From Lender of Last Resort to Bailout as First Resort

In the annals of central banking economic literature, there is one name that looms large: Walter Bagehot. As editor of The Economist from 1861-1877, he built up that publication’s reputation and turned it into a newspaper of economic renown. But Bagehot is particularly known for his theory of central banking.

His theories were put on display in his book Lombard Street, which in some circles is considered almost the Bible of central banking. In particular, Bagehot is known for his advice to central banks to stave off a financial panic:

1. Lend freely;
2. Against good collateral;
3. At rates of interest high enough to dissuade those institutions not really in need of assistance.

Regardless of your opinion of central banking, those three points can be considered advice to live by, and form the basis for central banks being considered the lender of last resort. Had central banks consistently stuck to that lender of last resort function, many financial crises and recessions that might have otherwise occurred might never have happened.

But because the lure of easy money is too great for many to pass up, central bankers have given in to the temptation to keep feeding money into the financial system. As a result, they have moved from being a lender of last resort into performing bailouts as a first resort. They don’t do due diligence when lending, and as a result have created massive imbalances in the economy that could eventually lead to a catastrophic collapse. And that could seriously affect your ability as an investor to continue building up your wealth.

Bailouts vs. Lender of Last Resort

The lender of last resort is supposed to be the last resort. When a company that is solvent but not liquid has trouble getting money to keep its operations going, the lender of last resort steps in to keep the company operating by loaning it money.

By following Bagehot’s dictums, the lender of last resort lends money against good collateral, perhaps real estate or some inventory. And the interest rate is supposed to be high enough that companies not in dire need would pay essentially a penalty rate from borrowing from the central bank. In other words, the rate should be higher than what market rates are. What happens in practice, however, is that central banks have run amok.

In the initial response to the 2008 financial crisis, the Federal Reserve set up numerous credit facilities. These were intended to make loans to keep vulnerable firms propped up. But while the Fed certainly lent freely, whether it did so against good collateral was debatable.

Remember that one of the major factors behind the financial crisis was the fact that banks had overleveraged themselves to lend money to people who were poor credit risks. Mortgage-backed securities that had been rated AAA were actually backed by subprime mortgages, and in fact should have probably been junk rated. Yet the Fed took hundreds of billions of dollars worth of these worthless securities as collateral for loans, something that likely would have left Bagehot aghast.

Nor did the Fed lend at penalty rates either. For one thing, the collateral was of such poor quality that no one would have loaned against it, so it would have been hard to calculate a market rate. But the Fed also was moving to push interest rates to near zero, so interest rates on loans were lower than they otherwise might have been.

Bailouts and Moral Hazard

Not content with acting as a lender of last resort, the Fed went on to begin its quantitative easing (QE) policies. These were open market operations on steroids, with the Fed purchasing trillions of dollars of Treasury debt and mortgage-backed securities in an attempt to stabilize financial markets. As a result, the lender of last resort function of central banks has become almost an afterthought, and QE and outright bailouts are the first resort.

While “no more bailouts” became something of a mantra in Congress after the 2008 bank bailout, what that meant in reality was that the bailout function was left completely in the hands of the Fed. As a result, we’ve seen the Fed’s balance sheet increase by over $4 trillion since last year, and the Fed plans to continue increasing it by around $1.5 trillion each year at its present rate of asset purchases.

Wall Street now expects a bailout every time stocks start to dip. They expect their losses to be covered by the Fed’s easy money. And up to now they’ve been placated every single time.

The result is that companies no longer fear market discipline. They no longer fear economic downturns or stock market crashes because they think the Fed is going to jump in and save the day. Many have taken on massive debt loads, incentivized by low interest rates, and as a result nearly 20% of companies today are considered zombies, only able to pay off the interest on their debt.

Many investors have become similarly casual in the treatment of their investments. They think stock markets will keep going up forever, and that if we experience another 35% drop like we did last year, the Fed will fire up the printing presses and get things back to where they were before.

The reality is that that’s not the case. We’re seeing the effects of the Fed’s response to last year’s lockdown-induced recession today in the form of rising inflation. Unemployment remains high while companies are struggling to find enough workers, supply chains remain disrupted, and the outlook for the future seems more and more negative each day.

When everything shakes out, we could see many companies going bankrupt, and many investors losing their hard-earned assets due to complacence about what is going on in the economy. The Fed’s easy money policy and bailouts have incentivized riskier and riskier behavior, and the end result of all of that could make the 2008 financial crisis look minuscule.

Protect Yourself With Gold

One of the characteristics of the 2008 financial crisis was over leveraging. It was a problem that exacerbated the severity of the crisis, and it’s one that could rear its head once again. Companies are growing increasingly indebted and over leveraged, and that will come back to haunt them. The massive levels of debt in our society today all but guarantee that the next financial crisis will be worse than 2008.

But just like in 2008, there will be ways you can protect yourself against the losses that will reverberate through markets. At the worst part of the crisis, stock markets lost nearly 55% of their value, and many investors lost more than that. But while that was going on, gold rose 25% in price and continued to gain in the subsequent years. By 2011 gold had set an all-time high price, nearly triple what it had been in 2008.

Gold saw phenomenal performance during the 1970s too, a stagflationary decade that could end up being a template for the 2020s. Once governments stopped trying to suppress the gold price, gold took off, with average annualized gains of over 30% through the entire 1970s.

In a future financial crisis, gold could demonstrate great performance too, which is why more and more investors are choosing to safeguard their retirement savings with gold. Through a gold IRA, you can invest in physical gold coins or bars while still enjoying the same tax benefits as a conventional IRA account. And if you have existing assets in a 401(k), IRA, TSP, or similar account, you can roll over or transfer those assets into a gold IRA tax-free.

But don’t just take my word for it. Talk to one of Goldco’s precious metals specialists today to learn more about how you can safeguard your savings with gold.