Lender of Last Resort: What It Is, Whence It Came, and Why the Fed Isn't It

Abstract

It has become commonplace in the current crisis to refer to the Federal Reserve as the economy’s lender of last resort (LLR). Typical is the observation of Glenn Hubbard, Hal Scott, and John Thornton (2009) that “Over many decades and especially in this financial crisis, the Fed has used its balance sheet to be a classical lender of last resort.” With all due respect to these authors and numerous others holding the same view, their statement is wrong, For while there exists such an entity as the classical lender of last resort—the traditional, standard LLR model, to be exact—the Fed has rarely adhered to it. And in the current crisis, the Fed has deviated from the classical model in so many ways as to make a mockery of the notion that it is an LLR. In short, the Fed may be many things, crisis manager included. But it is not an LLR in the traditional sense of that term. True, Fed spokesmen pay lip service to the classical prescription, all the while thinking that they can outperform it with additional intervention. They believe that while the classical theory of LLR policy is valid as far as it goes, it doesn’t go far enough to solve current financial and credit market problems. To this end, the Fed has ambitiously extended the role of the LLR so far beyond what classical

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