The Fed is considered the “lender of last resort.” But is it really? Today, we’re going to see why that’s not true and why the Fed is basically irrelevant. Let’s dive in…
The dollar is the world’s leading reserve currency. Dollar-denominated assets make up about 60% of global reserves, and dollars account for about 80% of all payments and almost 100% of all oil and natural gas purchases.
Dollar-denominated markets in stocks and bonds are multiples of markets priced in other currencies. The EUR/USD cross-rate is by far the most heavily traded foreign exchange pair in the world.
The Federal Reserve System creates dollars. They do this by buying U.S. Treasury securities and other assets from bank dealers and large institutional investors. When the Fed buys securities, they take delivery from the banks and pay for the securities with dollars that come from thin air.
(The same system works in reverse. When the Fed wants to reduce money supply, they sell securities to banks for dollars and those dollars simply disappear.)
If the world runs on dollars for trade, commerce and reserves, and if the Fed is the official source of dollars, it would seem to follow that the Fed is the world’s lender of last resort.
When there’s a run on money market funds or banks are nearing insolvency or major corporations such as AIG or General Motors are nearing bankruptcy, the Fed can swoop in, buy assets, create new lending programs, cut rates to zero and take other extraordinary actions to keep the system afloat.
In that sense, the Fed poses as the global lender of last resort.
But the reality of the financial system is much more complicated and more opaque than the Fed narrative suggests. To understand why, some historical perspective is helpful…
Few Americans realize that the U.S. had no central bank for 84 years out of its 232-year history. Those 84 years, 36% of the country’s history, included some of the most prosperous and innovative periods in that history.
George Washington was sworn in as the first president in 1789. The First Bank of the United States was given a 20-year charter from 1791–1811. The Second Bank of the United States had a 20-year charter from 1816–1836. The Federal Reserve System was created in 1913 and exists today.
This means the U.S. had no central bank from 1789–1791, again from 1812–1816 and again from 1836–1913.
During those periods that the U.S. had no central bank, there was no official lender of last resort. If such a lender were needed in a financial panic, it had to come from the private sector — or not at all.
This state of affairs culminated in one of the greatest financial rescues in U.S. history — the Panic of 1907. The panic was a consequence of the San Francisco earthquake of 1906. Western insurance companies had to sell assets to satisfy damage claims. This put pressure on New York banks to provide liquidity.
In the middle of a budding liquidity crisis, a fraud occurred involving lending by the Knickerbocker Trust and others in an attempt to corner the market in the stock of the United Copper Co.
When the fraud was revealed, a full-scale banking panic erupted. This led to the ninth-largest stock market crash in U.S. history.
Pierpont Morgan convened a meeting of New York City’s top banks in his townhouse in the Murray Hill section of Manhattan to assess the damage. He instructed his agents to examine the books of all of the major city banks.
These banks were divided into three categories: those that were sound despite the panic, those that were solvent but illiquid and those that were insolvent. It was financial triage.
Pierpont’s plan was to have the sound banks lend to the illiquid banks to see them through the crisis. The insolvent banks would be allowed to fail with losses to depositors and stockholders.
The bankers could not agree at first, but Morgan had his servants lock them in his library and told them they would not be allowed out until they had a plan.
By the next morning, they had agreed. The plan was announced, the illiquid banks were saved and the panic was soon over.
Despite that success, the bankers and politicians realized that J. Pierpont Morgan was one of a kind and would not live forever (Morgan died in 1913). A lender of last resort was needed that would be institutional and would not rely on any one individual or private bank.
Read on to see how the Federal Reserve has bungled that job and why the Fed is not really the lender of last resort, despite what most people, including many economic commentators, believe.
A plan was devised at a secret meeting in Jekyll Island, Georgia, in 1910 attended by representatives of the Rockefeller, Morgan and Warburg interests. The result was the creation of the Federal Reserve System in 1913.
Problem solved? Not exactly. The Fed was a theoretical lender of last resort, but it bungled the job time and again. The Fed kept monetary policy too loose in the 1920s, which led to a stock market bubble. It then tightened too quickly, which led to the 1929 stock market crash. The Fed was completely unsuccessful at ending the Great Depression and made it worse with another monetary policy blunder in 1937.
The real lender of last resort in the 1994 Tequila Crisis involving Mexico was the U.S. Treasury, using the Exchange Stabilization Fund. The lender of last resort in the 1998 Russia-LTCM crisis was Wall Street, which organized a $4 billion all-cash rescue over four days in September. I negotiated that rescue.
Our bailout model was the Panic of 1907, not anything the Fed had done in the meantime. There was no lender of last resort in the 2000 dot-com crash because that asset bubble involved little leverage. The banks were not in jeopardy.
The Fed did step forward as a lender of last resort in the 2008 global financial crisis, but that came only after ignoring the liquidity crisis for over a year (it started in July 2007), and only after allowing Lehman Bros. to go bankrupt, causing a full-scale run on the banks. Once again, the Fed proved it was impotent.
The 2009–2019 recovery was the weakest in the history of U.S. recoveries with average annual growth of only 2.2%. So-called quantitative easing, QE, did no good at all and only bloated the Fed’s balance sheet.
The 2020 economic crisis was not really a financial crisis. The economy closed down in March–April 2020 and then bounced back in July–August 2020. This was neither a normal business cycle recession nor a financial collapse. The banks were in much better shape in 2020 than in 2008.
In 2020, the Fed went through the motions of cutting rates, buying assets and flooding the zone with new money, but it had little impact. The new money went to the banks that gave it back to the Fed in the form of excess reserves. The money never made it to the real economy.
Output levels of December 2019 were not recovered until June 2021. Employment levels of 2019 still have not been recovered. Instead of stimulus and robust growth, the Fed gave us more of the same — slow growth, low labor force participation and stagnant wages.
After the pandemic interruption, the economy is returning to the same below-trend weak growth of 2009–2019. The Fed didn’t rescue anyone; we’re back in the long depression that began in 2007.
This financial history including Fed blunders (1929, 1937, 2007), Fed impotence (2009–2021), and Fed irrelevance (1994, 1998, 2000, 2020) points to the least understood aspect of today’s global financial system:
The Fed is not the lender of last resort. The Fed can put on a show of policy changes and announcements, but it doesn’t matter to markets. The 2009 market bottom was reversed by a Financial Accounting Standards Board (FASB) ruling, not the Fed. The 2020 market bottom was reversed by congressional handouts, not the Fed. The Fed doesn’t matter.
Why is the Fed irrelevant? The reason is that the Fed doesn’t create the money that matters. Fed money (technically base money, or M0) is sterile. Private banks are the entities that create real money, as they have since the Middle Ages. This is done through the credit system.
The interbank credit system depends on collateral, and the best form of collateral are U.S. Treasury bills. When the Fed prints money, it buys Treasury bills from banks, thus depriving the system of valuable collateral.
Treasury bill collateral is moved around the financial system through repurchase agreements (repos), and involves chains of pledges and repledges (rehypothecation), which create leverage and new credit. Less collateral means less leverage, which means monetary tightening.
Fed money printing is not a form of ease. It’s a form of tightening because it drains the system of good collateral. The Fed doesn’t understand this, which is why they are now blundering into a new financial crisis.
So who’s the real lender of last resort? There isn’t one; unless you say the financial system is its own savior through the repo markets. In 1907, J. Pierpont Morgan was the system personified.
The founders of the Fed were right to create a substitute for Morgan, but they failed because the Fed’s mission has always been to save banks rather than save the economy.
Morgan had the right idea in 1907 when he allowed the insolvent banks to fail while saving the rest.
The Fed is wandering in a wilderness of mirrors imposed by monetarists, especially Milton Friedman. The economy is not driven by money supply. It’s driven by credit, confidence and behavioral psychology, which are reflected in the turnover of money (velocity).
The Fed can’t help confidence, but they can hurt it: They’re doing so now. There’s a worldwide shortage of dollar credit and collateral driven in part by the Fed draining the system of Treasury bills. The global economy is slowing dramatically as a result.
The demographic collapse in China will be so great that it may actually destroy the credibility of the Communist Party of China, something the Chinese themselves describe as losing the Mandate of Heaven. This could lead to internal turmoil or even breakaway provinces not unlike Taiwan today.
The combination of geopolitical instability, excessive debt, reduced output and weakening legitimacy will make China one of the least attractive destinations for capital over the coming decades.
This hidden credit crunch may come to a head as early as October 2021 as the banks struggle through Sept. 30 quarter-end balance-sheet window-dressing. January 2022 could be another critical date because of the Dec. 31 quarter-end. Precise timing is difficult to forecast; foreseeing a credit crisis is not.
Pierpont Morgan died the same year the Fed was created. There has been no real lender of last resort ever since. The financial system is on a high wire with no net.
And the wire is going wobbly.