Unintended Consequences Show Up Again

The Wall Street Journal has a long feature today (“The Day the Coronavirus Nearly Broke the Financial Markets“) about the breakdown and near collapse of the credit markets on March 16. As the story’s short nut graf puts it, “March 16 was the day a microscopic virus brought the financial system to the brink. Few realized how close it came to going over the edge entirely.” It makes for great reading, though the substance of the piece overall is not especially unique, as the credit crunch in March fits a familiar pattern of financial panics that have been seen repeatedly throughout history—as recently as September 2008, for example.

The swift and bold moves of the Federal Reserve and other central banks shows that we’ve learned to be effective in stanching a panic and preventing a total crash, though we’ll have to wait and see what are the longer term effects of the Fed once again swelling its balance sheet to galactic dimensions and manipulating short term interest rates (the only rates the Fed can actually control).

There is one angle in the story worth dwelling on for a moment, though. In the aftermath of the 2008 financial collapse, banks have built up their balance sheets and reserves, partly because new laws and regulations required them to, in order to forestall another 2008-style crash. But that’s where the story of government intervention gets interesting. As the story explains, lots of our banks have decent reserves and were theoretically positioned to be able to handle the liquidity crisis of mid-March—except that new government regulations prevented them from doing so:

In theory, there should have been some give in the system. U.S. regulators had rewritten the rules on money funds in the wake of the 2008 financial crisis. . .

So when Mr. [Vikram] Rao [of Capital Group Co.] called senior executives for an explanation on why they wouldn’t trade, they had the same refrain: There was no room to buy bonds and other assets and still remain in compliance with tougher guidelines imposed by regulators after the previous financial crisis. In other words, capital rules intended to make the financial system safer were, at least in this instance, draining liquidity from the markets.

Another textbook example of how government micromanagement of a market nearly always has negative unintended consequences and perverse results somewhere down the line.

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