CENTRAL BANKING 101:
WHAT THE FED CAN DO AS “LENDER OF LAST RESORT”
"Many of us were, shall we say, if not surprised, taken aback when the Fed had $80 billion to invest -- to put into AIG just out of the blue. All of a sudden we wake up one morning and AIG has received $80 billion from the Fed. . . . So of course we're saying, Where's this money come from? ‘Oh, we have it. And not only that, we have more.’”
“$12.3 trillion of our taxpayer money!” shout the bemused spectators as pigeons emerge from the showman’s gloved hands. “We could have used that money to build roads and bridges, pay down the state’s debts, keep homeowners in their homes!”
“Not exactly tax money,” says the magician with his mysterious Mona Lisa smile. “When did you have $12.3 trillion in tax money sitting idle?”
“[T]he Federal Reserve made $9 trillion in overnight loans to major banks and Wall Street firms during the Wall Street crisis . . . . All the loans were backed by collateral and all were paid back with a very low interest rate to the Fed -- an annual rate of between 0.5% to 3.5%. . . .
“In addition to the loan program for bond dealers, the data covered the Fed's purchases of more than $1 trillion in mortgages, and spending to back consumer and small business loans, as well as commercial paper used to keep large corporations running. . . .
“Most of the special programs set up by the Fed in response to the crisis of 2008 have since expired, although it still holds close to $2 trillion in assets it purchased during that time. The Fed said it did not lose money on any of the transactions that have been closed, and that it does not expect to lose money on the assets it still holds.”
The Central Bank as Lender of Last Resort
“A lender of last resort is an institution willing to extend credit when no one else will. Originally the term referred to a reserve financial institution, most often the central bank of a country, that secured well-connected banks and other institutions that are too-big-to-fail against bankruptcy.”
“The bank lends out some or most of the deposited funds, while still allowing all deposits to be withdrawn upon demand. Fractional reserve banking necessarily occurs when banks lend out funds received from deposit accounts, and is practiced by all modern commercial banks.”
“A lender of last resort serves as a stopgap to protect depositors, prevent widespread panic withdrawal, and otherwise avoid disruption in productive credit to the entire economy caused by the collapse of one or a handful of institutions. . . .
“In the United States the Federal Reserve serves as the lender of last resort to those institutions that cannot obtain credit elsewhere and the collapse of which would have serious implications for the economy. It took over this role from the private sector ‘clearing houses’ which operated during the Free Banking Era; whether public or private, the availability of liquidity was intended to prevent bank runs.
“. . . [T]his role is undertaken by the Bank of England in the United Kingdom (the central bank of the UK), in the Eurozone by the European Central Bank, in Switzerland by the Swiss National Bank, in Japan by theBank of Japan and in Russia by the Central Bank of Russia.”
QE3: Some Creative Proposals
“I was at the Fed last week in Washington for one of its occasional meetings with academics . . .
“The Fed is especially concerned about unemployment and the weak housing market. . . .
“Quantitative easing remains the only economic show in town given that Congress and President Barack Obama have been cowed into inaction.
“Quantitative easing” (QE) involves central bank purchases with money created on a computer screen. Blanchflower asked:
“What will they buy? They are limited to only federally insured paper, which includes Treasuries and mortgage-backed securities insured by Fannie Mae and Freddie Mac. But they are also allowed to buy short-term municipal bonds, and given the difficulties faced by state and local governments, this may well be the route they choose, at least for some of the quantitative easing. Even if the Fed wanted to, it couldn’t buy other securities, such as corporate bonds, as it would require Congress’s approval, which won’t happen anytime soon.” [Emphasis added.]
“The Fed can legally buy as many municipal bonds as it wants without congressional approval. . . . This is a big story. Blanchflower is essentially saying that the U.S. government can bail out both the housing market via Fannie and Freddie paper purchases and the state governments via Muni purchases. And, of course, the banks get to dump these assets onto the Fed who will hold them to maturity. I guarantee you this will have a very nice kick since it is the states where the biggest employment cuts are.”
Closing the Social Security Gap
“[I]t does not raise the gross national debt, because it simply transfers bonds from one government entity (the Social Security trust fund) to a semi-government entity (the Fed); and . . . it gives the Fed the extra ammo (treasury bonds) it will need when the time comes to restrain inflationary pressures and pull reserves out of the banking system. (It does this by selling bonds to banks.)”