According to John Maynard Keynes, money, as the institution that founds the exchange system, is a link between the present and the future. The existence of a monetary economy of production is founded on credit relations, organized markets of financial assets, speculation and uncertainty. In a monetary economy, there is a set of interrelated balance sheets and cash flows among income-producing companies, households and banks. As Keynes highlighted, the tensions between money as a public good, issued by central banks, and money as a private good, created by banks, is inherent to the capitalist institutional set up. On behalf of these tensions, trust is decisive to support financial stability.
Looking back, Walter Bagehot warned that trust influences the dynamics of finance. In his seminal 1873 book, Lombard Street, he says:
“The peculiar essence of our banking system is an unprecedented trust between man and man: and when that trust is much weakened by hidden causes, a small accident may greatly hurt it, and a great accident for a moment may almost destroy it.“
One of Bagehot’s main concern was about the central banks’ most feasible instrument to defeat panics in the banking sector. In his view, the main function of the lender of last resort involves the quick provision of liquidity to banks in order to accommodate sudden and sharp increases in the demand for liquidity. Thus, central banks may influence the evolution of the credit markets by changing the availability and cost of the banks’ demand for liquidity (reserves). More generally, the lender of last resort would not prevent financial shocks, but minimize their impacts on the economy and society. Its aim would not be the prevention of bank failures at all costs, but rather the prevention of the spread of liquidity risk to sound institutions
More recently, the 2008 global financial crisis and the unprecedented actions of the Federal Reserve, European Central Bank and the Bank of England, for example, suggest the need to rethink the role of the lender of last resort. The scope of the recent central banks’ interventions has been expanded in order to include not only the provision of liquidity as lender of last resort, but also to include the expansion of repurchase agreements as buyer of last resort and the supply of liquidity to specific markets as market maker of last resort.
Considering the historical financial changes and the relevance of financial issues to the economics curriculum, some interesting questions arise: Is the lender of last resort theory proposed by Bagehot old fashioned? Or Can we include the actions of the central bank as market maker of last resort and buyer of last resort within the scope of the lender of last resort interventions aimed to stabilize the financial markets?