The Federal Reserve – Lender and Buyer of Last Resort

Can the Federal Reserve save the U.S. economy from failure? Is this their mandate? When you research “lender of last resort (LLR),” which is what the Fed is supposed to be, you mostly find the source to be Walter Bagehot’s Lender of Last Resort Doctrine.  This doctrine came about from Bagehot’s book, Lombard Street: A Description of the Money MarketHartley Withers, in 1915 wrote of the book; “It is a wonderful achievement, that a book dealing with the shifting quicksands of the money market should still, after more than forty years, be a classic of which no one who wishes to understand the subject can afford to be ignorant.” This could be true even of today.

When it comes to Central Banks, lets face it; most of us in America are ignorant. Hopefully this article will clear things up a bit and help you make good decisions on your investments moving forward, or at a minimum explain to you why gold is still needed today, just as it was when gold was the standard and base of the monetary system when Bagehot wrote his Lombard Street book, before the Federal Reserve even existed.

Bagehot’s main LLR thesis about the Bank of England (the Federal Reserve had not yet come into existence), was the following;

In ordinary times the Bank is only one of many lenders, whereas in a panic it is the sole lender, and we want, as far as we can, to bring back the unusual state of a time of panic to the common state of ordinary times.

In other words, the Bank of England, in times of panic, could step in and provide liquidity to calm any fears that may arise. Then the economy would revert back to business as usual. The LLR was always there if needed. This isn’t such a bad thing, but even good things can be abused if the actions of some central characters are not controlled or reversed.

In the U.S., before they had a Central Bank, the LLR was primarily one man; J.P. Morgan and a few of his banking friends in New York, who together prevented the Panic of 1907 from getting worse as they shored up the banking system with their own money.

If you have read my book, Buy Gold and Silver Safely, or my articles over the years, all crises stem from a banking problem or issue. This will be how things unfold in the future as well. We got a good idea of how far out of control things became in the 2007/2008 Financial Crisis, but I’m getting ahead of myself.

Enter the Federal Reserve 

According to Michael D. Bordo, PhD Professor of Economics and Director of the Center for Monetary and Financial History at Rutgers University, and his article “The Lender of Last Resort: Alternative Views and Historical Experience” listed on the Federal Reserve Federal Reserve Board (FRB) website;

The Federal Reserve System was created in 19 14 to serve as a lender of last resort. The U.S. did not experience a banking panic until 1930, but as Friedman and Schwartz point out, during the ensuing three years, a succession of nationwide banking panics accounted for the destruction of one-third of the money stock and the permanent closing of 40 percent of the nation’s banks. Only with the establishment of federal deposit insurance in 1934 did the threat of banking panics recede.

But what Professor Bordo didn’t say was the other reason for the Fed’s success in stemming the banking panic; they confiscated gold and then devalued Federal Reserve Notes by 40%! The price of gold was $20 an ounce in 1933 and in 1934 when Roosevelt signed an Executive Order for citizens to turn in their gold for Federal Reserve Notes. The administration artificially moved the price of gold from $20 to $34 an ounce, a 70% increase. This meant that your $20 gold piece that you didn’t turn into the government was now worth $34. But the $20 bill in your pocket that the bank gave back to you for your $20 gold coin a year earlier, could only buy you 41% of the gold you used to be able to buy.

How did the Lender of Last Resort do? They saved the system, right? But at who’s expense? Those that held Federal Reserve Notes, of course. While the Fed, via the government confiscated the People’s gold, the monetary system still used gold to trade from country to country to settle accounts. This continued until 1971 when multiple countries were asking for settlement in gold, rather than Federal Reserve Notes. 

In 1971 Nixon took us off the Gold Standard completely and told the world, take our dollars only as you aren’t getting anymore of our gold. The other countries had no choice.

What did the price of gold do for the next 10 years after the Fed changed the game? It shot straight up.

gold prices 1971

Some of you may be asking, “Why is all of this knowledge of what the Federal Reserve does important to me? It’s simply because they will always do what it takes to make whole the banks, at your expense. They do it under various guises like; “if we don’t do this, then the system will collapse.” But would it? Wouldn’t another system take its place? Or do we all just rollover and die? Rome collapsed. Did Rome die? Germany collapsed. Did Germany die? Argentina collapsed in the late 80’s. Did they die? 

Sure there will be some that are hurt, but whom? And for how long? There will always be individuals, companies, charities, community organizations that will band together to help those in need. That’s what’s so great about America. But if a bank failed? It would be replaced by a stronger bank that didn’t take the same risk as the bank that failed. Banks that take on unnecessary risk don’t need a handout, they need to fail. As a result of us bailing out the banks that made mistakes, we now have QE infinity and you can bet there will be more Fed action to come that are just going to make matters worse. We are simply digging a hole that we won’t be able to climb out of. Meanwhile, Congress does what they do best; agreeing to raise the debt ceiling because all they have to do is ask the Fed for more money to pay for things….again….at your expense either through higher taxes or eventual higher inflation that destroys your purchasing power.

These Guys Will Fix the System, Right?

Who did we turn to as a nation to fix our banking problems? None other than two individuals who were part of the original problem and other problems to begin with; Senator’s Dodd (D-CT) and Barney Frank (D-MA). Senator Dodd, along with Charles Schumer (D-NY) and Phil Gramm (R-TX) were responsible for the deregulation of banks with the repeal of the Glass–Steagall Act of 1933, which removed the barriers for banking, securities and insurance companies who had given the Senator’s mentioned and other lobbyists over $250 million to get the act repealed.  This deregulation is what led to banks and other financial institutions taking on more risk and playing the derivatives market. While there are other reasons for the failure of the system, like making loans to anyone with a pulse and not doing their own due diligence, it was this deregulation that has haunted us then and still will in the future.

Both Dodd and Frank also denied rumors Fannie Mae and Freddie Mac were in a financial crisis and Dodd over the years was the number one recipient of funds from Fannie and Freddie. Anyone who tells you that Senators can’t be bought and paid for is lying. And with all of this, Dodd and Frank were put in charge of the Wall Street Reform and Consumer Protection Act in 2010. This is the Act that gave the Federal Reserve, of all entities, the Governance and oversight and required the Federal Reserve to establish prudent standards for the institutions they supervise. In other words, the Wolf is in charge of the Hen House.

The fact that Dodd and Frank were elected year after year in Connecticut and Massachusetts will be addressed, among many other things, in a forthcoming book, “We the Serfs!”

With programs like TARP, QE and various other government regulations, the Fed (LLR) gets credit for “saving the system.” Life is good. Stock market is up. Gold is ignored as a non-producing asset. The economy is improving. Or is it? Maybe, just maybe, it’s a house of cards destined to fall. You be the judge based on the evidence.

The Fed’s Dual Mandate and Changes to the LLR System

The Fed’s dual mandate is supposed “to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.” During the 2008 Financial Crisis, the Fed became not only the Lender of Last Resort: they also became the Buyer of Last Resort. Up until 2008, the Fed’s Balance Sheet reflected normal treasury holdings that were bought and sold along with a few other assets. But “to save the system,” the Fed had to do something they had never done before. They had to buy assets that the market didn’t want, just to save some banks and a few other companies like GM and AIG. Take a look at how the Balance Sheet of the Fed changed since 2008 below.

Feds Balance Sheet

The above charts are a recipe for disaster. But it’s not just the U.S. Central Bank; the Fed, it’s the BOE and ECB as well. I’m leaving Japan out of this analysis as I have written about them in several other articles.

Central Banks Buyer of Last Resort

The Fed’s policy along with all other Central Banks, including Japan has been to lower interest rates (see chart below) to try and stimulate their various economies. Their theory is that they somehow can force banks to loan and companies to borrow. In fact, as the table below shows, the Fed especially is “vigorous” in their current policies as outlined in The Changed Role of the Lender of Last Resort: Crisis Responses of the Federal Reserve, European Central Bank and Bank of England.

Result of Central Bank Actions

Central Bank Actions

What makes matters worse, the Fed is failing to increase credit to the private sector as the chart below shows. The chart below that shows why; the banks simply won’t loan and are sitting on huge reserves.

qe failure

Fed M2

Where to From Here?

While no one has a crystal ball and can predict with accuracy the success of the various Central Banks, it is clear they are grasping for air. Any talk of the Federal Reserve tapering is just that “talk” as I had predicted they would not taper anytime soon in Calling the Fed Taper Bluff and What Gold Might Do Next. But I have said many times the Fed (and other Central Banks) are still relevant. The stock market waits patiently to hear what the Fed might do next and goes up or down accordingly. This is not an investment climate that is built on anything but fluff and I caution stock investors to consider taking some profit, even though I do think we’ll move higher in stocks through the end of the year. But I also have said I see lower gold prices through the end of the year. I can’t have people claim I am biased saying sell stocks and buy gold. I’m not. I simply call it like I see it.

I see some major selling of gold by Hedge Funds, Mutual Funds and Professional Traders through the end of the year and the Market Makers will possibly utilize this opportunity to push gold and silver down to lower levels, possibly breaking the 52 week lows. By next year we should be off to the races. My recommendation is still to dollar cost average into an allocation for your portfolio.

I do want to remind everyone what Richard Russell has said about gold when it enters its 3rd “euphoria” stage. He said that gold will go to “undreamed of heights.” Keep that in mind, especially if you don’t own any gold.

While the Fed has maybe transpired from Lender of Last Resort to Buyer of Last Resort, they will eventually have to keep on buying and buying and buying even more toxic assets that no one else wants, including their own treasuries (although I am bullish on treasuries at present). If one bank has issues, the Fed will be there to bail them out. This is how America works and if you weren’t aware of it before, you are now.

A little patience is needed for those who own gold and silver. Our time will come. You can bank on it.


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About Doug Eberhardt

Doug Eberhardt is a 28 year financial services veteran and precious metals broker selling gold and silver at 1% over wholesale cost. Doug has written a book to help investors understand how gold and silver fit into a diversified portfolio, how to buy gold and silver, and what metals to buy. The book; “Buy Gold and Silver Safely” is available by clicking here Contact phone number for Buy Gold and Silver Safely is 888-604-6534


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