Hard Assets Alliance was created as a cooperative of investment professionals who believe there's a better way to invest in precious metals. This is a guest perspective on the markets from one of these partners; we hope you enjoy it.

Dear Reader,
 
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.

J. 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.

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