Legal Restrictions, Financial Weakening, and the Lender of Last Resort

A popular defense of central banks and fiat money claims that they are needed to protect the payments system against the peril of financial crises. A central bank can act as a “lender of last resort” to other banks, assuring depositors that they need never fear a general banking collapse; fiat money in turn guarantees that the lender of last resort itself will never go broke.’ A crucial assumption behind the lender of last resort argument is that fractional-reserve banking is inherently “fragile” and crisis prone—that central banking and fiat money are an unavoidable response tomarket failure. According to Minsky (1982, p. 17), “conditions conducive to financialcrises emerge from the normal functioning of a capitalist economy.” In a free market, says Minsky, such conditions will occasionally produce “wide and spreading bankruptcies” that could, however, be prevented by “an alert lender of last resort” (p. 13).2