The Real Lender of Last Resort

The Real Lender of Last Resort

The 2020 economic crisis was not really a financial crisis. The economy closed down in March­–April 2020, 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 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 who 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 labour force participation, and stagnant wages. After the pandemic interruption, the economy is returning to the same below trend weak growth of 2009–19. The Fed didn’t rescue anyone; we’re back in the long depression that began in 2007.

The Fed is not the lender of last resort

This financial history including Fed blunders (1929, 1937, 2007), Fed impotence (2009–21), 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 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 US 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 (repo) 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.

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So who’s the real lender of last resort?

There isn’t one; unless you say the financial system is its own saviour through the repo markets. In 1907, 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 behavioural 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 30 September quarter-end balance sheet window dressing. January 2022 could be another critical date because of the 31 December 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.

Where does this leave us now? In my next issue of The Daily Reckoning Australia, I’ll tell you more about the pandemic-fuelled economic crisis we are in now. Make sure you stay tuned for that one.


Jim Rickards Signature

Jim Rickards,
Strategist, The Daily Reckoning Australia

PS: This content was originally published by Jim Rickards’ Strategic Intelligence Australia, a financial advisory newsletter designed to help you protect your wealth and potentially profit from unseen world events.