Lender of Last Resort

A look at how a Central Bank may act as lender of last resort – and under what circumstances it helps.

Readers Question: if the lender of last resort calms gilts investors, keeps the yields low and helps government borrow cheaply and finance its deficit cheerfully, why is printing money bad news as it sends gilts upwards and generates inflation. in essence lender of last resort = money printing press, so how are these re conciliated?

It is an interesting observation. But, we can reconcile the two.

The Central Bank can act as a lender of last resort to prevent the government suffering a liquidity shortage and failing to meet is short-term spending commitments.

Suppose a government is largely solvent. Only 3% of its tax revenues are devoted to interest payments, and public sector debt is around 60-70% of GDP.

The government may have a debt auction where it tries to sell £70bn of bonds. If markets were short of cash during this sale or just generally unwilling to buy, there maybe a temporary liquidity shortage. Then the government would fail to sell sufficient bonds on this particular auction; this would cause a temporary shortage of money for the government. This gives the impression that the government is insolvent – when really it is just a liquidity shortage. But, fears over liquidity can be enough for investors to avoid countries who don’t have a lender of last resort.

This lack of lender of a last resort has pushed interest rates on Euro debt close to 6% for many countries such as Ireland, Spain, Greece, Italy. Even France has recently seen rising bond yields.


By, contrast, UK and US bond yields have fallen to record lows. Certainly having a lender of last resort is one important factor in keeping UK bond yields low. (UK deficit is actually higher than many EU countries with high bond yields).

bond yields on US 10 year treasuries (inflation indexed)

But, Doesn’t Quantitative Easing and Fears of Inflation Cause higher Interest Rates?

Yes, it definitely can. Usually, if a countries Central Bank started printing money to buy government debt, fears over future inflation would lead to rising bond yields. (how printing money can cause inflation)

In most economic circumstances, the Bank of England’s decision to create £275bn money and buy government bonds would create a much bigger fear of inflation and bond yields would rise much more.

However, in the current liquidity trap, the created money is not really inflationary (commercial banks are largely sitting on the extra cash) Therefore, although there is the theoretical risk of inflation, markets are not too concerned about inflation. At the moment, they prefer the risk of inflation from quantitative easing, rather than the risk of not having a lender of last resort.

Also, low bond yields on UK and US debt reflect markets expect low growth. Therefore investors prefer bonds to risk of investing in stock market.

When the Bank announce a new policy of quantitative easing, there has been a small rise in bond yields as markets price in risk of inflation. But, the increase in yields has been quite small because the risk of inflation is quite small.

If they printed money in an economic boom, the rise in interest rates would be much greater because the inflation risk would be much greater.

Note: The Bank of England can also act as lender of last resort to commercial banks.


By on November 30th, 2011

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