Lender of Last Resort: You, Not the Federal Reserve

It is often said that the Federal Reserve System is the lender of last resort. This indicates a misunderstanding of the financial system. The Federal Reserve is the lender of next-to-last resort. Holders of money are the lenders of last resort.

The lenders have no choice. They lend because there are two loan officers: Congress and the Federal Reserve. Congress collects the loans through direct taxation. The Federal Reserve collects it by indirect taxation: inflation.

Let us begin with Congress.


We all know about Bernard Madoff. He ran a Ponzi scheme for over two decades. It siphoned off about $50 billion. No one besides Madoff knows where the money went. For decades, no one with big money asked this question: “How can thus guy beat the markets every year?” Instead, they asked: “How can I get inside Madoff’s system? How can I become one of the chosen?” The winners were those got in early and got out, and those who never got in at all.

Madoff was a piker. Substitute “trillions” for “billions,” and you have Social Security and Medicare.

Everyone gets on the inside. Everyone is forced to. Nobody gets out of the system.

Very few people ask this question: “How will the government pay off the participants?” Those who do ask are dismissed as cranks.

Who will redeem all those nonmarketable IOUs from the U.S. government that sit in the computerized accounts of the Social Security Trust Fund and the Medicare Trust Fund? No one in authority dares to ask this question in public view.

Madoff ran his scam through secrecy. He escaped detection. Congress runs a far larger scam in full public view. Hardly anyone notices. Of those who do notice, almost none say: “This Ponzi scheme will surely go bankrupt.” This includes economists. Most of them are employed in universities, and they are counting on Social Security and Medicare for their retirement years. When it comes to faith, economists believe in statistical impossibilities. They see a Ponzi scheme in action, and they think: “I will get out in time. I will die.”

Who will redeem those IOUs? To redeem is to buy back. Who will be the redeemer?

The Federal Reserve System, of course. It can afford to. It has the right to print money. A lack of money is never a problem for the FED.


In the Mosaic law, there was a peculiar office: the ga’al. The word means “redeemer.” This office had two aspects: vengeance and redemption. The ga’al was both the blood-avenger and the kinsman-redeemer. He was the nearest of kin. When his closest relative was killed because of an alleged accident, the blood-avenger was legally allowed to pursue the suspect and kill him. The only way for the suspect to escape vengeance was to flee to a city of refuge. There, he would be tried by a court. If he was convicted of what we call manslaughter or criminal negligence, the ga’al could not legally kill him, unless he caught the man outside the gates of the city. He went completely free upon the death of the high priest (Deut. 19).

The ga’al also had the responsibility of buying his nearest of kin out of slavery, if the kinsman went into slavery because of forfeiting on a debt (Lev. 25:48—49). A central bank is the unofficial ga’al of the fractional reserve banking system. It is an agency of vengeance. It pursues those banks and would-be banks that offer loans that are more competitive than the banking cartel has established through the central bank. It is also the agency of redemption. When a big bank gets into a crisis because of its pyramiding of debt, the central bank redeems that bank.

The Federal Reserve System redeems large banks in two ways. First, it lends a technically bankrupt bank lots of newly created money. The bank puts up as collateral some of its nearly worthless assets, which it bought as sure things during the boom phase. Second, the FED temporarily swaps AAA-rated Treasury debt for the bank’s depreciated assets, for which there is no market. It swaps at face value: like for like. This is like swapping a sterling silver set for a pile of crushed beer cans. As the senior bank regulator, it then tells the government’s accountants that the borrowed AAA-rated securities are to be counted as the bank’s assets, not as borrowed assets. The bank thereby meets its legal requirements for solvency.

This two-part strategy of redemption, along with some even more arcane subsets, is regarded by the media as financial wizardry of a high order.

No one has yet commented on what should be obvious. The Federal Reserve’s solution to the bank capitalization crisis is a variant of the government’s accounting solution to the Federal deficit. This accounting solution has been used by every Administration since Lyndon Johnson’s. Congress consents.

The government borrows money from the Social Security Trust Fund, issuing nonmarketable IOUs as receipts. This is a swap. It then tells the government’s accountants to count the borrowed money as net revenue in the government’s on-budget account, thereby reducing the deficit. It also tells the accountants not to count the IOUs as liabilities.

This is how Enron shoved its liabilities off its books: dummy corporations taking the liabilities. This is also how hedge funds did it. Substitute “Social Security Trust Fund” and “Medicare Trust Fund” for “dummy corporations,” and you have the government’s program to reduce the deficit. Voters are the dummies.

Senior politicians always have known how this accounting charade works. The average voter, who trusts in Social Security, does not.

The public is forced to play the role of kinsman-redeemer. It puts up the money to redeem its profligate nearest of kin: Uncle Sam. It gets IOUs for its money. It thereby redeems the government.

The difference between redemption by taxpayers and redemption by the FED is this: the taxpayers surrender their own money. The FED creates money as an agency of the government. The government then spends the money.

The Federal Reserve System is the kinsman-redeemer of the big banks. The investment world knows this. The media know this. Almost everyone accepts this as a good thing. We need a lender of last resort.

The FED is not the lender of last resort. The lender of last resort is the taxpayer, who rests his hope of retirement in those IOUs in the trust funds. The lender of last resort is the holder of promises to pay fiat money. The money will be paid. It just will not buy much.

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May 12, 2009

Gary North [send him mail] is the author of Mises on Money. Visit He is also the author of a free 20-volume series, An Economic Commentary on the Bible.

Copyright © 2009 Gary North