‘Trust Us’

There is validity in (not “to”) the myth of central banking, one that has important and very serious implications right down the smallest and most immediate terms. The first task of every central bank was currency elasticity, which simply meant the bank would endeavor to supply (at penalty rates, according to Bagehot, such that banks do not fund themselves on central banks but private money) sufficiently what the private market might not in periods of distress. It wasn’t meant necessarily to bail out institutions, but rather to keep money from being the central issue in any economic crisis.

This primal relationship of money to economy was predicated on hard experience. In Bagehot’s own institution, the Bank of England, it was incorporated into the very building and to the room in which monetary policy was formed in the early industrialist economy. As the Financial Times recalled in May 2007:

High up on the wall of the Court Room at the Bank of England is a dial, linked to a weather vane on the building’s roof. Now a novelty for visitors to the Bank’s grandest function room, knowing the direction of the wind was a deadly serious tool of monetary policy on its installation in 1805.

If the wind was coming from the east, ships would soon be sailing up the Thames to unload goods in London. The Bank would need to supply lots of money, so traders could buy the wares landed at the docks. If a westerly was blowing, the Bank would mop up any excess money issued to stop too much money chasing too few goods, thereby avoiding inflation.

It’s not just a cute story about ancient times, it speaks directly to the basic andnecessary connection between money and economy in whatever forms the former might take. In the modern system the relationship might be several layers removed, but it remains even if now more a matter for banking and banks than ships sailing up the Thames.

The difference between 2006 and 2007 was first that money market participants in the eurodollar learned the hard way that the Federal Reserve had no backstop abilities. It was taken for granted that they had, a myth that went unchallenged the entire eurodollar evolution until August 9, 2007. When unsecured markets fragmented, that was, essentially, the practical outcome of figuring out the Fed was not going to (indeed could not) overcome the geographical divide (even the dollar swaps of late 2008 were no deterrent to the last liquidation or crisis leg in early 2009) – let alone the dimensional divide of the eurodollar system across all its various capacities (including derivatives like interest rate swaps).