The Fed’s COVID-19 Policy Actions Are Treating the Symptoms, Not the Problem

On Sunday, in response to the COVID-19 pandemic, the Federal Reserve dropped its benchmark interest rate to zero and launched a new round of quantitative easing (QE): “The QE program will entail $700 billion worth of asset purchases entailing Treasuries and mortgage-backed securities,” reports CNBC.

This action did not have the sustained, positive effect on the market policymakers had hoped for. On Monday, according, again, to CNBC, the “Dow Jones Industrial Average closed 2,997.10 points lower, or 12.9%, at 20,188.52. The S&P 500 dropped 12% to 2,386.13 … while the Nasdaq Composite closed 12.3% lower at 6,904.59 in its worst day ever.”

The Fed’s policy moves failed because they did not recognize a critical fact: the market rout is a continuation of the financial crisis of 2008. As they did in 2008, the Fed has focused on the symptoms, not the cause, of the crisis.

The true cause of the Financial Crisis of 2008 was a massive decline in ethical standards of behavior. The decline led to a significant, meaningful weakening of trust. Opportunistic behavior increased dramatically and has remained at elevated levels.

We have a track record of bringing these factors to the forefront. In October 1998, in a petition to the United States Court of Appeals for the District of Columbia Circuit, we noted growing risks in financial markets, risks that reduced the safety and soundness of large financial institutions. On Feb. 6, 2006, statistical models using the Fully Adjusted Return® Methodology confirmed that system-wide economic and market failure was a growing possibility.

Our economic analysis, compiled using the Fully Adjusted Return® Methodology, indicates that “social transaction costs” caused the earlier crisis and that these costs still dominate.

Much of the current problem has to do with the Federal Reserve Board. On Sept. 18, 2019, the Fed cut interest rates, under inappropriate pressure from the executive branch. How do we know the pressure was inappropriate? The Bank of Japan and the Bank of England left interest rates unchanged. Norway actually RAISED rates—as it turned out, the appropriate monetary policy stance. Had the Fed left U.S. rates unchanged or even increased rates, they would have had more room to manage the decline in rates it implemented on Sunday night. Now, the Fed has nowhere to go but negative, a foolish and desperate policy that reflects the complete lack of ethical options.

We know, from the Mueller Report, that the current administration is both unusually unskilled and unusually unethical. The lack of ethics led them to pressure the Fed for an over-accommodative monetary policy. Meaningful financial institution regulation and enforcement, weakened after decades of ineffectiveness, means that unethical and opportunistic behavior remains unpunished. Trust remains low, as evidenced by failures in the repo market.

This lack of ethical monetary policy encouraged excess economic activity. In other words, the global economy overheated. (Perhaps a decline in manic levels of economic activity would have had a dampening effect on sales at the exotic food market cited as the source of the virus.)

Widespread fraud in the marketplace revealed a generalized, deep and pervasive decline in ethical standards of business behavior, one that continues to this day. Efforts have been made to repair the ethical damage. House Financial Service Committee Chair Maxine Waters launched a successful effort to replace two board members at recidivist financial institution Wells Fargo, but more is needed.

Removing all bonus payments made to executives and board members of the financial institutions responsible for the 2008 financial crisis may be required. It may also be necessary to reach back and close several of the financial institutions who were responsible for the 2008 financial crisis.

The damage to the economy from the COVID-19/coronavirus crisis will be severe. We estimate the U.S. economy will experience a 13% decline in gross domestic product (GDP). Given the lack of effective, meaningful financial institution regulatory oversight, ethical standards have not been re-elevated. We have seen that bad behavior leads to a lack of trust and a lack of consideration for the long-term well-being of the community (ALL members of the community, not just the wealthy and the white). Under these conditions, the market will continue to fall.

Perhaps we can use this crisis to help restore ethics to financial institutions. This should be the price they must pay for being bailed out yet again.