pretty high.

So that's what this course is all about.

And I will leave it there.

Any questions, or?

>> [NOISE]

[INAUDIBLE]

>> Operation Twisty's asking about what he

means is this that the Fed >> The Fed has been entering

into the longterm bond market, okay?

It has been buying longterm bonds.

It has not been sticking with just fixing the overnight industry.

And so, yes that is an attempt to influence the shape of this

pyramid Whether it's been very effective or not and even what the mechanism is.

There's a lot of debates about if it's been effective, why has it been effective.

Nobody really knows.

I have a view on that, which we'll get to later on.

Managing the Hierarchy

Economics of Money and Banking

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