This diary/comment illustrates and greatly clarifies the mechanisms by which the Central Banks use Public Open Market Operations, POMO, such as purchasing bonds, to control interest rates. So let me see if I have got this right.

Mig noted that POMO is the current tool of choice for central bankers. The other major tool available is the "discount window", where banks can receive unrestricted funds for a specified term by posting performing mortgages, etc. with a "haircut" in return for cash, or "high powered money" which is one way banks turn a large portion of performing loans back into lend-able cash. These operations are called repurchase agreements or "repos". The bank posts a $100K face value loan document, takes a 5% "haircut" and gets $95K for one week, one month, one year at a specific interest rate. At the end of the agreed time it pays back the amount loaned and the interest owed. The "haircut" was the margin that protected the CB against a decline in value of the collateral. Is the terminology used and the process described correct?

In a comment on his Minsky's Wheel diary Mig noted that CB practice, prior to the GFC, had been to rely on open market operations almost exclusively, as people had come to associate access to the "discount window" with a bank being in distress. But Mig noted that use of the discount window gave the CB a greater insight into the condition of the bank's balance sheet, and therefore should be a better way of controlling the monetary system than the comparatively crude means of using open market operations. It doesn't seem too surprising that the banks preferred less oversight by the central banks.

When we look at the GFC we see that one of the chief methods by which the great debacle was brought about was through the use of Mortgage Backed Securities, which were private market, presumably permanent alternatives to CB "repo" operations and which were highly profitable to the originators, but which were highly dangerous to the financial system. The same function as performed by the MBSs could have been performed by central banks, but they then would have been responsible to actually look at the mortgages they were taking in for "repo" and the loan originators could not have assumed that they were no longer responsible for any aspect of the loan, as they would be liable to repurchase the loans after a fixed time. Actually, the HFA, Fanny Mae and Freddy Mac were facilities for underwriting and permanently holding mortgages while returning money to the originators, but they had standards, even if inadequate. There were no such problems with the MBS packagers.

This whole process was endorsed by prize winning economists of the highest repute who worked at universities that were supported by people who believed that businessmen should have the fewest restraints possible and would, in their own self-interest, police and restrain themselves. The result is the ongoing, unacknowledged process of debt-deflation which we are experiencing. And in this climate it is acceptable to use the discount window because no one now trusts the large commercial banks that remain to put together a mortgage backed security and not design it to fail and simultaneously bet against it with a CDO.

The remaining question is how many of those involved were consciously involved in a confidence game, how many were victims and how many were both. The remaining task, if it is ever undertaken, is to prosecute those who broke laws. Normally, those who can be shown to have done so knowingly and deliberately would be dealt with more harshly. Who knows what will actually happen.

"It is not necessary to have hope in order to persevere."