On Wednesday, the Fed rushed out another crisis-propelled interim rule, this one temporarily retracting the supplementary leverage ratio (SLR) for Treasuries and central-bank reserves.  It’s unbecoming to say I told them so, but politeness fades in the face of fury about the acute harm foreseeable mistakes are doing to millions of vulnerable Americans and the fragile financial system on which they depend.  Federal Financial Analytics’ studies in 2015 and 2016 laid out how acute stress scenarios would flood banks with flight-to-safety deposits that banks would be unable to accept due to the SLR.  In 2016, we also laid out unintended consequences for systemic resilience and equality stemming from the reverberations between post-crisis, bank-centric monetary and regulatory policy under stress.  Indeed, our first look at post-crisis rules in 2011 saw more than a bit of this coming.  A decade ago, I didn’t understand how unequal America was soon to become due in good part to post-crisis policy, but this too was foreseeable, as was the inexorable nexus between inequality and financial crises.  All of this work relies on a simple rule I learned decades ago at MIT:  the more highly-constructed the theorem, the more likely it is to be wrong.  With this rule in mind, what can we expect from the trillions now flowing from the Treasury’s and Fed’s desperate efforts to rewrite the rules in which they had such unbounded confidence just six weeks ago?

Anything I say now is only a guess because nothing can be reliably known about COVID-19’s apocalyptic course until it blessedly begins to ebb.  In this midst of a five-rated hurricane, neither meteorologists nor engineers know what will stay dry or float away; similarly, neither epidemiologists nor economists seem now to have a clue.  Treasury and the Fed are throwing trillions into the macroeconomic equivalent of the levee.  Whether these dollar-filled sandbags are sufficient will be known only when the flood subsides, but I suspect that, as in most disasters, the well-off will do pretty well and it will take years for the rest of the nation to rebuild.

Convinced by the lessons of the Great Depression, complex models, and the fact that big banks behaved badly before 2008, post-crisis financial policy had two axiomatic principles: 1) taking trillions of safe assets from financial markets and lowering rates spurs productivity; and 2) imposing giant capital and liquidity burdens on very big banks makes them impregnable centers of global financial stability.  This paradigm collapsed, as we now know all too well, but it didn’t have to do so as disastrously or completely.  As James Grant said earlier this week, the Fed laid the groundwork after 2008 for a financial system that empowered wild speculation, weakened the financial infrastructure, and impoverished millions along the way.

Had the Fed first forecast what the financiers of 2008 and beyond would do with all this money under all these new rules, it would have been clear that banks would take the trillions the Fed paid them for QE’s assets and put them right back into the Fed.  When banks lent funds, it was to those who wanted them not to build new factories in the deep recession that gripped the nation in 2009 and 2010, but instead to chase yields, not structural, shared growth.  When banks could no longer oblige due to all the new rules and the nascent sense of caution hard learned during the crisis, nonbanks fueled by debt and free of rules stepped in, exploiting government-sponsored mortgage markets, throwing trillions into new subprime markets such as auto finance, and powering up corporate debt used for high-leverage, high-risk investment. 

The Fed foresaw none of this because the Fed believed the U.S. economy was structured much as it was in the 1970s when its leaders, like me, learned their trade.  Then, the U.S. had a robust middle class with strong “marginal propensity to consume” that permitted ramped-up household borrowing in response to low rates to fuel durable-goods and home purchases.  Now, as we’ve repeatedly shown on our Economic Equality blog posts, the U.S middle class holds a far smaller amount of U.S. wealth – as we noted just a few months ago, the top one percent now has more wealth than the bottom ninety percent.  Most middle-class households live hand-to-mouth, getting by thanks to still more credit-card debt instead of rainy-day funds or sustainable investment for the future. 

The Fed’s latest financial rescues still proceed from the top-down view of the economy that backfired so badly after 2008.  Unless or until policy abandons this trickle-down approach to instead support bottom-up economic recovery, the post-COVID construct may have the semblance of systemic stability, but its foundations will be still weaker, the nation still less equal, and most Americans even more furious with failed financial policy-makers and the financiers who profited by them.

In London’s Great Plague of 1666, Isaac Newton retreated to his estate and blasted through the complex, mechanistic physics of preceding generations to realize the simplicity of motion:  force equals mass times acceleration.  Had he extended this to finance, Sir Isaac might not have lost all of his wealth in the South Sea Bubble a decade or two later.  It was true then as now that the force of a financial crisis equals the mass of financial resources times the speed at which they ricochet into each other.  When this gravitational force is exerted on very large masses, the mass may hold together if acceleration doesn’t make the force too great – i.e., giant financial companies like boulders may fall but they will only crack, not disintegrate.  An apple falling from the same tree at the same speed will smash.  We’re all apples now.