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July 23, 2008

The Myth of the Lender of Last Resort

Many who oppose the inflationary actions of the Federal Reserve nevertheless favor it as a “lender of last resort.” Of course, by definition, there would always be a lender of last resort even if there were no Federal Reserve. Just as any item you’ve misplaced is always found in the last place you look, the lender of last resort is simply the last entity willing to provide a loan, so clearly something else is meant by the term “lender of last resort.” What it means is this . . .

The Fed is always willing to loan funds to banks that have made bad decisions, even when no one else will. But is this really a good thing? Just imagine how poorly many people would perform if there was an “employer of last resort” to provide everyone a job and a paycheck, regardless of their work habits. America would be a lazy, sloppy, impoverished place. But this is the role the Fed plays in the banking system. Thus, the Fed is the guarantor and encourager of bad banking practices.

But even this meaning of “lender of last resort” is misleading. It implies that the Fed lends bad banks its own money. This may be true to some extent, as the Fed does earn some profits. But it is also true that the Fed can create new money. Whenever it does this the cost is transferred to you in the form of higher prices and devalued savings. Doesn’t this make YOU the lender of last resort, and not the Fed?

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